[Federal Register Volume 79, Number 21 (Friday, January 31, 2014)]
[Rules and Regulations]
[Pages 5536-5806]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2013-31511]
[[Page 5535]]
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
[[Page 5536]]
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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, [email protected], or Karl R.
Reitz, Chief, Capital Markets Strategies Section, [email protected],
Capital Markets Branch, Division of Risk Management Supervision, (202)
898-6888; Michael B. Phillips, Counsel, [email protected], or Gregory
S. Feder, Counsel, [email protected], 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
[[Page 5537]]
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
[[Page 5539]]
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.
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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.
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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\
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\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\
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\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).
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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.
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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\
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\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.
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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\
---------------------------------------------------------------------------
\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).
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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.
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\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.''
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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\
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\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\
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\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\
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\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.
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\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).
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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.
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\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.
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[[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.
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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\
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\502\ See Joint Proposal, 76 FR 68,869; CFTC Proposal, 77 FR
8354-8355.
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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\
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\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.
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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\
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\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.
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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\
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\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).
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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\
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\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).
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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\
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\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.
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\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\
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\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.
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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\
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\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.
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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).
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[[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\
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\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.
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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.
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\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\
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\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).
---------------------------------------------------------------------------
[[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.
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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.
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\894\ See final rule Sec. ----.4(b)(2)(iii)(B), (C).
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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.
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\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.
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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.
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\896\ See SIFMA (Asset Mgmt.) (Feb. 2012); T. Rowe Price; CIEBA;
ICI (Feb. 2012) RBC.
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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\
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\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.
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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.
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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\
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\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\
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\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).
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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\
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\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\
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\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.
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\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).
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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.
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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.
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[[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.
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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).
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[[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.
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\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\
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\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.
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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\
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\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.
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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\
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\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.
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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\
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\1428\ See, e.g., Am. Express; SIMFA et al. (Prop. Trading)
(Feb. 2012).
\1429\ See Am. Express.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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 behalf of customers.
---------------------------------------------------------------------------
\1442\ See final rule Sec. ----.6(c)(2).
\1443\ Some commenters urged the Agencies to ensure that the
banking entity passes on all gains (or losses) from the transaction
to the customers. See Occupy; Public Citizen.
\1444\ See RBC; SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------
Several commenters requested that the final rule explain how a
banking entity may determine when it is acting as riskless
principal.\1445\ The Agencies note that riskless principal transactions
typically are undertaken as an alternative method of executing orders
by customers to buy or sell financial instruments on an agency basis.
Acting as riskless principal does not include acting as underwriter or
market maker in the particular financial instrument and is generally
understood to be equivalent to agency or brokerage transactions in
which all of the risks associated with ownership of financial
instruments are borne by customers. The Agencies have generally
equivalent standards for determining when a banking entity acts as
riskless principal and require that the banking entity, after receiving
an order to buy (or sell) a financial instrument from a customer, buys
(or sells) the instrument for its own account to offset a
contemporaneous sale to (or purchase from) the customer.\1446\ The
Agencies intend to determine whether a banking entity acts as riskless
principal in accordance with and subject to the requirements of these
standards.
---------------------------------------------------------------------------
\1445\ See, e.g., Am. Express; SIFMA et al. (Prop. Trading)
(Feb. 2012).
\1446\ See, e.g., 12 CFR 225.28(b)(7)(ii); 17 CFR 240.3a5-1(b);
OCC Interpretive Letter 626 (July 7, 1993). One commenter stated
that a banking entity should only be allowed to engage in a riskless
principal transaction where the banking entity has already arranged
for another customer to be on the other side of the transaction. See
Public Citizen. The Agencies believe that the contemporaneous
requirement in the final rule addresses this comment.
---------------------------------------------------------------------------
Some commenters requested that the final rule permit a greater
variety of transactions to be conducted on behalf of customers. Many of
these transactions, such as transactions that facilitate customer
liquidity needs or block positioning transactions \1447\ or
transactions in which the banking entity acts as principal to
accommodate a customer and substantially and promptly hedges the risks
of the transaction,\1448\ may be permissible under the market-making
exemption. To the extent these transactions are conducted by a market
maker, the Agencies believe that the restrictions and limits required
in connection with market making-related activities are important for
limiting the risks to the banking entity from these transactions.\1449\
While some commenters requested that clearing and settlement activities
and prime brokerage activities be viewed as permitted proprietary
trading on behalf of customers,\1450\ these transactions are not
considered proprietary trading as an initial matter under the final
rule.\1451\
---------------------------------------------------------------------------
\1447\ One commenter requested an exemption for transactions 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. See RBC.
\1448\ Some commenters requested an exemption for these types of
transactions. See BoA; SIFMA et al. (Prop. Trading) (Feb. 2012).
\1449\ Some commenters stated that the potential uncertainty and
costs of determining whether an activity qualifies for the market-
making exemption would discourage banking entities from taking
principal risks to accommodate customer needs. See, e.g., SIFMA et
al. (Prop. Trading) (Feb. 2012). The Agencies believe that
adjustments made to the market-making exemption in the final rule
help address this concern. Specifically, the final market-making
exemption better accounts for the varying characteristics of market-
making across markets and assets classes.
\1450\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012).
\1451\ See final rule Sec. ----.3(d)(4)-(6). See also infra
Part IV.A.1.d.3-4.
---------------------------------------------------------------------------
Finally, the Agencies have decided to move the exemption for
trading activity conducted by an insurance company for a separate
account into the provision exempting trading activity in an insurance
company's general account in order to better align the two
exemptions.\1452\ As discussed below in Part IV.A.7., the final rule
provides exemptions for trading activity conducted by an insurance
company that is a banking entity either in the general account or in a
separate account of customers in Sec. ----.6(d). As explained below,
the statute specifically exempts trading activity that is conducted by
a regulated insurance company engaged in the business of insurance for
the general account of the company if conducted in accordance with
applicable state law and if not prohibited by the appropriate Federal
banking agencies.\1453\ Unlike activity for the general account of an
insurance company, investments made by regulated insurance companies in
separate accounts in accordance with applicable state law are made on
behalf of and for the benefit of customers of the insurance
company.\1454\ Also unlike general accounts (which are supported by all
of the assets of the insurance company), a separate account is
supported only by the assets in that account and does not have call on
the other assets of the company. The customer benefits (or loses) based
solely on the performance of the assets in the separate account. These
arrangements are the equivalent for insurance companies of fiduciary
accounts at banks. For these reasons, the final rule recognizes that
separate accounts at regulated insurance companies maintained in
accordance with applicable state insurance laws are exempt from the
prohibitions in section 13 as acquisitions on behalf of customers.
---------------------------------------------------------------------------
\1452\ Some commenters requested that the Agencies more closely
align the exemptions for trading by an insurance company for the
general account and separate account. See ACLI; Sutherland (on
behalf of Comm. of Annuity Insurers); Fin. Services Roundtable (Feb.
3, 2012); NAMIC.
\1453\ See 12 U.S.C. 1851(d)(1)(F).
\1454\ One commenter requested clarification on 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. See Chris
Barnard. The Agencies note that the proposed requirement that all
profits and losses arising from the purchase or sale of a financial
instrument inure to the benefit or detriment of the ``owners of the
insurance policies supported by the separate account'' has been
removed. See proposed rule Sec. ----.6(b)(2)(iii)(C). Instead, the
final rule requires that the income, gains, and losses from assets
allocated to a separate account be credited to or charged against
the account without regard to other income, gains or losses of the
insurance company. See final rule Sec. ----.2(z) (definition of
``separate account''). Thus, the final rule no longer references
``owners of the insurance policies supported by the separate
account.'' The Agencies note, however, that the final rule requires
exempted separate account transactions to be ``conducted in
compliance with, and subject to, the insurance company investment
laws, regulations, and written guidance of the State or jurisdiction
in which such insurance company is domiciled.'' See final rule Sec.
----.6(d)(3).
---------------------------------------------------------------------------
7. Section ----.6(d): Permitted Trading by a Regulated Insurance
Company
Section 13(d)(1)(F) permits a banking entity that is a regulated
insurance company acting for its general account,
[[Page 5650]]
or an affiliate of an insurance company acting for the insurance
company's general account, to purchase or sell a financial instrument
subject to certain conditions (the ``general account
exemption'').\1455\ Section 13(d)(1)(D) permits a banking entity to
purchase or sell a financial instrument on behalf of customers.\1456\
In the proposed rule, the Agencies viewed Section 13(d)(1)(D) as
permitting an insurance company to purchase or sell a financial
instrument for certain separate accounts (the ``separate account
exemption''). The proposal implemented both these exemptions with
respect to activities of insurance companies, in each case subject to
the restrictions discussed below.\1457\
---------------------------------------------------------------------------
\1455\ See 12 U.S.C. 1851(d)(1)(F).
\1456\ See 12 U.S.C. 1851(d)(1)(D).
\1457\ See proposed rule Sec. Sec. ----.6(b)(2)(iii), --
--.6(c).
---------------------------------------------------------------------------
Section ----.6(c) of the proposed rule implemented the general
account exemption by generally restating the statutory requirements of
the exemption that:
The insurance company directly engage in the business of
insurance and be subject to regulation by a State insurance regulator
or foreign insurance regulator;
The insurance company or its affiliate purchase or sell
the financial instrument solely for the general account of the
insurance company;
The purchase or sale be conducted in compliance with, and
subject to, the insurance company investment laws, regulations, and
written guidance of the State or jurisdiction in which such insurance
company is domiciled; and
The appropriate Federal banking agencies, after
consultation with the Council and the relevant insurance commissioners
of the States, must not have jointly determined, after notice and
comment, that a particular law, regulation, or written guidance
described above is insufficient to protect the safety and soundness of
the banking entity or of the financial stability of the United States.
The proposed rule defined the term ``general account'' to include
all of the assets of the insurance company that are not legally
segregated and allocated to separate accounts under applicable State
law.\1458\
---------------------------------------------------------------------------
\1458\ See proposed rule Sec. ----.3(c)(6).
---------------------------------------------------------------------------
As noted above in Part IV.A.6.a., Sec. ----.6(b)(iii) of the
proposed rule provided an exemption for a banking entity that is an
insurance company when it acted through a separate account for the
benefit of insurance policyholders. The proposed rule defined a
``separate account'' as an account established or maintained by a
regulated insurance company subject to regulation by a State insurance
regulator or foreign insurance regulator under which income, gains, and
losses, whether or not realized, from assets allocated to such account,
are, in accordance with the applicable contract, credited to or charged
against such account without regard to other income, gains, or losses
of the insurance company.\1459\
---------------------------------------------------------------------------
\1459\ See proposed rule Sec. ----.2(z).
---------------------------------------------------------------------------
To limit the potential for abuse of the separate account exemption,
the proposed rule included requirements designed to ensure that the
separate account trading activity is subject to appropriate regulation
and supervision under insurance laws and not structured so as to allow
gains or losses from trading activity to inure to the benefit or
detriment of the banking entity.\1460\ In particular, the proposed rule
provided that a purchase or sale of a financial instrument qualified
for the separate account exemption only if:
---------------------------------------------------------------------------
\1460\ The Agencies noted in the proposal they would not
consider profits to inure to the benefit of the banking entity if
the banking entity were solely to receive payment, out of separate
account profits, of fees unrelated to the investment performance of
the separate account.
---------------------------------------------------------------------------
The banking entity is an insurance company directly
engaged in the business of insurance and subject to regulation by a
State insurance regulator or foreign insurance regulator; \1461\
---------------------------------------------------------------------------
\1461\ The proposed rule provided definitions of the terms
``State insurance regulator'' and ``foreign insurance regulator.''
See proposed rule Sec. Sec. ----.3(c)(4), (13).
---------------------------------------------------------------------------
The banking entity purchases or sells the financial
instrument solely for a separate account established by the insurance
company in connection with one or more insurance policies issued by
that insurance company;
All profits and losses arising from the purchase or sale
of the financial instrument are allocated to the separate account and
inure to the benefit or detriment of the owners of the insurance
policies supported by the separate account, and not the banking entity;
and
The purchase or sale is conducted in compliance with, and
subject to, the insurance company investment and other laws,
regulations, and written guidance of the State or jurisdiction in which
such insurance company is domiciled.
The proposal explained that the proposed separate account exception
represented transactions on behalf of customers because the insurance-
related transactions are generally 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 may be treated as the owner of
those assets for certain purposes.
Commenters generally supported the general account exemption and
the separate account exemption for regulated insurance companies as
consistent with both the statute and Congressional intent to
accommodate the business of insurance.\1462\ For instance, commenters
argued that the statute was designed to appropriately accommodate the
business of insurance, subject to regulation in accordance with
relevant insurance company investment laws, in recognition that
insurance company investment activities are already subject to
comprehensive regulation and oversight.\1463\
---------------------------------------------------------------------------
\1462\ See, e.g., Alfred Brock; Chris Barnard; Fin. Services
Roundtable (Feb. 3, 2012); Sutherland (on behalf of Comm. of Annuity
Insurers); TIAA-CREF; NAMIC.
\1463\ See, e.g., ACLI (Jan. 2012); Fin. Services Roundtable
(Feb. 3, 2012); Country Fin. et al.; Sutherland (on behalf of Comm.
of Annuity Insurers).
---------------------------------------------------------------------------
A few commenters expressed concerns about the definition of
``general account'' and ``separate account.'' \1464\ One commenter
argued the definition of general account was unclear.\1465\ A few
commenters expressed concern that the proposed definition of separate
account inappropriately excluded some separate accounts, such as
certain insurance company investment activities such as guaranteed
investment contracts, which would also not fall within the proposed
definition of general account.\1466\ Several commenters argued that the
final rule should be modified so that all insurance company investment
activity permitted under applicable insurance laws would qualify for
either the general account exemption or the separate account
exemption.\1467\
---------------------------------------------------------------------------
\1464\ See, e.g., Fin. Services Roundtable (Feb. 3, 2012); ACLI
(Jan. 2012); Sutherland (on behalf of Comm. of Annuity Insurers).
\1465\ See Sutherland (on behalf of Comm. of Annuity Insurers).
\1466\ See ACLI (Jan. 2012); NAMIC.
\1467\ See Fin. Services Roundtable (Feb. 3, 2012); ACLI (Jan.
2012); NAMIC; See also Nationwide.
---------------------------------------------------------------------------
Some commenters argued that the prohibition in the proposed
definition of separate account against any profits or losses from
activity in the account inuring to the benefit (or detriment) of the
insurance company would exclude some activity permitted by insurance
regulation in separate accounts.\1468\ For example, commenters
contended that an insurer may allocate its own funds to a separate
account as ``seed money'' and
[[Page 5651]]
the profits and losses on those funds inure to the benefit or detriment
of the insurance company.\1469\
---------------------------------------------------------------------------
\1468\ See Fin. Services Roundtable (Feb. 3, 2012); ACLI (Jan.
2012); NAMIC; Sutherland (on behalf of Comm. of Annuity Insurers);
See also Nationwide.
\1469\ See Fin. Services Roundtable (Feb. 3, 2012); ACLI (Jan.
2012).
---------------------------------------------------------------------------
Some commenters expressed specific concerns about the scope or
requirements of the proposal. For instance, one commenter argued that
the final rule should provide that a trade is exempt if the trade is
made by an affiliate of the insurance company in accordance with state
insurance law.\1470\ Another commenter urged that the Agencies consult
with the foreign insurance supervisor of an insurance company regulated
outside of the United States before finding that an insurance activity
conducted by the foreign insurance company was inconsistent with the
safety and soundness or financial stability.\1471\
---------------------------------------------------------------------------
\1470\ See USAA.
\1471\ See HSBC Life.
---------------------------------------------------------------------------
One commenter suggested that insurance company affiliates of
banking entities should expressly be made subject to data collection
and reporting requirements to prevent possible evasion of the
restrictions of section 13 and the final rule using their insurance
affiliates.\1472\ By contrast, other commenters argued that the
reporting and recordkeeping and compliance requirements of the rule
should not apply to permitted insurance company investment
activities.\1473\ These commenters argued that insurance companies are
already subject to comprehensive regulation of the kinds and amounts of
investments they can make under insurance laws and regulations and that
additional recordkeeping obligations would impose unnecessary
compliance burdens on these entities without producing significant
offsetting benefits.
---------------------------------------------------------------------------
\1472\ See Sens. Merkley & Levin (Feb. 2012).
\1473\ See ACLI (Jan. 2012); Fin. Services Roundtable (Feb. 3,
2012); Mutual of Omaha; NAMIC.
---------------------------------------------------------------------------
After considering the comments received and the language and
purpose of the statute, the final rule has been modified to better
account for the language of the statute and more appropriately
accommodate the business of insurance.
As explained in the proposal, section 13(d)(1)(F) of the BHC Act
specifically and broadly exempts the purchase, sale, acquisition, or
disposition of securities and other instruments by a regulated
insurance company engaged in the business of insurance for the general
account of the company (and by an affiliate solely for the general
account of the regulated insurance company). Section 13(d)(1)(D) of the
statute also specifically exempts the same activity when done on behalf
of customers. As explained in the proposal, separate accounts managed
and maintained by insurance companies as part of the business of
insurance are generally customer-driven and do not expose the banking
entity to gains or losses on the value of assets held in the separate
account, even though the banking entity may be treated as the owner of
the assets for certain purposes. Unlike the general account of the
insurance company, separate accounts are managed on behalf of specific
customers, much as a bank would manage a trust or fiduciary account.
For these reasons, the final rule retains both the general account
exemption and the separate account exemption. The final rule removes
any gap between the definition of general account and the definition of
separate account by defining the general account to be all of the
assets of an insurance company except those allocated to one or more
separate accounts.\1474\
---------------------------------------------------------------------------
\1474\ See final rule Sec. Sec. ----.2(p), (bb). Some
commenters expressed concerns about the proposed definitions of
``general account'' and ``separate account,'' including that the
proposed definition of ``separate account'' excluded some legitimate
separate account activities that do not fall within the proposed
general account definition. See, e.g., ACLI (Jan. 2012); NAMIC;
Sutherland (on behalf of Comm. of Annuity Insurers). See also
proposed rule Sec. Sec. ----.2(z), ----.3(c)(5).
---------------------------------------------------------------------------
The final rule also combines the general account exemption and the
separate account exemption into a single section. This makes clear that
both exemptions are available only:
If the insurance company or its affiliate purchases or
sells the financial instruments solely for the general account of the
insurance company or a separate account of the insurance company;
The purchases or sales of financial instruments are
conducted in compliance with, and subject to, the insurance company
investment laws, regulations, and written guidance of the State or
jurisdiction in which such insurance company is domiciled; and
The appropriate Federal banking agencies, after
consultation with the Financial Stability Oversight Council and the
relevant insurance commissioners of the States and relevant foreign
jurisdictions, as appropriate, have not jointly determined, after
notice and comment, that a particular law, regulation, or written
guidance regarding insurance is insufficient to protect the safety and
soundness of the banking entity, or the financial stability of the
United States.\1475\
---------------------------------------------------------------------------
\1475\ The Federal banking agencies have not at this time
determined, as part of the final rule, that the insurance company
investment laws, regulations, and written guidance of any particular
State or jurisdiction are insufficient to protect the safety and
soundness of the banking entity, or of the financial stability of
the United States. The Federal banking agencies expect to monitor,
in conjunction with the FSOC, the insurance company investment laws,
regulations, and written guidance of States or jurisdictions to
which exempt transactions are subject and make such determinations
in the future, where appropriate. The Agencies believe the final
approach addresses one commenter's request that the Agencies consult
with the foreign insurance supervisor of an insurance company
regulated outside of the United States before finding that an
insurance activity conducted by the foreign company was inconsistent
with the safety and soundness or financial stability. See HSBC Life.
---------------------------------------------------------------------------
Like section 13(d)(1)(F) of the BHC Act, the final rule permits an
affiliate of an insurance company to purchase and sell financial
instruments in reliance on the general account exemption, so long as
that activity is for the general account of the insurance company.
Similarly, the final rule implements section 13(d)(1)(D) and permits an
affiliate of an insurance company to purchase and sell financial
instruments for a separate account of the insurance company, so long as
the separate account is established and maintained at the insurance
company.
Importantly, the final rule applies only to covered trading
activity in a general or separate account of a licensed insurance
company engaged in the business of insurance under the supervision of a
State or foreign insurance regulator. As in the statute, an affiliate
of an insurance company may not rely on this exemption for activity in
any account of the affiliate (unless it, too, meets the definition of
an insurance company). An affiliate may rely on the exemption to the
limited extent that the affiliate is acting solely for the account of
the insurance company.\1476\
---------------------------------------------------------------------------
\1476\ Although one commenter requested that the final rule
exempt a trade as long as the trade is made by an affiliate of the
insurance company in accordance with state insurance law, the
Agencies believe the final approach properly implements the statute.
See USAA.
---------------------------------------------------------------------------
As noted above, one commenter requested that the final rule impose
special data and reporting obligations on insurance companies. Other
commenters argued that insurance companies are already subject to
comprehensive regulation under insurance laws and regulations and that
additional recordkeeping obligations would impose unnecessary
compliance burdens on these entities without producing significant
offsetting benefits.
[[Page 5652]]
In accordance with the statute,\1477\ the Agencies expect insurance
companies to have appropriate compliance programs in place for any
activity subject to section 13 of the BHC Act.
---------------------------------------------------------------------------
\1477\ See 12 U.S.C. 1851(e)(1) (requiring that the Agencies
issue regulations regarding ``internal controls and recordkeeping,
in order to insure compliance with this section'').
---------------------------------------------------------------------------
The final rule contains a number of other related definitions that
are intended to help make clear the limitations of the insurance
company exemption, including definitions of foreign insurance regulator
and State insurance regulator.
8. Section ----.6(e): Permitted Trading Activities of a Foreign Banking
Entity
Section 13(d)(1)(H) of the BHC Act \1478\ permits certain foreign
banking entities to engage in proprietary trading that occurs solely
outside of the United States (the ``foreign trading exemption'').\1479\
The statute does not define when a foreign banking entity's trading
occurs solely outside of the United States.
---------------------------------------------------------------------------
\1478\ Section 13(d)(1)(H) of the BHC Act provides an exemption
to the prohibition on proprietary trading for trading conducted by a
foreign banking entity pursuant to paragraph (9) or (13) of section
4(c) of the BHC Act, if the trading occurs solely outside of the
United States, and the banking entity is not directly or indirectly
controlled by a banking entity that is organized under the laws of
the United States or of one or more States. See 12 U.S.C.
1851(d)(1)(H).
\1479\ This section's discussion of the concept ``solely outside
of the United States'' is provided solely for purposes of the rule's
implementation of section 13(d)(1)(H) of the BHC Act, and does not
affect a banking entity's obligation to comply with additional or
different requirements under applicable securities, banking, or
other laws.
---------------------------------------------------------------------------
The proposed rule defined both the type of foreign banking entity
that is eligible for the exemption and activity that constitutes
trading solely outside of the United States. The proposed rule
effectively precluded a foreign banking entity from engaging in
proprietary trading through a transaction that had any connection with
the United States, including: Trading with any party located in the
United States; allowing U.S. personnel of the foreign banking entity to
be involved in the purchase or sale; or executing any transaction in
the United States (on an exchange or otherwise).\1480\
---------------------------------------------------------------------------
\1480\ See proposed rule Sec. ----.6(d).
---------------------------------------------------------------------------
In general, commenters emphasized the importance of and supported
an exemption for foreign trading activities of foreign banking
entities. However, a number of commenters expressed concerns that the
proposed foreign trading exemption was too narrow and would not be
effective in permitting foreign banking entities to engage in foreign
trading activities.\1481\ For instance, many commenters stated that the
proposal's prohibition on trading activities that have any connection
to the U.S. was not consistent with the purpose of section 13 of the
BHC Act where the risk of the trading activity is taken or held outside
of the United States and does not implicate the U.S. safety net.\1482\
These commenters argued that, since one of the principal purposes of
section 13 of the BHC Act is to limit the risk posed by prohibited
proprietary trading to the federal safety net, the safety and soundness
of U.S. banking entities, and the financial stability of the United
States, the exemption for foreign trading activity should similarly
focus on whether the trading activity involves principal risk being
taken or held by the foreign banking entity inside the United
States.\1483\
---------------------------------------------------------------------------
\1481\ See, e.g., IIB/EBF; ICI Global; ICI (Feb. 2012); Wells
Fargo (Prop. Trading); BoA.
\1482\ See IIB/EBF; Ass'n. of Banks in Malaysia; EBF; Credit
Suisse (Seidel); Cadwalader (on behalf of Thai Banks).
\1483\ See BaFin/Deutsche Bundesbank; ICSA; IIB/EBF; Allen &
Overy (on behalf of Canadian Banks); Credit Suisse (Seidel); George
Osbourne.
---------------------------------------------------------------------------
Many commenters argued that the proposal's transaction-based
approach to implementing the foreign trading exemption would harm U.S.
markets and U.S. market participants. For example, some commenters
argued that the proposed exemption would cause foreign banks to exit
U.S. markets or shrink their U.S.-based operations, thereby resulting
in less liquidity and greater fragmentation in markets without
producing any significant offsetting benefit.\1484\ Commenters also
asserted that the proposal would impose significant compliance costs on
the foreign operations of foreign banking entities and would lead to
foreign firms refusing to trade with U.S. counterparties, including the
foreign operations of U.S. entities, to avoid compliance costs
associated with relying on another exemption under the proposed
rule.\1485\ Additionally, commenters argued that the proposal
represented an improper extraterritorial application of U.S. law that
could be found to violate international treaty obligations of the
United States, such as those under the North American Free Trade
Agreement, and might result in retaliation by foreign countries in
their treatment of U.S. banking entities abroad.\1486\
---------------------------------------------------------------------------
\1484\ See ICE; ICI Global; BoA; Citigroup (Feb. 2012); British
Bankers' Ass'n.; IIB/EBF.
\1485\ See BaFin/Deutsche Bundesbank; Norinchukin; IIF; Allen &
Overy (on behalf of Canadian Banks); ICFR; BoA; Citigroup (Feb.
2012). As discussed below in Part IV.C. of this SUPPLEMENTARY
INFORMATION, other parts of the final rule address commenters'
concerns regarding the compliance burden on foreign banking
entities.
\1486\ See Norinchukin; Cadwalader (on behalf of Thai Banks);
Barclays; EBF; Commissioner Barnier; Ass'n. of German Banks;
Soci[eacute]t[eacute] G[eacute]n[eacute]rale; Chamber (Dec. 2012).
---------------------------------------------------------------------------
a. Foreign Banking Entities Eligible for the Exemption
The statutory language of section 13(d)(1)(H) provides that, in
order to be eligible for the foreign trading exemption, the banking
entity must not be directly or indirectly controlled by a banking
entity that is organized under the laws of the United States or of one
or more States. The proposed rule limited the scope of the exemption to
banking entities that are organized under foreign law and, as
applicable, controlled only by entities organized under foreign law.
Commenters generally supported this aspect of the proposal.\1487\
However, some commenters requested that the final rule be modified to
allow U.S. banking entities' affiliates or branches that are physically
located outside of the United States (``foreign operations of U.S.
banking entities'') to engage in proprietary trading outside of the
United States pursuant to this exemption.\1488\ These commenters argued
that, unless foreign operations of U.S. banking entities are provided
similar authority to engage in proprietary trading outside of the
United States, foreign operations of U.S. banking entities would be at
a competitive disadvantage abroad with respect to foreign banking
entities. One commenter also asserted that, unless foreign operations
of U.S. banking entities were able to effectively access foreign
markets, they could be shut out of those markets and would be unable to
effectively manage their risks in a safe and sound manner.\1489\
---------------------------------------------------------------------------
\1487\ See Sens. Merkley & Levin (Feb. 2012) (arguing that the
final rule's foreign trading exemption should not exempt foreign
affiliates of U.S. banking entities when they engage in trading
activity abroad); See also Occupy; Alfred Brock.
\1488\ See Citigroup (Feb. 2012); Sen. Carper; IIF; ABA
(Keating); Wells Fargo (Prop. Trading); Abbot Labs. et al. (Feb. 14,
2012).
\1489\ See Citigroup (Feb. 2012).
---------------------------------------------------------------------------
As noted above, section 13(d)(1)(H) of the BHC Act specifically
provides that its exemption is available only to a banking entity that
is not ``directly or indirectly'' controlled by a banking entity that
is organized under the laws of the United States or of one or more
States.\1490\ Because of this express statutory threshold requirement,
a foreign subsidiary controlled, directly or indirectly, by a banking
entity organized under the laws of the United States or
[[Page 5653]]
one of its States, and a foreign branch office of a banking entity
organized under the laws of the United States or one of the States, may
not take advantage of this exemption.
---------------------------------------------------------------------------
\1490\ See 12 U.S.C. 1851(d)(1)(H).
---------------------------------------------------------------------------
Like the proposal, the final rule incorporates the statutory
requirement that the banking entity conduct its trading activities
pursuant to sections 4(c)(9) or 4(c)(13) of the BHC Act.\1491\ The
final rule retains the tests in the proposed rule for determining when
a banking entity would meet that requirement. The final rule provides
qualifying criteria for both a banking entity that is a qualifying
foreign banking organization under the Board's Regulation K and a
banking entity that is not a foreign banking organization for purposes
of Regulation K.\1492\
---------------------------------------------------------------------------
\1491\ See final rule Sec. ----.6(e)(1)(ii).
\1492\ Section ----.6(e)(2) addresses only when a transaction
will be considered to have been conducted pursuant to section
4(c)(9) of the BHC Act. Although the statute also references section
4(c)(13) of the BHC Act, the Board has to date applied the general
authority contained in that section solely to the foreign activities
of U.S. banking organizations which, by the express terms of section
13(d)(1)(H) of the BHC Act, are unable to rely on the foreign
trading exemption.
---------------------------------------------------------------------------
Section 4(c)(9) of the BHC Act applies to any company organized
under the laws of a foreign country the greater part of whose business
is conducted outside the United States, if the Board by regulation or
order determines that, under the circumstances and subject to the
conditions set forth in the regulation or order, the exemption would
not be substantially at variance with the purposes of the BHC Act and
would be in the public interest.\1493\ The Board has implemented
section 4(c)(9) as part of subpart B of the Board's Regulation K,\1494\
which specifies a number of conditions and requirements that a foreign
banking organization must meet in order to act pursuant to that
authority.\1495\ The qualifying conditions and requirements include,
for example, that the foreign banking organization demonstrate that
more than half of its worldwide business is banking and that more than
half of its banking business is outside the United States.\1496\ Under
the final rule a banking entity that is a qualifying foreign banking
organization for purposes of the Board's Regulation K, other than a
foreign bank as defined in section 1(b)(7) of the International Banking
Act of 1978 that is organized under the laws of any commonwealth,
territory, or possession of the United States, will qualify for the
exemption for proprietary trading activity of a foreign banking
entity.\1497\
---------------------------------------------------------------------------
\1493\ See 12 U.S.C. 1843(c)(9).
\1494\ See 12 CFR 211.20 et seq.
\1495\ Commenters noted that the Board's Regulation K contains a
number of limitations that may not be appropriate to include as part
of the requirements of the foreign trading exemption. See Allen &
Overy (on behalf of Foreign Bank Group); HSBC Life. Accordingly, the
final rule does not retain the proposal's requirement that the
activity be conducted in compliance with subpart B of the Board's
Regulation K (12 CFR 211.20 through 211.30). However, the exemption
in section 13(d)(1)(H) of the BHC Act and the final rule operates as
an exemption and is not a separate grant of authority to engage in
an otherwise impermissible activity. To the extent a banking entity
is a foreign banking organization, it remains subject to the Board's
Regulation K and must, as a separate matter, comply with any and all
applicable rules and requirements of that regulation.
\1496\ See 12 CFR 211.23(a), (c), and (e). The proposed rule
referenced only the qualifying test under section 211.23(a) of the
Board's Regulation K; however, because there are two other methods
by which a foreign banking organization may meet the requirements to
be considered a qualified foreign banking organization, the final
rule incorporates a reference to those provisions as well.
\1497\ This modification to the definition of foreign banking
organization is necessary because, under the International Banking
Act and the Board's Regulation K, depository institutions that are
located in, or organized under the laws of a commonwealth,
territory, or possession of the United States, are foreign banking
organizations. However, for purposes of the Federal securities laws
and certain banking statutes, such as section 2(c)(1) of the BHC Act
and section 3 of the FDI Act, these same entities are defined to be
and treated as domestic entities. For instance, these entities act
as domestic broker-dealers under U.S. securities laws and their
deposits are insured by the FDIC. Because one of the purposes of
section 13 is to protect insured depository institutions and the
U.S. financial system from the perceived risks of proprietary
trading and covered fund activities, the Agencies believe that these
entities should be considered to be located within the United States
for purposes of section 13. The final rule includes within the
definition of State a commonwealth, territory or possession of the
United States, the District of Columbia, the Commonwealth of Puerto
Rico, the Commonwealth of the Northern Mariana Islands, American
Samoa, Guam, or the United States Virgin Islands.
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Section 13 of the BHC Act also applies to foreign companies that
control a U.S. insured depository institution but that are not
currently subject to the BHC Act generally or to the Board's Regulation
K--for example, because the foreign company controls a savings
association or an FDIC-insured industrial loan company. Accordingly,
the final rule also provides that a foreign banking entity that is not
a foreign banking organization would be considered to be conducting
activities ``pursuant to section 4(c)(9)'' for purposes of this
exemption \1498\ if the entity, on a fully-consolidated basis, meets at
least two of three requirements that evaluate the extent to which the
foreign banking entity's business is conducted outside the United
States, as measured by assets, revenues, and income.\1499\ This test
largely mirrors the qualifying foreign banking organization test that
is made applicable under section 4(c)(9) of the BHC Act and section
211.23(a), (c), or (e) of the Board's Regulation K, except that the
test does not require the foreign entity to demonstrate that more than
half of its banking business is outside the United States.\1500\ This
difference reflects the fact that foreign entities subject to section
13 of the BHC Act, but not the BHC Act generally, are likely to be, in
many cases, predominantly commercial firms. A requirement that such
firms also demonstrate that more than half of their banking business is
outside the United States would likely make the exemption unavailable
to such firms and subject their global activities to the prohibition on
proprietary trading.
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\1498\ This clarification would be applicable solely in the
context of section 13(d)(1) of the BHC Act. The application of
section 4(c)(9) to foreign companies in other contexts is likely to
involve different legal and policy issues and may therefore merit
different approaches.
\1499\ See final rule Sec. ----.6(e)(2)(ii)(B). For purposes of
determining whether, on a fully consolidated basis, it meets the
requirements under Sec. ----.6(e)(2)(ii)(B), a foreign banking
entity that is not a foreign banking organization should base its
calculation on the consolidated global assets, revenues, and income
of the top-tier affiliate within the foreign banking entity's
structure.
\1500\ See 12 U.S.C. 1843(c)(9); 12 CFR 211.23(a), (c), and (e);
final rule Sec. ----.6(e)(2)(ii)(B).
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b. Permitted Trading Activities of a Foreign Banking Entity
As noted above, the proposed rule laid out a transaction-based
approach to implementing the foreign trading exemption and provided
that a transaction would be considered to qualify for the exemption
only if (i) the transaction was conducted by a banking entity not
organized under the laws of the United States or of one or more States;
(ii) no party to the transaction was a resident of the United States;
(iii) no personnel of the banking entity that was directly involved in
the transaction was physically located in the United States; and (iv)
the transaction was executed wholly outside the United States.\1501\
---------------------------------------------------------------------------
\1501\ See proposed rule Sec. ----.6(d).
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Many commenters objected to the proposed exemption, arguing that it
was unworkable and would have unintended consequences. For example,
commenters argued that prohibiting a foreign banking entity from
conducting a proprietary trade with a resident of the United States,
including a subsidiary or branch of a U.S. banking entity, wherever
located, would likely cause foreign banking entities to be unwilling to
enter into permitted trading transactions with foreign subsidiaries or
branches of U.S. firms.\1502\ In addition,
[[Page 5654]]
some commenters represented that it would be difficult to determine and
track whether a party is a resident of the United States or that this
requirement would require non-U.S. banking entities to inefficiently
bifurcate their activities into U.S.-facing and non-U.S.-facing trading
desks.\1503\ For example, one commenter noted that trading on many
exchanges and platforms is anonymous (i.e., each party to the trade is
unaware of the identity of the other party to the trade), so a foreign
banking entity would likely have to avoid U.S. trading platforms and
exchanges entirely to avoid transactions with any resident of the
United States.\1504\ Further, commenters stated that the proposed rule
could deter foreign banking entities from conducting business with U.S.
parties outside of the United States, which could also incentivize
foreign market centers to limit participation by U.S. parties on their
markets.\1505\
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\1502\ See BoA; Citigroup (Feb. 2012); British Bankers' Ass'n.;
Credit Suisse (Seidel); George Osbourne; IIB/EBF.
\1503\ See Cadwalader (on behalf of Singapore Banks); Ass'n. of
Banks in Malaysia; Cadwalader (on behalf of Thai Banks); IIF; ICE;
Banco de M[eacute]xico; ICFR; Australian Bankers Ass'n. (Feb. 2012);
BAROC.
\1504\ See ICE.
\1505\ See, e.g., RBC.
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Commenters also expressed concern about the requirement that
transactions be executed wholly outside of the United States in order
to qualify for the proposed foreign trading exemption. Commenters
represented that foreign banking entities currently use U.S. trading
platforms to trade in certain products (such as U.S.-listed securities
or a variety of derivatives contracts), to take advantage of robust
U.S. infrastructure, and for time zone reasons.\1506\ Commenters
indicated that the proposed requirement could harm the competitiveness
of U.S. trading platforms and the liquidity available on such
facilities.\1507\ Some commenters stated that this requirement would
effectively result in most foreign banking entities moving their
trading operations and personnel outside of the United States and
executing transactions on exchanges outside of the United States.\1508\
These commenters stated that the relocation of these activities would
reduce trading activity in the United States that supports the
financial stability and efficiency of U.S. markets. Moreover, these
commenters argued that, if foreign banking entities relocate their
personnel from the United States to overseas, this would diminish U.S.
jobs with no concomitant benefit. They also contended that the proposal
was at cross purposes with other parts of the Dodd-Frank Act and would
hinder growth of market infrastructure being developed under the
requirements of Title VII of that Act, including use of swap execution
facilities and security-based swap execution facilities to enhance
transparency in the swaps markets and use of central clearinghouses to
reduce counterparty risk for the parties to a swap transaction.\1509\
For example, one commenter represented that the proposed exemption
could make it difficult for non-U.S. swap entities to comply with
potential mandatory execution requirements under Title VII of the Dodd-
Frank Act and could cause market fragmentation across borders through
the creation of parallel execution facilities outside of the United
States, which would result in less transparency and greater systemic
risk.\1510\ In addition, another commenter stated that the proposed
requirement would force issuers to dually list their securities to
permit trading on non-U.S. exchanges and, further, clearing and
settlement systems would have to be set up outside of the United
States, which would create inefficiencies, operational risks, and
potentially systemic risk by adding needless complexity to the
financial system.\1511\
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\1506\ See, e.g., IIF; ICE; Soci[eacute]t[eacute]
G[eacute]n[eacute]rale; Mexican Banking Comm'n.; Australian Bankers
Ass'n. (Feb. 2012); Banco de M[eacute]xico; OSFI. In addition, a few
commenters argued that Canadian and Mexican financial firms
frequently use U.S. infrastructure to conduct their trading
activities in Canada or Mexico. See, e.g., OSFI; Banco de
M[eacute]xico; Mexican Banking Comm'n.
\1507\ See, e.g., ICE; Soci[eacute]t[eacute]
G[eacute]n[eacute]rale (arguing that the requirement would impair
capital raising efforts of many U.S. companies); Australian Bankers
Ass'n. (Feb. 2012); Canadian Minister of Fin.; Ass'n. of German
Banks.
\1508\ See IIB/EBF.
\1509\ See Bank of Canada; Banco de M[eacute]xico; Allen & Overy
(on behalf of Canadian Banks).
\1510\ See Allen & Overy (on behalf of Candian Banks).
\1511\ See IIF.
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Instead of the proposal's transaction-based approach to
implementing the foreign trading exemption, many commenters suggested
the final rule adopt a risk-based approach.\1512\ These commenters
noted that a risk-based approach would prohibit or significantly limit
the amount of financial risk from such activities that could be
transferred to the United States by the foreign trading activity of
foreign banking entities.\1513\ Commenters also noted that foreign
trading activities of most foreign banking entities are already subject
to activities limitations, capital requirements, and other prudential
requirements of their home-country supervisor(s).\1514\
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\1512\ See BaFin/Deutsche Bundesbank; ICSA; IIB/EBF; Allen &
Overy (on behalf of Canadian Banks); Credit Suisse (Seidel); George
Osbourne.
\1513\ See IIB/EBF.
\1514\ See IIB/EBF.
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The Agencies have carefully considered these comments and have
determined to modify the approach in the final rule. The Agencies
believe that the revisions mitigate the potential adverse impacts of
the proposed approach while still remaining faithful to the overall
purpose of section 13(d)(1)(H). Also, the Agencies believe that section
13(d)(1)(J) of the BHC Act, which authorizes the Agencies to provide an
exemption from the prohibition on proprietary trading for any activity
the Agencies determine by rule ``would promote and protect the safety
and soundness of the banking entity and the financial stability of the
United States,'' \1515\ supports allowing foreign banking entities to
use U.S. infrastructure and trade with certain U.S. counterparties in
certain circumstances, which will promote and protect the safety and
soundness of banking entities and U.S. financial stability.
---------------------------------------------------------------------------
\1515\ See 12 U.S.C. 1851(d)(1)(J).
---------------------------------------------------------------------------
Overall, the comments illustrated that both the mechanical steps of
the specified transactions to purchase or sell various instruments
(e.g., execution, clearing), and the identity of the entity for whose
trading account the specified trading is conducted are important.\1516\
Consistent with the comments described above, the Agencies believe that
the application of section 13(d)(1)(H) and their exemptive authority
under section 13(d)(1)(J) should focus on both how the transaction
occurs and which entity will bear the risk of those transactions.
Although the statute does not define expressly what it means to act
``as a principal'' (acting as principal ordinarily means acting for
one's own account), the combination of references to engaging as
principal and to a trading account focuses on an entity's incurring
risks of profit and loss through taking ownership of securities and
other instruments. Thus, the final rule provides an exemption for
trading activities of foreign banking entities that addresses both the
location of the facilities that effect the acquisition, holding, and
disposition of such positions, and the location of the banking entity
that incurs such risks through acquisition, holding, and disposition of
such positions.
The Agencies believe this approach is consistent with one of the
principal purposes of section 13, which is to limit risks that
proprietary trading poses to
[[Page 5655]]
the U.S. financial system.\1517\ Further, the purpose of section
13(d)(1)(H) is to limit the extraterritorial application of section 13
as it applies to foreign banking entities.\1518\
---------------------------------------------------------------------------
\1517\ See, e.g., 12 U.S.C. 1851(b)(1) (directing the FSOC to
study and make recommendations on implementing section 13 so as to,
among other things, protect taxpayers and consumers and enhance
financial stability by minimizing the risk that insured depository
institutions and the affiliates of insured depository institutions
will engage in unsafe and unsound activities).
\1518\ See, e.g., 156 Cong. Rec. S5897 (daily ed. July 15, 2010)
(statement of Sen. Merkley) (stating that the foreign trading
exemption ``recognize[s] rules of international comity by permitting
foreign banks, regulated and backed by foreign taxpayers, in the
course of operating outside of the United States to engage in
activities permitted under relevant foreign law.'').
---------------------------------------------------------------------------
In addition, prohibiting foreign banking entities from using U.S.
infrastructure or trading with all U.S. counterparties could cause
certain trading activities to move offshore, with corresponding
negative impacts on U.S. market participants, including U.S. banking
entities. For example, movement of trading activities offshore,
particularly in U.S. financial instruments, could result in bifurcated
markets for these instruments that are less efficient and less liquid
and could reduce transparency for oversight of trading in these
instruments. In addition, reducing access to foreign counterparties for
U.S. instruments could concentrate risks in the United States and to
its financial system. Moreover, the statute provides separate
exemptions for U.S. banking entities to engage in underwriting and
market making-related activities, subject to certain requirements, and
there is no evidence that limiting the range of potential customers for
these entities would further the purposes of the statute. In fact, it
is possible that limiting the customer bases of U.S. banking entities,
as well as other U.S. firms that are not banking entities, could reduce
their ability to effectively manage their inventories and risks and
could also result in concentration risk.
These potential effects of the approach taken in the proposal
appear to be inconsistent with the statute's goals, including the
promotion and protection of the safety and soundness of banking
entities and U.S. financial stability. To the contrary, the exemptive
approach taken in the final rule appears to be more consistent with the
goals of the statute and would promote and protect the safety and
soundness of banking entities and U.S. financial stability by limiting
the risks of foreign banking entities' proprietary trading activities
to the U.S. financial system, while also allowing U.S. markets to
continue to operate efficiently in conjunction with foreign markets
(rather than creating incentives to establish barriers between U.S. and
foreign markets).\1519\
---------------------------------------------------------------------------
\1519\ 12 U.S.C. 1851(d)(1)(J).
---------------------------------------------------------------------------
Thus, in response to commenter concerns, the final rule has been
modified to better reflect the text and achieve the overall purposes of
the statute (by ensuring that the principal risks of proprietary
trading by foreign banking entities allowed under the foreign trading
exemption remain solely outside of the United States) while mitigating
potentially adverse effects on competition.\1520\ In order to ensure
these risks remain largely outside of the United States, and to limit
potential risk that could flow to the U.S. financial system through
trades by foreign banking entities with or through U.S. entities, the
final rule includes several conditions on the availability of the
exemption. Specifically, in addition to limiting the exemption to
foreign banking entities, the final rule provides that the exemption
for the proprietary trading activity of a foreign banking entity is
available only if:
---------------------------------------------------------------------------
\1520\ The proposed rule also contained a definition of
``resident of the United States'' that was designed to capture the
scope of U.S. counterparties that, if involved in the transaction,
would preclude that transaction from being considered to have
occurred solely outside the United States. The final rule addresses
this point by including a definition, for purposes of Sec. --
--.6(e) only, of the term ``U.S. entity.''
---------------------------------------------------------------------------
(i) The banking entity engaging as principal in the purchase or
sale (including any personnel of the banking entity or its affiliate
that arrange, negotiate or execute such purchase or sale) is not
located in the United States or organized under the laws of the United
States or of any State; \1521\
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\1521\ Personnel that arrange, negotiate, or execute a purchase
or sale conducted under the exemption for trading activity of a
foreign banking entity must be located outside of the United States.
Thus, for example, personnel in the United States cannot solicit or
sell to or arrange for trades conducted under this exemption.
Personnel in the United States also cannot serve as decision makers
in transactions conducted under this exemption. Personnel that
engage in back-office functions, such as clearing and settlement of
trades, would not be considered to arrange, negotiate, or execute a
purchase or sale for purposes of this provision.
---------------------------------------------------------------------------
(ii) The banking entity (including relevant personnel) that makes
the decision to purchase or sell as principal is not located in the
United States or organized under the laws of the United States or of
any State;
(iii) The purchase or sale, including any transaction arising from
risk-mitigating hedging related to the instruments purchased or sold,
is not accounted for as principal directly or on a consolidated basis
by any branch or affiliate that is located in the United States or
organized under the laws of the United States or of any State;
(iv) No financing for the banking entity's purchase or sale is
provided, directly or indirectly, by any branch or affiliate that is
located in the United States or organized under the laws of the United
States or of any State; \1522\
---------------------------------------------------------------------------
\1522\ This provision is not intended to restrict the ability of
a U.S. branch or affiliate of a foreign banking entity to provide
funds collected in the United States to its foreign parent for
general purposes.
---------------------------------------------------------------------------
(v) The purchase or sale is not conducted with or through any U.S.
entity,\1523\ other than:
---------------------------------------------------------------------------
\1523\ ``U.S. entity'' is defined for purposes of this provision
as any entity that is, or is controlled by, or is acting on behalf
of, or at the direction of, any other entity that is, located in the
United States or organized under the laws of the United States or of
any State. See final rule Sec. ----.6(e)(4).
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(A) A purchase or sale with the foreign operations of a U.S.
entity, if no personnel of such U.S. entity that are located in the
United States are involved in the arrangement, negotiation or execution
of such purchase or sale.
The Agencies believe it is appropriate to exercise their exemptive
authority under section 13(d)(1)(J) to also allow, under clause (vi) of
the final rule, the following types of purchases or sales conducted
with a U.S. entity:
(B) A purchase or sale with an unaffiliated market intermediary
acting as principal,\1524\ provided the purchase or sale is promptly
cleared and settled through a clearing agency or derivatives clearing
organization acting as a central counterparty; or
---------------------------------------------------------------------------
\1524\ This provision would generally allow market
intermediaries to engage in market-making, underwriting or similar
market intermediation functions.
---------------------------------------------------------------------------
(C) A purchase or sale through an unaffiliated market intermediary,
provided the purchase or sale is conducted anonymously (i.e. each party
to the purchase or sale is unaware of the identity of the other
party(ies) to the purchase or sale) on an exchange or similar trading
facility and promptly cleared and settled through a clearing agency or
derivatives clearing organization acting as a central counterparty.
The requirements are designed to ensure that any foreign banking
entity engaging in trading activity under this exemption does so in a
manner that ensures the risk, decision-making, arrangement,
negotiation, execution and financing of the activity resides solely
outside the United States and limits the risk to the U.S. financial
system from trades by foreign banking entities with or through U.S.
entities.
The final rule specifically recognizes that, for purposes of the
exemption for
[[Page 5656]]
trading activity of a foreign banking entity, a U.S. branch, agency, or
subsidiary of a foreign bank, or any subsidiary thereof, is located in
the United States; however, a foreign bank that operates or controls
that branch, agency, or subsidiary is not considered to be located in
the United States solely by virtue of operation of the U.S. branch,
agency, or subsidiary.\1525\ This provision helps give effect to the
statutory language limiting the foreign trading exemption to activities
of foreign banking entities that occur solely outside of the United
States by clarifying that the U.S. operations of foreign banking
entities may not conduct proprietary trading based on this exemption.
---------------------------------------------------------------------------
\1525\ See final rule Sec. ----.6(e)(5).
---------------------------------------------------------------------------
The Agencies have considered whether the concerns raised by
commenters that the foreign operations of U.S. banking entities would
be disadvantaged in competing outside the United States warrant an
exemption under section 13(d)(1)(J) of the BHC Act that extends to
foreign operations of U.S. banking entities. The competitiveness of
U.S. banking entities outside the United States often improves the
potential for the operations of U.S. firms outside the United States to
succeed and be profitable, and thereby, often improves the safety and
soundness of the entity and financial stability in the United States.
However, Congress has determined to generally prohibit U.S. banking
entities (including foreign branches and subsidiaries thereof) from
engaging in proprietary trading because of the perceived risks of those
activities to banking entities and the U.S. economy.\1526\ Allowing
U.S. banking entities to conduct, through branches or subsidiaries that
are physically located outside the United States, the same proprietary
trading activities those U.S. firms are expressly prohibited from
conducting directly through their operations located within the United
States would subject U.S. banking entities and the U.S. economy to the
very risks section 13 is designed to avoid. The risks of proprietary
trading would continue to be borne by the U.S. banking entity whether
the activity is conducted by the U.S. banking entity through units
physically located inside or outside of the United States. Moreover,
the robust trading markets that exist overseas could allow U.S. banking
entities to shift their prohibited proprietary trading activities to
branches or subsidiaries that are physically located outside the United
States under such an exemption, without achieving a meaningful
elimination of risk. Accordingly, the Agencies have not exercised their
authority under section 13(d)(1)(J) at this time to allow U.S. banking
entities to conduct otherwise prohibited proprietary trading activities
through operations located outside the United States. As a consequence,
and consistent with the statutory language and purpose of section
13(d)(1)(H) of the BHC Act, the final rule provides that the exemption
is available only if the banking entity is not organized under, or
directly or indirectly controlled by a banking entity that is organized
under, the laws of the United States or of one or more States.\1527\
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\1526\ See, e.g., 156 Cong. Rec. S5897 (daily ed. July 15, 2010)
(statement of Sen. Merkley) (``However, these subparagraphs are not
intended to permit a U.S. banking entity to avoid the restrictions
on proprietary trading simply by setting up an offshore subsidiary
or reincorporating offshore, and regulators should enforce them
accordingly.'').
\1527\ See final rule Sec. ----.6(e)(1)(i).
---------------------------------------------------------------------------
As discussed above, many commenters requested that the final rule
permit a foreign banking entity to engage in proprietary trading
transactions with a greater variety of counterparties, including
counterparties that are located in or organized and incorporated under
the laws of the United States or of one or more States.\1528\ These
commenters also requested that the final rule not require that any
purchase or sale under the exemption be executed wholly outside of the
United States.
---------------------------------------------------------------------------
\1528\ A number of commenters also requested that the foreign
trading exemption permit proprietary trading of foreign sovereign
debt or similar obligations of foreign governments. As discussed in
Part IV.A.5.b. of this SUPPLEMENTARY INFORMATION, the final rule
addresses banking entities' ability to engage in transaction in
these types of instruments in Sec. ----.6(b).
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As described above and in response to commenters' concerns, the
final rule provides that a foreign banking entity generally may engage
in trading activity under the exemption with U.S. entities, provided
the transaction is with the foreign operations of an unaffiliated U.S.
firm (whether or not the U.S. firm is a banking entity subject to
section 13 of the BHC Act) and does not involve any personnel of the
U.S. entity that are in the United States and involved in the
arrangement, negotiation, or execution of the transaction. The Agencies
have also exercised their exemptive authority under section 13(d)(1)(J)
to allow foreign banking entities to engage in a transaction that is
either through an unaffiliated market intermediary and executed
anonymously on an exchange or similar trading facility (regardless of
whether the ultimate counterparty is a U.S. entity or not) or is
executed with a U.S. entity that is an unaffiliated market intermediary
acting as principal, provided in either case that the transaction is
promptly cleared and settled through a clearing agency or derivatives
clearing organization acting as a central counterparty.
For purposes of the final rule, market intermediary is defined as
an unaffiliated entity, acting as an intermediary, that is: (i) A
broker or dealer registered with the SEC under section 15 of the
Exchange Act or exempt from registration or excluded from regulation as
such; (ii) a swap dealer registered with the CFTC under section 4s of
the Commodity Exchange Act or exempt from registration or excluded from
regulation as such; (iii) a security-based swap dealer registered with
the SEC under section 15F of the Exchange Act or exempt from
registration or excluded from regulation as such; or (iv) a futures
commission merchant registered with the CFTC under section 4f of the
Commodity Exchange Act or exempt from registration or excluded from
regulation as such.\1529\
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\1529\ See final rule Sec. ----.6(e)(5). For example, under
this definition, a bank that is exempt from registration as a swap
dealer under the de minimis exception to swap dealer registration
requirements could be a market intermediary for transactions in
swaps. See 17 CFR 1.3(ggg)(4).
---------------------------------------------------------------------------
These provisions of the final rule, viewed as a whole, prevent the
exemption for trading of foreign banking entities from weakening U.S.
trading markets and U.S. firms that are either not subject to the
provisions of section 13 or that conduct activities in compliance with
other parts of section 13. For instance, the final rule permits a
foreign banking entity to trade under the exemption with the foreign
operations of a U.S. firm, so long as the purchase or sale does not
involve any personnel of the U.S. firm who are located in the United
States and involved in arranging, negotiating or executing the
trade.\1530\ Transactions that occur outside of the United States
between foreign operations of U.S. entities and foreign banking
entities improve access to and functioning of liquid markets without
raising the concerns for increased risk to banking entities in the U.S.
that motivated enactment of section 13 of the BHC Act. The final rule
permits a foreign banking entity to engage in transactions with the
foreign operations of both U.S. non-banking and U.S. banking entities.
Among other things, this approach will ensure that the foreign
operations of
[[Page 5657]]
U.S. banking entities continue to be able to access foreign
markets.\1531\ The language of the exemption expressly requires that
trading with the foreign operations of a U.S. entity may not involve
the use of personnel of the U.S. entity who are located in the United
States for purposes of arranging, negotiating, or executing
transactions.
---------------------------------------------------------------------------
\1530\ See final rule Sec. ----.6(e)(3)(v)(A).
\1531\ The Agencies believe that this provision should address
commenters' concerns that the proposed rule could cause foreign
banking entities to avoid conducting business with U.S. firms
outside the United States or could incentivize foreign market places
to restrict access to U.S. firms. See, e.g., RBC.
---------------------------------------------------------------------------
Under the final rule, the exemption in no way exempts the U.S. or
foreign operations of the U.S. banking entities from having to comply
with the restrictions and limitations of section 13. Thus, the U.S. and
foreign operations of a U.S. banking entity that is engaged in
permissible market making-related activities or other permitted
activities may engage in those transactions with a foreign banking
entity that is engaged in proprietary trading in accordance with the
exemption under Sec. ----.6(e) of the final rule. Importantly, the
final rule does not impose a duty on the foreign banking entity or the
U.S. banking entity to ensure that its counterparty is conducting its
activity in conformance with section 13 of the BHC Act and the final
rule. Rather, that burden is at all times on each party subject to
section 13 to ensure that it is conducting its activities in accordance
with section 13 and this implementing rule.
The final rule also permits, pursuant to section 13(d)(1)(J), a
foreign banking entity to trade through an unaffiliated market
intermediary if the trade is conducted anonymously on an exchange or
similar trading facility and is promptly cleared and settled through a
clearing agency or derivatives clearing organization.\1532\ Allowing
foreign banking entities to generally conduct anonymous proprietary
trades on U.S. exchanges and similar anonymous trading facilities
allows these exchanges and facilities--which are generally not subject
to section 13 and do not take the risks section 13 is designed to
address--to serve the widest possible range of counterparties. This
prevents the potential adverse impacts from possible reductions in
competitiveness of or liquidity available on these regulated exchanges
and facilities, which could also harm other U.S. market participants
who trade on these exchanges and facilities. In addition, the Agencies
recognize that anonymous trading on exchanges and similar anonymous
trading facilities promotes transparency and that prohibiting foreign
banking entities from trading on U.S. exchanges and similar anonymous
trading facilities under this exemption would likely reduce
transparency for trading in U.S. financial instruments. All of these
considerations support the Agencies' exercise of their exemptive
authority under section 13(d)(1)(J) to allow such trading by foreign
banking entities.
---------------------------------------------------------------------------
\1532\ Under the final rule, ``anonymous'' means that each party
to a purchase or sale is unaware of the identity of the other
party(ies) to the purchase or sale. See final rule Sec. --
--.3(e)(1).
---------------------------------------------------------------------------
The final rule requires that foreign banking entities trade through
an unaffiliated market intermediary to access a U.S. exchange or
trading facility in recognition that existing laws and regulations
generally require this structure.\1533\ For purposes of this exemption,
an exchange would include, unless the context otherwise requires, any
designated contract market, swap execution facility, or foreign board
of trade registered with the CFTC, and any exchange or security-based
swap execution facility, as such terms are defined under the Exchange
Act.\1534\
---------------------------------------------------------------------------
\1533\ See, e.g., 15 U.S.C. 78f(c)(1) (providing that a national
securities exchange shall deny membership to (A) any person, other
than a natural person, which is not a registered broker or dealer or
(B) any natural person who is not, or is not associated with, a
registered broker or dealer).
\1534\ See final rule Sec. ----.3(e)(6) (defining the term
``exchange''). The rule refers to an ``exchange or similar trading
facility.'' A similar trading facility for these purposes may
include, for example, an alternative trading system.
---------------------------------------------------------------------------
This provision of the final rule requires that foreign banking
entities trade anonymously and that the trade be centrally cleared and
settled. The Agencies understand that in these circumstances, the
foreign banking entity would not have any prior information regarding
its counterparty to the trade. Requiring that the trade be executed
anonymously preserves the benefits of allowing U.S. entities to
participate in such trades, while reducing the potential for evasion of
section 13 that could occur if foreign banking entities directly
arranged purchases and sales with U.S. entities.\1535\ The final rule
specifies that a trade is anonymous if each party to the purchase or
sale is unaware of the identity of the other party(ies) to the purchase
or sale. That is, it is lack of knowledge of the identity of the
counteryparty(ies) to the trade that is relevant. The final rule does
not prohibit foreign banking entities from accessing a trading facility
through an unaffiliated U.S. market intermediary (which the foreign
banking entity would necessarily know), so long as the foreign banking
entity is not aware of the identity of the counterparty to the
transaction.
---------------------------------------------------------------------------
\1535\ In addition, allowing a foreign banking entity to trade
directly with a U.S. end user customer under the foreign trading
exemption could give the foreign banking entity a competitive
advantage over U.S. banking entities with respect to trading in the
United States.
---------------------------------------------------------------------------
Similarly, also pursuant to section 13(d)(1)(J), the final rule
allows a foreign banking entity to trade with an unaffiliated market
intermediary acting in a principal capacity and effecting a market
intermediation function, in a transaction that is not conducted on an
exchange or similar anonymous trading facility, as long as the trade is
promptly cleared and settled through a clearing agency or derivatives
clearing organization. This provision recognizes that not all financial
instruments are traded on an exchange or similar anonymous trading
facility and, thus, allows foreign banking entities to trade and
contribute to market liquidity in all types of U.S. financial
instruments without requiring separate market infrastructure to be
developed outside the U.S. for such trading activity, which could
result in inefficiencies and reduce U.S. market liquidity. Market
intermediaries can serve the same general purpose as exchanges or
similar trading facilities in intermediating between buyers and
sellers, particularly in asset classes that do not generally trade on
these exchanges or facilities, although this intermediation function
may not be as immediate in the case of market intermediaries.
In either case (i.e., for either an anonymous trade or a trade with
an unaffiliated market intermediary), if the U.S. counterparty to the
transaction is a banking entity subject to section 13 and these rules,
it must comply with an exemption to the prohibition on proprietary
trading, such as the market-making exemption or the exemption for
riskless principal transactions. Allowing foreign banking entities to
trade with unaffiliated U.S. market intermediaries, including banking
entities engaged in permitted market making-related activities, expands
the range of potential buyers and sellers for which the U.S. entities
can trade and may result in more efficient and timely matching of
trades, reducing inventory risks to the U.S. market intermediary. At
the same time, this exemption does not permit a U.S. market
intermediary that is subject to section 13 of the BHC Act to conduct
trading activities other than in compliance with the provisions of
section 13. Thus, the Agencies believe it is appropriate to allow
foreign banking entities to conduct such trading under the exemption in
section 13(d)(1)(J).
To reduce risks to U.S. entities and the potential for evasion, the
provisions
[[Page 5658]]
allowing trading with U.S. entities include two additional protections.
First, the final rule does not allow a foreign banking entity to trade
through an affiliated U.S. entity under the exemption out of concern
that it could increase the risk of evasion.\1536\ Second, a foreign
banking entity's trades conducted through an unaffiliated market
intermediary on an exchange or conducted directly with an unaffiliated
market intermediary must be promptly cleared and settled through a
clearing agency or derivatives clearing organization acting as central
counterparty. Consistent with the goals of section 13 to reduce risk to
banking entities and the U.S. financial system, this requirement is
designed to reduce risk to U.S. entities arising from foreign banking
entities' proprietary trading activity, particularly counterparty risk,
and preclude foreign banking entities from relying on the exemption for
trading that creates exposure of U.S. counterparties pursuant to
bilateral, uncleared transactions, which poses heightened counterparty
credit risks.\1537\ This condition is also consistent with the systemic
risk benefits of central clearing and may incentivize the use of
central clearing for trading by foreign banking entities and foreign
affiliates of U.S. banking entities. The Agencies believe this approach
is consistent with and reinforces the goals of the central clearing
framework of Title VIII of the Dodd-Frank Act.
---------------------------------------------------------------------------
\1536\ In addition, allowing a foreign banking entity to trade
through or with a U.S. affiliate under the exemption for trading
activity of a foreign banking entity could give the foreign banking
entity a competitive advantage over U.S. banking entities that are
subject to limitations on their trading activities. Thus, the
Agencies are not permitting a foreign banking entity to trade
through a U.S. affiliate as agent, as requested by some commenters.
See, e.g., IIB/EBF. However, the Agencies recognize that, with
respect to trading anonymously, there is no way to know the identity
of the counterparty to the trade. Thus, a foreign banking entity
would not be in violation of this rule if it traded through an
unaffiliated market intermediary on an exchange, in accordance with
the exemption for trading activity of a foreign banking entity, and
the counterparty to its trade happened to be an affiliated entity.
\1537\ As discussed above, centralized clearing redistributes
counterparty risk among members of a clearing agency or derivatives
clearing organization through mutualization of losses, reducing the
likelihood of sequential counterparty failure and contagion. See
supra note 266 and accompanying text.
---------------------------------------------------------------------------
The final rule does not allow a foreign banking entity to trade
with a broader range of U.S. entities under the exemption because the
Agencies are concerned such an approach may result in adverse
competitive impacts between U.S. banking entities and foreign banking
entities with respect to their trading in the United States, which
could harm the safety and soundness of banking entities and U.S.
financial stability. For example, such an approach could allow foreign
banking entities to act as market makers for U.S. customers under the
exemption in Sec. ----.6(e) of the final rule so long as the foreign
banking entity held the risk of its market-making trades outside the
United States. In turn, this could give foreign banking entities a
competitive advantage over U.S. banking entities with respect to U.S.
market-making activities because foreign banking entities could trade
directly with U.S. non-banking entities without incurring the
additional costs, or being subject to the limitations, associated with
the market-making or other exemptions under the rule. This competitive
disparity in turn could create a significant potential for regulatory
arbitrage. The Agencies do not believe this result was intended by the
statute. Instead, the final rule seeks to alleviate the concern that an
overly broad approach to the exemption (e.g., permitting trading with
all U.S. counterparties) may result in competitive impacts and
increased risks to the U.S. financial system, while mitigating the
concern that an overly narrow approach to the exemption (e.g.,
prohibiting trading with any U.S. counterparty) may cause market
bifurcations, reduce the efficiency and liquidity of markets, and harm
U.S. market participants.
9. Section ----.7: Limitations on Permitted Trading Activities
Section ----.8 of the proposed rule implemented section 13(d)(2) of
the BHC Act,\1538\ which provides that a banking entity may not engage
in certain exempt activities (e.g., permitted market making-related
activities, risk-mitigating hedging, etc.) if the activity would
involve or result in a material conflict of interest between the
banking entity and its clients, customers, or counterparties; result,
directly or indirectly, in a material exposure by the banking entity to
a high-risk asset or a high-risk trading strategy; or pose a threat to
the safety and soundness of the banking entity or U.S. financial
stability.\1539\ The Agencies sought comment on proposed definitions of
the terms ``material conflict of interest,'' ``high-risk asset,'' and
``high-risk trading strategy'' for these purposes.
---------------------------------------------------------------------------
\1538\ Section ----.8 of the proposed rule regarding limitations
on permitted trading activities is consistent with Sec. ----.17 of
the proposed rule regarding other limitations on permitted covered
funds activities. Accordingly, the discussion regarding proposed
rule Sec. ----.8 and final rule Sec. ----.7 in this part also
pertain to Sec. ----.17 of the proposed rule and Sec. ----.16 of
the final rule. See also Part IV.B.6., infra.
\1539\ See 12 U.S.C. 1851(d)(2).
---------------------------------------------------------------------------
With respect to general comments regarding the proposed rule,
commenters generally agreed on the need to limit banking entities'
proprietary trading activities so as to avoid material conflicts of
interest and material exposures to high-risk trading strategies and
high-risk assets.\1540\ One commenter expressed support for the
Agencies' proposed approach, stating that the proposed rule was clear
and structured in such a manner so that it should remain effective even
as financial markets evolve and change.\1541\ As discussed in greater
detail below, most commenters suggested amendments, clarification, or
alternative approaches. For example, some commenters expressed concern
regarding the application of the prudential backstops to the activities
of foreign banking entities.\1542\ The Agencies did not receive any
comments on the prohibition against transactions or activities that
pose a threat to the safety or soundness of the banking entity or the
financial stability of the United States.
---------------------------------------------------------------------------
\1540\ See, e.g., Sens. Merkley & Levin (Feb. 2012); Public
Citizen; Paul Volcker.
\1541\ See Alfred Brock.
\1542\ See IIB/EBF; Ass'n. of German Banks.
---------------------------------------------------------------------------
As explained in detail below, the Agencies have carefully reviewed
comments on the proposed rule's implementation of the prudential
backstops under section 13(d)(2) of the BHC Act, including commenters'
suggestions for expanding, contracting, or revising the proposed rule.
After carefully considering these comments, the Agencies continue to
believe the expansive scope of section 13 of the BHC Act supports a
similarly inclusive approach focusing on the facts and circumstances of
each potential conflict or high-risk activity. Therefore, and in
consideration of all issues discussed below, the Agencies are adopting
the final rule substantially as proposed.\1543\ The Agencies intend to
develop additional guidance regarding best practices for addressing
potential material conflicts of interest, high-risk assets and trading
strategies and practices that pose significant risks to safety and
soundness and to the U.S. financial system as the Agencies and banking
entities gain experience with implementation of the requirements and
[[Page 5659]]
limitations in section 13 of the BHC Act and this rule, which are all
generally designed to limit risky behavior in trading and investment
activities.
---------------------------------------------------------------------------
\1543\ The Agencies note that proposed Appendix C, which
required banking entities to describe how they comply with these
provisions, will be adopted as Appendix B with similar requirements
regarding compliance with the limitations on permitted activities.
---------------------------------------------------------------------------
a. Scope of ``Material Conflict of Interest''
1. Proposed Rule
Section ----.8(b) of the proposed rule defined the scope of
material conflicts of interest which, if arising in connection with a
permitted trading activity, were prohibited under the proposal.\1544\
As noted in the proposal, conflicts of interest may arise in a variety
of circumstances related to permitted trading activities. For example,
a banking entity may acquire substantial amounts of nonpublic
information about the financial condition of a particular company or
issuer through its lending, underwriting, investment advisory or other
activities which, if improperly transmitted to and used in trading
operations, would permit the banking entity to use such information to
its customers', clients' or counterparties' disadvantage. Similarly, a
banking entity may conduct a transaction that places the banking
entity's own interests ahead of its obligations to its customers,
clients or counterparties, or it may seek to gain by treating one
customer involved in a transaction more favorably than another customer
involved in that transaction. Concerns regarding conflicts of interest
are likely to be elevated when a transaction is complex, highly
structured or opaque, involves illiquid or hard-to-value instruments or
assets, requires the coordination of multiple internal groups (such as
multiple trading desks or affiliated entities), or involves a
significant asymmetry of information or transactional data among
participants.\1545\ In all cases, the existence of a material conflict
of interest depends on the specific facts and circumstances.\1546\
---------------------------------------------------------------------------
\1544\ Section ----.17(b) of the proposed rule defined the scope
of material conflicts of interest which, if arising in connection
with permitted covered fund activities, are prohibited.
\1545\ See, e.g., U.S. Senate Permanent Subcommittee on
Investigations, Wall Street and the Financial Crisis: Anatomy of a
Financial Collapse (Apr. 13, 2011), available at http://hsgac.senate.gov/public/_files/Financial_Crisis/FinancialCrisisReport.pdf.
\1546\ See Joint Proposal, 76 FR 68,893.
---------------------------------------------------------------------------
To address these types of material conflicts of interest, Sec. --
--.8(b) of the proposed rule specified that a material conflict of
interest between a banking entity and its clients, customers, or
counterparties exists if the banking entity engages in any transaction,
class of transactions, or activity that would involve or result in the
banking entity's interests being materially adverse to the interests of
its client, customer, or counterparty with respect to such transaction,
class of transactions, or activity, unless the banking entity has
appropriately addressed and mitigated the conflict of interest, and
subject to specific requirements provided in the proposal, through
either (i) timely and effective disclosure, or (ii) information
barriers.\1547\ Unless the conflict of interest is addressed and
mitigated in one of the two ways specified in the proposal, the related
transaction, class of transactions or activity would be prohibited
under the proposed rule, notwithstanding the fact that it may be
otherwise permitted under Sec. Sec. ----.4 through ----.6 of the
proposed rule.\1548\
---------------------------------------------------------------------------
\1547\ See proposed rule Sec. ----.8(b)(1).
\1548\ See Joint Proposal, 76 FR 68,893.
---------------------------------------------------------------------------
However, the Agencies determined that while these conflicts may be
material for purposes of the proposed rule, the mere fact that the
buyer and seller are on opposite sides of a transaction and have
differing economic interests would not be deemed a ``material''
conflict of interest with respect to transactions related to bona fide
underwriting, market making, risk-mitigating hedging or other permitted
activities, assuming the activities are conducted in a manner that is
consistent with the proposed rule and securities, derivatives, and
banking laws and regulations.
Section ----.8(b)(1) of the proposed rule described the two
requirements that must be met in cases where a banking entity addresses
and mitigates a material conflict of interest through timely and
effective disclosure. First, Sec. ----.8(b)(1)(A)(i) of the proposed
rule required that the banking entity, prior to effecting the specific
transaction or class or type of transactions, or engaging in the
specific activity, for which a conflict may arise, make clear, timely
and effective disclosure of the conflict or potential conflict of
interest, together with any other necessary information. This would
also require such disclosure to be provided in reasonable detail and in
a manner sufficient to permit a reasonable client, customer, or
counterparty to meaningfully understand the conflict of interest.\1549\
Disclosure that is only general or generic, rather than specific to the
individual, class, or type of transaction or activity, or that omits
details or other information that would be necessary to a reasonable
client's, customer's, or counterparty's understanding of the conflict
of interest, would not meet this standard. Second, Sec. --
--.8(b)(1)(ii) of the proposed rule required that the disclosure be
made explicitly and effectively, and in a manner that provides the
client, customer, or counterparty the opportunity to negate, or
substantially mitigate, any materially adverse effect on the client,
customer, or counterparty that was created or would be created by the
conflict or potential conflict.\1550\
---------------------------------------------------------------------------
\1549\ See id.
\1550\ See proposed rule Sec. ----.8(b)(1)(B).
---------------------------------------------------------------------------
The Agencies noted that, in order to provide the requisite
opportunity for the client, customer or counterparty to negate or
substantially mitigate the disadvantage created by the conflict, the
disclosure would need to be provided sufficiently close in time to the
client's, customer's, or counterparty's decision to engage in the
transaction or activity to give the client, customer, or counterparty
an opportunity to meaningfully evaluate and, if necessary, take steps
that would negate or substantially mitigate the conflict. Disclosure
provided far in advance of a particular transaction, such that the
client, customer, or counterparty is unlikely to take that disclosure
into account when evaluating the transaction, would not suffice.
Conversely, disclosure provided without a sufficient period of time for
the client, customer, or counterparty to evaluate and act on the
information it receives, or disclosure provided after the fact, would
also not suffice under the proposal. The Agencies note that the
proposed definition would not prevent or require disclosure with
respect to transactions or activities that align the interests of the
banking entity with its clients, customers, or counterparties or that
otherwise do not involve ``material'' conflicts of interest as
discussed above.
The proposed disclosure standard reflected the fact that some types
of conflicts may be appropriately resolved through the disclosure of
clear and meaningful information to the client, customer, or
counterparty that provides such party with an informed opportunity to
consider and negate or substantially mitigate the conflict. However, in
the case of a conflict in which a client, customer, or counterparty
does not have sufficient information and opportunity to negate or
mitigate the materially adverse effect on the client, customer, or
counterparty created by the conflict, the existence of that conflict of
interest would prevent the banking entity from availing itself of any
exemption (e.g., the underwriting or market-making exemptions) with
respect to the relevant transaction, class of transactions, or
activity. The
[[Page 5660]]
Agencies note that the proposed disclosure provisions were provided
solely for purposes of the proposed rule's definition of material
conflict of interest, and did not affect a banking entity's obligation
to comply with additional or different disclosure or other requirements
with respect to a conflict under applicable securities, banking, or
other laws (e.g., section 27B of the Securities Act, which governs
conflicts of interest relating to certain securitizations; section 206
of the Investment Advisers Act of 1940, which governs conflicts of
interest between investment advisers and their clients; or 12 CFR 9.12,
which applies to conflicts of interest in the context of a national
bank's fiduciary activities).
Section ----.8(b)(2) of the proposed rule described the
requirements that must be met in cases where a banking entity uses
information barriers that are reasonably designed to prevent a material
conflict of interest from having a materially adverse effect on a
client, customer or counterparty. Information barriers can be used to
restrict the dissemination of information within a complex organization
and to prevent material conflicts by limiting knowledge and
coordination of specific business activities among units of the entity.
Examples of information barriers include, but are not limited to,
restrictions on information sharing, limits on types of trading, and
greater separation between various functions of the firm. Information
barriers may also require that banking entity units or affiliates have
no common officers or employees. Such information barriers have been
recognized in Federal securities laws and rules as a means to address
or mitigate potential conflicts of interest or other inappropriate
activities.\1551\
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\1551\ See, e.g., 15 U.S.C. 78c(a)(4)(B)(i)(I)-(IV) (finding
that disclosure and physical separation of personnel and activities
addresses the potential that consumers might be misled by the
broker-dealer activities of banks). 15 U.S.C. 80b-6(3) (``It shall
be unlawful for any investment adviser, by use of the mails or any
means or instrumentality of interstate commerce, directly or
indirectly . . . acting as principal for his own account, knowingly
to sell any security to or purchase any security from a client, or
acting as broker for a person other than such client, knowingly to
effect any sale or purchase of any security for the account of such
client, without disclosing to such client in writing before the
completion of such transaction the capacity in which he is acting
and obtaining the consent of the client to such transaction.''). See
also Form ADV, the form used by investment advisers to register with
the Securities and Exchange Commission and state securities
authorities, and, in particular, Form ADV Part 2: Uniform
Requirements for the Investment Adviser Brochure and Brochure
Supplements. A registered investment adviser generally must deliver
the Form ADV brochure, which contains disclosure about conflicts of
interest, to its prospective and existing clients. See 17 CFR
275.204-3; Amendments to Form ADV, Investment Advisers Act Release
No. 3060 (July 28, 2010), 75 FR 49234 (Aug. 12, 2010) (``We are
adopting a requirement that investment advisers registered with us
provide prospective and existing clients with a narrative brochure
written in plain English . . . We believe these amendments will
greatly improve the ability of clients and prospective clients to
evaluate firms offering advisory services and the firms' personnel,
and to understand relevant conflicts of interest that the firms and
their personnel face and their potential effect on the firms'
services.'').
---------------------------------------------------------------------------
In order to address and mitigate a conflict of interest through the
use of the information barriers pursuant to Sec. ----.8(b)(2) of the
proposed rule, a banking entity would be required to establish,
maintain, and enforce information barriers that are memorialized in
written policies and procedures, including physical separation of
personnel, functions, or limitations on types of activity, that are
reasonably designed, taking into consideration the nature of the
banking entity's business, to prevent the conflict of interest from
involving or resulting in a materially adverse effect on a client,
customer, or counterparty. Importantly, the proposed rule also provided
that, notwithstanding a banking entity's establishment of such
information barriers if the banking entity knows or should reasonably
know that a material conflict of interest arising out of a specific
transaction, class or type of transactions, or activity may involve or
result in a materially adverse effect on a client, customer, or
counterparty, the banking entity may not rely on those information
barriers to address and mitigate any conflict of interest. In such
cases, the transaction or activity would be prohibited, unless the
banking entity otherwise complied with the requirements of proposed
Sec. ----.8(b)(1).\1552\ This aspect of the proposal was intended to
make clear that, in specific cases in which a banking entity has
established an information barrier but knows or should reasonably know
that it has failed or will fail to prevent a conflict of interest
arising from a specific transactions or activity that disadvantages a
client, customer, or counterparty, the information barrier is
insufficient to address that conflict and the transaction would be
prohibited, unless the banking entity is otherwise able to address and
mitigate the conflict through timely and effective disclosure under the
proposal.\1553\
---------------------------------------------------------------------------
\1552\ See proposed rule Sec. ----.8(b)(2).
\1553\ See Joint Proposal, 76 FR 68,894.
---------------------------------------------------------------------------
The proposed definition of material conflict of interest did not
address instances in which a banking entity has made a material
misrepresentation to its client, customer, or counterparty in
connection with a transaction, class of transactions, or activity, as
such transactions or activity appears to involve fraud rather than a
conflict of interest. This is because such misrepresentations are
generally illegal under a variety of Federal and State regulatory
schemes (e.g., the Federal securities laws).\1554\ In addition, the
Agencies noted that any activity involving a material misrepresentation
to, or other fraudulent conduct with respect to, a client, customer, or
counterparty would not be permitted under the proposed rule in the
first instance.
---------------------------------------------------------------------------
\1554\ See 12 U.S.C. 1851(g)(3).
---------------------------------------------------------------------------
2. Comments on the Proposed Limitation on Material Conflicts of
Interest
Commenters expressed a variety of views regarding the treatment of
material conflicts of interest under the proposal, including the manner
in which conflicts may be mitigated or eliminated. One commenter
believed that the proposed material conflict of interest provisions
would be effective.\1555\ Another commenter stated that conflicts of
interest were unavoidable but that the final rule should ensure that
institutional investors have confidence that the banking entities they
are dealing with are not operating at a conflict with investors'
goals.\1556\
---------------------------------------------------------------------------
\1555\ See Alfred Brock.
\1556\ See Paul Volcker.
---------------------------------------------------------------------------
Other commenters expressed differing views on whether the proposed
rule's provisions for addressing conflicts of interest through
disclosure or information barriers were appropriate. A few commenters
stated there is no statutory basis for allowing conflicts of interest
in connection with exempted activities even if banking entities provide
disclosure or establish information barriers, and the rule should
prohibit banking entities from engaging in permitted activities if
material conflicts of interest exist.\1557\ One commenter believed the
definition did not appear to address issues of customer favoritism, in
which a bank is financially incentivized to treat one customer more
favorably than another (typically less sophisticated) customer.\1558\
Some commenters believed that the proposed definition of material
conflict of interest was too vague or narrow and suggested it should be
strengthened by either expanding the types of transactions that may
result in
[[Page 5661]]
a material conflict of interest or by imposing additional limitations
or restrictions on transactions.\1559\ For instance, one commenter
suggested the final rule consider depositors of a banking entity to be
``customers'' for the purpose of this provision, impose a fiduciary
duty on any banking entity conducting an exempt activity pursuant to
section 13(d)(1) of the BHC Act, and impose size restrictions on any
banking entity engaging in proprietary trading under an exemption. This
commenter also stated that a banking entity inherently has a material
conflict of interest with its customer when it takes the opposite side
of a transaction and, therefore, that the final rule should require a
banking entity to disgorge all principal gains from transactions
conducted pursuant to any exemption under section 13(d)(1) of the BHC
Act, including market-making, trading in U.S. government obligations,
insurance company activities and other exempt activities.\1560\ In
addition, a few commenters stated that, if disclosure or information
barriers were permitted to mitigates conflicts under the final rule,
clients of the banking entity must be required to acknowledge in
writing that they understand the potential conflicts of interest
present in order for any disclosure to be effective in mitigating a
conflict of interest.\1561\
---------------------------------------------------------------------------
\1557\ See Public Citizen; Sens. Merkley & Levin; Occupy; AFR et
al. (Feb. 2012).
\1558\ See Public Citizen.
\1559\ See, e.g., Occupy; AFR et al. (Feb. 2012); Sens. Merkley
& Levin (Feb. 2012).
\1560\ See Occupy.
\1561\ See, e.g., Lynda Aiman-Smith; AFR et al. (Feb. 2012);
Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------
Some commenters believed that the Agencies should consider issuing
additional guidance regarding the definition of material conflicts of
interest, high-risk assets, and high-risk trading strategies.\1562\ One
commenter stated that the final rule should limit the extraterritorial
impact of section 13 by only applying the restrictions of section
13(d)(2) of the BHC Act to the U.S. operations or activities of foreign
banking entities and that the regulation of safety and soundness of the
foreign operations and activities of foreign banking entities should be
left to the home country regulator or supervisor of a foreign banking
entity.\1563\
---------------------------------------------------------------------------
\1562\ See Rep. Blumenauer et al.; Sens. Merkley & Levin (Feb.
2012).
\1563\ See IIB/EBF; EBF.
---------------------------------------------------------------------------
Some commenters provided general suggestions on enhancing
compliance with the prohibition on material conflicts of interest. A
common suggestion among industry participants was to implement the
prohibition on material conflicts of interest under these rules in a
manner consistent with the implementation of section 621 of Dodd-
Frank.\1564\ One commenter suggested that trading in government
obligations should not be subject to the material conflict of interest
provision because government obligations are broadly traded and do not
present the types of conflicts addressed by the proposed rule.\1565\ In
contrast, one commenter stated banking entities should be required to
receive pre-trade clearance from the Federal Reserve for trading in
certain government obligations like municipal bonds and mortgage-backed
securities, due to their role in the 2008 financial crisis.\1566\
---------------------------------------------------------------------------
\1564\ See ASF (Conflicts) (Feb. 2012); SIFMA et al. (Prop.
Trading) (Feb. 2012); SIFMA (Securitization) (Feb. 2012); LSTA (Feb.
2012); Sens. Merkley & Levin (Feb. 2012).
\1565\ See BDA (Feb. 2012).
\1566\ See Occupy.
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a. Disclosure
Some commenters expressed concern about potential difficulties
associated with the proposed disclosure provision and provided
suggestions to address these difficulties. For example, a few
commenters noted the difficulty in determining what constitutes
effective disclosure,\1567\ especially in relation to the volume of
disclosure or the impact of information asymmetry in illiquid
markets.\1568\ One commenter stated that unless the rule requires full
disclosure of a banking entity's trading strategy and the rationale
behind it, allowing disclosure will permit the banking entity to
protect itself without adequately mitigating the harm of the conflict.
This commenter also noted the practical difficulties associated with
disclosing anticipated future conflicts and conflicts in the context of
block trading.\1569\ Another commenter stated market participants
understand inherent conflicts of interest and believed disclosure in
such situations would be burdensome and unnecessary.\1570\ One
commenter stated that the rule should require a banking entity to
negate, not just permit the client, customer, or counterparty to
substantially mitigate, the materially adverse effect of the
conflict.\1571\
---------------------------------------------------------------------------
\1567\ See Occupy; ISDA (Apr. 2012); Better Markets (Feb. 2012);
SIFMA et al. (Prop. Trading) (Feb. 2012); ICFR.
\1568\ See Occupy.
\1569\ See Public Citizen; See also AFR et al. (Feb. 2012).
\1570\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
\1571\ See Occupy.
---------------------------------------------------------------------------
A few commenters disagreed with the disclosure provision, noting
that Congress specifically considered and rejected disclosure as a
mitigation method for purposes of section 621 of the Dodd-Frank Act and
that this indicates the Agencies should not permit a material conflict
of interest to be mitigated through disclosure for purposes of section
13 of the BHC Act.\1572\
---------------------------------------------------------------------------
\1572\ See, e.g, Occupy.
---------------------------------------------------------------------------
Commenters were in disagreement as to the extent and timing of
disclosure that should be required under the rule. Some commenters
stated the disclosure provisions would slow trading, and suggested the
rule require only one-time disclosure at the inception of the business
relationship\1573 \ or periodic disclosures to address ongoing
conflicts.\1574\ One of these commenters noted that extensive trade-by-
trade disclosure requirements create the risk of unintended breaches of
confidentiality.\1575\ Other commenters requested the Agencies provide
additional guidance, such as when transaction-specific disclosure is
necessary,\1576\ whether disclosure should be written,\1577\ and what
constitutes ``reasonable detail.'' \1578\
---------------------------------------------------------------------------
\1573\ See ISDA (Apr. 2012); Arnold & Porter.
\1574\ See SIFMA et al. (Prop. Trading) (Feb. 2012); ISDA (Apr.
2012).
\1575\ See ISDA (Apr. 2012).
\1576\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
\1577\ See Sens. Merkley & Levin (Feb. 2012); ICFR (questioning
the effectiveness of enforcement mechanisms if oral disclosure
permitted under the rule); Occupy.
\1578\ See ICFR.
---------------------------------------------------------------------------
In addition, some commenters provided suggestions on whether
parties should be required to acknowledge receipt of disclosures \1579\
or affirmatively consent to the conflict.\1580\ One commenter proposed
allowing a majority of a committee of independent board members to
approve consent to waivers of conflicts of interest.\1581\ One
commenter believed disclosure and consent by a sophisticated investor
ought to be sufficient to serve as a waiver to most types of conflict
of interest.\1582\ In contrast, another commenter asserted general
disclosure or waivers of conflicts should never be allowed, and the
Agencies should not provide any additional guidance as to the extent,
timing, frequency, or scope of disclosure appropriate in any given
situation.\1583\ Similarly, one commenter asserted the Agencies should
not provide guidance on what issues can be addressed by disclosure, as
such guidance would be ``dangerously
[[Page 5662]]
prescriptive and would introduce moral hazards.'' \1584\
---------------------------------------------------------------------------
\1579\ See, e.g., Arnold & Porter; Sens. Merkley & Levin (Feb.
2012); Better Markets (Feb. 2012); Public Citizen; AFR et al. (Feb.
2012); Lynda Aiman-Smith.
\1580\ See Public Citizen; Sens. Merkley & Levin (Feb. 2012);
Better Markets (Feb. 2012).
\1581\ See Arnold & Porter.
\1582\ See Arnold & Porter.
\1583\ See Alfred Brock (stating there is no such thing as a
``sophisticated party'').
\1584\ See ICFR.
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Information Barriers
A few commenters addressed the information barriers provision of
the proposed rule. One commenter expressed support for the proposed
approach,\1585\ while three commenters stated this provision was
ineffective.\1586\ A few commenters opposed the information barriers
provision because they believed information barriers would make
conflict mitigation more difficult \1587\ or would effectively mandate
that no single officer be aware of a banking entity's collective
operations.\1588\
---------------------------------------------------------------------------
\1585\ See Alfred Brock.
\1586\ See Better Markets (Feb. 2012); Occupy; Public Citizen.
\1587\ See Occupy.
\1588\ See Public Citizen (contending that this would undermine
the Dodd-Frank Act's requirement to promote sound management, ensure
financial stability, and reduce systemic risk).
---------------------------------------------------------------------------
A few commenters also requested the Agencies provide guidance
regarding the use of information barriers. One commenter requested the
Agencies specify the type and nature of information barriers and where
they are practical to implement.\1589\ Another commenter believed that
the Agencies should view information barriers favorably. This commenter
stated that information barriers should be permitted for addressing
conflicts of interest unless the banking entity knows, or should
reasonably know, that the information barrier would not be effective in
restricting the spread of information that could lead to the
conflict.\1590\ To provide greater clarity, another commenter
recommended the Agencies provide guidance on certain elements that may
be used to determine the reasonableness of information barriers, such
as memorialization of procedures and documentation of actions taken
pursuant to such procedures.\1591\
---------------------------------------------------------------------------
\1589\ See AFR et al. (Feb. 2012).
\1590\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
\1591\ See ISDA (Apr. 2012) (arguing that its suggested guidance
was derived from prior SEC and self-regulatory organization guidance
on information barriers).
---------------------------------------------------------------------------
3. Final Rule
After considering carefully comments received on the proposal as
well as the purpose and language of section 13 of the BHC Act, the
Agencies have adopted the final rule largely as proposed. Under the
final rule, a banking entity that engages in any transaction, class of
transactions, or activity that would involve or result in the banking
entity's interests being materially adverse to the interests of its
client, customer, or counterparty with respect to the transaction,
class of transactions, or activity, must address and mitigate the
conflict of interest, where possible, through either timely and
effective disclosure or informational barriers.\1592\ This requirement
is in addition to, and does not supplant, any limitations or
prohibitions contained in other laws. For example, a material
misrepresentation by a banking entity to its client, customer, or
counterparty in connection with market-making activities may involve
fraud and is generally illegal under a variety of Federal and State
regulatory schemes (e.g., the Federal securities laws) \1593\ as well
as being prohibited under section 13 of the BHC Act.
---------------------------------------------------------------------------
\1592\ The Agencies note that the definition of material
conflict of interest and the disclosure provisions related to that
definition apply solely for purposes of the rule's definition of
material conflict of interest, and does not affect the scope of that
term in other contexts or a banking entity's obligation to comply
with additional or different requirements with respect to a conflict
under applicable securities, banking, or other laws (e.g., section
27B of the Securities Act, which governs conflicts of interest
relating to certain securitizations; section 206 of the Investment
Advisers Act of 1940, which applies to conflicts of interest between
investment advisers and their clients; or 12 CFR 9.12, which applies
to conflicts of interest in the context of a national bank's
fiduciary activities).
\1593\ See 12 U.S.C. 1851(g)(3).
---------------------------------------------------------------------------
The Agencies believe that certain of commenters' suggested
modifications to the proposed rule are outside the scope of the
Agencies' statutory authority. For example, the Agencies do not believe
section 13 of the BHC Act provides statutory authority to directly
impose limits on the size of banking entities \1594\ or to implement
specific fiduciary standards on banking entities.\1595\ In addition,
the Agencies do not believe it is appropriate to expand the definition
of ``customer'' to include individuals and entities that solely make
use of the bank's traditional banking services because section 13 is
focused on the trading activities and investment in which banking
entities may be involved.\1596\
---------------------------------------------------------------------------
\1594\ See Occupy.
\1595\ See Occupy.
\1596\ See Occupy.
---------------------------------------------------------------------------
The final rule recognizes that a banking entity may address or
substantially mitigate a potential conflict of interest by making
adequate disclosures or creating and enforcing informational barriers.
Some commenters argued that the legislative history of the Dodd-Frank
Act suggests that disclosure or informational barriers are not adequate
to address a material conflict of interest.\1597\ However, section 13
of the BHC Act directs the Agencies to define ``material conflict of
interest'' and gives the Agencies discretion to determine how to define
this term for purposes of the rule. Under the final rule, a material
conflict of interest exists when the banking entity engages in
transactions or activities that cause its interests to be materially
adverse to the interests of its client, customer, or counterparty. At
the same time, the final rule provides banking entities the opportunity
to take certain actions to address the conflict, such that the conflict
does not have a materially adverse effect on that client, customer, or
counterparty. Under the final rule, a banking entity may address a
conflict by establishing, maintaining, and enforcing information
barriers reasonably designed to avoid a conflict's materially adverse
effect, or by disclosing the conflict in a manner that allows the
client, customer, or counterparty to substantially mitigate or negate
any materially adverse effect created by the conflict of interest. The
Agencies believe that, to the extent the materially adverse effect of a
conflict has been substantially mitigated, negated, or avoided, it is
appropriate to allow the transaction, class of transaction, or activity
under the final rule. Continuing to view the conflict as a material
conflict of interest under these circumstances would not appear to
benefit the banking entity's client, customer, or counterparty. The
disclosure standard under the final rule requires clear and meaningful
information be provided to the client, customer, or counterparty in a
manner that provides such party the opportunity to negate or
substantially mitigate, any materially adverse effects on such party
created by the conflict.
---------------------------------------------------------------------------
\1597\ See Public Citizen; Sens. Merkley & Levin (Feb. 2012);
Occupy; AFR et al. (Feb. 2012).
---------------------------------------------------------------------------
Some commenters suggested that obtaining consent to or waiver of
disclosed conflicts should be sufficient to comply with the rule.\1598\
The Agencies do not believe that consent or waivers alone are
sufficient to address material conflicts of interest, and continue to
believe that any banking entity using disclosure to address a conflict
of interest should be required to provide any client, customer, or
counterparty with whom the banking entity has a conflict with the
opportunity to negate or substantially mitigate the materially adverse
effect of the conflict on the client, customer, or counterparty. The
Agencies believe this approach, which applies equally to all
[[Page 5663]]
types of clients, customers, or counterparties, will reduce the
potential for unintended or differing impacts on certain types of
clients, customers, or counterparties. In response to one commenter's
suggestion that the final rules require full negation of the materially
adverse effect on the client, customer, or counterparty, the Agencies
continue to believe it is appropriate to allow a transaction or
activity to continue if the client, customer, or counterparty is
provided an opportunity to substantially mitigate the materially
adverse effect.\1599\ The Agencies are concerned that requiring the
conflict's impact to be fully negated under all circumstances could
prevent a banking entity from providing a service to a particular
customer despite that customer's knowledge of the conflict and ability
to substantially reduce the effect of the conflict on that customer.
---------------------------------------------------------------------------
\1598\ See, e.g., Arnold & Porter.
\1599\ See Occupy.
---------------------------------------------------------------------------
With regards to commenters' statements that information barriers
and disclosure will not work to address the harm caused by conflicts,
the Agencies emphasize that under the final rule, like the proposed
rule, a banking entity may use disclosure or information barriers to
address a conflict only in those instances where the disclosure
provides the client, customer, or counterparty with the opportunity to
negate or substantially mitigate any materially adverse effect of the
conflict on that entity or the information barriers are reasonably
designed to prevent the conflict of interest from involving or
resulting in a materially adverse effect on a client, customer, or
counterparty. If the banking entity is unable to effectively use
disclosure or information barriers in a way that meets the rule's
requirements, then the banking entity is prohibited from engaging in
the conflicted transaction, class of transaction, or activity.
Additionally, the Agencies note that the material conflict of interest
provisions in the final rule do not preempt any duties owed to parties
outside the transaction, including any duty of confidentiality.\1600\
---------------------------------------------------------------------------
\1600\ See ISDA (Apr. 2012).
---------------------------------------------------------------------------
In response to commenters' statements that the volume of
information included in a disclosure or the manner in which the
disclosure is presented may make it difficult for a customer to
identify and understand the relevant information regarding the
conflict,\1601\ the Agencies note that the final rule requires
disclosure of the conflict or potential conflict be clear, timely, and
effective and that the disclosure includes any other necessary
information. Disclosure is also required to be provided in reasonable
detail and in a manner sufficient to permit a reasonable client,
customer, or counterparty to meaningfully understand the conflict of
interest.\1602\ Thus, disclosure that is only general or generic, that
omits details or other information that would be necessary to a
reasonable client's, customer's, or counterparty's understanding of the
conflict of interest, or that is hidden in a large volume of needless
information would not meet this standard. The Agencies believe these
provisions of the final rule are designed to ensure that customers
receive sufficient information about the conflict of interest so that
they are well informed and, as required by the rule, able to negate or
substantially mitigate any materially adverse effect of the conflict.
---------------------------------------------------------------------------
\1601\ See Better Markets (Feb. 2012) (suggesting that a
disclosure regime can facilitate abuse by enabling market
participants to point to obscure and meaningless disclosure as a
shield against liability); Occupy (arguing that a large volume of
disclosed information can be difficult to understand or can serve to
hide relevant information).
\1602\ See final rule Sec. ----.7(b)(1)(i) and final rule Sec.
----.16(b)(1)(i).
---------------------------------------------------------------------------
In addition to requiring that customers are provided with detailed
information about the conflict, the final rule, like the proposal,
requires that disclosure is made prior to effecting the specific
transaction or class or type of transactions, or engaging in the
specific activity, for which a conflict may arise and is otherwise
timely. As a result, under Sec. ----.7(b)(2)(i), disclosure must be
provided sufficiently close in time to the client's, customer's, or
counterparty's decision to engage in the transaction or activity to
give the client, customer, or counterparty an opportunity to
meaningfully evaluate and take steps that would negate or substantially
mitigate the conflict. This approach is similar to the approach
permitted by a variety of consumer protection statutes and regulations
for addressing potential conflicts of interest in consumer
transactions.\1603\
---------------------------------------------------------------------------
\1603\ See, e.g., 15 U.S.C. 78c(a)(4)(B)(i)(I)-(IV) (finding
that disclosure and physical separation of personnel and activities
addresses the potential that consumers might be misled by the
broker-dealer activities of banks); 15 U.S.C. 80b-6(3) (``It shall
be unlawful for any investment adviser, by use of the mails or any
means or instrumentality of interstate commerce, directly or
indirectly . . . acting as principal for his own account, knowingly
to sell any security to or purchase any security from a client, or
acting as broker for a person other than such client, knowingly to
effect any sale or purchase of any security for the account of such
client, without disclosing to such client in writing before the
completion of such transaction the capacity in which he is acting
and obtaining the consent of the client to such transaction.''). See
also Form ADV, the form used by investment advisers to register with
the Securities and Exchange Commission and state securities
authorities, and, in particular, Form ADV Part 2: Uniform
Requirements for the Investment Adviser Brochure and Brochure
Supplements. A registered investment adviser generally must deliver
the Form ADV brochure, which contains disclosure about conflicts of
interest, to its prospective and existing clients. See 17 CFR
275.204-3; Amendments to Form ADV, Investment Advisers Act Release
No. 3060 (July 28, 2010), 75 FR 49234 (Aug. 12, 2010) (``We are
adopting a requirement that investment advisers registered with us
provide prospective and existing clients with a narrative brochure
written in plain English . . . We believe these amendments will
greatly improve the ability of clients and prospective clients to
evaluate firms offering advisory services and the firms' personnel,
and to understand relevant conflicts of interest that the firms and
their personnel face and their potential effect on the firms'
services.'').
---------------------------------------------------------------------------
Some commenters requested that the final rule permit a conflict to
be negated or substantially mitigated through generic or periodic
disclosures, such as at the beginning of a trading relationship or on
an annual basis. Other commenters stated that some conflicts, such as
anticipated future conflicts or those that arise in the context of
block trading, may require the banking entity to provide disclosure in
advance of the actual conflict in order to allow the client, customer,
or counterparty the opportunity to mitigate the materially adverse
effect.\1604\ The Agencies emphasize, however, that disclosure provided
far in advance of a particular transaction, such that the client,
customer, or counterparty is unlikely to take that disclosure into
account when evaluating the transaction, would not suffice. At the same
time, disclosure provided without a sufficient period of time for the
client, customer, or counterparty to evaluate and act on the
information it receives, or disclosure provided after the fact, would
also not be permissible disclosure under the final rules. The Agencies
believe that, in considering the effectiveness of disclosures, the
type, timing and frequency of disclosures depends significantly on the
customer relationship, the type of transaction, and the matter that
creates the potential conflict. Therefore, while written disclosures
may be appropriate in certain circumstances, the Agencies are not
requiring banking entities to provide written disclosure,\1605\ or
obtain documentation showing that disclosure was received,\1606\
because the Agencies believe it is more important that disclosure is
timely than documented. For example, if disclosure were required
[[Page 5664]]
to be in writing, this might slow a banking entity's ability to provide
the disclosure to the relevant customer, which could impede the
customer's ability to consider the disclosed information and take steps
to negate or substantially mitigate the conflict's effect on the
customer. The Agencies further note that the final rule does not
prevent or require disclosure with respect to transactions or
activities that align the interests of the banking entity with its
clients, customers, or counterparties.
---------------------------------------------------------------------------
\1604\ See Public Citizen; See also AFR et al. (Feb. 2012).
\1605\ See Sens. Merkley & Levin (Feb. 2012); ICFR; Occupy;
Alfred Brock.
\1606\ See, e.g., Arnold & Porter; Sens. Merkley & Levin (Feb.
2012); Better Markets (Feb. 2012); Public Citizen; AFR et al. (Feb.
2012); Lynda Aiman-Smith.
---------------------------------------------------------------------------
As noted above, one commenter expressed concern about the burdens
of disclosing inherent conflicts and stated such disclosure is
unnecessary because market participants understand inherent conflicts
of interest.\1607\ As noted in the proposal, certain inherent
conflicts, such as the mere fact that the buyer and seller are on
opposite sides of a transaction and have differing economic interests,
would not be deemed a ``material'' conflict of interest with respect to
permitted activities.\1608\
---------------------------------------------------------------------------
\1607\ See SIFMA et al. (Prop. Trading) (Feb. 2012); but See
Occupy.
\1608\ See Joint Proposal, 76 FR 68,893. Thus, the Agencies are
not adopting one commenter's suggestion that the final rule consider
all transactions by a banking entity to involve a material conflict
of interest because the banking entity is necessarily on the
opposite side of a transaction with its client, customer, or
counterparty. See Occupy.
---------------------------------------------------------------------------
The Agencies continue to believe that information barriers can be
an effective means of addressing conflicts of interest that may arise
through, for example, the spread of information among trading desks
engaged in different trading activities that may result in potentially
inappropriate informational advantage. The Agencies are not adopting
one commenter's suggestion that the final rule specify the particular
types of scenarios where information barriers may be effective \1609\
because, as discussed below, the Agencies believe banking entities are
better positioned to determine when information barriers may be
effective given their trading activities and business structure.\1610\
In response to one commenter's concern that information barriers may
result in the banking entity's management not being aware of the firm's
collective operations,\1611\ the Agencies note that information
barriers do not require this result. Rather, information barriers would
be established between relevant personnel or functions while other
personnel, including senior managers, internal auditors, and compliance
personnel, would have access to each group separated by the barrier.
---------------------------------------------------------------------------
\1609\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
\1610\ The Agencies note examples of information barriers that
may address or substantially mitigate a material conflict of
interest include restrictions on information sharing, limits on
types of trading, prohibitions on common officers or employees
between functions. Such information barriers have been recognized in
Federal securities laws as a means to address or mitigate potential
conflicts of interest or other inappropriate activities. See, e.g.,
17 U.S.C. 78o(g).
\1611\ See Public Citizen.
---------------------------------------------------------------------------
The final rule continues to recognize that a banking entity may
address or substantially mitigate a conflict of interest through use of
information barriers. In order to address and mitigate a conflict of
interest through the use of the information barriers, a banking entity
is required to establish, maintain, and enforce information barriers
that are memorialized in written policies and procedures, including
physical separation of personnel, functions, or limitations on types of
activity, that are reasonably designed, taking into consideration the
nature of the banking entity's business, to prevent the conflict of
interest from involving or resulting in a materially adverse effect on
a client, customer or counterparty.\1612\ Importantly, the final rule
also provides that, notwithstanding a banking entity's establishment of
such information barriers, if the banking entity knows or should
reasonably know that a material conflict of interest arising out of a
specific transaction, class or type of transactions, or activity may
involve or result in a materially adverse effect on a client, customer,
or counterparty, the banking entity may not rely on those information
barriers to address and mitigate any conflict of interest. In such
cases, the transaction or activity would be prohibited, unless the
banking entity otherwise complied with the requirements of Sec. --
--.7(b)(2)(i).\1613\
---------------------------------------------------------------------------
\1612\ The Agencies note that a banking entity subject to
Appendix B of the final rule must implement a compliance program
that includes, among other things, policies and procedures that
explain how the banking entity monitors and prohibits conflicts of
interest with clients, customers, and counterparties. As part of
maintaining and enforcing information barriers, a banking entity
should have processes to review, test, and modify information
barriers on a continuing basis. In addition, banking entities should
have ongoing monitoring to maintain and to enforce information
barriers, for example by identifying whether such barriers have not
prevented unauthorized information sharing and addressing instances
in which the barriers were not effective. This may require both
remediating any identified breach as well as updating the
information barriers to prevent further breaches, as necessary.
Periodic assessment of the effectiveness of information barriers and
periodic review of the written policies and procedures are also
important to the maintenance and enforcement of effective
information barriers and reasonably designed policies and
procedures. Such assessments can be done either (i) internally by a
qualified employee or (ii) externally by a qualified independent
party. See Part IV.C.2.e., infra.
\1613\ If a conflict occurs to the detriment of a client,
customer, or counterparty despite an information barrier, the
Agencies would also expect the banking entity to review the
effectiveness of its information barrier and make adjustments, as
necessary, to avoid future occurrences, or review whether such
information barrier is appropriate for that type of conflict.
---------------------------------------------------------------------------
While some commenters requested that the final rule include
additional limitations as part of implementing the material conflict of
interest provisions in section 13(d)(2), the Agencies do not believe
additional restrictions are appropriate at this time. Concerns
regarding conflicts of interest are likely to be elevated when a
transaction is complex, highly structured or opaque, involves illiquid
or hard-to-value instruments or assets, requires the coordination of
multiple internal groups (such as multiple trading desks or affiliated
entities), or involves a significant asymmetry of information or
transactional data among participants.\1614\ In all cases, the question
of whether a material conflict of interest exists will depend on an
evaluation of the specific facts and circumstances. For example,
certain simple transactions may implicate conflicts of interest that
cannot be mitigated by disclosure or restricted by information
barriers. On the other hand, certain highly structured and complex
transactions may involve conflicts of interest that can be mitigated by
disclosure or restricted by information barriers.
---------------------------------------------------------------------------
\1614\ See, e.g., U.S. Senate Permanent Subcommittee on
Investigations, Wall Street and the Financial Crisis: Anatomy of a
Financial Collapse (Apr. 13, 2011), available at http://hsgac.senate.gov/public/_files/Financial_Crisis/FinancialCrisisReport.pdf.
---------------------------------------------------------------------------
The Agencies believe that conflicts of interest must be determined
and addressed in accordance with the specific facts and circumstances
presented. One commenter suggested that the proposed rule be modified
so that a banking entity could conclusively rely on information
barriers unless it knows or has reason to know that policies,
procedures, and controls establishing barriers would not be effective
in restricting the spread of information.\1615\ By focusing on whether
a banking entity knows or has reason to know that its policies and
procedures would not be effective, rather than on what the banking
entity knows or should reasonably know about a conflict of interest
that may involve or result in a material adverse effect on a client,
customer, or counterparty, the commenter's suggestion has the potential
to allow a banking entity to engage in transactions that involve a
material conflict of interest. Therefore, the Agencies have determined
not to
[[Page 5665]]
adopt the commenter's suggested approach. Similarly, the Agencies are
rejecting some commenters' suggestions that the final rule prescribe
the method, scope, or specific content of disclosures.\1616\ The
Agencies believe that specific guidance on disclosure may provide an
incentive for banking entities to consider the form of disclosure
provided, rather than whether disclosure can address the substance of
the conflict as determined by the specific facts and circumstances at
hand. Moreover, the Agencies believe banking entities are in the best
position to identify and evaluate the conflicts present in their
business as well as the most effective method of disclosing such
conflicts. Banking entities must tailor their compliance programs to
identify, monitor, and evaluate potential conflicts based on their
business structure and specific activities and customer
relationships.\1617\
---------------------------------------------------------------------------
\1615\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
\1616\ See Occupy; ISDA (Apr. 2012); Better Markets (Feb. 2012);
SIFMA et al. (Prop. Trading) (Feb. 2012); ICFR; Alfred Brock; Public
Citizen; AFR et al. (Feb. 2012); Arnold & Porter; Sens. Merkley &
Levin (Feb. 2012).
\1617\ For a full discussion of the final rule's compliance
requirements, including a discussion of the specific compliance
requirements applicable to different banking entities, See Part
IV.C. of this SUPPLEMENTARY INFORMATION, infra.
---------------------------------------------------------------------------
Finally, some commenters requested that the final rule specifically
address the conflict of interest provisions related to asset-backed
securitizations contained in section 621 of the Dodd-Frank Act. As
explained below in Part IV.B.1., some securitizations are subject to
the final rule, and others such as securitizations of loans are not
subject to section 13 of the BHC Act. For any securitization that meets
the definition of covered fund under the final rule, relationships with
and transactions by a banking entity involving those securitizations
remain subject to the requirements of section 13, including the
requirements of section 13(d)(2). In addition, the banking entity would
be subject to the limitations contained in section 621 of the Dodd-
Frank Act and any rules regarding conflicts of interest relating to
securitizations implemented under that section. The final rule in no
way limits the application of section 621 of that Act with respect to
an asset-backed security that is subject to that section.
b. Definition of ``High-Risk Asset'' and ``High-Risk Trading Strategy''
1. Proposed Rule
Section ----.8(c) of the proposed rule defined ``high-risk asset''
and ``high-risk trading strategy'' for purposes of the proposed
limitations on permitted trading activities. Proposed Sec. --
--.8(c)(1) defined a ``high-risk asset'' as an asset or group of assets
that would, if held by the banking entity, significantly increase the
likelihood that the banking entity would incur a substantial financial
loss or would fail. Proposed Sec. ----.8(c)(2) defined a ``high-risk
trading strategy'' as a trading strategy that would, if engaged in by
the banking entity, significantly increase the likelihood that the
banking entity would incur a substantial financial loss or would
fail.\1618\
---------------------------------------------------------------------------
\1618\ See Joint Proposal, 76 FR 68,894. The Agencies noted that
a banking entity subject to proposed Appendix C must implement a
compliance program that includes, among other things, policies and
procedures that explain how the banking entity monitors and
prohibits exposure to high-risk assets and high-risk trading
strategies, and identifies a variety of assets and strategies (e.g.,
assets or strategies with significant embedded leverage). See Joint
Proposal, 76 FR 68,894 n.215.
---------------------------------------------------------------------------
2. Comments on Proposed Limitations on High-Risk Assets and Trading
Strategies
With respect to the prohibition on transactions or activities that
expose banking entities to high-risk assets or high-risk trading
strategies, one commenter stated the provisions were effective,\1619\
while other commenters stated the proposed rule was too vague \1620\
and implied that banking entities may be required to exit positions in
periods of market stress, further reducing liquidity.\1621\ A few
commenters suggested the Agencies identify and prohibit certain types
of high-risk assets or high-risk trading strategies under the
rule.\1622\ In contrast, one commenter asserted the Agencies should not
specify certain classes of assets or trading strategies as ``high
risk.'' \1623\ A few commenters requested greater clarity on the
proposed definitions and suggested the Agencies provide additional
guidance.\1624\ One of these commenters suggested the Agencies simplify
compliance by establishing safe harbors, setting pre-determined risk
limits within risk-based approaches, or allowing individual banking
entities to set practical risk-based standards that the Agencies can
review.\1625\
---------------------------------------------------------------------------
\1619\ See Alfred Brock.
\1620\ See AFR et al. (Feb. 2012); Japanese Bankers Ass'n.;
Investure; AllianceBernstein; Comm. on Capital Markets Regulation.
\1621\ See Obaid Syed.
\1622\ See Sens. Merkley & Levin (Feb. 2012); Johnson & Prof.
Stiglitz; Occupy.
\1623\ See Alfred Brock.
\1624\ See Japanese Bankers Ass'n.; Sens. Merkley & Levin (Feb.
2012); Occupy; Public Citizen.
\1625\ See Japanese Bankers Ass'n.
---------------------------------------------------------------------------
One commenter suggested integrating the ban on high-risk activities
throughout the rule and stated that, given the evolving nature of
financial markets, regulators should have the flexibility to update
criteria for identifying high-risk assets or high-risk trading
strategies.\1626\ This commenter stated the definition of high-risk
trading strategies was appropriately broad and flexible, but suggested
improving the rule by encompassing trading strategies that are so
complex the risk or value thereof cannot be reliably and objectively
determined.\1627\ The commenter also suggested that the quantitative
measurements collected under proposed Appendix A could be utilized to
help inform whether a high-risk asset or trading strategy exists.\1628\
---------------------------------------------------------------------------
\1626\ See Sens. Merkley & Levin (Feb. 2012).
\1627\ See Sens. Merkley & Levin (Feb. 2012).
\1628\ See Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------
One commenter stated that in large concentrations, all assets can
be high risk. This commenter suggested evaluating transactions on a
case-by-case basis and believed all activity exempted under section
13(d)(1) of the BHC Act should be viewed as ``high-risk'' absent prior
regulatory approval. This commenter further suggested that high-risk
assets or trading strategies be defined to include any asset or trading
strategy that would have forced a banking entity to exit the market
during the 2008 financial crisis, and that leverage, rehypothecation,
concentration limits, and high frequency trading should be viewed as
indicia of high-risk trading strategies. Finally, this commenter
suggested the Agencies require banking entity CEOs to certify that
their institution's activities do not result in a material exposure to
high-risk assets or high-risk trading strategies.\1629\
---------------------------------------------------------------------------
\1629\ See Occupy.
---------------------------------------------------------------------------
3. Final Rule
After considering carefully the comments received, the Agencies
have modified the final rule to provide that a high-risk asset means an
asset or group of assets that would, if held by a banking entity,
significantly increase the likelihood that the banking entity would
incur a substantial financial loss or would pose a threat to the
financial stability of the United States. Similarly, the final rule
defines high-risk trading strategy to include any strategy that would,
if engaged in by a banking entity, significantly increase the
likelihood that the banking entity would incur a substantial financial
loss or would pose a threat to the financial stability of the United
States.
Importantly, under the final rule, banking entities that engage in
activities
[[Page 5666]]
pursuant to an exemption must have a reasonably designed compliance
program in place to monitor and understand whether it is exposed to
high-risk assets or trading strategies. For instance, any banking
entity engaged in activity pursuant to the market-making exemption in
Sec. ----.4(b) must, as part of its compliance program, have
reasonably designed written policies and procedures, internal controls,
analysis and independent testing regarding the limits for each trading
desk, including limits on the level of exposures to relevant risk
factors that the trading desk may incur. These policies and procedure
and any activity conducted pursuant to the final rule will be evaluated
by the Agencies, as appropriate, as part of ensuring the safety and
soundness of banking entities and monitoring for exposures to high-risk
activities or assets.
While some commenters stated that the definition of high risk asset
or trading strategy should be more clearly defined, the Agencies
believe that it is appropriate to include a broad definition of these
terms that accounts for different facts and circumstances that may
impact whether a particular asset or trading strategy is high-risk with
respect to a banking entity. As stated by commenters, this framework is
effective and flexible enough to be utilized by the Agencies in a
variety of contexts. For instance, a trading strategy or asset may be
high-risk to one banking entity but not another, or may be high-risk to
a banking entity under some market conditions but not others. As part
of evaluating whether a banking entity is exposed to a high-risk asset
or trading strategy, the Agencies expect that a variety of factors will
be considered, such as the presence of excess leverage, rehypothecation
or excessively high concentration of assets, or unsafe and unsound
trading strategies.
We believe an approach limiting this provision's applicability to
certain permitted activities or creating a safe harbor for certain
assets or trading strategies would be inconsistent with the statutory
language, which prohibits any permitted activity that involves or
results in a material exposure to a high-risk asset or high-risk
trading strategy.\1630\ In addition, the Agencies decline to identify
any particular assets or trading strategies as per se high-risk because
a determination of the specific risk posed to a banking entity depends
on the facts and circumstances.\1631\ Certain facts and circumstances
may include, but are not limited to, the amount of capital at risk in a
transaction, whether or not the transaction can be hedged, the amount
of leverage present in the transaction, and the general financial
condition of the banking entity engaging in the transaction. In
response to one commenter's recommendation that the Agencies adopt a
CEO certification requirement specific to the high-risk
provisions,\1632\ the Agencies believe such a requirement is
unnecessary in light of the required management framework in the
compliance program provision of Sec. ----.20 of the final rule, as
well as the CEO certification requirement included in the final
rule.\1633\
---------------------------------------------------------------------------
\1630\ See BDA (Feb. 2012); Japanese Bankers Ass'n.
\1631\ See Occupy.
\1632\ See Occupy.
\1633\ See Sec. ----.20 and Appendix B of the final rule, also
discussed in Part IV.C., infra.
---------------------------------------------------------------------------
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
Finally, as the Agencies did not receive any comments on the
proposed rule's limitations on permitted activities that pose a threat
to the safety and soundness of the banking entity or to the financial
stability of the United States and the proposed approach mirrored the
statutory language, the Agencies have determined no changes to final
rule are necessary.
B. Subpart C--Covered Fund Activities and Investments
As noted above and except as otherwise permitted, section
13(a)(1)(B) of the BHC Act generally prohibits a banking entity from
acquiring or retaining any ownership in, or acting as sponsor to, a
covered fund.\1634\ Section 13(d) of the BHC Act contains certain
exemptions to this prohibition. Subpart C of the final rule implements
these and other provisions of section 13 related to covered funds.
Additionally, subpart C contains a discussion of the internal controls,
reporting and recordkeeping requirements applicable to covered fund
activities and investments, and incorporates by reference the minimum
compliance standards for banking entities contained in subpart D of the
final rule, as well as Appendix B, to the extent applicable.
---------------------------------------------------------------------------
\1634\ See 12 U.S.C. 1851(a)(1)(B).
---------------------------------------------------------------------------
1. Section ----.10: Prohibition on Acquisition or Retention of
Ownership Interests in, and Certain Relationships With, a Covered Fund
Section ----.10 of the final rule defines the scope of the
prohibition on the acquisition and retention of ownership interests in,
and certain relationships with, a covered fund. It also defines a
number of key terms, including the definition of covered fund.
The term ``covered fund'' specifies the types of entities to which
the prohibition contained in Sec. ----.10(a) applies, unless the
activity is specifically permitted under an available exemption
contained in subpart C of the final rule.\1635\ The final rule modifies
the proposed definition of covered fund in a number of key aspects. The
Agencies have defined the term ``covered fund'' with reference to
sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940
(``Investment Company Act'') with some additions and subject to a
number of exclusions, several of which have been modified from
permitted activity exemptions included in the proposal.
---------------------------------------------------------------------------
\1635\ See final rule Sec. Sec. ----.10(b)-(c). The term
banking entity is defined in final rule Sec. ----.2(c).
---------------------------------------------------------------------------
The Agencies have tailored the final definition to include entities
of the type that the Agencies believe Congress intended to capture in
its definition of private equity fund and hedge fund in section
13(h)(2) of the BHC Act by reference to section 3(c)(1) and 3(c)(7) of
the Investment Company Act. Thus, the final definition focuses on the
types of entities formed for the purpose of investing in securities or
derivatives for resale or otherwise trading in securities or
derivatives, and that are offered and sold in offerings that do not
involve a public offering, but typically involve offerings to
institutional investors and high-net worth individuals (rather than to
retail investors). These types of funds are not subject to all of the
securities law protections applicable with respect to funds that are
registered with the SEC as investment companies, and the Agencies
therefore believe that these types of entities may be more likely to
engage in risky investment strategies. At the same time, the Agencies
have tailored the definition to exclude entities that have more general
corporate purposes and do not present the same risks for banking
entities as those associated with the funds described above, as well as
certain other entities as further discussed below.
The final rule also contains a revised version of the proposal's
treatment of certain foreign funds as covered funds, which has been
modified from the proposal and tailored to include only the types of
foreign funds that the Agencies believe are intended to be the focus of
the statute, such as certain foreign funds that are established by
[[Page 5667]]
U.S. banking entities and not otherwise subject to the Investment
Company Act.
The Agencies have not included all commodity pools within the
definition of covered fund as proposed. Instead, and as discussed in
more detail below, the Agencies have included only commodity pools for
which the commodity pool operator has claimed exempt pool status under
section 4.7 of the CFTC's regulations or that could qualify as exempt
pools and which have not been publicly offered \1636\ to persons who
are not qualified eligible persons under section 4.7 of the CFTC's
regulations.\1637\ Qualified eligible persons are typically
institutional investors, banking entities and high net worth
individuals (rather than retail investors). This more tailored
approach, together with the various exclusions from the covered fund
definition in the final rule, is designed to include as covered funds
those commodity pools that are similar to funds that rely on section
3(c)(1) or 3(c)(7) while not also including as covered funds entities,
like commercial end-users or registered investment companies, whose
activities do not implicate the concerns that section 13 was designed
to address.
---------------------------------------------------------------------------
\1636\ See infra note 1721 and accompanying text regarding the
meaning of the term ``offer'' as used in the final rule's inclusion
of certain commodity pools as covered funds.
\1637\ See final rule Sec. ----.10(b)(1)(ii).
---------------------------------------------------------------------------
Finally, other related terms, including ``ownership interest,''
``resident of the United States,'' ``sponsor,'' and ``trustee,'' are
also defined in Sec. ----.10(d) of the final rule.\1638\ As explained
below, these terms are largely defined in the same manner as in the
proposal although with certain changes, including changes to help
clarify the scope of these definitions as requested by commenters. Some
of these terms and related provisions also have been reorganized to
improve clarity. As explained in more detail below, the Agencies
received a number of comments relating to some of the terms defined in
Sec. ----.10. Some comments directly relate to the scope of the
proposed rule and the economic effects associated with the prohibitions
on covered funds activities and investments, some of which commenters
argued did not further the purposes of section 13.\1639\ The Agencies
have carefully considered these and other comments when defining the
key terms used in the statute and in providing certain exclusions to
the definition of the term covered fund. The Agencies also have sought
to provide guidance below, where appropriate, on how these key terms
would operate in order to better enable banking entities to understand
their obligations under section 13 and the final rule.
---------------------------------------------------------------------------
\1638\ See final rule Sec. ----.10(d)(6), (8), (9), and (10).
\1639\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012); BoA;
Goldman (Covered Funds); Rep. Himes; SVB; Scale.
---------------------------------------------------------------------------
a. Prohibition Regarding Covered Fund Activities and Investments
Section ----.10(a) of the final rule implements section 13(a)(1)(B)
of the BHC Act and prohibits a banking entity from, directly or
indirectly, acquiring or retaining as principal an equity, partnership,
or other ownership interest in, or acting as sponsor to, a covered
fund, unless otherwise permitted under subpart C of the final
rule.\1640\ This provision of the rule reflects the statutory
prohibition.
---------------------------------------------------------------------------
\1640\ See final rule Sec. ----.10(a).
---------------------------------------------------------------------------
The general prohibition in Sec. ----.10(a) of the proposed rule
applied solely to the acquisition or retention of an ownership interest
in, or acting as sponsor to, a covered fund, ``as principal.'' \1641\
Commenters generally supported this approach, arguing that applying the
prohibition related to covered fund activities and investments by a
banking entity only to instances where the banking entity acts as
principal is consistent with the statutory focus on principal
activity.\1642\ The final rule takes this approach as discussed below.
---------------------------------------------------------------------------
\1641\ See proposed rule Sec. ----.10(a); See also Joint
Proposal, 76 FR 68,896.
\1642\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012);
SIFMA et al. (Mar. 2012).
---------------------------------------------------------------------------
The proposed rule and preamble accompanying it described potential
exemptions from the definition of ownership interest for a variety of
interests, including interests related to employee benefit plans,
interests held in the ordinary course of collecting a debt previously
contracted, positions as trustee, or interests acquired as agent,
broker or custodian. Commenters provided information on each of these
types of ownership interests, and generally supported excluding each of
these from the section's prohibition on acquiring or retaining an
ownership interest in a covered fund.
A significant number of commenters focused on employee benefit
plans. Commenters generally argued that the prohibition in section
13(a) of the BHC Act did not encompass interests held on behalf of
employees through an employee benefit plan. While the proposed rule did
not explicitly cover certain ``qualified plans'' under the Internal
Revenue Code, a number of commenters argued that the prohibition should
not cover activity or investments related to other types of employee
benefit plans that are not a ``qualified plan'' under the Internal
Revenue Code.\1643\ A significant number of commenters urged exclusion
of interests in and relationships with foreign employee benefit
plans.\1644\ Commenters argued that the risks of investments made
through employee benefit plans are borne by the employee beneficiaries
of these plans, and any decision to cover employee benefit plans or
investments made by these plans under the prohibitions in section 13 of
the BHC Act would eliminate or severely restrict the availability of
employee programs that are widely offered, regulated and endorsed under
a system of Federal, state and foreign laws.\1645\
---------------------------------------------------------------------------
\1643\ See Credit Suisse (Williams); Arnold & Porter; UBS; Hong
Kong Inv. Funds Ass'n.
\1644\ See, e.g., Credit Suisse (Williams); Arnold & Porter;
UBS; NAB; Hong Kong Inv. Funds Ass'n; Australian Bankers Ass'n.
(Feb. 2012).
\1645\ See, e.g., Arnold & Porter.
---------------------------------------------------------------------------
Commenters also supported the exemption under the proposed rule for
holdings in satisfaction of a debt previously contracted in good
faith.\1646\ This provision of the proposal recognized that banking
entities may acquire an ownership interest in or relationship with a
covered fund as a result of a counterparty's failure to repay a bona
fide debt and without an intent to engage in those activities as
principal.\1647\
---------------------------------------------------------------------------
\1646\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012); LSTA
(Feb. 2012).
\1647\ See proposed rule Sec. ----.14(b).
---------------------------------------------------------------------------
Several commenters urged revision to the proposal to add a specific
exclusion for investments held by a banking entity in the capacity of
trustee (including as trustee for a charitable trust).\1648\ These
commenters argued that failing to recognize and exempt these types of
activities in the final rule would prevent banking entities that act as
trustees from effectively meeting their trust and fiduciary obligations
and from providing these services to customers. Commenters also argued
that the exemption for trust activities should not be dependent on the
duration of the trust because the law governing the duration of trusts
is changing and varies across jurisdictions.\1649\
---------------------------------------------------------------------------
\1648\ See, e.g., ABA (Keating).
\1649\ See, e.g., ABA (Keating); Arnold & Porter; NAB.
---------------------------------------------------------------------------
As with the proposed rule, the prohibition in Sec. ----.10(a) of
the final rule applies only to the acquisition or retention of an
ownership interest in, or sponsorship of, a covered fund as
[[Page 5668]]
principal. The Agencies continue to believe section 13 of the BHC Act
was designed to address the risks attendant to principal activity and
not those that are borne by customers of the banking entity or for
which the banking entity lacks design or intent to take a proprietary
interest as principal.
In order to address commenter concerns regarding the types of
activity that are subject to the prohibition, the Agencies have
modified and reorganized the final rule to make the scope of acting
``as principal'' clear and more consistent with the proprietary trading
restrictions under the final rule.\1650\ The final rule provides that
the prohibition does not include acquiring or retaining an ownership
interest in a covered fund by a banking entity: (1) Acting solely as
agent, broker, or custodian, so long as the activity is conducted for
the account of, or on behalf of, a customer, and the banking entity and
its affiliates do not have or retain beneficial ownership of the
ownership interest;\1651\ (2) through a deferred compensation, stock-
bonus, profit-sharing, or pension plan of the banking entity (or an
affiliate thereof) that is established and administered in accordance
with the law of the United States or a foreign sovereign, if the
ownership interest is held or controlled directly or indirectly by a
banking entity as trustee for the benefit of people who are or were
employees of the banking entity (or an affiliate thereof); \1652\ (3)
in the ordinary course of collecting a debt previously contracted in
good faith, provided that the banking entity divests the ownership
interest as soon as practicable, and in no event may the banking entity
retain such instrument for longer than such period permitted by the
appropriate agency; or (4) on behalf of customers as trustee or in a
similar fiduciary capacity for a customer that is not a covered fund,
so long as the activity is conducted for the account of, or on behalf
of, the customer, and the banking entity and its affiliates do not have
or retain beneficial ownership of such ownership interest.\1653\
---------------------------------------------------------------------------
\1650\ See final rule Sec. ----.3(d)(7) (9).
\1651\ A banking entity acting as agent, broker, or custodian is
not acting ``as principal'' under the final rule so long as the
activity is conducted for the account of, or on behalf of, a
customer and the banking entity does not have or retain beneficial
ownership of such ownership interest, as noted above. This provision
is consistent with the final rule's treatment of banking entities
acting on behalf of customers as trustee or in a fiduciary capacity.
\1652\ The Agencies note that this provision does not permit
joint investments between the banking entity and its employees.
Rather, this provision is intended to enable banking entities to
maintain deferred compensation and other similar plans formed for
the benefit of employees. The Agencies recognize that, since it is
possible an employee may forfeit its interest in such a plan, the
banking entity may have a residual or reversionary interest in the
assets referenced under the plan. However, other than such residual
or reversionary interests, a banking entity may not rely on this
provision to invest in a covered fund.
\1653\ See final rule Sec. ----.10(a)(2). For instance, as part
of engaging in its traditional trust company functions, a bank or
savings association typically may act through an entity that is
excluded from the definition of investment company under section
3(c)(3) or 3(c)(11). This would be included within the scope of
acting on behalf of customers as trustee or in a similar fiduciary
capacity, provided that it meets the applicable requirements of the
exclusion under the final rule.
---------------------------------------------------------------------------
Because these activities do not involve the banking entity engaging
in an activity intended or designed to take ownership interests in a
covered fund as principal, they do not appear to be the types of
activities that section 13 of the BHC Act was designed to address.
However, the Agencies note that in order to prevent a banking entity
from evading the requirements of section 13 and the final rule, the
exclusions for these activities do not permit a banking entity to
engage in establishing, organizing and offering, or acting as sponsor
to a covered fund in a manner other than as permitted elsewhere in the
final rule. The Agencies intend to monitor these activities and
investments for efforts to evade the restrictions in section 13 of the
BHC Act and the final rule on banking entities' investments in and
relationships with covered funds.
b. ``Covered Fund'' Definition
Section 13(h)(2) of the BHC Act defines hedge fund and private
equity fund to mean an issuer that would be an investment company, but
for section 3(c)(1) or 3(c)(7) of the Investment Company Act, or ``such
similar funds'' as the Agencies determine by rule.\1654\ Given that the
statute defines ``hedge fund'' and ``private equity fund'' without
differentiation, the proposed rule and the final rule combine the terms
into the definition of a ``covered fund.'' Sections 3(c)(1) and 3(c)(7)
of the Investment Company Act are exclusions commonly relied on by a
wide variety of entities that would otherwise be covered by the broad
definition of ``investment company'' contained in that Act.\1655\ The
proposal included as a covered fund any entity that would be an
investment company but for the exclusion from that definition contained
in section 3(c)(1) or 3(c)(7) of the Investment Company Act, any
foreign entity that would also be an investment company but for those
same exclusions were the foreign entity to be organized or offered in
the United States, and a commodity pool as defined in section 1a(10) of
the Commodity Exchange Act.\1656\ The preamble to the proposal
recognized that this definition was broad and specifically requested
comment on whether and how the definition of covered fund should be
modified for purposes of the final rule.
---------------------------------------------------------------------------
\1654\ See 12 U.S.C. 1851(h)(2).
\1655\ 12 U.S.C. 1851(h)(2). Sections 3(c)(1) and 3(c)(7) of the
Investment Company Act, in relevant part, provide two exclusions
from the definition of ``investment company'' for: (1) Any issuer
whose outstanding securities are beneficially owned by not more than
one hundred persons and which is not making and does not presently
propose to make a public offering of its securities (other than
short-term paper); or (2) any issuer, the outstanding securities of
which are owned exclusively by persons who, at the time of
acquisition of such securities, are qualified purchasers, and which
is not making and does not at that time propose to make a public
offering of such securities. See 15 U.S.C. 80a-3(c)(1) and (c)(7).
\1656\ See proposed rule Sec. ----.10(b)(1).
---------------------------------------------------------------------------
Commenters contended that the definition of covered fund should not
focus exclusively on whether an entity relies on section 3(c)(1) or
3(c)(7) of the Investment Company Act. Commenters argued that sections
3(c)(1) and 3(c)(7) of the Investment Company Act are exclusions
commonly relied on by a wide variety of entities that would otherwise
be covered by the broad definition of ``investment company'' contained
in that Act. Under the Investment Company Act, any entity that holds
investment securities (i.e., generally all securities other than U.S.
government securities) representing at least 40 percent of the entity's
total assets would be an investment company.\1657\ According to
commenters, this definition and the accompanying exclusions are part of
a securities law and regulatory framework designed for purposes
different than the prudential purpose that underlies section 13 of the
BHC Act.\1658\
---------------------------------------------------------------------------
\1657\ 15 U.S.C. 80a-3(a)(1)(A) & (C). The definition of
securities is very broad under the Investment Company Act and has
been interpreted to include instruments such as loans, that would
not be regarded as securities under the Securities Act of 1933 and
the Securities Exchange Act of 1934. In addition, the determination
of what constitutes an ``investment security'' under the Investment
Company Act requires complex analysis and consideration of a broad
set of facts and circumstances.
\1658\ See, e.g., NVCA.
---------------------------------------------------------------------------
A number of comments received on the proposal argued that the
proposed definition of covered fund was overly broad and would lead to
anomalous results inconsistent with the words, structure, and purpose
of section 13.\1659\ For instance, many commenters asserted that the
proposed rule's definition of covered fund would cause a number of
commonly used corporate entities that are not traditionally thought of
as hedge
[[Page 5669]]
funds or private equity funds, such as wholly-owned subsidiaries, joint
ventures, and acquisition vehicles, to be subject to the covered fund
restrictions of section 13. These commenters argued that this
interpretation of section 13 would cause a disruption to the operations
of banking entities and their closely related affiliates that does not
relate to the intent of section 13 and therefore cause an unnecessary
burden on banking entities. Commenters argued that the words, structure
and purpose of section 13 allow the Agencies to adopt a more tailored
definition of covered fund that focuses on vehicles used for investment
purposes that were the target of section 13's restrictions.
---------------------------------------------------------------------------
\1659\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012);
BlackRock; AHIC; Sen. Carper et al.; Rep. Garrett et al.
---------------------------------------------------------------------------
In particular, commenters requested that the final rule exclude at
least the following from the definition of covered fund: U.S.
registered investment companies (including mutual funds); the foreign
equivalent of U.S. registered investment companies; business
development companies; wholly-owned subsidiaries; joint ventures;
acquisition vehicles; financial market utilities; foreign pension or
retirement funds; insurance company separate accounts; loan
securitizations, including asset-backed commercial paper conduits; cash
management vehicles or cash collateral pools; credit funds; real estate
investment trusts; various securitization vehicles; tender option bond
programs; and venture capital funds.\1660\ Commenters requested some of
these exclusions in order to mitigate the impact of the proposal's
inclusion of commodity pools as part of the definition of covered
fund.\1661\
---------------------------------------------------------------------------
\1660\ See ABA (Keating); ABA (Abernathy); SIFMA et al. (Covered
Funds) (Feb. 2012); Allen & Overy (on behalf of Foreign Bank Group);
Allen & Overy (on behalf of Canadian Banks); Deutsche Bank
(Repackaging Transactions); ICI (Feb. 2012); Putnam; JPMC; GE (Feb.
2012); Chamber (Feb. 2012); Rep. Himes; BOK; Ass'n. of Institutional
Investors (Feb. 2012); Wells Fargo (Covered Funds); BoA; NAIB et
al.; PNC; SunTrust; Nationwide; STANY; BNY Mellon et al.; RMA;
Goldman (Covered Funds); Japanese Bankers Ass'n; IRSG; ISDA (Feb.
2012); IIB/EBF; Citigroup (Jan. 2012); SSgA (Feb. 2012); State
Street (Feb. 2012); Eaton Vance; Fidelity; SBIA; River Cities;
Ashurst; Sen. Hagan; Sen. Bennet.
\1661\ As discussed below, the Agencies have modified the final
rule to include only certain commodity pools within the definition
of covered fund.
---------------------------------------------------------------------------
Some commenters argued that the proposal failed to distinguish
between different types of investment funds.\1662\ These commenters
expressed the view that the statute provides the Agencies with the
discretion to distinguish between investment funds generally and a
subset of funds--hedge funds and private equity funds--that may engage
in particularly risky trading and investment activities. For example,
several commenters argued that the proposed rule's restrictions on
covered fund investments should not cover venture capital funds that
provide investment capital to new businesses.\1663\ Others argued for
an exclusion for securitization vehicles such as securitizations that
are backed, in whole or in part, by assets that are not loans,
including corporate debt repackagings,\1664\ CLOs,\1665\ ABCP
conduits,\1666\ insurance-linked securities,\1667\ and synthetic
securitizations backed by derivatives.\1668\
---------------------------------------------------------------------------
\1662\ See NVCA; See also SIFMA et al. (Covered Funds) (Feb.
2012); ABA (Keating).
\1663\ See, e.g., ABA (Keating); ABA (Abernathy); Canaan
(Young); Canaan (Ahrens); Canaan (Kamra); Growth Managers; River
Cities; SVB; EVCA.
\1664\ See AFME et al.; Allen & Overy (on behalf of Foreign Bank
Group); ASF (Feb. 2012); Cleary Gottlieb; Deutsche Bank (Repackaging
Transactions); SIFMA (Securitization) (Feb. 2012).
\1665\ See SIFMA (Securitization) (Feb. 2012); Allen & Overy (on
behalf of Foreign Bank Group); ASF (Feb. 2012); Cleary Gottlieb;
Credit Suisse (Williams); JPMC; LSTA (Feb. 2012).
\1666\ See Allen & Overy (on behalf of Foreign Bank Group); ASF
(Feb. 2012); Credit Suisse (Williams); Eaton Vance; Fidelity; GE
(Feb. 2012); GE (Aug. 2012); ICI (Feb. 2012); IIB/EBF; JPMC; PNC;
RBC; SIFMA (Securitization) (Feb. 2012); AFME et al.
\1667\ See AFME et al.; SIFMA (Securitization) (Feb. 2012).
\1668\ See AFME et al.; ASF (Feb. 2012); Cleary Gottlieb; Credit
Suisse (Williams); SIFMA (Securitization) (Feb. 2012); ABA
(Keating).
---------------------------------------------------------------------------
As a potential solution to some of these concerns, a number of
commenters argued that the Agencies should define covered fund by
reference to characteristics that are designed to distinguish hedge
funds and private equity funds from other types of entities that rely
on section 3(c)(1) or 3(c)(7) of the Investment Company Act.\1669\
Commenters believed this approach would help exclude some of the
corporate vehicles and funds mentioned above that they did not believe
were intended by Congress to be included as hedge funds and private
equity funds and therefore reduce costs that, in the commenters' view,
did not further the purposes of section 13.\1670\
---------------------------------------------------------------------------
\1669\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012);
BlackRock; Credit Suisse (Williams); SSgA (Feb. 2012); State Street
(Feb. 2012); Deutsche Bank (Repackaging Transactions); Allen & Overy
(on behalf of Foreign Bank Group).
\1670\ See SIFMA et al. (Covered Funds) (Feb. 2012); AFME et al;
Allen & Overy (on behalf of Foreign Bank Group); ASF (Feb. 2012);
Ashurst; Barclays; BDA (Feb. 2012); Credit Suisse (Williams);
Commercial Real Estate Fin. Council; Fidelity; ICI (Feb. 2012); ISDA
(Feb. 2012); JPMC; Nuveen Asset Mgmt.; PNC; RBC; SIFMA et al.
(Covered Funds) (Feb. 2012); SIFMA (Municipal Securities) (Feb.
2012); SSgA (Feb. 2012); State Street (Feb. 2012); Vanguard; Wells
Fargo (Covered Funds).
---------------------------------------------------------------------------
These commenters proposed a number of different potential types of
characteristics for defining hedge fund and private equity fund. Some
commenters focused on certain structural or investment characteristics
found in traditional private equity funds and hedge funds, such as
investor redemption rights, performance compensation fees, leverage and
the use of short-selling.\1671\ Another commenter argued that the
characteristics used to define a covered fund should focus on the types
of speculative behavior that the statute was intended to address,
citing characteristics such as volatility of asset performance and high
leverage.\1672\
---------------------------------------------------------------------------
\1671\ See Ass'n. of Institutional Investors (Feb. 2012);
Barclays; JPMC; SIFMA et al. (Covered Funds) (Feb. 2012); See also
FSOC study at 62-63 (suggesting a characteristics-based approach
considering compensation structure; trading/investment strategy; use
of leverage; investor composition); ABA (Keating); BNY Mellon et
al.; Northern Trust, SSgA (Feb. 2012); State Street (Feb. 2012);
Deutsche Bank (Repackaging Transactions); T. Rowe Price; RMA
(suggesting use of characteristics derived from the SEC's Form PF
for registration of investment advisers of private funds).
\1672\ See RBC (citing FSOC study).
---------------------------------------------------------------------------
In contrast to the majority of the commenters, one commenter urged
that characteristics be used to expand the proposed definition to
include any issuer that exhibits characteristics of proprietary trading
that the statute prohibits to be done by a banking entity.\1673\
According to this commenter, any fund engaging in more than minimal
proprietary trading should be a covered fund and subject to the
requirements of section 13.
---------------------------------------------------------------------------
\1673\ See Occupy.
---------------------------------------------------------------------------
However, not all commenters supported a characteristics-based
definition. One commenter opposed a characteristics-based definition,
suggesting that the final rule rely only on the statutory reference to
the Investment Company Act, and arguing that using characteristics to
define a covered fund (e.g., leverage) could create opportunities for
circumvention of the rule.\1674\ Commenters that generally supported
the proposed definition argued that its broad scope prevented
circumvention.\1675\
---------------------------------------------------------------------------
\1674\ See AFR et al. (Feb. 2012).
\1675\ See Sens. Merkley & Levin (Feb. 2012); AFR et al. (Feb.
2012); Alfred Brock.
---------------------------------------------------------------------------
One commenter argued in favor of broadening the definition of
covered fund to include entities that rely on an exclusion from the
definition of investment company other than those contained in section
3(c)(1) and 3(c)(7), such as section 3(c)(2) (which provides an
exclusion for underwriters and brokers) or 3(c)(6) (which provides an
exclusion for entities engaged in a business other than investing in
[[Page 5670]]
securities).\1676\ By contrast, other commenters argued that an entity
should not be considered a covered fund if the entity relies on an
exclusion or exemption contained in the Investment Company Act other
than an exclusion contained in section 3(c)(1) or 3(c)(7) under that
Act, such as the exclusion contained in section 3(c)(3) for bank
collective investment funds.\1677\
---------------------------------------------------------------------------
\1676\ See Occupy (also arguing in favor of including entities
that rely on rule 3a-1 (which provides an exemption for issuers that
hold less than 45% of their assets in securities excluding
government securities) or 3a-6 (which provides an exemption for
foreign banks and insurance companies) to avoid being regulated as
investment companies under the Investment Company Act).
\1677\ See, e.g., ABA (Keating).
---------------------------------------------------------------------------
The Agencies have carefully considered all of the comments related
to the definition of covered fund. While the Agencies believe that the
proposal reflected a reasonable interpretation of the statutory
provision, on further review and in light of the comments the Agencies
have determined to adopt a different approach. The Agencies have
revised the final rule to address many of the concerns raised by
commenters regarding the scope of the original proposal in a manner the
Agencies believe is a better reading of the statutory provision because
it is both consistent with the language, purpose and structure of
section 13 and avoids unintended consequences of the less precise
definitional approach of the proposal.
In the final rule, the Agencies have joined the definitions of
``hedge fund'' and ``private equity fund'' into a single definition
``covered fund'' (as in the statute) and have defined this term as any
issuer that would be an investment company as defined in the Investment
Company Act but for section 3(c)(1) or 3(c)(7) of that Act with a
number of express exclusions and additions (explained below) as
determined by the Agencies. Thus, for example, an entity that invests
in securities and relies on any exclusion or exemption from the
definition of ``investment company'' under the Investment Company Act
other than the exclusion contained in section 3(c)(1) or 3(c)(7) of
that Act would not be considered a covered fund so long as it satisfies
the conditions of another Investment Company Act exclusion or
exemption.\1678\ Such an entity would not be an investment company but
for section 3(c)(1) or 3(c)(7), and the Agencies have modified the
final rule to explicitly exclude such an entity.\1679\
---------------------------------------------------------------------------
\1678\ For instance, bank common trust and collective funds that
qualify for the exclusion from the definition of investment company
pursuant to section 3(c)(3) or 3(c)(11) of the Investment Company
Act are not covered funds. See 15 U.S.C. 78a-3(c)(3) and (c)(11).
These funds are subject to supervision and regulation by a Federal
banking agency, thus helping to distinguish them from traditional
hedge funds and private equity funds which are generally not
themselves subject to such supervision or regulation.
\1679\ See final rule Sec. ----.10(c)(12).
---------------------------------------------------------------------------
The Agencies believe this definition is consistent with the words,
structure, purpose and legislative history of section 13 of the BHC
Act. As noted above, section 13(h)(2) provides that:
The terms ``hedge fund'' and ``private equity fund'' mean an issuer
that would be an investment company as defined in the [Investment
Company Act] (15 U.S.C. 80a-1 et seq.), but for section 3(c)(1) or
3(c)(7) of that Act, or such similar funds as the [Agencies] may, by
rule, as provided in subsection (b)(2), determine.\1680\
---------------------------------------------------------------------------
\1680\ See 12 U.S.C. 1851(h)(2) (emphasis added).
The statutory provision contains two parts: a first part that
refers to any issuer that is ``an investment company, as defined in the
Investment Company Act, but for section 3(c)(1) and 3(c)(7) of the
Act''; and a second part that covers ``such similar funds as the
[Agencies] may, by rule . . . determine.'' The proposed rule offered a
reading of this provision as a simple concurrent definition with two
self-contained, supplementary parts. Under this approach, all entities
covered by part one of the definition would be included in the
definitions of ``hedge fund'' and ``private equity fund,'' and the role
of the Agencies under the second part was limited to considering
whether and how to augment the scope of the primary statutory
definition.
As noted above, commenters argued that this interpretation led to
unintended consequences that were not consistent with other provisions
of section 13 or the purposes of section 13, and that other
interpretations of the definition of covered fund were consistent with
both the words and the purpose of the statute. Also as explained above,
commenters offered multiple alternative interpretations of the
definition of, the scope of the prohibition on ownership interests in,
and relationships with, a covered fund.\1681\
---------------------------------------------------------------------------
\1681\ In addition to the readings described above, one
commenter argued that the section could be read to provide that both
the reference to issuers covered by section 3(c)(1) or 3(c)(7) of
the Investment Company Act in the first part of section 13(h)(2) and
the reference to similar funds in the second part of the section
should be read as qualified by the clause ``as the Agencies may by
rule . . . determine.'' Under this reading, Congress granted the
Agencies authority to determine by rule whether an entity described
by the first part would be covered and whether an issuer would be
deemed to be a similar fund under the second part. See SIFMA et al.
(Covered Funds) (Feb. 2012).
---------------------------------------------------------------------------
The Agencies believe that the language of section 13(h)(2) can best
be interpreted to provide two alternative definitions of the entities
to be covered by the statutory terms ``hedge fund'' and ``private
equity fund.'' Under this reading, the first part of section 13(h)(2)
contains a base definition that references the noted exclusions under
the Investment Company Act (the ``default definition''), while the
second part grants the Agencies the authority to adopt an alternate
definition that is triggered by agency action (the ``tailored
definition''). Thus, if the Agencies do not act by rule, the definition
is set by reference to the Investment Company Act and the relevant
exclusions alone; if the Agencies act by rule, the definitions are set
by the Agencies under that rule. As noted above, the Agencies have
determined to exercise the authority under the second part of the
statute to define ``hedge fund'' and ``private equity fund'' in the
final rule.
Relying on the Agencies' authority to adopt an alternative,
tailored definition of ``hedge fund'' and ``private equity fund,'' the
final rule references funds that are similar to the funds in the base
alternative provided in the first alternative definition--that is, an
issuer that would be an investment company under the Investment Company
Act but for section 3(c)(1) or 3(c)(7) of that Act. The additions and
exclusions from that definition represent further determinations by the
Agencies regarding the scope of that definition that were made in the
course of a rulemaking conducted in accordance with section 13(b)(2) of
the BHC Act.
The Agencies believe that this reading of the statutory provision
is consistent with the purpose of section 13. That purpose appears to
be to limit the involvement of banking entities in high-risk
proprietary trading, as well as their investment in, sponsorship of,
and other connections with, entities that engage in investment
activities for the benefit of banking entities, institutional investors
and high-net worth individuals.\1682\ Further, the Agencies believe
that the provision permits them to tailor the scope of the definition
to funds that engage in the investment activities contemplated by
section 13 (as opposed, for example, to vehicles that merely serve to
facilitate corporate structures); doing so allows the Agencies to avoid
the unintended results, some of which commenters identified, that might
[[Page 5671]]
follow from a definition that is inappropriately imprecise.\1683\
---------------------------------------------------------------------------
\1682\ See 156 Cong. Reg. S.5894-5895 (daily ed. July 15, 2010)
(statement of Sen. Merkley).
\1683\ The Agencies believe that the choice of the tailored
definition is supported by the legislative history that suggests
that Congress may have foreSeen that its base definition could lead
to unintended results and might be overly broad, too narrow, or
otherwise off the mark. Part two of the statutory definition was not
originally included in the bill reported by the Senate Committee on
April 30, 2010. While the addition of part two did not receive
specific comment, Rep. Frank, a co-sponsor and principal architect
of the Dodd-Frank Act, noted that the default definition ``could
technically apply to lots of corporate structures, and not just the
hedge funds and private equity funds'' and confirmed that ``[w]e do
not want these overdone.'' See 156 Cong. Rec. H5226 (daily ed. June
30, 2010) (statement of Reps. Himes and Frank) (noting intent that
subsidiaries or joint ventures not be included within the definition
of covered fund); 156 Cong. Rec. S5904-05 (daily ed. July 15, 2010)
(statement of Sens. Boxer and Dodd) (noting broad definition of
hedge fund and private equity fund and recommending that the
Agencies take steps to ensure definition is reasonably tailored).
---------------------------------------------------------------------------
The Agencies also note that nothing in the structure or history of
the Dodd-Frank Act suggests that the definition of hedge fund and
private equity fund was intended to necessitate a fundamental
restructuring of banking entities by disallowing investments in common
corporate vehicles such as intermediate holding companies, joint
operating companies, acquisition vehicles and similar entities that do
not engage in the types of investment activities contemplated by
section 13. Moreover, other provisions of the Dodd-Frank Act and
existing banking laws and regulations would be undermined or vitiated
by a reading that restricts investments in these types of corporate
vehicles and structures.\1684\
---------------------------------------------------------------------------
\1684\ For example, the Dodd-Frank Act requires banking entities
to serve as a source of financial strength to their insured
depository institutions and requires certain banking entities to
form intermediate holding companies to separate their financial and
non-financial activities. See Sections 167, 616(d) & 626 of the
Dodd-Frank Act. These provisions would be severely undermined if the
prohibitions on investments and activities contained in section 13
were applied to ownership of intermediate holding companies. For
instance, a bank holding company would not be able to serve as a
source of strength to an intermediate holding company (or any
subsidiary thereof) that is a covered fund due to the transaction
restrictions contained in section 13(f). See 12 U.S.C. 1851(f). As
another example, the Agencies have made certain modifications to the
final rule to make clear that it will not affect the resolution
authority of the Federal Deposit Insurance Corporation, including by
excluding from the covered fund definition issuers formed by or on
behalf of the Corporation for the purpose of facilitating the
disposal of assets acquired in the Corporation's capacity as
conservator or receiver. See Sec. ----.10(c)(13).
---------------------------------------------------------------------------
Based on the interpretive and policy considerations raised by
commenters, the language of section 13(h)(2), and the language,
structure, and purpose of the Dodd-Frank Act, the Agencies have adopted
a tailored definition of covered fund in the final rule that covers
issuers of the type that would be investment companies but for section
3(c)(1) or 3(c)(7) of the Investment Company Act with exclusions for
certain specific types of issuers in order to focus the covered fund
definition on vehicles used for the investment purposes that were the
target of section 13. The definition of covered fund under the final
rule also includes certain funds organized and offered outside of the
United States in order to address foreign fund structures and certain
commodity pools that might otherwise allow circumvention of the
restrictions of section 13. The Agencies also expect to exercise the
statutory anti-evasion authority provided in section 13(e) of the BHC
Act and other prudential authorities in order to address instances of
evasion.\1685\
---------------------------------------------------------------------------
\1685\ As discussed in Part IV.C.1 of this SUPPLEMENTARY
INFORMATION regarding the compliance program requirements of the
final rule, the Agencies will consider information maintained and
provided by banking entities under the compliance program mandate to
help monitor potential evasions of the prohibitions and restrictions
of section 13. Additionally and consistent with the statute, the
final rule permits the Agencies to jointly determine to include
within the definition of covered fund any fund excluded from that
definition. The Agencies expect that this authority may be used to
help address situations of evasion.
---------------------------------------------------------------------------
As discussed above, an alternative approach to defining a covered
fund would be to reference fund characteristics. Commenters arguing for
a characteristics-based approach stated that it would more precisely
tailor the final rule to the intent of section 13 and limit the
potential for undue burden on banking entities. A characteristics-based
definition, however, could be less effective than the approach taken in
the final rule as a means to prohibit banking entities, either directly
or indirectly, from engaging in the covered fund activities limited or
proscribed by section 13. A characteristics-based approach also could
require more analysis by banking entities to apply those
characteristics to every potential covered fund on a case-by-case
basis, and create greater opportunity for evasion. As discussed below,
the Agencies have sought to address some of the concerns raised by
commenters suggesting a characteristics-based approach by tailoring the
definition of covered fund to provide exclusions for certain entities
that rely on section 3(c)(1) or 3(c)(7) of the Investment Company Act
and otherwise would be treated as covered funds.
Some commenters discussed the potential cost to banking entities to
analyze the covered fund status of certain entities if the Agencies
were to define the term covered fund by reference to sections 3(c)(1)
and 3(c)(7), arguing that this analysis would be costly.\1686\ A
characteristics-based approach could mitigate the costs associated with
an investment company analysis but, depending on the characteristics,
could result in additional compliance costs in some cases to the extent
banking entities would be required to implement policies and procedures
to prevent potential covered funds from having characteristics that
would bring them within the covered fund definition. Furthermore,
banking entities may currently rely on section 3(c)(1) and 3(c)(7) of
the Investment Company Act to avoid registering various entities under
the Investment Company Act, and the costs to analyze the status of
these entities under a statutory-based definition of covered fund are
generally already included as part of the fund formation process and
the costs of determining covered fund status may thus be mitigated,
especially given the exclusions provided in the final rule.
---------------------------------------------------------------------------
\1686\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012).
---------------------------------------------------------------------------
The entities excluded from the definition of covered fund are
described in detail in section (c) below.
1. Foreign Covered Funds
In order to prevent evasion of the prohibition and purposes of
section 13, the proposal included within the definition of covered fund
any issuer organized or offered outside of the United States (``foreign
covered fund'') that would be a covered fund were it organized or
offered in the United States.\1687\
---------------------------------------------------------------------------
\1687\ See proposed rule Sec. ----.10(b)(1)(iii).
---------------------------------------------------------------------------
Commenters expressed concern that the proposed treatment of foreign
covered funds was overly broad, exceeded the Agencies' statutory
authority, was not consistent with principles of national treatment,
and violated international treaties.\1688\ Commenters expressed concern
about the difficulties of applying Investment Company Act concepts to
foreign funds that are structured to comply with
[[Page 5672]]
regulatory schemes under local laws outside the United States. They
also argued that it would be burdensome and costly to require foreign
banking entities to interpret and apply U.S. securities laws to foreign
structures that are designed primarily to be offered and sold outside
the United States.\1689\ Commenters also contended that foreign mutual
fund equivalents, such as retail Undertakings for Collective
Investments in Transferable Securities (``UCITS''),\1690\ would be
treated as covered funds under the proposal even though they generally
are similar to U.S. registered investment companies, which are not
covered funds, meaning that under the proposal the scope of foreign
funds captured was broader than the scope of domestic funds.\1691\
These commenters argued that a foreign fund organized and offered
outside of the United States should not be treated as a covered fund
simply because the foreign fund may (or could) rely on the exclusion
under section 3(c)(1) or 3(c)(7) of the Investment Company Act were it
to be offered in the United States.\1692\
---------------------------------------------------------------------------
\1688\ See SIFMA et al. (Covered Funds) (Feb. 2012); BNY Mellon
et al.; BlackRock; ABA (Keating); AFTI; AFG; ICI Global; Ass'n. of
Institutional Investors (Feb. 2012); ICI (Feb. 2012); SSgA (Feb.
2012); State Street (Feb. 2012); JPMC; BoA; Goldman (Covered Funds);
Bank of Montreal et al. (Jan. 2012); AGC; Cadwalader (on behalf of
Thai Banks); ALFI; BVI; EBF; British Bankers Ass'n.; French ACP;
AFME et al.; F&C; IIF; ICSA; IMA; EFAMA; UKRCBC; AIMA; AFMA;
Australian Bankers Ass'n. (Feb. 2012); Allen & Overy (on behalf of
Foreign Bank Group); IFIC; Allen & Overy (on behalf of Canadian
Banks); RBC; French Treasury et al.; Hong Kong Inv. Funds Ass'n.;
TCW; Govt. of Japan/Bank of Japan.
\1689\ See JPMC; See also Cadwalader (on behalf of Thai Banks);
Cadwalader (on behalf of Singapore Banks); Ass'n. of Banks in
Malaysia; Govt. of Japan/Bank of Japan.
\1690\ UCITS are public limited companies that, under a series
of directives issued by the EU Commission, coordinate distribution
and management of unit trusts or collective investment schemes in
financial instruments on a cross-border basis throughout the
European Union on the basis of the authorization of a single member
state.
\1691\ See Allen & Overy (on behalf of Foreign Bank Group); ABA
(Keating); AFG; AFTI; BoA; French Banking Fed'n.; SIFMA et al.
(Covered Funds) (Feb. 2012); See also BNY Mellon et al.; BlackRock;
ICI Global; Ass'n. of Institutional Investors (Feb. 2012); ICI (Feb.
2012); SSgA (Feb. 2012); State Street (Feb. 2012); JPMC; BoA;
Goldman (Covered Funds); Bank of Montreal et al. (Jan. 2012); AGC;
Cadwalader (on behalf of Thai Banks); ALFI; BVI; EBF; British
Bankers Ass'n.; French ACP; AFME et al.; F&C; IIF; ICSA; IMA; EFAMA;
UKRCBC; AIMA; AFMA; Australian Bankers Ass'n. (Feb. 2012); Allen &
Overy (on behalf of Foreign Bank Group); IFIC; Allen & Overy (on
behalf of Canadian Banks); RBC; French Treasury et al.; Hong Kong
Inv. Funds Ass'n.; HSBC Life; ICSA Ass'n. of Banks in Malaysia
(arguing that foreign banking organization would have to determine
how a fund would be regulated under U.S. law before making
investments in funds in their home markets).
\1692\ See Allen & Overy (on behalf of Foreign Bank Group); ABA
(Keating); SSgA (Feb. 2012); BoA; Goldman (Covered Funds).
---------------------------------------------------------------------------
Some commenters argued that the proposal did not clearly identify
which foreign funds would be covered, thereby creating uncertainty
about the scope of funds to which section 13 would apply.\1693\ Several
commenters argued that the proposal's foreign covered fund definition
could be read to include a foreign fund, even if its securities were
never offered and sold to U.S. persons, because the fund could
theoretically be offered in the United States in reliance on section
3(c)(1) or 3(c)(7).\1694\ Commenters argued that the definition of
foreign covered fund should be tailored.\1695\ Some commenters argued
that foreign funds that are not made available for sale in the U.S. or
actively marketed to U.S. investors should be specifically excluded
from the definition of covered fund.\1696\ Several other commenters
supported narrowing the definition of foreign covered fund to those
foreign funds with characteristics similar to domestic hedge funds or
private equity funds.\1697\
---------------------------------------------------------------------------
\1693\ See Australian Bankers Ass'n. (Feb. 2012); BlackRock.
\1694\ See BlackRock; SIFMA et al. (Covered Funds) (Feb. 2012);
JPMC; ABA (Keating); IIB/EBF. These commenters argued that the
proposed definition of a covered fund could result in virtually
every foreign fund being considered a covered fund, regardless of
whether the fund is similar to a hedge fund or private equity fund.
\1695\ See, e.g., AGC; Ass'n. of Institutional Investors (Feb.
2012); ABA (Keating); Goldman (Covered Funds); BoA; GE (Feb. 2012);
Japanese Bankers Ass'n.; EBF.
\1696\ See Australian Bankers Ass'n. (Feb. 2012); AFG; BNY
Mellon et al.; BlackRock; Goldman (Covered Funds); IIB/EBF.
\1697\ See SIFMA et al. (Covered Funds) (Feb. 2012); JPMC;
Goldman (Covered Funds); Credit Suisse (Williams); ABA (Keating);
IIB/EBF; Barclays; BoA; GE (Feb. 2012) (discussing the uncertainty
with respect to foreign-based loan and securitization programs and
whether they would be deemed covered funds).
---------------------------------------------------------------------------
After considering the comments in light of the statutory provisions
and purpose of section 13, the Agencies have modified the final rule to
more effectively tailor the scope of foreign funds that would be
covered funds under the rule and better implement the language and
purpose of section 13. As noted above, section 13 of the BHC Act
applies to the global operations of U.S. banking entities, and one of
the purposes of section 13 is to reduce the risk to the U.S. financial
system of activities with and investments in covered funds. The
Agencies proposed to include foreign funds within the definition of
covered fund in order to more effectively accomplish the purpose of
section 13. In particular, the Agencies were concerned that a
definition of covered fund that did not include foreign funds would
allow U.S. banking entities to be exposed to risks and engage in
covered fund activities outside the United States that are specifically
prohibited in the United States. This result would undermine section 13
and pose risks to U.S. banking entities and the stability of the U.S.
financial system that section 13 was designed to prevent.
At the same time, section 13 includes other provisions that
explicitly limit its extra-territorial application to the activities of
foreign banks outside the United States. As explained below, section 13
specifically exempts certain activities in covered funds conducted by
foreign banking entities solely outside of the United States.
Based on these considerations and the information provided by
commenters, the Agencies have revised the definition of covered fund in
the final rule to include certain foreign funds under certain
circumstances. The final rule provides that a foreign fund is included
within the definition of covered fund only for any banking entity that
is, or is controlled directly or indirectly by a banking entity that
is, located in or organized or established under the laws of the United
States or of any State. Under this definition a foreign fund becomes a
covered fund only with respect to the U.S. banking entity (or foreign
affiliate of a U.S. banking entity) that acts as a sponsor to the
foreign fund or has an ownership interest in the foreign fund. Under
the rule, a foreign fund is any entity that: (i) is organized or
established outside the United States and the ownership interests of
which are offered and sold solely outside the United States; (ii) is,
or holds itself out as being, an entity or arrangement that raises
money from investors primarily for the purpose of investing in
securities for resale or other disposition or otherwise trading in
securities; and (iii) has as its sponsor the U.S. banking entity (or an
affiliate thereof) or has issued an ownership interest that is owned
directly or indirectly by the U.S. banking entity (or an affiliate
thereof).\1698\ A foreign fund therefore may be a covered fund with
respect to the U.S. banking entity that sponsors the fund, but not be a
covered fund with respect to a foreign bank that invests in the fund
solely outside the United States.
---------------------------------------------------------------------------
\1698\ See final rule Sec. ----.10(b)(1)(iii).
---------------------------------------------------------------------------
This approach is designed to include within the definition of
covered fund only foreign entities that would pose risks to U.S.
banking entities of the type section 13 was designed to address. The
Agencies note that any foreign fund, including a foreign fund sponsored
or owned by a foreign banking entity, that is offered or sold in the
United States in reliance on the exclusions in section 3(c)(1) or
3(c)(7) of the Investment Company Act would be included in the
definition of covered fund under Sec. ----.10(b)(1)(i) of the final
rule unless it meets the requirements of an exclusion from that
definition as discussed below.\1699\ Thus, the rule is
[[Page 5673]]
designed to provide parity--and no competitive advantages or
disadvantages--between U.S. and non-U.S. funds sold within the United
States.
---------------------------------------------------------------------------
\1699\ See also Goodwin, Procter & Hoar LLP, SEC Staff No-Action
Letter (Feb. 28, 1997); Touche Remnant & Co., SEC Staff No-Action
Letter (Aug. 27, 1984).
---------------------------------------------------------------------------
To further ensure that this approach to foreign funds is consistent
with the scope of coverage applied within the United States, the final
rule excludes from the definition of covered fund any foreign issuer
that, were it subject to U.S. securities laws, would be able to rely on
an exclusion or exemption from the definition of investment company
other than the exclusions contained in section 3(c)(1) or 3(c)(7) of
the Investment Company Act.\1700\
---------------------------------------------------------------------------
\1700\ See final rule Sec. ----.10(b)(2). Because any issuer
that offers its securities under the U.S. securities laws that may
rely on an exclusion or exemption from the definition of investment
company other than the exclusions contained in section 3(c)(1) or
3(c)(7) of the Investment Company Act would not be a covered fund,
this exclusion is designed to provide equivalent treatment for
foreign covered funds.
---------------------------------------------------------------------------
As explained below, the final rule also contains an exclusion for
foreign public funds.\1701\ This is designed to prevent the extension
of the definition of covered fund from including foreign funds that are
similar to U.S. registered investment companies, which are by statute
not covered by section 13.
---------------------------------------------------------------------------
\1701\ See Sec. ----.10(c)(1).
---------------------------------------------------------------------------
2. Commodity Pools
Under the proposal, the Agencies proposed to use their authority to
expand the definition of covered fund to include a commodity pool as
defined in section 1a(10) of the Commodity Exchange Act.\1702\ A
commodity pool is defined in the Commodity Exchange Act to mean any
investment trust, syndicate, or similar form of enterprise operated for
the purpose of trading in commodity interests.\1703\ The Agencies
proposed to include commodity pools in the definition of covered fund
because some commodity pools are managed and structured in a manner
similar to a covered fund.
---------------------------------------------------------------------------
\1702\ See proposal rule Sec. ----.10(b)(1)(ii).
\1703\ Commodity interests include: (i) commodity for future
delivery, security futures product, or swap; (ii) agreement,
contract, or transaction described in section 2(c)(2)(C)(i) or
2(c)(2)(D)(i) of the Commodity Exchange Act; (iii) commodity option
authorized under section 4c of the Commodity Exchange Act; or (iv)
leveraged transaction authorized under section 23 of the Commodity
Exchange Act. See Joint Proposal, 76 FR 68,897 n.224 and
accompanying text.
---------------------------------------------------------------------------
Some commenters objected to this expansion of the definition of
covered fund as beyond the scope of section 13. Commenters argued that
covering commodity pools would extend section 13 of the BHC Act to any
entity that engages in a single commodity, futures or swap transaction,
including entities that share few, if any, of the characteristics or
risk associated with private equity funds or hedge funds.\1704\ For
example, some commenters argued that many non-bank businesses that are
not investment companies but that hedge risks using commodity interests
would be treated as covered funds if all commodity pools were
covered.\1705\ In addition, registered mutual funds, pension funds, and
many investment companies that rely on exclusions or exceptions other
than section 3(c)(1) or 3(c)(7) of the Investment Company Act would be
covered as commodity pools. Commenters argued that the CFTC has ample
authority to regulate the activities of commodity pools and commodity
pool operators, and nothing in section 13 indicates that Congress
intended section 13 to govern commodity pool activities or investments
in commodity pools.\1706\ Commenters also argued that expanding the
definition of covered fund to include commodity pools would have the
unintended consequence of limiting all covered transactions between a
banking entity sponsor or investor in a commodity pool and the
commodity pool itself.\1707\ If a commercial end user is a commodity
pool for example, this restriction could limit access to credit for
that entity.
---------------------------------------------------------------------------
\1704\ See, e.g., ABA (Keating) (citing See, e.g., CFTC
Interpretative Letter No. 86-22, Comm. Fut. L. Rep. (CCH) ] 23,280
(Sept. 19, 1986)); SIFMA et al. (Covered Funds) (Feb. 2012); ICI
(Feb. 2012); BlackRock; Goldman (Covered Funds); Wells Fargo
(Covered Funds); BoA; EFAMA; TCW; ISDA (Feb. 2012); Arnold & Porter;
BNY Mellon et al.; SSgA (Feb. 2012); State Street (Feb. 2012);
Credit Suisse (Williams); RMA; IIB/EBF.
\1705\ See Goldman (Covered Funds); TCW; IIB/EBF.
\1706\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012); ICI
(Feb. 2012); BlackRock.
\1707\ See, e.g., BoA.
---------------------------------------------------------------------------
Commenters that opposed the proposal's inclusion of commodity pools
generally asserted that, if commodity pools were nonetheless included
as covered funds under the final rule, the definition of commodity pool
should be modified so that it would include only those pools that
engage ``primarily'' or ``principally'' in commodities trading and
exhibit characteristics similar to those of conventional hedge funds
and private equity funds.\1708\ Other commenters urged the Agencies to
incorporate the exemptions from the commodity pool operator
registration requirements under the Commodity Exchange Act (such as
rule 4.13(a)(4)).\1709\
---------------------------------------------------------------------------
\1708\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012);
Goldman (Covered Funds); BlackRock; Wells Fargo (Covered Funds); BNY
Mellon, et al.; SSgA (Feb. 2012); State Street (Feb. 2012); Credit
Suisse (Williams); ABA (Keating); FIA; IIB/EBF; BoA.
\1709\ See Credit Suisse (Williams).
---------------------------------------------------------------------------
Some commenters supported including commodity pools within the
definition of covered fund,\1710\ with some suggesting that this
approach would be consistent with the goals of the statute.\1711\ One
commenter asserted that including commodity pools would be necessary to
prevent banking entities from indirectly engaging in prohibited
proprietary trading through commodity pools.\1712\ Another commenter
asserted that the inclusion of commodity pools was advisable because
the CFTC has in the past viewed many commodity pools as similar to
hedge funds.\1713\
---------------------------------------------------------------------------
\1710\ See AFR et al. (Feb. 2012); Alfred Brock; Occupy; Sens.
Merkley & Levin (Feb. 2012).
\1711\ See Sens. Merkley & Levin (Feb. 2012); Occupy; AFR et al.
(Feb. 2012); Alfred Brock.
\1712\ See Sens. Merkley & Levin (Feb. 2012).
\1713\ See Occupy.
---------------------------------------------------------------------------
After carefully considering these comments, the Agencies have
determined not to include all commodity pools as covered funds as
proposed. Instead, and taking into account commenters' concerns, the
Agencies have taken a more tailored approach that is designed to more
accurately identify those commodity pools that are similar to issuers
that would be investment companies as defined the Investment Company
Act of 1940 but for section 3(c)(1) or 3(c)(7) of that Act, consistent
with section 13(h)(2) of the BHC Act.
Under the final rule, as a threshold matter, a collective
investment vehicle must determine whether it is a ``commodity pool'' as
that term is defined in section 1a(10) of the Commodity Exchange
Act.\1714\ The Agencies note that collective investment vehicles need
to make this determination for purposes of complying with the Commodity
Exchange Act regardless of whether commodity pools are covered funds.
Under section 1a(10), a commodity pool is ``any investment trust,
syndicate, or similar form of enterprise operated for the purpose of
trading commodity interests.'' \1715\ If a collective investment
[[Page 5674]]
vehicle meets that definition, the commodity pool would be considered a
covered fund provided it meets one of two alternative tests and does
not also qualify for an exclusion from the covered fund definition
(e.g., the exclusion for registered investment companies).
---------------------------------------------------------------------------
\1714\ See 7 U.S.C. 1a(10).
\1715\ Id. The CFTC and its divisions have provided
interpretative guidance with respect to the meaning of the
definition of commodity pool. See, e.g., 46 FR 26004, 26005 (May 8,
1981) (adopting the CFTC's regulatory definition of commodity pool
in 17 CFR 4.10(d), which is substantively identical to the
definition in section 1a(10) of the Commodity Exchange Act); 77 FR
11252, 11258 (Feb. 24, 2012) (explaining the need for swaps to be
included in the de minimis exclusion and exemption in 17 CFR 4.5 and
4.13); CFTC Staff Letter 12-13 (Oct. 11, 2012) (providing
interpretative guidance to equity real estate investment trusts);
and CFTC Staff Letters Nos. 12-14 (Oct. 11, 2012) and 12-45 (Dec. 7,
2012) (providing interpretative relief that certain securitization
vehicles are not commodity pools).
---------------------------------------------------------------------------
First, a commodity pool will be a covered fund if it is an ``exempt
pool'' under section 4.7(a)(1)(iii) of the CFTC's regulations,\1716\
meaning that it is a commodity pool for which a registered commodity
pool operator has elected to claim the exemption provided by section
4.7 of the CFTC's regulations. The Agencies believe that such commodity
pools are appropriately considered covered funds because, like funds
that rely on section 3(c)(1) or 3(c)(7), these commodity pools sell
their participation units in restricted offerings that are not
registered under the Securities Act of 1933 and are offered only to
investors who meet certain heightened qualification standards, as
discussed above.\1717\ The Agencies therefore have determined that they
properly are considered ``such similar funds'' as specified in section
13(h)(2) of the BHC Act.
---------------------------------------------------------------------------
\1716\ 17 CFR 4.7(a)(1)(iii).
\1717\ Although section 3(c)(1) itself does not limit the types
of investors who may invest in a fund relying on that exclusion,
section 3(c)(1) provides that the fund may not conduct a public
offering. A fund relying on section 3(c)(1) therefore must offer and
sell its interests in offerings that are not registered under the
Securities Act of 1933, which offerings generally are limited to
persons who meet certain qualification standards.
---------------------------------------------------------------------------
Alternatively, a commodity pool for which exempt pool status under
section 4.7 of the CFTC's regulations has not been elected may also be
a covered fund if the pool features certain elements that make the pool
substantively similar to exempt pools under section 4.7. The Agencies
are including the alternative definition of commodity pools that are
covered funds because, if the Agencies had included only pools for
which exempt pool status had been elected, covered fund status for
pools in which banking entities are invested could easily be avoided
merely by not electing exempt pool status under section 4.7. The
following is a description of the elements of a pool that would cause a
pool that is not an exempt pool under section 4.7 to be a covered fund.
The first element is that a commodity pool operator for the pool is
registered pursuant to the Commodity Exchange Act in connection with
the operation of that commodity pool. This element is present for all
pools that are exempt pools under section 4.7 because exempt pool
status can only be elected by registered commodity pool operators. This
element excludes from the definition of covered fund an entity that is
a commodity pool, but for which the pool operator has been either
exempted from registration as a commodity pool operator or excluded
from the definition of commodity pool operator under the CFTC's
regulations or pursuant to a no-action letter issued by CFTC
staff.\1718\
---------------------------------------------------------------------------
\1718\ See, e.g., CFTC regulations 3.10(c) and 4.13 and CFTC
Staff Letters Nos. 12-37 (Nov. 29, 2012) (relief from registration
for operators of certain types of family office pools), 12-40 (Dec.
4, 2012) (relief from registration for operators of business
development companies that meet certain conditions) and 12-44 (Dec.
7, 2012) (relief from registration for operators of mortgage real
estate investment trusts that meet certain conditions). See also
supra note 1715.
---------------------------------------------------------------------------
The second element under the alternative definition is that
substantially all of the commodity pool's participation units are owned
only by qualified eligible persons under section 4.7(a)(2) and
(a)(3).\1719\ This element is consistent with the requirement under
section 4.7 that exempt pool status can only be claimed if the
participation units in the pool are only offered or sold to qualified
eligible persons.\1720\ Moreover, the inclusion of this element aligns
the elements of the alternative test with features that define funds
that rely on sections 3(c)(1) and 3(c)(7) of the Investment Company Act
of 1940.
---------------------------------------------------------------------------
\1719\ 17 CFR 4.7(a)(2) and (a)(3).
\1720\ Although section 4.7 requires that all participation
units be owned by qualified eligible persons, this element of the
final rule has been modified to include pools for which
``substantially all'' participation units are owned by qualified
eligible persons to prevent avoidance of covered fund status by
distributing a small number of participation units to persons who
are not qualified eligible persons.
---------------------------------------------------------------------------
The assessment as to whether the commodity pool in question
satisfies this condition must be made at the time that the banking
entity is required to make the following determinations: Whether it can
obtain new participation units in the commodity pool, whether it can
retain previously purchased participation units in the commodity pool,
and whether it can act as the commodity pool's sponsor. The Agencies
believe this to be appropriate because it would require the banking
entity to consider current information regarding the commodity pool and
its participants rather than assess the composition of the pool's
participants over time even though its investments in or relationships
with the pool do not change, which could be difficult depending upon
the length of time that the pool has been in operation and the records
available at the time of determination.
Finally, the third element under the alternative definition is that
the commodity pool participation units have not been publicly offered
to persons other than qualified eligible persons. Consistent with CFTC
regulations addressing the meaning of ``offer'' in the context of the
CFTC's regulations, the term ``offer'' as used in Sec. --
--.10(b)(1)(ii)(B) ``has the same meaning as in contract law, such
that, if accepted the terms of the offer would form a binding
contract.'' \1721\ This aspect of the alternative definition is
intended to limit the ability for commodity pools to avoid
classification as covered funds through an offer, either in the past or
currently ongoing, to non-qualified eligible persons ``in name only''
where there is no actual offer to non-qualified eligible persons.
---------------------------------------------------------------------------
\1721\ See 77 FR 9734, 9741 (Feb. 17, 2012) (describing the
meaning of the term ``offer'' in the context of the business conduct
standards for swap dealers and major swap participants with
counterparties adopted by the CFTC). The term ``offered'' as used in
this section of the final rule is not intended to denote an
``offer'' for purposes of the Securities Act of 1933.
---------------------------------------------------------------------------
Accordingly, unless the pool operator can show that the pool's
participation units have been actively and publicly offered to non-
affiliated parties that are not qualified eligible persons whereby such
non-qualified eligible persons could in fact purchase a participation
unit in the commodity pool, a pool that features the other elements
listed in the alternative definition would be a covered fund. Such a
showing will not turn solely on whether the commodity pool has filed a
registration statement to offer its participation units under the
Securities Act of 1933 or whether the commodity pool operator has
prepared a disclosure document consistent with the provisions of
section 4.24 of the CFTC's regulations.\1722\ Rather, the pool operator
would need to show that a reasonably active effort, based on the facts
and circumstances, has been undertaken by brokers and other sales
personnel to publicly offer the pool's participation units to non-
affiliated parties that are not qualified eligible persons.
---------------------------------------------------------------------------
\1722\ 17 CFR 4.24 (2013).
---------------------------------------------------------------------------
In taking this more tailored approach to commodity pools that will
be covered funds, the Agencies are more closely aligning the types of
commodity pools that will be covered funds under the final rule with
section 13's definition of a hedge fund and private equity fund by
reference to section 3(c)(1) or section 3(c)(7), and addressing
concerns of commenters that the proposal was
[[Page 5675]]
overly broad and would lead to outcomes inconsistent with the words,
structure, and purpose of section 13.\1723\ The Agencies believe that
the types of commodity pools described above generally are similar to
funds that rely on section 3(c)(1) and 3(c)(7) in that, like funds that
rely on section 3(c)(1) or 3(c)(7), these commodity pools may be owned
only by investors who meet certain heightened qualification standards,
as discussed above.\1724\ Further, the Agencies believe that the final
rule's identification of the elements of a commodity pool that is a
covered fund are clearly established and readily ascertainable such
that once it is determined whether an entity is a commodity pool, an
assessment that is already necessary to comply with the Commodity
Exchange Act, then the further determination of whether an entity that
is a commodity pool is also a covered fund can be made based on readily
ascertainable information.
---------------------------------------------------------------------------
\1723\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012);
BlackRock; AHIC; Sen. Carper et al.; Rep. Garrett et al.
\1724\ Funds relying on section 3(c)(7) must be owned
exclusively by qualified purchasers, as defined in the Investment
Company Act. The Agencies note in this regard that section 4.7 of
the CFTC's regulations use substantially the same definition of a
qualified purchaser in defining the term qualified eligible person.
---------------------------------------------------------------------------
In adopting this approach, the Agencies also are utilizing the
current regulatory structure promulgated by the CFTC under the CEA. As
the CFTC regulates commodity pools, commodity pool operators, and
commodity trading advisors that advise commodity pools, the Agencies
believe that it is beneficial to utilize an already established set of
rules, regulations, and guidance. The Agencies considered alternative
approaches provided by the commenters, but have adopted the approach
taken in the final rule for the reasons discussed above and because the
Agencies believe that the final rule, by incorporating concepts with
which commodity pools and their operators are familiar, more clearly
delineates the commodity pools that are covered funds.\1725\
---------------------------------------------------------------------------
\1725\ Operators of commodity pools currently must consider
whether they are required to register with the CFTC as commodity
pool operators, and whether the pools have the characteristics that
would make it possible for the operator to claim an exemption under
section 4.7. These concepts thus should be familiar to commodity
pools and their operators, and including these concepts in the final
rule should allow banking entities more easily to determine if a
particular commodity pools is a covered fund than if the Agencies
were to develop new concepts solely for purposes of the final rule.
---------------------------------------------------------------------------
The Agencies believe that the final rule's tailored approach to
commodity pools includes in the definition of covered fund commodity
pools that are similar to funds that rely on section 3(c)(1) and
3(c)(7). The Agencies also note in this regard that a commodity pool
that would be a covered fund even under this tailored approach will not
be a covered fund if the pool also qualifies for an exclusion from the
covered fund definition, including the exclusion for registered
investments companies. Accordingly, this approach excludes from covered
funds entities like commercial end users and registered investment
companies, whose activities do not implicate the concerns section 13
was designed to address. Rather, the final rule limits the commodity
pools that will be included as covered funds to those that are similar
to other covered funds except that they are not generally subject to
the Investment Company Act of 1940 due to the instruments in which they
invest. For all of these reasons, the Agencies believe that the final
rule's approach to commodity pools addresses both the Agencies'
concerns about the potential for evasion and commenters' concerns about
the breadth of the proposed rule, and provides that the commodity pools
captured as covered funds are ``such similar funds,'' consistent with
section 13(h)(2) of the BHC Act.
The Agencies acknowledge that as a result of including certain
commodity pools in the definition of covered fund, the prohibitions
under section 13(f) and Sec. ----.14 may result in certain structural
changes in the industry. The Agencies note that these changes (e.g.,
bank-affiliated FCMs may not be able to lend money in certain clearing
transactions to affiliated commodity pools that are covered funds) may
result in certain changes in the way related entities do business with
each other. However, the Agencies believe that because the industry is
competitive with a significant number of alternative non-affiliate
competitors, the changes would not result in a less competitive
landscape for investors in commodity pools.
3. Entities Regulated Under the Investment Company Act
The proposed rule did not specifically include registered
investment companies (including mutual funds) or business development
companies within the definition of covered fund.\1726\ As explained
above, the statute references funds that rely on section 3(c)(1) or
3(c)(7) of the Investment Company Act. Registered investment companies
and business development companies do not rely on either section
3(c)(1) or 3(c)(7) of the Investment Company Act and are instead
registered or regulated in accordance with the Investment Company Act.
---------------------------------------------------------------------------
\1726\ See proposed rule Sec. ----.10(b)(1).
---------------------------------------------------------------------------
Many commenters argued that registered investment companies and
business development companies would be treated as covered funds under
the proposed definition if commodity pools are treated as covered
funds.\1727\ A few commenters argued that the final rule should
specifically provide that all SEC-registered funds are excluded from
the definition of covered fund (and the definition of banking entity)
to avoid any uncertainty about whether section 13 applies to these
types of funds.\1728\
---------------------------------------------------------------------------
\1727\ See, e.g., Arnold & Porter; BoA; Goldman (Covered Funds);
ICI (Feb. 2012); Putnam; TCW; Vanguard. According to these
commenters, a registered investment company may use security or
commodity futures, swaps, or other commodity interests in various
ways to manage its investment portfolio and be swept into the broad
definition of ``commodity pool'' contained in the Commodity Exchange
Act.
\1728\ See Arnold & Porter; Goldman (Covered Funds); See also
SIFMA et al. (Covered Funds) (Feb. 2012); SIFMA et al. (Mar. 2012);
ABA (Keating); BoA; ICI (Feb. 2012); JPMC; (requesting clarification
that registered investment companies are not banking entities); TCW.
---------------------------------------------------------------------------
Commenters also requested that the final rule exclude from the
definition of covered fund entities formed to establish registered
investment companies during the seeding period. These commenters
contended that, during the early stages of forming and seeding a
registered investment company, an entity relying on section 3(c)(1) or
(3)(c)(7) may be created to facilitate the development of a track
record for the registered investment company so that it may be marketed
to unaffiliated investors.\1729\
---------------------------------------------------------------------------
\1729\ See ICI (Feb. 2012); TCW.
---------------------------------------------------------------------------
The Agencies did not intend to include registered investment
companies and business development companies as covered funds under the
proposal. Section 13's definition of private equity fund and hedge fund
by reference to section 3(c)(1) and 3(c)(7) of the Investment Company
Act appears to reflect Congress' concerns about banking entities'
exposure to and relationships with investment funds that explicitly are
excluded from SEC regulation as investment companies. The Agencies do
not believe it would be appropriate to treat as a covered fund
registered investment companies and business development companies,
which are regulated by the SEC as investment companies. The Agencies
believe that the proposed rule's inclusion of commodity pools would
have resulted in some registered investment companies and business
development companies being covered
[[Page 5676]]
funds, a result the Agencies did not intend. The Agencies, in addition
to narrowing the commodity pools that will be included as covered funds
as discussed above, have also modified the final rule to exclude SEC-
registered investment companies and business development companies from
the definition of covered fund.\1730\
---------------------------------------------------------------------------
\1730\ See final rule Sec. ----.10(c)(12).
---------------------------------------------------------------------------
The Agencies also recognize that an entity that becomes a
registered investment company or business development company might,
during its seeding period, rely on section 3(c)(1) or 3(c)(7). The
Agencies have determined to exclude these seeding vehicles from the
covered fund definition for the same reasons the Agencies determined to
exclude entities that are operating as registered investment companies
or business development companies as discussed in more detail below in
Part IV.B.1.c.12 of this SUPPLEMENTARY INFORMATION.
The Agencies also understand that registered investment companies
may establish and hold subsidiary entities that rely on section 3(c)(1)
or 3(c)(7) in order to trade in various financial instruments for the
registered investment company parent. If a registered investment
company were itself a banking entity, section 13 and the final rule
would prohibit the registered investment company from sponsoring or
investing in such an investment subsidiary. But a registered investment
company would only itself be a banking entity if it is an affiliate of
an insured depository institution. As explained in the proposal, a
registered investment company, such as a mutual fund or exchange traded
fund, or an entity that has made an effective election to be regulated
as a business development company, would not be an affiliate of a
banking entity for purposes of section 13 of that Act solely by virtue
of being advised, or organized, sponsored and managed by a banking
entity in accordance with the BHC Act (including section 13) and the
Board's Regulation Y.\1731\
---------------------------------------------------------------------------
\1731\ See Joint Proposal, 76 FR 68,856.
---------------------------------------------------------------------------
Under the BHC Act, an entity (including a registered investment
company) would generally be considered an affiliate of a banking
entity, and therefore a banking entity itself, if it controls, is
controlled by, or is under common control with an insured depository
institution.\1732\ Pursuant to the BHC Act, a company controls another
company if: (i) The company directly or indirectly or acting through
one or more other persons owns, controls, or has power to vote 25 per
cent or more of any class of voting securities of the company; (ii) the
company controls in any manner the election of a majority of the
directors of trustees of the other company; or (iii) the Board
determines, after notice and opportunity for hearing, that the company
directly or indirectly exercises a controlling influence over the
management or policies of the company.\1733\
---------------------------------------------------------------------------
\1732\ See final rule Sec. ----.2(a) (defining ``affiliate''
for purposes of the final rule).
\1733\ See 12 U.S.C. 1841(a)(2); 12 CFR 225.2(e).
---------------------------------------------------------------------------
The Board's regulations and orders have long recognized that a bank
holding company may organize, sponsor, and manage a mutual fund such as
a registered investment company, including by serving as investment
adviser to registered investment company, without controlling the
registered investment company for purposes of the BHC Act.\1734\ For
example, the Board has permitted a bank holding company to own up to 5
percent of the voting shares of a registered investment company for
which the bank holding company provides investment advisory,
administrative, and other services, and has a number of director and
officer interlocks, without finding that the bank holding company
controls the fund.\1735\ The Board has also permitted a bank holding
company to own less than 25 percent of the voting shares of a
registered investment company and provide similar services without
finding that the bank holding company controls the fund, so long as the
fund limits its investments to those permissible for the holding
company to make itself.\1736\
---------------------------------------------------------------------------
\1734\ See, e.g., 12 CFR 211.10(a)(11); 225.28(b)(6)(i);
225.86(b)(3); Unicredito, 86 Fed. Res. Bull. 825 (2000); Societe
Generale, 84 Fed. Res. Bull. 680 (1998); Commerzbank AG, 83 Fed.
Res. Bull. 678 (1997); The Governor and Company of the Bank of
Ireland, 82 Fed. Res. Bull. 1129 (1996); Mellon Bank Corp., 79 Fed.
Res. Bull. 626 (1993); Bayerische Vereinsbank AG, 73 Fed. Res. Bull.
155 (1987).
\1735\ See, e.g., Societe Generale, 84 Fed. Res. Bull. 680
(1998) (finding that a bank holding company does not control a
mutual fund for which it holds up to 5 percent of the voting shares
and also provides investment advisory, administrative and other
services, has directors or employees who comprise less than 25
percent of the board of directors of the fund (including the
chairman of the board), and has three senior officer interlocks and
a number of junior officer interlocks).
\1736\ See letter dated June 24, 1999, to H. Rodgin Cohen, Esq.,
Sullivan & Cromwell (First Union Corp.), from Jennifer J. Johnson,
Secretary of the Board of Governors of the Federal Reserve System
(finding that a bank holding company does not control a mutual fund
for which it provides investment advisory and other services and
that complies with the limitations of section 4(c)(7) of the BHC Act
(12 U.S.C. 1843(c)(7)), so long as (i) the bank holding company
reduces its interest in the fund to less than 25 percent of the
fund's voting shares after a six-month period, and (ii) a majority
of the fund's directors are independent of the bank holding company
and the bank holding company cannot select a majority of the board)
(``First Union Letter''); H.R. Rep. No. 106-434 at 153 (1999) (Conf.
Rep.) (noting that the Act permits a financial holding company to
sponsor and distribute all types of mutual funds and investment
companies); See also 12 U.S.C. 1843(k)(1), (6).
---------------------------------------------------------------------------
The BHC Act, as amended by the Gramm-Leach-Bliley Act, and the
Board's Regulation Y authorize a bank holding company that qualifies as
a financial holding company to engage in a broader set of activities,
and to have a broader range of relationships or investments with
entities, than bank holding companies.\1737\ For instance, a financial
holding company may engage in, or acquire shares of any company engaged
in, any activity that is financial in nature or incidental to such
financial activity, including any activity that a bank holding company
is permitted to engage in or acquire by regulation or order.\1738\ In
light of the foregoing, for purposes of section 13 of the BHC Act a
financial holding company may own more than 5 percent (and less than 25
percent) of the voting shares of a registered investment company for
which the holding company provides investment advisory, administrative,
and other services and has a number of director and officer interlocks,
without controlling the fund for purposes of the BHC Act.\1739\
---------------------------------------------------------------------------
\1737\ See, e.g., H.R. Rep. No. 106-434 at 153 (1999) (Conf.
Rep.) (noting that the Act permits a financial holding company to
sponsor and distribute all types of mutual funds and investment
companies).
\1738\ See 12 U.S.C. 1843(k)(1); 12 CFR 225.86.
\1739\ See First Union Letter (June 24, 1999); See also 12 CFR
225.86(b)(3) (authorizing a financial holding company to organize,
sponsor, and manage a mutual fund so long as (i) the fund does not
exercise managerial control over the entities in which the fund
invests, and (ii) the financial holding company reduces its
ownership in the fund, if any, to less than 25 percent of the equity
of the fund within one year of sponsoring the fund or such
additional period as the Board permits).
---------------------------------------------------------------------------
So long as a bank holding company or financial holding company
complies with these limitations, it would not, absent other facts and
circumstances, control a registered investment company and the
registered investment company for purposes of section 13 (and any
subsidiary thereof) would not itself be a banking entity subject to the
restrictions of section 13 of the BHC Act and any final implementing
rules (unless the registered investment company itself otherwise
controls an insured depository institution). Also consistent with the
Board's precedent regarding bank holding company control of and
relationships with funds, a seeding vehicle that will become a
registered investment company or SEC-regulated business development
[[Page 5677]]
company would not itself be viewed as violating the requirements of
section 13 during the seeding period so long as the banking entity that
establishes the seeding vehicle operates the vehicle pursuant to a
written plan, developed in accordance with the banking entity's
compliance program, that reflects the banking entity's determination
that the vehicle will become a registered investment company or SEC-
regulated business development company within the time period provided
by section 13(d)(4) and Sec. ----.12 for seeding a covered fund.\1740\
---------------------------------------------------------------------------
\1740\ See final rule Sec. Sec. ----.10(c)(12) and ----.20(e).
Under the final rule, these Seeding vehicles also must comply with
the limitations on leverage under the Investment Company Act that
apply to registered investment companies and SEC-regulated business
development companies. See final rule Sec. ----.10(c)(12).
---------------------------------------------------------------------------
c. Entities Excluded From Definition of Covered Fund
As noted above, the final rule excludes a number of entities from
the definition of covered fund.\1741\ As discussed in more detail
below, these exclusions more effectively tailor the definition of
covered fund to those types of entities that section 13 was designed to
focus on. The exclusions thus are designed to provide certainty,
mitigate compliance costs and other burdens, and address the potential
over-breadth of the covered fund definition and related requirements
without such exclusions by permitting banking entities to invest in and
have other relationships with entities that do not relate to the
statutory purpose of section 13. These exclusions, described in more
detail below, take account of information provided by many commenters
regarding entities that would likely be included within the proposed
definition of a covered fund, but that are not traditionally thought of
as hedge funds or private equity funds.\1742\ Finally, the Agencies
note that providing exclusions from the covered fund definition, rather
than providing permitted activity exemptions as proposed in some cases,
aligns the final rule with the statute in applying the restrictions
imposed by section 13(f) on transactions with covered funds only to
transactions with issuers that are defined as covered funds and thus
raise the concerns section 13 was designed to address.
---------------------------------------------------------------------------
\1741\ See final rule Sec. ----.10(c).
\1742\ See 156 Cong. Rec. H5226 (daily ed. June 30, 2010)
(statement of Reps. Himes and Frank) (noting intent that
subsidiaries or joint ventures not be included within the definition
of covered fund); 156 Cong. Rec. S5904-05 (daily ed. July 15, 2010)
(statement of Sens. Boxer and Dodd) (noting broad definition of
hedge fund and private equity fund and recommending that the
Agencies take steps to ensure definition is reasonably tailored);
See also FSOC study at 61-63.
---------------------------------------------------------------------------
The Agencies recognize, however, that the final rule's definition
of covered fund does not include certain pooled investment vehicles.
For example, the definition of covered fund excludes business
development companies, entities that rely on section 3(c)(5)(C),
3(c)(3), or 3(c)(11) of the Investment Company Act, and certain foreign
public funds that are subject to home-country regulation. The Agencies
expect that the types of pooled investment vehicles sponsored by the
financial services industry will continue to evolve, including in
response to the final rule, and the Agencies will be monitoring this
evolution to determine whether excluding these and other types of
entities remains appropriate. The Agencies will also monitor use of the
exclusions for attempts to evade the requirements of section 13 and
intend to use their authority where appropriate to prevent evasions of
the rule.
1. Foreign Public Funds
As discussed above, under the proposal a covered fund was defined
to include the foreign equivalent of any covered fund in order to
address the potential for circumvention. Many commenters argued that
the proposed definition could capture non-U.S. public retail funds,
such as UCITS.\1743\ These commenters contended that non-U.S. public
retail funds should be excluded from the definition of covered fund
because they are regulated in their home jurisdiction; commenters noted
that similar funds registered in the United States, such as mutual
funds, are not covered funds.\1744\
---------------------------------------------------------------------------
\1743\ As discussed above, the proposed rule generally included
in the covered fund definition a foreign fund that, were it
organized or offered under the laws of the United States or offered
to U.S. residents, would meet the definition of a domestic covered
fund (i.e., would need to rely section 3(c)(1) or 3(c)(7) of the
Investment Company Act). Many commenters argued that this definition
is too broad and could include as covered funds various types of
foreign funds, like UCITS, that commenters argued should not be
included. See, e.g., JPMC; BlackRock.
\1744\ See SIFMA et al. (Covered Funds) (Feb. 2012); Hong Kong
Inv. Funds Ass'n.; UBS; ICI Global; BlackRock; TCW; State Street
(Feb. 2012); SSgA (Feb. 2012); IAA; JPMC; Goldman (Covered Funds);
BoA; Credit Suisse (Williams); BNY Mellon, et al.; Union Asset;
EFAMA; BVI; IRSG, SEB; IIB/EBF; GE (Feb. 2012) (commenting on the
overbreadth of the definition because of the effect on foreign
issuers of asset-backed securities); Allen & Overy (on behalf of
Foreign Bank Group).
---------------------------------------------------------------------------
Some commenters were concerned that the proposed definition could
inadvertently capture exchange-traded funds trading in foreign
jurisdictions,\1745\ separate accounts set up to fund foreign pension
plans,\1746\ non-U.S. issuers of asset-backed securities,\1747\ and
non-U.S. regulated funds specifically designed for institutional
investors.\1748\ Commenters also provided several potential effects of
capturing foreign public funds under the covered fund definition: U.S.
banking entities would incur unnecessary and substantial costs to
rebrand and restructure their non-U.S. regulated funds,\1749\ banking
entities could be eliminated from the potential pool of counterparties,
thereby affecting pricing and efficiency,\1750\ U.S. banking entities
may exit the UCITS market and lose competitiveness,\1751\ the growth of
mutual fund formation in foreign countries could be limited,\1752\ and
market liquidity in foreign jurisdictions could be impaired.\1753\
---------------------------------------------------------------------------
\1745\ See BlackRock; Vanguard.
\1746\ See BlackRock.
\1747\ See ASF (Feb. 2012).
\1748\ See Union Asset; EFAMA; BVI.
\1749\ See Goldman (Covered Funds).
\1750\ See AFMA.
\1751\ See BoA.
\1752\ See BVI.
\1753\ See Goldman (Covered Funds).
See AFMA.
See BoA.
---------------------------------------------------------------------------
Some commenters supported excluding any foreign public fund that is
organized or formed under non-U.S. law, authorized for public sale in
the jurisdiction in which it is organized or formed, and regulated as a
public investment company in that jurisdiction.\1754\ In light of the
proposal's broad definition of covered fund, some commenters
recommended explicitly excluding non-U.S. regulated funds based on
characteristics to distinguish the foreign funds that should be treated
as covered funds.\1755\ Several commenters recommended excluding non-
U.S. funds based upon whether the funds are subject to a regulatory
framework comparable to that which is imposed on SEC-registered
funds;\1756\ one commenter specifically identified European UCITS,
Canadian mutual funds, Australian unit trusts, and Japanese investment
trusts as examples of regulated funds to be excluded.\1757\
---------------------------------------------------------------------------
\1754\ See ICI Global; ICI (Feb. 2012); SSgA (Feb. 2012); BNY
Mellon et al.
\1755\ See UBS; ICI Global; ICI (Feb. 2012); Allen & Overy (on
behalf of Foreign Bank Group); T. Rowe Price; HSBC Life; Union
Asset; EFAMA; BVI; EBF; Hong Kong Inv. Funds Ass'n.; IMA; Ass'n. of
Institutional Investors (Feb. 2012); Katten (on behalf of Int'l
Clients); Credit Suisse (Williams).
\1756\ See T. Rowe Price; Credit Suisse (Williams); SSgA (Feb.
2012); BNY Mellon et al.
\1757\ See T. Rowe Price.
---------------------------------------------------------------------------
To address these concerns, the final rule generally excludes from
the definition of covered fund any issuer
[[Page 5678]]
that is organized or established outside of the United States and the
ownership interests of which are authorized to be offered and sold to
retail investors in the issuer's home jurisdiction and are sold
predominantly through one or more public offerings outside of the
United States.\1758\ Foreign funds that meet these requirements will
not be covered funds, except that an additional condition applies to
U.S. banking entities\1759\ with respect to the foreign public funds
they sponsor. The foreign public fund exclusion is only available to a
U.S. banking entity with respect to a foreign fund sponsored by the
U.S. banking entity if, in addition to the requirements discussed
above, the fund's ownership interests are sold predominantly to persons
other than the sponsoring banking entity, affiliates of the issuer and
the sponsoring banking entity, and employees and directors of such
entities.
---------------------------------------------------------------------------
\1758\ See final rule Sec. ----.10(c)(1).
\1759\ Although the discussion of this condition generally
refers to U.S. banking entities for ease of reading, the condition
also applies to foreign affiliates of a U.S. banking entity. See
final rule Sec. ----.10(c)(1)(ii) (applying this limitation
``[w]ith respect to a banking entity that is, or is controlled
directly or indirectly by a banking entity that is, located in or
organized under the laws of the United States or of any State and
any issuer for which such banking entity acts as sponsor'').
---------------------------------------------------------------------------
For purposes of this exclusion, the Agencies note that the
reference to retail investors, while not defined, should be construed
to refer to members of the general public who do not possess the level
of sophistication and investment experience typically found among
institutional investors, professional investors or high net worth
investors who may be permitted to invest in complex investments or
private placements in various jurisdictions. Retail investors would
therefore be expected to be entitled to the full protection of
securities laws in the home jurisdiction of the fund, and the Agencies
would expect a fund authorized to sell ownership interests to such
retail investors to be of a type that is more similar to a U.S.
registered investment company rather than to a U.S. covered fund.
In order to help maintain this distinction and to avoid
circumstances that could result in an evasion of section 13 and the
final rule, the ownership interests of the fund must be sold
predominantly in one or more public offerings outside of the United
States to qualify for the exclusion. Given this restriction, a U.S.
banking entity therefore could not rely on this exclusion to set up a
foreign public fund for the purpose of selling a significant amount of
ownership interests in the fund through one or more offerings conducted
on an unregistered basis (whether in a foreign jurisdiction or in the
United States). The Agencies generally expect that an offering is made
predominantly outside of the United States if 85 percent or more of the
fund's interests are sold to investors that are not residents of the
United States.
The requirements that a foreign public fund both be authorized for
sale to retail investors and sold predominantly in public offerings
outside of the United States are based in part on the Agencies' view
that foreign funds that meet these requirements generally will be
sufficiently similar to U.S. registered investment companies such that
it is appropriate to exclude these foreign funds from the covered fund
definition. A foreign fund authorized for sale to retail investors that
is also publicly offered may, for example, provide greater information
than funds that are sold through private offerings like funds that rely
on section 3(c)(1) or 3(c)(7). Such foreign funds also may be subject
to various restrictions, as deemed appropriate by foreign regulators in
light of local conditions and practices, that exceed those applicable
to privately offered funds. Foreign regulators may apply these or other
enhanced restrictions or other requirements to funds that are offered
on a broad basis to the general public for the protection of investors
in those jurisdictions.
A foreign fund that purports to publicly offer its shares but in
fact offers them on a more limited basis, however, may be less likely
to resemble a registered investment company in these and other
respects. In order to limit the foreign public fund exclusion to funds
that publicly offer their shares on a sufficiently broad basis, the
final rule defines the term ``public offering'' for purposes of this
exclusion to mean a ``distribution'' (as defined in Sec. ----.4(a)(3)
of subpart B) of securities in any jurisdiction outside the United
States to investors, including retail investors, provided that (i) the
distribution complies with all applicable requirements in the
jurisdiction in which such distribution is being made; (ii) the
distribution does not restrict availability to investors having a
minimum level of net worth or net investment assets; and (iii) the
issuer has filed or submitted, with the appropriate regulatory
authority in such jurisdiction, offering disclosure documents that are
publicly available.\1760\
---------------------------------------------------------------------------
\1760\ See final rule Sec. ----.10(c)(1)(iii).
---------------------------------------------------------------------------
Under the final rule, therefore, a foreign fund's distribution
would not be a public offering for purposes of the foreign public fund
exclusion if the distribution imposes investor restrictions based on a
required minimum level of net worth or net investment assets. This
would not be affected by any suitability requirements that may be
imposed under applicable local law. In addition, the final rule
requires that, in connection with a public offering by a foreign public
fund, the offering disclosure documents must be ``publicly available.''
This requirement will provide assurance regarding the transparency for
such an offering and will generally be satisfied where the documents
are made accessible to all persons in such jurisdiction. Disclosure
documents may be made publicly available in a variety of means, such as
through a public filing with a regulatory agency or through a Web site
that provides broad accessibility to persons in such jurisdiction.
In addition and as discussed above, the final rule also places an
additional condition on a U.S. banking entity's ability to rely on the
foreign public fund exclusion with respect to the foreign public funds
it sponsors. For a U.S. banking entity to rely on the foreign public
fund exclusion with respect to a foreign public fund it sponsors, the
ownership interests in the fund must be sold predominantly to persons
other than the sponsoring U.S. banking entity and certain persons
connected to that banking entity. Consistent with the Agencies' view
concerning whether a foreign public fund has been sold predominantly
outside of the United States, the Agencies generally expect that a
foreign public fund will satisfy this additional condition if 85
percent or more of the fund's interests are sold to persons other than
the sponsoring U.S. banking entity and certain persons connected to
that banking entity.
This additional condition reflects the Agencies' view that the
foreign public fund exclusion is designed to treat foreign public funds
consistently with similar U.S. funds and to limit the extraterritorial
application of section 13 of the BHC Act, including by permitting U.S.
banking entities and their foreign affiliates to carry on traditional
asset management businesses outside of the United States. The exclusion
is not intended to permit a U.S. banking entity to establish a foreign
fund for the purpose of investing in the fund as a means of avoiding
the restrictions imposed by section 13. Permitting a U.S. banking
entity to invest in a foreign public fund under this exclusion only
[[Page 5679]]
when that fund is sold predominantly to persons other than the
sponsoring U.S. banking entity and certain persons connected to that
banking entity permits U.S. banking entities to continue their asset
management businesses outside of the United States while also limiting
the opportunity for evasion of section 13 as discussed below.
This additional condition only applies to U.S. banking entities
with respect to the foreign public funds they sponsor because the
Agencies believe that a foreign public fund sponsored by a U.S. banking
entity may present heightened risks of evasion. Absent the additional
condition, a U.S. banking entity could establish a foreign public fund
for the purpose of itself investing substantially in that fund and,
through the fund, making investments that the banking entity could not
make directly under section 13. The Agencies believe it is less likely
that a U.S. banking entity effectively could evade section 13 by
investing in third-party foreign public funds that the banking entity
does not sponsor. In those cases it is less likely that the U.S.
banking entity would be able to control the investments of the fund,
and the fund thus likely would be a less effective means for the
banking entity to engage in proprietary trading through the fund. The
Agencies therefore have declined to apply this additional condition
with respect to any foreign public fund in which a U.S. banking entity
invests but does not act as sponsor.
The Agencies note that the foreign public fund exclusion is not
intended to permit a banking entity to sponsor a foreign fund for the
purpose of selling ownership interests to any banking entity
(affiliated or unaffiliated) that is, or is controlled directly or
indirectly by a banking entity that is, located in or organized under
the laws of the United States or of any State (or to a limited group of
such banking entities). The Agencies intend to monitor banking
entities' investments in foreign public funds to ensure that banking
entities do not use the exclusion for foreign public funds in a manner
that functions as an evasion of section 13 in this or any other way.
The Agencies expect that one area of focus for such monitoring would be
significant investments in a foreign public fund, including a fund that
is unaffiliated with any banking entity located in or organized under
the laws of the United States or of any State, where such investments
represent a substantial percentage of the ownership interests in such
fund.
In order to conduct this monitoring more effectively, the Agencies
also are adopting certain documentation requirements concerning U.S.
banking entities' investments in foreign public funds, as discussed in
more detail below in Part IV.C.1 of this SUPPLEMENTARY INFORMATION.
Under the final rule, a U.S. banking entity with more than $10 billion
in total consolidated assets will be required to document its
investments in foreign public funds, broken out by each foreign public
fund and each foreign jurisdiction in which any foreign public fund is
organized, if the U.S. banking entity and its affiliates' ownership
interests in foreign public funds exceed $50 million at the end of two
or more consecutive calendar quarters. This requirement thus is
tailored to apply only to U.S. banking entities above a certain size
that also have substantial investments in foreign public funds.\1761\
The Agencies believe this approach appropriately balances the Agencies'
evasion concerns and the burdens that documentation requirements
impose.
---------------------------------------------------------------------------
\1761\ See final rule Sec. ----.20(e).
---------------------------------------------------------------------------
For all of the reasons discussed above, the Agencies believe that
the final rule's approach to foreign public funds is consistent with
the final rule's exclusion of registered or otherwise exempt (without
reliance on the exemptions in section 3(c)(1) or 3(c)(7)) funds in the
United States. It also limits the extraterritorial application of
section 13 of the BHC Act and reduces the potential economic and other
burdens commenters argued would result for banking entities. The
Agencies believe that this exclusion represents an appropriate
balancing of considerations that should not significantly increase the
risks to the U.S. financial system that section 13 was designed to
limit.
2. Wholly-Owned Subsidiaries
Under the proposed rule, a banking entity would have been permitted
to invest in or sponsor a wholly-owned subsidiary that relies on the
exclusion contained in section 3(c)(1) or 3(c)(7) of the Investment
Company Act to avoid being an investment company under that Act if the
subsidiary was carried on the balance sheet of its parent and was
engaged principally in performing bona fide liquidity management
activities.\1762\
---------------------------------------------------------------------------
\1762\ See proposed rule Sec. ----.14(a)(2)(iv); Joint
Proposal, 76 FR 68,913.
---------------------------------------------------------------------------
Commenters argued that, instead of providing a permitted activity
exemption for banking entities to invest in or sponsor certain wholly-
owned subsidiaries as proposed, all wholly-owned subsidiaries should be
excluded from the definition of covered fund under the final rule
because wholly-owned subsidiaries are typically used for organizational
convenience and generally do not have the characteristics, risks, or
purpose of a hedge fund or private equity fund, which involves
unaffiliated investors owning interests in the structure for the
purpose of sharing in the profits and losses from investment
activities.\1763\ Commenters explained that publicly traded companies
often establish wholly-owned intermediate companies for the purpose of
holding securities of operating entities or other corporate vehicles
necessary to the business of the entity. Because these intermediate
companies invest entirely (or substantially) in the securities of other
entities, these intermediate companies may be investment companies for
purposes of the Investment Company Act but for the exclusion provided
by section 3(c)(1) or 3(c)(7) of the Investment Company Act.\1764\
---------------------------------------------------------------------------
\1763\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012),
JPMC; Goldman (Covered Funds), NAIB et al.; GE (Feb. 2012); BoA;
Chamber (Feb. 2012); Wells Fargo (Covered Funds); ABA (Keating);
Ass'n. of Institutional Investors (Feb. 2012); Credit Suisse
(Williams); Rep. Himes; BOK.
\1764\ See 15 U.S.C. 80a-3(a)(1)(A) & (C).
---------------------------------------------------------------------------
Commenters contended that requiring banking entities to divest
their interests in wholly-owned subsidiaries and cease certain
intercompany transactions would have a material adverse effect on the
safety, soundness, efficiency and stability of the U.S. and global
financial systems, which could in turn have a material adverse effect
on the wider economy in terms of reduced credit, increased unemployment
and reduced output.\1765\ Commenters also argued that an exclusion for
wholly-owned subsidiaries is necessary in order to avoid a conflict
with other important requirements in the Dodd-Frank Act. For example,
commenters alleged that including wholly-owned subsidiaries within the
definition of covered fund for purposes of section 13 would create a
conflict with the requirement that a banking entity that is a bank
holding company serve as a source of strength to its subsidiaries
because the prohibition in section 13(f) on transactions between a
banking entity and covered funds owned or sponsored by the banking
entity would effectively prohibit the banking entity from providing
financial resources to wholly-owned intermediate holding companies and
their subsidiaries.\1766\ Other commenters argued that banking entities
would bear extensive compliance costs and operational burdens and
likely would be
[[Page 5680]]
restricted from structuring themselves effectively.\1767\
---------------------------------------------------------------------------
\1765\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012).
\1766\ See SIFMA et al. (Covered Funds) (Feb. 2012); BoA; Rep.
Himes.
\1767\ See, e.g., Goldman (Covered Funds); BoA.
---------------------------------------------------------------------------
Commenters proposed several alternatives to address these concerns.
For instance, commenters recommended that the final rule exclude all
wholly-owned subsidiaries from the definition of covered fund.\1768\
Commenters also urged that the final rule include ownership interests
held by employees of a banking entity with any ownership interests held
directly by the banking entity for purposes of qualifying for any
exclusion granted by the rule for wholly-owned subsidiaries.\1769\
Another commenter recommended the exclusion of subsidiaries, wholly
owned or not, that engage in bona fide liquidity management.\1770\
---------------------------------------------------------------------------
\1768\ See Rep. Himes; Fin. Services Roundtable (June 14, 2011);
SIFMA et al. (Covered Funds) (Feb. 2012); BOK; Chamber (Feb. 2012);
ABA (Keating); GE (Feb. 2012); Wells Fargo (Covered Funds); Goldman
(Covered Funds); Ass'n. of Institutional Investors (Feb. 2012); BoA;
NAIB et al.
\1769\ See Wells Fargo (Covered Funds); Credit Suisse
(Williams).
\1770\ See Credit Suisse (Williams).
---------------------------------------------------------------------------
In light of these comments and consistent with the purposes of
section 13 and the terms of the Dodd-Frank Act as discussed in more
detail above, the Agencies have revised the final rule to exclude
wholly-owned subsidiaries from the definition of covered fund,
including those not engaged in liquidity management.\1771\ A wholly-
owned subsidiary, as defined in the final rule, is an entity, all of
the outstanding ownership interests of which are owned directly or
indirectly by the banking entity (or an affiliate thereof), except that
(i) up to five percent of the entity's ownership interests may be owned
by directors, employees, and certain former directors and employees of
the banking entity (or an affiliate thereof); and (ii) within the five
percent ownership interests described in clause (i), up to 0.5 percent
of the entity's outstanding ownership interests may be held by a third
party if the ownership interest is held by the third party for the
purpose of establishing corporate separateness or addressing
bankruptcy, insolvency, or similar concerns.\1772\
---------------------------------------------------------------------------
\1771\ Although not a condition of the exclusion, banking
entities may use wholly-owned subsidiaries to engage in bona fide
liquidity management. As discussed below, however, a wholly-owned
subsidiary is itself a banking entity, and thus is subject to all of
the requirements that apply to banking entities, including the
requirements applicable to a banking entity's liquidity management
activities under Sec. ----.3(d)(3).
\1772\ See final rule Sec. ----.10(c)(2).
---------------------------------------------------------------------------
Although the final rule includes ownership interests held by
certain former directors and employees for purposes of qualifying for
the exclusion, the exclusion requires that an interest held by a former
(or current) director or employee must actually be held by that person
(or by the banking entity) and must have been acquired while employed
by or in the service of the banking entity. For example, if a former
employee subsequently transfers his/her interest to a third party
(other than to immediate family members of the employee or through
intestacy of the employee), then the ownership interest would no longer
be held by the banking entity or persons whose ownership interests may
be aggregated with interests held by the banking entity for purposes of
the exclusion for wholly-owned subsidiaries under the final rule.
The final rule also permits up to 0.5 percent of the ownership
interest of a wholly-owned subsidiary to be held by a third party if
the interest is held by the third party for the purpose of establishing
corporate separateness or addressing bankruptcy, insolvency, or similar
concerns, and the ownership interest is included when calculating the
five percent cap on employee and director ownership. The Agencies
understand that it is often important, or in certain circumstances
required, under the laws of various jurisdictions for a parent company
to establish corporate separation of a subsidiary through the issuance
of a small amount of ownership interest to a third party.
The Agencies believe that permitting limited employee and director
ownership of a vehicle and accommodating the foreign law requirements
discussed above is consistent with a vehicle's treatment as a wholly-
owned subsidiary. Under the final rule, the banking entity (or an
affiliate thereof) will control the vehicle because it must, as
principal, own at least 95% of the vehicle.\1773\ These conditions are
designed to exclude from the covered fund definition vehicles that are
formed for corporate and organizational convenience, as discussed
above, and that thus do not engage in the investment activities
prohibited by section 13. The exclusion also should reduce the
disruption to the operations of banking entities that commenters
asserted would result from the proposed rule.\1774\
---------------------------------------------------------------------------
\1773\ Cf. Section 2(a)(43) of the Investment Company Act
(defining a ``wholly-owned subsidiary'' of a person to mean ``a
company 95 per centum or more of the outstanding voting securities
of which are owned by such person, or by a company which, within the
meaning of this paragraph, is a wholly-owned subsidiary of such
person'').
\1774\ The Agencies also note that depositors for asset-backed
securities offerings are important to the process of securitization.
See, e.g., ASF (July 2012) (noting that a depositor, as used in a
securitization structure, is an entity that generally acts only as a
conduit to transfer the loans from the originating bank to the
issuing entity for the purpose of facilitating a securitization
transaction and engages in no discretionary investment or securities
issuance activities). See also, Rule 191 under the Securities Act of
1933 (17 CFR 230.191) (depositor as issuer for registered asset-
backed securities offerings). Commenters raised a question about the
treatment of depositors under the Investment Company Act, and
therefore, whether they would technically fall within the definition
of covered fund. See ASF (July 2012); GE (Aug. 2012). For purposes
of the covered fund prohibitions, the Agencies note that depositors
may fall within the wholly-owned subsidiary exclusion from the
covered fund definition.
---------------------------------------------------------------------------
Importantly, the Agencies note that a wholly-owned subsidiary of a
banking entity--although excluded from the definition of covered fund--
still would itself be a banking entity, and therefore remain subject to
the prohibitions and other provisions of section 13 of the BHC Act and
the final rule.\1775\ Accordingly, a wholly-owned subsidiary of a
banking entity would remain subject to the restrictions of section 13
and the final rule (including the ban on proprietary trading) and may
not engage in activity in violation of the prohibitions of section 13
and the final rule.
---------------------------------------------------------------------------
\1775\ See 12 U.S.C. 1851(h)(1) (defining banking entity to
include any affiliate or subsidiary of a banking entity).
---------------------------------------------------------------------------
3. Joint Ventures
The proposed rule would have permitted a banking entity to invest
in or manage a joint venture between the banking entity and any other
person, provided that the joint venture was an operating company and
did not engage in any activity or any investment not permitted under
the proposed rule. As noted in the proposal, many joint ventures rely
on the exclusion contained in section 3(c)(1) or 3(c)(7) of the
Investment Company Act.\1776\ Joint ventures are a common form of
business, especially for firms seeking to enter new lines of business
or new markets, or seeking to share complementary business expertise.
---------------------------------------------------------------------------
\1776\ See Joint Proposal, 76 FR 68,913.
---------------------------------------------------------------------------
Commenters supported this aspect of the proposal and argued that
joint ventures do not share the same characteristics as a hedge fund or
private equity fund. However, they expressed concern that joint
ventures were defined too narrowly under the proposal because the
exclusion was limited to joint ventures that were operating
companies.\1777\ Some
[[Page 5681]]
commenters criticized the lack of guidance regarding the meaning of
operating company.\1778\ One commenter proposed defining operating
company as any company engaged in activities that are permissible for a
financial holding company under sections 3 or 4 of the BHC Act, other
than a company engaged exclusively in investing in securities of other
companies for resale or other disposition.\1779\
---------------------------------------------------------------------------
\1777\ See, e.g., ABA (Keating); Chamber (Feb. 2012); SIFMA et
al. (Covered Funds) (Feb. 2012); GE (Aug. 2012); Goldman (Covered
Funds); NAIB et al.; Rep Himes; Sen. Bennet; See also 156 Cong Rec.
H5226 (daily ed. June 30, 2010) (statement of Rep. Himes).
\1778\ See, e.g., ABA (Keating); NAIB et al.; GE (Aug. 2012);
Chamber (Feb. 2012); SIFMA et al. (Covered Funds) (Feb. 2012); Wells
Fargo (Covered Funds); Credit Suisse (Williams); Goldman (Covered
Funds).
\1779\ See SIFMA et al. (Covered Funds) (Feb. 2012).
---------------------------------------------------------------------------
Another commenter argued that joint ventures are often used to
share risk from non-performing loans, credit card receivables, consumer
loans, commercial real estate loans or automobile loans.\1780\
According to this commenter, these joint ventures, while not generally
viewed as operating companies, promote safety and soundness by allowing
a banking entity to limit the size of its exposure to permissible
investments or to more efficiently transfer the risk of existing assets
to a small number of partners. Commenters stated that banking entities
often employ similar types of non-operating company joint ventures to
engage in merchant banking activities or other permissible banking
activities, and that the final rule should not prevent a banking entity
from sharing the risk of a portfolio company investment with third
parties.\1781\ A number of commenters argued that treating joint
ventures as covered funds would create the same inconsistencies with
other provisions and principles embodied in the Dodd-Frank Act noted
for wholly-owned subsidiaries, were they to be treated as covered
funds.\1782\ Several commenters argued that the proposed exemption, as
drafted, was unworkable because it did not appear to provide an
exception to the intercompany limitations on transactions under section
13(f), which prohibits transactions between a banking entity and a
related covered fund.\1783\
---------------------------------------------------------------------------
\1780\ See Goldman (Covered Funds).
\1781\ See ABA (Keating); SIFMA et al. (Covered Funds) (Feb.
2012).
\1782\ See SIFMA et al. (Covered Funds) (Feb. 2012); Goldman
(Covered Funds); ABA (Keating); Chamber (Feb. 2012).
\1783\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012);
Goldman (Covered Funds); ABA (Keating); GE (Feb. 2012); Chamber
(Feb. 2012).
---------------------------------------------------------------------------
Commenters proposed several alternatives to address these issues.
Several commenters recommended that the final rule eliminate the
operating company condition under the proposed exemption.\1784\ Other
commenters recommended excluding joint ventures that have an
unspecified but limited number of partners (such as five or fewer joint
venture partners).\1785\ One commenter recommended excluding all
``controlled joint ventures'' but did not provide an explanation of how
to define that term.\1786\ Another commenter suggested defining a joint
venture in one of the following ways: (1) Any company with a limited
number of co-venturers that is managed pursuant to a shareholders'
agreement, as opposed to managed by a general partner; \1787\ or (2) a
joint venture in which: (a) There are a limited number of unaffiliated
partners; (b) the parties operate the venture on a joint basis or in
proportion to their relative ownership, including pursuant to a
shareholders' agreement; (c) material decisions are made by one party
(for example, a general partner); and (d) the joint venture does not
engage in any activity or investment not permitted under section 13,
other than activities or investments incidental to its permissible
business.\1788\
---------------------------------------------------------------------------
\1784\ See SIFMA et al. (Covered Funds) (Feb. 2012); ABA
(Keating); Credit Suisse (Williams).
\1785\ See SIFMA et al. (Covered Funds) (Feb. 2012); Credit
Suisse (Williams); GE (Feb. 2012).
\1786\ See Goldman (Covered Funds).
\1787\ See ABA (Keating); Credit Suisse (Williams); SIFMA et al.
(Covered Funds) (Feb. 2012); SIFMA et al. (Mar. 2012); See also GE
(Feb. 2012); NAIB et al.
\1788\ See Goldman (Covered Funds).
---------------------------------------------------------------------------
In response to commenter concerns, the final rule excludes joint
ventures from the definition of covered fund with some modifications
from the proposal to more clearly identify entities that are excluded.
Under the final rule, a joint venture is excluded from the definition
of covered fund if the joint venture is between the banking entity or
any of its affiliates and no more than 10 unaffiliated co-venturers, is
in the business of engaging in activities that are permissible for the
banking entity other than investing in securities for resale or other
disposition, and is not, and does not hold itself out as being, an
entity or arrangement that raises money from investors primarily for
the purpose of investing in securities for resale or other disposition
or otherwise trading in securities.\1789\ Banking entities, therefore,
will continue to be able to share the risk and cost of financing their
banking activities through these types of entities which, as noted by
commenters as discussed above, may allow banking entities to more
efficiently manage the risk of their operations.
---------------------------------------------------------------------------
\1789\ See final rule Sec. ----.10(c)(3).
---------------------------------------------------------------------------
The Agencies have specified a limit on the number of joint venture
partners at the request of many commenters that suggested such a limit
be added (though typically without suggesting the specific number of
partners). The Agencies believe that a limit of 10 partners allows
flexibility in structuring larger business ventures without involving
such a large number of partners as to suggest the venture is in reality
a hedge fund or private equity fund established for investment
purposes. The Agencies will monitor joint ventures--and other excluded
entities--to ensure that they are not used by banking entities to evade
the provisions of section 13.
The final rule's requirement that a joint venture not be an entity
or arrangement that raises money from investors primarily for the
purpose of investing in securities for resale or other disposition or
otherwise trading in securities prevents a banking entity from relying
on this exclusion to evade section 13 of the BHC Act by owning or
sponsoring what is or will become a covered fund. Consistent with this
restriction and to prevent evasion of section 13, a banking entity may
not use a joint venture to engage in merchant banking activities
because that involves acquiring or retaining shares, assets, or
ownership interests for the purpose of ultimate resale or disposition
of the investment.\1790\
---------------------------------------------------------------------------
\1790\ See 12 U.S.C. 1843(k)(4)(H).
---------------------------------------------------------------------------
As with wholly-owned subsidiaries, if a banking entity owns 25
percent or more of the voting securities of the joint venture or
otherwise controls an entity that qualifies for the joint venture
exclusion, the joint venture would then itself be a banking entity and
would remain subject to the restrictions of section 13 and the final
rule (including the ban on proprietary trading).
The Agencies note that the statute defines banking entity to
include not only insured depository institutions and bank holding
companies, but also their affiliates. In the context of a company that
owns an insured depository institution but is not a bank holding
company or savings and loan holding company, the insured depository
institution's affiliates may engage in commercial activities
impermissible for banks and bank holding companies. However, section 13
of the BHC Act and the final rule do not authorize a banking entity to
engage in otherwise impermissible activities. Because of this, the
scope of activities in which a joint venture may engage under the final
rule will depend on the status and identity of its co-venturers. For
instance, a joint venture between a bank holding
[[Page 5682]]
company and unaffiliated companies may not engage in commercial
activities impermissible for a bank holding company.
4. Acquisition Vehicles
Similar to wholly-owned subsidiaries and joint ventures, the
proposed rule would have permitted a banking entity to invest in or
sponsor an acquisition vehicle provided that the sole purpose and
effect of the acquisition vehicle was to effectuate a transaction
involving the acquisition or merger of an entity with or into the
banking entity or one of its affiliates. As noted in the proposal,
banking entities often form corporate vehicles for the purpose of
accomplishing a corporate merger or asset acquisition.\1791\ Because of
the way they are structured, acquisition vehicles may rely on section
3(c)(1) or 3(c)(7) of the Investment Company Act.\1792\
---------------------------------------------------------------------------
\1791\ Cf. Joint Proposal, 76 FR 68,897.
\1792\ See Joint Proposal, 76 FR 68,913; SIFMA et al. (Covered
Funds) (Feb. 2012).
---------------------------------------------------------------------------
Commenters supported the exclusion of acquisition vehicles from the
restrictions governing covered funds, and argued that acquisition
vehicles do not share the same characteristics as a hedge fund or
private equity fund.\1793\ However, similar to concerns articulated
above with respect to wholly-owned subsidiaries and joint ventures,
commenters argued that the proposed rule, as drafted, left uncertain
how other provisions of section 13 would apply to these vehicles.\1794\
---------------------------------------------------------------------------
\1793\ See, e.g., JPMC; SIFMA et al. (Covered Funds) (Feb.
2012); GE (Feb. 2012); Sen. Bennet; Sen. Carper et al.
\1794\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012);
JPMC; GE (Feb. 2012).
---------------------------------------------------------------------------
In light of the comments, the final rule has been modified to
exclude acquisition vehicles from the definition of covered fund,
rather than provide a permitted activity exemption for banking entities
to invest in or sponsor the vehicles, so long as the vehicle is formed
solely for the purpose of engaging in a bona fide merger or acquisition
transaction and the vehicle exists only for such period as necessary to
effectuate the transaction.\1795\ The final rule thus reflects
modifications from the exemption for acquisition vehicles in the
proposal, which was available for acquisition vehicles where the sole
purpose and effect of the entity was to effectuate a transaction
involving the acquisition or merger of one entity with or into the
banking entity.\1796\ The Agencies modified the conditions in the final
rule, as discussed above, to more clearly reflect the limited
activities in which an excluded acquisition vehicle may engage and to
exclude acquisition vehicles from the definition of covered fund,
rather than only permit banking entities to invest in or sponsor them
pursuant to an exemption.
---------------------------------------------------------------------------
\1795\ See final rule Sec. ----.10(c)(4).
\1796\ The proposed rule contained an exemption for investments
in acquisition vehicles, provided that the ``the sole purpose and
effect of such entity is to effectuate a transaction involving the
acquisition or merger of one entity with or into the covered banking
entity or one of its affiliates.'' See proposed rule Sec. --
--.14(a)(2)(ii). The final rule excludes an acquisition vehicle,
which is defined as an issuer that is ``[f]ormed solely for the
purpose of engaging in a bona fide merger or acquisition
transaction'' and that ``exists only for such period as necessary to
effectuate the transaction.'' See final rule Sec. ----.10(c)(4).
---------------------------------------------------------------------------
The Agencies also note that an acquisition vehicle that survives a
transaction would likely be excluded from the definition of covered
fund under the separate exclusion for either joint ventures or wholly-
owned subsidiaries described above. An acquisition vehicle that is
controlled by a banking entity would be a banking entity itself and
would be subject to the restrictions of section 13 and the final rule
that apply to a banking entity.
5. Foreign Pension or Retirement Funds
Under the proposed rule, a foreign pension plan that relied on
section 3(c)(1) or 3(c)(7) of the Investment Company Act to avoid being
an investment company (or that was a commodity pool), would have been a
covered fund. Commenters argued that including pension funds within the
definition of covered fund would produce many unexpected results for
pension plans as well as plan participants.\1797\
---------------------------------------------------------------------------
\1797\ As explained above, commenters also argued that a foreign
pension plan should not be considered a banking entity if the plan
is sponsored by a banking entity or is established for the benefit
of employees of the banking entity. If deemed a banking entity, the
pension plan could become subject to the limits on section 13 on
investing in covered funds. See Allen & Overy (on behalf of Canadian
Banks); Arnold & Porter; Credit Suisse (Williams). The final rule
addresses these comments with the exclusions described above.
---------------------------------------------------------------------------
Commenters generally argued that foreign pension or retirement
funds are established by a foreign company or foreign sovereign for the
purpose of providing a specific group of foreign persons with income
during retirement or when they reach a certain age or meet certain
predetermined criteria and are typically eligible for preferential tax
treatment, and are not formed for the same purposes as hedge funds or
private equity funds.\1798\ Commenters argued that the definition of
covered fund should not include certain foreign pension or retirement
funds, including managed investment arrangements and wrap platforms,
such as so-called ``superannuation funds,'' that are managed by foreign
banks as part of providing retirement or pension schemes to foreign
citizens pursuant to foreign law and are generally not available for
sale to U.S. citizens. Commenters asserted that many foreign banking
entities act as sponsor to and organize and offer foreign pension funds
abroad as part of a foreign sovereign program to provide retirement,
pension, or similar benefits to its citizens or workforce.\1799\ These
commenters contended that a foreign pension plan might itself rely on
the exclusion in section 3(c)(1) or 3(c)(7) in order to avoid being an
investment company if it is offered to citizens of the foreign
sovereign present in the United States.\1800\
---------------------------------------------------------------------------
\1798\ See, e.g., Allen & Overy (on behalf of Canadian Banks).
\1799\ See Allen & Overy (on behalf of Canadian Banks); Arnold &
Porter; UBS; Hong Kong Inv. Funds Ass'n.
\1800\ See Allen & Overy (on behalf of Canadian Banks); Arnold &
Porter; UBS; Hong Kong Inv. Funds Ass'n.; Credit Suisse (Williams).
---------------------------------------------------------------------------
Several commenters argued that foreign pension and retirement plans
should be excluded from the definition of covered fund on the same
basis as U.S. pension and retirement funds that are ERISA-qualified
funds that rely on the exclusion from the definition of investment
company provided under section 3(c)(11) of the Investment Company
Act.\1801\ Commenters alleged that without an exclusion for foreign
pension or retirement funds, section 13 of the BHC Act would have an
extra-territorial effect on pension or retirement benefits abroad that
would be severe and beyond what was contemplated by section 13 of the
BHC Act.
---------------------------------------------------------------------------
\1801\ See Arnold & Porter; UBS; Hong Kong Inv. Funds Ass'n.;
Credit Suisse (Williams).
---------------------------------------------------------------------------
In light of comments received on the proposal, the final rule
excludes from the definition of covered fund a plan, fund, or program
providing pension, retirement, or similar benefits that is: (i)
Organized and administered outside of the United States; (ii) a broad-
based plan for employees or citizens that is subject to regulation as a
pension, retirement, or similar plan under the laws of the jurisdiction
in which the plan, fund, or program is organized and administered; and
(iii) established for the benefit of citizens or residents of one or
more foreign sovereign or any political subdivision thereof.\1802\ This
is similar to the treatment provided to U.S. pension funds by virtue of
the exclusion from the definition of investment company under the
Investment Company Act for certain broad-based
[[Page 5683]]
employee benefit plans provided by section 3(c)(11) of that Act. The
exclusion from the covered fund definition for foreign plans would be
available for bona fide plans established for the benefit of employees
or citizens outside the U.S. even if some of the beneficiaries of the
fund reside in the U.S. or subsequently become U.S. residents.
---------------------------------------------------------------------------
\1802\ See final rule Sec. ----.10(c)(5).
---------------------------------------------------------------------------
The Agencies believe this exclusion is appropriate in order to
facilitate parallel treatment of domestic and foreign pension and
retirement funds to the extent possible and to assist in ensuring that
section 13 of the BHC Act does not apply to foreign pension,
retirement, or similar benefits programs.\1803\
---------------------------------------------------------------------------
\1803\ Additionally and as discussed above, the prohibitions of
section 13 and the final rule do not apply to an ownership interest
that is acquired or retained by a banking entity through a deferred
compensation, stock-bonus, profit-sharing, or pension plan of the
banking entity that is established and administered in accordance
with the law of the United States or a foreign sovereign, if the
ownership interest is held or controlled directly or indirectly by a
banking entity as trustee for the benefit of persons who are or were
employees of the banking entity.
---------------------------------------------------------------------------
6. Insurance Company Separate Accounts
Under the proposed rule, insurance company separate accounts would
have been covered funds to the extent that the separate accounts relied
on section 3(c)(1) or 3(c)(7). Such reliance would generally occur in
circumstances where policies funded by the separate account are
distributed in an unregistered securities offering solely to qualified
purchasers or on a limited basis to accredited investors. While the
proposed rule did not generally exclude insurance company separate
accounts from the definition of covered fund, the proposed rule did
provide a limited exemption for investing in or acting as sponsor to
separate accounts that were used for the purpose of allowing a banking
entity to purchase bank owned life insurance (``BOLI''), subject to
certain restrictions.\1804\
---------------------------------------------------------------------------
\1804\ See proposed rule Sec. ----.14(a)(1).
---------------------------------------------------------------------------
Various state or foreign laws allow regulated insurance companies
to create separate accounts that are generally not separate legal
entities but represent a segregated pool of assets on the balance sheet
of the insurance company that support a specific policy claim on the
insurance company. These accounts have assets and obligations that are
separate from the general account of the insurance company. Insurance
companies often utilize these separate accounts to allow policyholders
of variable annuity and variable life insurance to allocate premium
amounts for the purpose of engaging in various investment strategies
that are tailored to the requirements of the individual policyholder.
The policyholder, and not the insurance company, primarily benefits
from the results of investments in the separate account. These separate
accounts are generally investment companies for purposes of the
Investment Company Act, unless an exclusion from that definition is
applicable,\1805\ and, as noted above, may rely on the exclusion
contained in section 3(c)(1) or 3(c)(7) of the Investment Company Act.
---------------------------------------------------------------------------
\1805\ See In re The Prudential Ins. Co. of Am., 41 S.E.C. 335,
345 (1963), aff'd, The Prudential Ins. Co. of Am. v. SEC, 326 F.2d
383 (3d Cir.), cert. denied, 377 U.S. 953 (1964).
---------------------------------------------------------------------------
While most commenters supported the proposal's recognition that
interests in BOLI separate accounts should be permitted, commenters
generally argued that the final rule should also provide a broader
exclusion from the definition of covered fund for all insurance company
separate accounts. Commenters argued that covering separate accounts
could lead to unintended consequences and was inconsistent with the
statutory recognition that the business of insurance should continue to
be accommodated.\1806\ These commenters argued that covering separate
accounts within the definition of covered fund would disrupt a
substantial portion of customer-driven insurance or retirement planning
activity and pose a burden on insurance companies and holders of
insurance policies funded by separate accounts, a result commenters
alleged Congress did not intend.\1807\
---------------------------------------------------------------------------
\1806\ See ACLI (Jan. 2012); Nationwide; Sutherland (on behalf
of Comm. of Annuity Insurers); See also STANY.
\1807\ See ACLI (Jan. 2012); Nationwide; Sutherland (on behalf
of Comm. of Annuity Insurers); See also STANY.
---------------------------------------------------------------------------
In response to commenter concerns and in order to more
appropriately accommodate the business of insurance in a regulated
insurance company, the final rule excludes an insurance company
separate account from the definition of covered fund under certain
circumstances. To prevent this exclusion from being used to evade the
restrictions on investments and sponsorship of covered funds by a
banking entity, the final rule provides that no banking entity other
than the insurance company that establishes the separate account may
participate in the account's profits and losses.\1808\ In this manner,
the final rule appropriately accommodates the business of insurance by
permitting an insurance company that is a banking entity to continue to
provide its customers with a variety of insurance products through
separate account structures in accordance with applicable insurance
laws while protecting against the use of separate accounts as a means
by which banking entities might take a proprietary or beneficial
interest in an account that engages in prohibited proprietary trading
and thereby evade the requirements of section 13 of the BHC Act. The
exclusion of insurance company separate accounts from the definition of
covered fund therefore is designed to reduce the potential burden of
the final rule on insurance companies and holders of insurance policies
funded by separate accounts while also continuing to prohibit banking
entities from taking ownership interests in, and sponsoring or having
certain relationships with, entities that engage in investment and
trading activities prohibited by section 13.
---------------------------------------------------------------------------
\1808\ See final rule Sec. ----.10(c)(6).
---------------------------------------------------------------------------
7. Bank Owned Life Insurance Separate Accounts
As explained above, bank owned life insurance (``BOLI'') is
generally offered through a separate account held by an insurance
company. In recognition of the fact that banking entities have for many
years invested in life insurance policies that covered key employees,
in accordance with supervisory policies established by the Federal
banking agencies, the proposal contained a provision that would permit
banking entities to invest in and sponsor BOLI separate accounts.\1809\
---------------------------------------------------------------------------
\1809\ See proposed rule Sec. ----.14(a)(1).
---------------------------------------------------------------------------
Many commenters supported the exemption in the proposal for BOLI
separate accounts, arguing that permitting this kind of activity was
appropriate and consistent with safety and soundness as well as
financial stability.\1810\ Conversely, one commenter objected to the
proposed rule's exemption for investments in BOLI separate accounts,
contending that such an exemption did not promote and protect the
safety and soundness of banking entities or the financial stability of
the United States.\1811\
---------------------------------------------------------------------------
\1810\ See ACLI (Jan. 2012); Mass. Mutual; Jones of
Northwestern; AALU; BBVA; BoA; Chris Barnard; Clark Consulting (Feb.
7, 2012); Clark Consulting (Feb. 13, 2012); Gagnon of GW Financial.
\1811\ See Occupy.
---------------------------------------------------------------------------
After considering comments received on the proposal, the final rule
excludes BOLI separate accounts from the definition of covered fund but
maintains the substance of the conditions from the proposal designed to
ensure that BOLI investments are not conducted in a manner that raises
the concerns that
[[Page 5684]]
section 13 of the BHC Act was designed to address. In particular, in
order for a separate account to qualify for the BOLI exclusion from the
definition of covered fund, the final rule requires that the separate
account be used solely for the purpose of allowing one or more banking
entities (which by definition includes their affiliates) to purchase a
life insurance policy for which such banking entity(ies) is a
beneficiary.\1812\ Additionally, if the banking entity is relying on
this exclusion, the banking entity that purchases the insurance policy
(i) must not control the investment decisions regarding the underlying
assets or holdings of the separate account,\1813\ and (ii) must
participate in the profits and losses of the separate account in
compliance with applicable supervisory guidance regarding BOLI.\1814\
---------------------------------------------------------------------------
\1812\ See final rule Sec. ----.10(c)(7).
\1813\ This requirement is not intended to preclude a banking
entity from purchasing a life insurance policy from an affiliated
insurance company.
\1814\ See, e.g., Bank Owned Life Insurance, Interagency
Statement on the Purchase and Risk Management of Life Insurance
(Dec. 7, 2004).
---------------------------------------------------------------------------
When made in the normal course, investments by banking entities in
BOLI separate accounts do not involve the types of speculative risks
section 13 of the BHC Act was designed to address. Rather, these
accounts permit the banking entity to effectively hedge and cover costs
of providing benefits to employees through insurance policies related
to key employees. Moreover, applying the prohibitions of section 13 to
investments in these accounts would eliminate an investment that helps
banking entities to efficiently reduce their costs of providing
employee benefits, and therefore potentially introduce a burden to
banking entities that would not further the statutory purpose of
section 13. The Agencies expect this exclusion to be used by banking
entities in a manner consistent with safety and soundness.
8. Exclusion for Loan Securitizations and Definition of Loan
a. Definition of Loan
The proposal defined the term ``loan'' for purposes of the
restrictions on proprietary trading and the covered funds provisions
and, as discussed in more detail below, provided an exemption for loan
securitizations in two separate sections of the proposed rule. As
proposed, loan was defined as ``any loan, lease, extension of credit,
or secured or unsecured receivable.'' \1815\ The definition of loan in
the proposed rule was expansive, and included a broad array of loans
and similar credit transactions, but did not include any asset-backed
security issued in connection with a loan securitization or otherwise
backed by loans.
---------------------------------------------------------------------------
\1815\ See proposed rule Sec. ----.2(q).
---------------------------------------------------------------------------
Some commenters requested that the Agencies narrow the proposed
definition of ``loan.'' \1816\ One of these commenters was concerned
that the proposed definition could apply to any banking activity and
argued that the definition of loan for purposes of the final rule
should not include securities.\1817\ Another commenter, citing a
statement made by Senator Merkley, asserted that Congress did not
intend the rule of construction for the sale and securitization of
loans in section 13(g)(2) to include ``loans that become financial
instruments traded to capture the change in their market value.''
\1818\
---------------------------------------------------------------------------
\1816\ See AFR et al. (Feb. 2012); Occupy; Public Citizen.
\1817\ See Public Citizen. This commenter argued that the loan
definition should be limited to the plain meaning of the term
``loan'' and noted that a loan is not a security. Id.
\1818\ See Occupy (citing 156 Cong. Rec. S5895 (daily ed. July
15, 2010)).
---------------------------------------------------------------------------
Other commenters requested that the Agencies expand the proposed
definition of ``loan'' to capture many traditional extensions of credit
that the proposal would otherwise exclude.\1819\ Examples of
traditional credit extensions that commenters requested be specifically
included within the definition of ``loan'' included loan
participations,\1820\ variable funding notes or certificates,\1821\
note purchase facilities,\1822\ certain forms of revolving credit
lines,\1823\ corporate bonds,\1824\ municipal securities,\1825\
securities lending agreements and reverse repurchase agreements,\1826\
auto lease securitizations,\1827\ and any other type of credit
extension that banking entities traditionally have been permitted to
issue under their lending authority.\1828\
---------------------------------------------------------------------------
\1819\ See Allen & Overy (on behalf of Foreign Bank Group); ASF
(Feb. 2012); Credit Suisse (Williams); GE (Feb. 2012); Goldman
(Covered Funds); ICI (Feb. 2012); Japanese Bankers Ass'n.; JPMC;
LSTA (Feb. 2012); RBC; SIFMA et al. (Covered Funds) (Feb. 2012);
SIFMA (Securitization) (Feb. 2012). One individual commenter
supported the proposed definition of loan. See Alfred Brock. For
example, one commenter requested that definition of ``loan'' be
revised to include ``(i) any loan, lease (including any lease
residual), extension [of] credit, or secured or unsecured
receivables, (ii) any note, bond or security collateralized and
payable from pools of loans, leases (including Lease residuals),
extensions of credit or secured or unsecured receivables, and (iii)
any contractual rights arising from, or security interests or liens,
assets, property guarantees, insurance policies, letters of credit,
or supporting obligations underlying or relating to any of the
foregoing.'' See RBC. Another commenter requested that the
definition of ``loan'' be revised to include ``any type of credit
extension (including bonds, other [banking entity-eligible] debt
securities, asset-backed securities [as defined in their letter],
variable funding notes and securities lending agreements, repurchase
agreements, reverse repurchase agreements and other similar
extensions of credit) that a banking entity could hold or deal in.''
See SIFMA (Securitization) (Feb. 2012).
\1820\ See JPMC.
\1821\ See ASF (Feb. 2012); Credit Suisse (Williams); JPMC
(arguing that such notes operate in economic substance as loans);
SIFMA (Securitization) (Feb. 2012).
\1822\ See ASF (Feb. 2012). This commenter asserted that a note
purchase facility is negotiated by the asset-backed commercial paper
conduit and allows the asset-backed commercial paper conduit to
purchase asset-backed securities issued by an intermediate special
purpose vehicle and backed by loans or asset-backed securities
backed by loans. Id.
\1823\ See ASF (Feb. 2012).
\1824\ See Allen & Overy (on behalf of Foreign Bank Group); ASF
(Feb. 2012); Credit Suisse (Williams); JPMC.
\1825\ See ASF (Feb. 2012). This commenter argued that certain
municipal securities may be ABS, including revenue bonds that
involve the issuance of senior and subordinate bonds. Id.
\1826\ See Credit Suisse (Williams); SIFMA (Securitization)
(Feb. 2012).
\1827\ See SIFMA (Securitization) (Feb. 2012). This commenter
contended that because securitization transactions have been viewed
by the Agencies and courts as `legally transparent' (i.e., as simply
another way for banking entities to buy and sell the loans or other
assets underlying such securities), auto lease securitizations
supported by a beneficial interest in a titling trust should be
treated as securitizations of the underlying auto leases and should
fall within the loan securitization exemption. This commenter also
argued that if the definition of ``loan'' is not expanded to include
securities, then banking entities could not act as sponsors for auto
lease securitizations (including resecuritizations) supported by a
beneficial interest in a titling trust.
\1828\ See Credit Suisse (Williams); Goldman (Covered Funds);
SIFMA et al. (Covered Funds) (Feb. 2012); SIFMA (Securitization)
(Feb. 2012).
---------------------------------------------------------------------------
The definition of ``loan'' in the final rule applies both in the
context of the proprietary trading restrictions as well as in
determining the scope of the exclusion of loan securitizations and
asset-backed commercial paper conduits from the definition of covered
fund. The final rule modifies the proposed definition and defines
``loan'' as ``any loan, lease, extension of credit, or secured or
unsecured receivable that is not a security or derivative.'' \1829\ The
definition of loan in the final rule specifically excludes loans that
are securities or derivatives because trading in these instruments is
expressly included in the statute's definition of proprietary
trading.\1830\ In addition, the Agencies believe these instruments, if
not excluded from the definition of loan, could be used to circumvent
the restrictions on proprietary trading.
---------------------------------------------------------------------------
\1829\ See final rule Sec. ----.2(s).
\1830\ 12 U.S.C. 1851(h)(4).
---------------------------------------------------------------------------
The definition of loan in the final rule excludes loans that are
securities or derivatives, including securities or derivatives of or
based on such instruments. The definition of ``loan''
[[Page 5685]]
does not specify the type, nature or structure of loans included within
the definition, other than by excluding securities and derivatives. In
addition, the definition of loan does not limit the scope of parties
that may be lenders or borrowers for purposes of the definition. The
Agencies note that the parties' characterization of an instrument as a
loan is not dispositive of its treatment under the federal securities
laws or federal laws applicable to derivatives. The determination of
whether a loan is a security or a derivative for purposes of the loan
definition is based on the federal securities laws and the Commodity
Exchange Act. Whether a loan is a ``note'' or ``evidence of
indebtedness'' and therefore a security under the federal securities
laws will depend on the particular facts and circumstances, including
the economic terms of the loan.\1831\ For example, loans that are
structured to provide payments or returns based on, or tied to, the
performance of an asset, index or commodity or provide synthetic
exposure to the credit of an underlying borrower or an underlying
security or index may be securities or derivatives depending on their
terms and the circumstances of their creation, use, and
distribution.\1832\ Regardless of whether a party characterizes the
instrument as a loan, these kinds of instruments, which may be called
``structured loans,'' must be evaluated based on the standards
associated with evaluating derivatives and securities in order to
prevent evasion of the restrictions on proprietary trading and
ownership interests in covered funds.
---------------------------------------------------------------------------
\1831\ See 15 U.S.C. 77b(a)(1) and 15 U.S.C. 78c(a)(10); Reves
v. Ernst & Young, 494 U.S. 56 (1990); Trust Company of Louisiana v.
N.N.P. Inc., 104 F.3d 1478 (5th Cir. 1997); Pollack v. Laidlaw
Holdings, 27 F.3d 808 (2d Cir. 1994); but See Marine Bank v. Weaver,
455 U.S. 551 (1982) ; Banco Espanol de Credito v. Security Pacific
National Bank, 973 F.2d 51 (2d Cir. 1992); Bass v. Janney Montgomery
Scott, Inc., 210 F.3d 577 (6th Cir. 2000); Piaubert v. Sefrioui,
2000 WL 194140 (9th Cir. 2000).
\1832\ Id.
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b. Loan Securitizations
An exemption for loan securitizations was contained in two separate
sections of the proposed rule. The first, in section ----.13(a), was
proposed as part of ``other permitted covered fund activities and
investments.'' The second, in Sec. ----.14(d), was proposed as part of
``covered fund activities determined to be permissible.'' These
proposed provisions would have acted in concert to permit a banking
entity to acquire and retain an ownership interest in, or act as
sponsor to, a loan securitization regardless of the relationship that
the banking entity had with the securitization. The Agencies have
evaluated all comments received on securitizations. These sections of
the proposed rule were intended to implement the rule of construction
contained in section 13(g)(2) of the BHC Act which provides that
nothing in section 13 of the BHC Act shall be construed to limit or
restrict the ability of a banking entity or nonbank financial company
supervised by the Board to sell or securitize loans in a manner that is
otherwise permitted by law.\1833\ The language of the proposed
exemption for loan securitizations would have permitted a banking
entity to acquire and retain an ownership interest in a covered fund
that is an issuer of asset-backed securities, the assets or holdings of
which were solely comprised of: (i) Loans (as defined); (ii) rights or
assets directly arising from those loans supporting the asset-backed
securities; and (iii) interest rate or foreign exchange derivatives
that (A) materially relate to the terms of such loans or rights or
assets and (B) are used for hedging purposes with respect to the
securitization structure.\1834\ The proposed rule in Sec. ----.13(d)
was further augmented by the proposed rule in Sec. ----.14(a)(2) so
that a banking entity would be permitted to purchase loan
securitizations and engage in the sale and securitization of loans.
This was accomplished through the authorization in proposed section --
--.14(a)(2) of a banking entity's acquisition or retention of an
ownership interest in such securitization vehicles that the banking
entity did not organize and offer, or for which it did not act as
sponsor, provided that the assets or holdings of such vehicles were
solely comprised of the instruments or obligations identified in the
proposed exemption.
---------------------------------------------------------------------------
\1833\ See 12 U.S.C. 1851(g)(2).
\1834\ See proposed rule Sec. ----.13(d); Joint Proposal, 76 FR
68,912.
---------------------------------------------------------------------------
The proposed rules would have allowed a banking entity to engage in
the sale and securitization of loans by acquiring and retaining an
ownership interest in certain securitization vehicles (which could be a
covered fund for purposes of the proposed rules) that the banking
entity organized and offered, or acted as sponsor to, without being
subject to the ownership and sponsor limitations contained in the
proposed rule.\1835\ As noted in the proposing release, the Agencies
recognized that by defining ``covered fund'' broadly, and, in
particular, by reference to sections 3(c)(1) and 3(c)(7) of the
Investment Company Act, securitization vehicles may be affected by the
restrictions and requirements of the proposed rule. The Agencies
attempted to mitigate the potential adverse impact on the
securitization market by excluding loan securitizations from the
restrictions on sponsoring or acquiring and retaining ownership
interests in covered funds, consistent with the rule of construction
contained in section 13(g)(2) of the BHC Act.\1836\ As a result, under
the proposal, loan securitizations would not be limited or restricted
because banking entities would be able to find investors or buyers for
their loans or loan securitizations. The proposing release included
several requests for comment on the proposed loan securitization
exemption and the application of the covered fund prohibitions to
securitizations.
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\1835\ Id.
\1836\ See Joint Proposal, 76 FR 68,931.
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Some commenters supported a narrow exemption for loan
securitizations and in some cases suggested that the proposed exemption
could be narrowed even further. For example, one commenter argued that
the definition of ``loan'' for purposes of the exemption could include
any extension of credit and any banking activity.\1837\ Also, in
response to the proposing release,\1838\ some commenters suggested that
any exemption for securitizations should seek to prevent evasion of the
covered fund prohibitions by issuers with ``hedge-fund or private
equity fund-like characteristics'' or issuers with ``hidden proprietary
trading operations.'' \1839\
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\1837\ See, e.g., Public Citizen. This commenter argued that any
exemption should prevent evasion, should ensure that each exempted
securitization reduces risk and should be designed to only serve
client needs. A different commenter recommended a safe harbor
available only to a particular pre-specified, transparent and
standardized securitization structure, where Agencies would need to
justify why the specified structure protects against the systemic
risks associated with securitization. See AFR (Nov. 2012).
\1838\ See Request for Comment No. 231 in the Proposing Release
(noting that many issuers of asset-backed securities have features
and structures that resemble some of the features of hedge funds and
private equity funds (e.g., CDOs are managed by an investment
adviser that has the discretion to choose investments, including
investments in securities) and requesting comment on how to prevent
hedge funds or private equity funds from structuring around an
exemption for asset-backed securities from the covered fund
prohibitions).
\1839\ See, e.g., AFR et al. (Feb. 2012); Occupy; Public
Citizen. But See Credit Suisse (Williams) (arguing it would be
difficult to use the typical structure and operation of
securitizations to avoid the prohibition on proprietary trading
because the structures are not set up to engage in the kind of
proprietary trading about which Congress was concerned).
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On the other hand, many commenters believed that the proposed
exemption
[[Page 5686]]
from the covered fund prohibitions for loan securitizations should be
expanded to cover securitizations generally and not just loan
securitizations. These commenters provided various arguments for their
request to exempt all securitizations from the covered fund
prohibitions, including that the regulation of securitizations was
addressed in other areas of the Dodd-Frank Act,\1840\ that
securitization is essentially a lending activity,\1841\ and that
securitizations have ``long been recognized as permissible activities
for banking entities.'' \1842\
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\1840\ See AFME et al.; Ass'n. of German Banks; Cleary
Glottlieb; Credit Suisse (Williams); GE (Feb. 2012); IIB/EBF; RBC;
SIFMA (Securitization) (Feb. 2012).
\1841\ See, e.g., Credit Suisse (Williams).
\1842\ See Credit Suisse (Williams); JPMC. These commenters
cited the sponsoring of asset-backed commercial paper conduits as an
example of permissible bank securitization activity.
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Commenters recommending a broader exclusion for securitizations
also provided a wide variety of specific suggestions or concerns. Some
commenters suggested that permissible assets for a loan securitization
include assets other than loans acquired in the course of collecting a
debt previously contracted, restructuring a loan, during a loan work
out or during the disposition of a loan or other similar
situation.\1843\ Commenters noted that, for example, rules 2a-7 and 3a-
7 under the Investment Company Act define eligible assets for a
securitization as not only including financial assets but also ``any
rights or other assets designed to assure the servicing or timely
distribution of proceeds to security holders.'' \1844\ Commenters
requested that various additional rights or assets be added to the list
of permissible assets held by a loan securitization such as cash and
cash accounts,\1845\ cash equivalents,\1846\ and various other high
quality short term investments, liquidity agreements or credit
enhancements, certain beneficial interests in titling trusts used in
lease securitizations or lease residuals.\1847\ One commenter suggested
that a loan securitization be permitted to include ``any contractual
rights arising from or supporting obligations underlying or relating to
the loans.'' \1848\
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\1843\ See Allen & Overy (on behalf of Foreign Bank Group);
Credit Suisse (Williams); JPMC.
\1844\ See GE (Feb. 2012); GE (Aug. 2012); ICI (Feb. 2012).
\1845\ See Allen & Overy (on behalf of Foreign Bank Group); ASF
(Feb. 2012); Cleary Gottlieb; Credit Suisse (Williams) (including
cash that did not arise directly from the underlying loans); JPMC;
LSTA (Feb. 2012); LSTA (July 2012); RBC; SIFMA (Securitization)
(Feb. 2012).
\1846\ See Cleary Gottlieb; Credit Suisse (Williams).
\1847\ See JPMC (requesting high quality, highly liquid
investments, including Treasury securities and highly rated
commercial paper); LSTA (Feb. 2012); LSTA (July 2012) (requesting
short-term highly liquid investments such as obligations backed by
the full faith and credit of the United States, deposits insured by
the Federal Deposit Insurance Corporation, various obligations of
U.S. financial institutions and investments in money market funds);
ASF (Feb. 2012); Commercial Real Estate Fin. Council; RBC
(requesting short-term, high quality investments); Allen & Overy (on
behalf of Foreign Bank Group) (requesting short-term eligible
investments); Credit Suisse (Williams) (requesting government
guaranteed securities, money market funds and other highly credit-
worthy and liquid investments); Cleary Gottlieb (requesting money-
market interests; SIFMA (Securitization) (Feb. 2012) (requesting
associated investments which are customarily employed in
securitization transactions). One commenter further noted that such
investments are required by securitization documents. See Commercial
Real Estate Fin. Council.
\1848\ RBC. This commenter argued that the loan securitization
exemptions as proposed would not permit ``traditional
securitizations and securitizations with the characteristics of
traditional securitizations'' and ``would effectively eliminate a
substantial portion of the very securitization activities carried on
by banks that the [loan securitization exemptions] are designed to
preserve.''
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Others requested that loan securitizations also be permitted to
hold repurchase agreements or unlimited amounts of various forms of
securities, including municipal securities, asset-backed securities,
credit-linked notes, trust certificates and ``equity like-rights.''
\1849\ Some commenters requested that loan securitizations be permitted
to hold a limited amount of certain rights such as securities.\1850\
Commenters also had suggestions about the types of derivatives that an
exempted securitization vehicle be permitted to hold.\1851\ For
example, one industry association requested that the loan
securitization exemption include securitizations where up to 10 percent
of the assets are held in the form of synthetic risk exposure that
references ``loans that could otherwise be held directly'' under the
proposal in order to achieve risk diversification.\1852\ This commenter
stated its belief that the rule of construction requires that synthetic
exposures be permitted because they are used in certain types of loan
securitizations.
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\1849\ See Allen & Overy (on behalf of Foreign Bank Group); ASF
(Feb. 2012); Credit Suisse (Williams); GE (Feb. 2012); JPMC; RBC;
SIFMA et al. (Covered Funds) (Feb. 2012); SIFMA (Securitization)
(Feb. 2012).
\1850\ See, e.g., ASF (Feb. 2012); Cleary Gottlieb; LSTA (Feb.
2012). LSTA (Feb. 2012) specifically requested that entities issuing
collateralized loan obligations that are primarily backed by loans
or loan participations also be permitted to hold a limited amount of
corporate credit obligations. This commenter provided
recommendations about such limitations--if the amount of such
corporate credit obligations exceeded 10 percent, a CLO would not be
able to purchase any assets other than senior, secured syndicated
loans and temporary investments (as defined in the letter). If the
amount of such assets exceeded 30 percent, the entity should not be
able to purchase any assets other than loans.
\1851\ See AFME et al.; Allen & Overy (on behalf of Foreign Bank
Group); Credit Suisse (Williams); Japanese Bankers Ass'n.; LSTA
(Feb. 2012); SIFMA (Securitization) (Feb. 2012).
\1852\ See ASF (Feb. 2012). Permissible synthetic exposure would
include ``credit default swaps, total return swaps or other
agreements referencing corporate loans or corporate bonds pursuant
to which the issuer is the seller of credit protection or otherwise
`long' the credit exposure of the reference corporate loan or bond,
and receives a yield derived from the yield on the reference
corporate loan or bond.''
---------------------------------------------------------------------------
In addition to requests that specific types of underlying assets be
permitted under the loan securitization exemption, the Agencies also
received comments about specific types of asset classes or structures.
Some commenters suggested certain asset classes or structures should be
an excluded securitization from the covered fund prohibitions including
insurance-linked securities, collateralized loan obligations, tender
option bonds, asset-backed commercial paper conduits (ABCP conduits),
resecuritizations of asset-backed securities, and corporate debt re-
packagings.\1853\ In some cases, commenters believed that the Agencies
should use their authority under section 13(d)(1)(J) of the BHC Act to
exempt these types of vehicles. Some commenters identified other
vehicles such as credit funds and issuers of covered bonds that they
believed should be excluded from the covered fund prohibitions.\1854\
On the other hand, the Agencies also received comment letters that
argued that certain securitizations should not be exempted from the
covered fund prohibitions, including resecuritizations, CDO-squared,
and CDO-cubed securitizations because of concern about their complexity
and lack of reliable performance data or ability to value those
securities.\1855\
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\1853\ See AFME et al.; ASF (July 2012); GE (Aug. 2012); Capital
Group; Goldman (Covered Funds); LSTA (Feb. 2012); SIFMA et al.
(Covered Funds) (Feb. 2012).
\1854\ See Goldman (Covered Funds) (requesting exclusion for
credit funds). AFME et al. (requesting exclusion for covered bonds);
FSA (Apr. 2012) (requesting exclusion for covered bonds); UKRCBC
(requesting exclusion for covered bonds).
\1855\ See Sens. Merkley & Levin (Feb. 2012). These commenters
argued that there should be increased capital charges in line with
the complexity of a securitization and using the ``high risk asset
limitations on permitted activities to bar any securitization by a
bank from using complex structures, re-securitization techniques,
synthetic features, or other elements that may increase risk or make
a risk analysis less reliable.''
---------------------------------------------------------------------------
Because a loan securitization could still be a covered fund,
several commenters expressed concern that the proposed loan
securitization exemption, as drafted, did not exempt loan
securitizations from the prohibitions of
[[Page 5687]]
section 13(f) of the BHC Act. As a result, one commenter noted that the
proposed loan securitization exemptions would not have their intended
result of excluding loan securitizations from the BHC Act restrictions
applicable to covered funds.\1856\
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\1856\ See AFME et al.; SIFMA (May 2012) (arguing that because
of the narrowness of the proposed exemption and because it would not
exempt securitizations from prohibitions on covered transactions
imposed by section 13(f), the rule as proposed ``will effectively
prevent banking entities from sponsoring and owning a large variety
of asset-backed securities, in contravention of the rule of
construction.'')
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Certain securitization transactions may involve the issuance of an
intermediate asset-backed security that supports the asset-backed
securities that are issued to investors, such as in auto lease
securitizations and ABCP conduits. Commenters suggested that the
Agencies should look through intermediate securitizations to the assets
that support the intermediate asset-backed security to determine if
those assets would satisfy the definition of ``loan'' for purposes of
the loan securitization exemption. If those assets are loans, these
commenters suggested that the entire securitization transaction should
be deemed a loan securitization, even if the assets supporting the
asset-backed securities issued to investors are not loans.\1857\
However, some commenters argued that each step in a multi-step
securitization should be viewed separately to ensure compliance with
the specific restrictions in the proposal because otherwise a multi-
step securitization could include impermissible assets.\1858\ Some
commenters also raised question about whether depositors would fall
within the definition of ``investment company'' under the Investment
Company Act and, therefore, may fall within the proposed definition of
covered fund.\1859\
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\1857\ See AFME et al.; ASF (Feb. 2012); SIFMA (Securitization)
(Feb. 2012).
\1858\ See Occupy; Public Citizen. Occupy contended that the
structured security issued in a multi-step securitization can hide
underlying risks under layers of structured complexity. See Occupy.
Public Citizen argued that prohibiting such activity would ensure
that securitizations do not become proprietary trading vehicles for
banking entities that are effectively off-balance sheet. See Public
Citizen. See infra Part IV.B.1.c.8.b.iv. of this SUPPLEMENTARY
INFORMATION.
\1859\ A depositor, as used in a securitization structure, is an
entity that generally acts only as a conduit to transfer the loans
from the originating bank to the issuing entity for the purpose of
facilitating a securitization transaction and engages in no
discretionary investment or securities issuance activities. See ASF
(July 2012); GE (Aug. 2012). For purposes of this rule, the Agencies
believe the wholly owned subsidiary exclusion is available for
depositors. See supra note 1774.
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After considering carefully the comments received on sections of
the proposed rule, the Agencies have determined to adopt a single
section in the final provision relating to loan securitizations that
would exclude loan securitizations that meet certain criteria contained
in the rule from the definition of covered fund. The rule, as adopted,
takes into account comments received on each of the conditions
specified in the two loan securitization sections of the proposed
provisions and has adopted those conditions with some clarifying
changes from the proposed language. In addition, in response to
comments, as discussed more fully below, the Agencies are adopting
additional exclusions from the definition of covered fund for certain
types of vehicles if they are backed by the same types of assets as the
assets that are permitted to be held in the loan securitization
exclusion. These additional exclusions are tailored to vehicles that
are very similar to loan securitizations but have particular structural
issues, which are described in more detail below.
In light of the comments received on the proposal, the final rule
was revised to exclude from the definition of covered fund an issuing
entity of asset-backed securities, as defined in Section 3(a)(79) of
the Exchange Act,\1860\ if the underlying assets or holdings are
comprised solely of: (A) loans, (B) any rights or other assets (i)
designed to assure the servicing or timely distribution of proceeds to
security holders or (ii) related or incidental to purchasing or
otherwise acquiring, and holding the loans, (C) certain interest rate
or foreign exchange derivatives, and (D) certain special units of
beneficial interests and collateral certificates (together, ``loan
securitizations'').\1861\ In addition, as discussed below, the Agencies
are adopting specific exclusions for certain vehicles that issue short
term asset-backed securities and for pools of assets that are part of
covered bond transactions which pools also meet the conditions
delineated above.\1862\
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\1860\ 15 U.S.C. 78c(a)(79). This definition was added by
Section 941 of the Dodd-Frank Act.
\1861\ See final rule Sec. ----.10(c)(8). Consistent with the
proposal, certain securitizations, regardless of asset composition,
would not be considered covered funds because the securitization
issuer is deemed not to be an investment company under Investment
Company Act exclusions other than section 3(c)(1) or 3(c)(7) of the
Investment Company Act. For example, this would include issuers that
meet the requirements of section 3(c)(5) or rule 3a-7 of the
Investment Company Act, and the asset-backed securities of such
issuers may be offered in transactions registered under the
Securities Act.
\1862\ As discussed below, the Agencies are adopting an
exclusion from the definition of covered funds for the pools of
assets that are involved in the covered bond financings. Although
the cover pools must satisfy the same criteria as the excluded loan
securitizations, a separate exclusion is needed because the
securities involved in the covered bond issuance are not asset-
backed securities.
---------------------------------------------------------------------------
Although commenters argued that various types of assets should be
included within the definition of loan or otherwise permitted to be
held under the loan securitization exclusion, the loan securitization
exclusion in the final rule has not been expanded to be a broad
exclusion for all securitization vehicles. Although one commenter
suggested that any securitization is essentially a lending
activity,\1863\ the Agencies believe such an expansion of the exclusion
would not be consistent with the rule of construction in section
13(g)(2) of the BHC Act, which specifically refers to the ``sale and
securitization of loans.'' The Agencies believe that a broad definition
of loan and therefore a broad exemption for transactions that are
structured as securitizations of pooled financial assets could
undermine the restrictions Congress intended to impose on banking
entities' covered fund activities, which could enable market
participants to use securitization structures to engage in activities
that otherwise are constrained for covered funds. The Agencies believe
the purpose underlying section 13 is not to expand the scope of assets
in an excluded loan securitization beyond loans as defined in the final
rule and the other assets that the Agencies are specifically permitting
in a loan securitization.
---------------------------------------------------------------------------
\1863\ See, e.g., Credit Suisse (Williams).
---------------------------------------------------------------------------
While not expanding the permitted assets under the loan
securitization exclusion, the Agencies have made modifications in
response to commenters to ensure that the provisions of the final rule
appropriately accommodate the need, in administering a loan
securitization transaction on an ongoing basis, to hold various assets
other than the loans that support the asset-backed securities.
Moreover, the Agencies do not believe that the assets permitted under
the loan securitization need to be narrowed further to prevent evasion
and hidden proprietary trading as requested by certain commenters
because the Agencies believe that the potential for evasion has been
adequately addressed through modifications to the definition of loan
and more specific limitations on the types of securities and
derivatives permitted in an excluded loan securitization. The Agencies
have revised the scope of the loan securitization exclusion to
accommodate existing market practice for securitizations as discussed
by
[[Page 5688]]
commenters while limiting the availability of the exclusion for these
particular types of securitization transactions to issuers of asset-
backed securities supported by loans.
The Agencies are not adopting specific exclusions for other
securitization vehicles identified by commenters, including insurance-
linked securities, collateralized loan obligations, and corporate debt
re-packagings.\1864\ The Agencies believe that providing such
exclusions would not be consistent with the rule of construction in
section 13(g)(2)of the BHC Act, which specifically refers to the ``sale
and securitization of loans.'' These other types of securitization
vehicles referenced by commenters are used to securitize exposures to
instruments which are not included in the definition of loan as adopted
by the final rule. Moreover, the Agencies note in response to
commenters that resecuritizations of asset-backed securities and CDO-
squared and CDO-cubed securitizations could be used as a means of
evading the prohibition on the investment in the ownership interests of
covered funds.
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\1864\ Commenters' concerns regarding credit funds are discussed
below in Part IV.B.1.d.6. of this SUPPLEMENTARY INFORMATION.
---------------------------------------------------------------------------
As with the proposed rules, the Agencies are excluding certain loan
securitizations from the definition of covered fund and therefore the
prohibitions applicable to banking entities' involvement in covered
funds in order to implement Congressional intent expressed in the rule
of construction in section 13(g)(2) of the BHC Act.\1865\ The Agencies
believe that, as reflected in the rule of construction, the continued
ability of banking entities to participate in loan securitizations is
important to enable banks of all sizes to be able to continue to
provide financing to loan borrowers at competitive prices. Loan
securitizations provide an important avenue for banking entities to
obtain investor financing for existing loans, which allows such banks
greater capacity to continuously provide financing and lending to their
customers. The Agencies also believe that loan securitizations that
meet the conditions of the rule as adopted do not raise the same types
of concerns as other types of securitization vehicles that could be
used to circumvent the restrictions on proprietary trading and
prohibitions in section 13(f) of the BHC Act.
---------------------------------------------------------------------------
\1865\ As discussed below, the Agencies are excluding those loan
securitizations that hold only loans (and certain other assets
identified in the final rule), consistent with the rule of
construction in section 13(g)(2) of the BHC Act.
---------------------------------------------------------------------------
Under the rule as adopted, loan securitizations that meet the
conditions of the rule as adopted are excluded from the definition of
covered fund and, consequently, banking entities are not restricted as
to their ownership of such entities or their ongoing relationships with
such entities by the final rule. As the Agencies stated in the
proposal, permitting banking entities to acquire or retain an ownership
interest in these loan securitizations will allow for a deeper and
richer pool of potential participants and a more liquid market for the
sale of such securitizations, which in turn should result in the
continued availability of funding to individuals and small businesses,
as well as provide an efficient allocation of capital and sharing of
risk. The Agencies believe that excluding these loan securitizations
from the definition of covered fund is consistent with the terms and
the purpose of section 13 of the BHC Act, including the rule of
construction regarding loan securitizations.\1866\
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\1866\ The Agencies note that the loan securitization and other
securitization exclusions apply only to the definition of covered
fund, and therefore the covered fund-related provisions of the rule,
and not to its prohibition on proprietary trading. The Agencies
recognize that trading in loans is not subject to the proprietary
trading restrictions.
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i. Loans
The first condition of the loan securitization exclusion from the
definition of covered fund is that the underlying assets or holdings
are comprised of loans. In the proposal, ``loan'' was a defined term
for purposes of the restrictions on proprietary trading and the covered
funds provisions. As proposed, a loan was defined as a loan, lease,
extension of credit, or secured or unsecured receivable.\1867\ The
definition of loan in the proposed rule was expansive, and included a
broad array of loans and similar credit transactions, but did not
include any asset-backed security that is issued in connection with a
loan securitization or otherwise backed by loans.
---------------------------------------------------------------------------
\1867\ See proposed rule Sec. ----.2(q).
---------------------------------------------------------------------------
As discussed above under ``Definition of Loan,'' the Agencies
received comments regarding the loan definition in the securitization
context. In particular, one commenter, citing a statement made by
Senator Merkley, argued that Congress did not intend the loan
securitization exemption to include ``loans that become financial
instruments traded to capture the change in their market value.''
\1868\
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\1868\ See Occupy (citing 156 Cong. Rec. S5895 (daily ed. July
15, 2010)).
---------------------------------------------------------------------------
The Agencies, after considering carefully the comments received,
have adopted a definition of loan that is revised from the proposed
definition. The final rule defines ``loan'' as ``any loan, lease,
extension of credit, or secured or unsecured receivable that is not a
security or derivative.'' \1869\ The definition of loan in the final
rule specifically excludes loans that are securities or derivatives
because trading in these instruments is expressly included in the
statute's definition of proprietary trading.\1870\ In addition, the
Agencies believe these instruments, if not excluded from the definition
of loan, could be used to circumvent the restrictions on proprietary
trading. Further, for purposes of the loan securitization exclusion,
the loan securitization must own the loan directly; a synthetic
exposure to a loan, such as through holding a derivative, such as a
credit default swap, will not satisfy the conditions for the loan
securitization exclusion.\1871\ As such, a securitization that owns a
tranche of another loan securitization is not itself a loan
securitization, even if the ownership of such tranche by a banking
entity would otherwise be permissible under the final rule.
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\1869\ See Sec. ----.2(r).
\1870\ 12 U.S.C. 1851(h)(4).
\1871\ Under the final provision, the issuing entity for the
SUBIs and collateral certificate may rely on the loan securitization
exclusion because of the separate provisions allowing such a
holding.
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As discussed above under ``Definition of Loan,'' the definition of
loan in the final rule has not been expanded as requested by some
commenters but has been clarified in some respects in response to
comments. The final rule explicitly excludes securities or
derivatives.\1872\ In addition, the definition of loan has not been
modified to include repurchase agreements or reverse repurchase
agreements regardless of the character of the underlying asset. The
Agencies are concerned that parties, under the guise of a ``loan''
might instead create instruments that provide the same exposures to
securities and derivatives that otherwise are prohibited by section 13
and might attempt to use the loan securitization exclusion to acquire
ownership interests in covered funds holding those types of
instruments,
[[Page 5689]]
counter to the terms and the purpose of section 13 of the BHC Act. As
the Agencies have noted previously, the rules relating to covered funds
and to proprietary trading are not intended to interfere with
traditional lending practices or with securitizations of loans
generated as a result of such activities. Although the Agencies have
revised the definition of loan in response to commenters' concerns as
discussed above, the Agencies are not adopting a separate definition of
loan for securitization transactions as requested by commenters. The
Agencies believe that the definition of loan adopted in the final rule
appropriately encompasses the financial instruments that result from
lending money to customers.
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\1872\ The determination of whether an instrument falls outside
the definition of loan because it is a security or a derivative is
based on the federal securities laws and the Commodity Exchange Act.
Whether a loan, lease, extension of credit, or secured or unsecured
receivable is a note or evidence of indebtedness that is defined as
a security under the federal securities laws will depend on the
particular facts and circumstances, including the economic terms of
the transaction. See supra note 1831 and accompanying text.
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ii. Contractual Rights or Assets
Under the proposed loan securitization definition, a covered fund
that is an issuer of asset-backed securities would have been permitted
to hold contractual rights or assets directly arising from those loans
supporting the asset-backed securities.\1873\ The proposal did not
identify or describe such contractual rights or assets.
---------------------------------------------------------------------------
\1873\ See proposed rule Sec. ----.13(d).
---------------------------------------------------------------------------
Commenters requested that the Agencies expand the list of
contractual rights and assets that an issuer of asset-backed securities
would be permitted to hold under the proposed loan securitization
exemption.\1874\ Examples of the additional rights and assets requested
by commenters include cash and cash accounts; \1875\ cash equivalents;
\1876\ liquidity agreements, including asset purchase agreements,
program support facilities and support commitments; \1877\ credit
enhancements; \1878\ asset-backed securities; \1879\ municipal
securities; \1880\ repurchase agreements; \1881\ credit-linked notes;
\1882\ trust certificates; \1883\ lease residuals; \1884\ debt
securities; \1885\ and derivatives.\1886\ As an alternative, commenters
requested that an issuer of asset-backed securities be permitted to
hold under the proposed loan securitization exemption certain of such
additional rights and/or assets up to a threshold, such as a specified
percentage of the assets of such covered fund.\1887\
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\1874\ See Allen & Overy (on behalf of Foreign Bank Group); AFME
et al.; ASF (Feb. 2012); Cleary Gottlieb; Credit Suisse (Williams);
Commercial Real Estate Fin. Council; GE (Feb. 2012); GE (Aug. 2012);
ICI (Feb. 2012); Japanese Bankers Ass'n.; JPMC; LSTA (Feb. 2012);
LSTA (July 2012); RBC; SIFMA et al. (Covered Funds) (Feb. 2012);
SIFMA (Securitization) (Feb. 2012); Vanguard.
\1875\ See Allen & Overy (on behalf of Foreign Bank Group); ASF
(Feb. 2012); Cleary Gottlieb; Credit Suisse (Williams).
\1876\ See Allen & Overy (on behalf of Foreign Bank Group); ASF
(Feb. 2012); Cleary Gottlieb; Credit Suisse (Williams); Commercial
Real Estate Fin. Council; JPMC; LSTA (Feb. 2012); LSTA (July 2012);
RBC; SIFMA (Securitization) (Feb. 2012). Commenters requested
inclusion of the following examples of cash equivalents: government
guaranteed securities, money market funds, and ``other highly
credit-worthy and liquid investments'' (Credit Suisse (Williams));
and high quality, highly liquid investments, including Treasury
securities and highly rated commercial paper (JPMC). In addition,
LSTA (Feb. 2012) requested inclusion of the following: (i) Short-
term highly liquid investments; (ii) direct obligations of, and
obligations fully guaranteed as to full and timely payment by, the
United States (or by any agency thereof to the extent such
obligations are backed by the full faith and credit of the United
States); (iii) demand deposits, time deposits or certificates of
deposit that are fully insured by the Federal Deposit Insurance
Corporation; (iv) corporate, non-extendable commercial paper; (v)
notes that are payable on demand or bankers' acceptances issued by
regulated U.S. financial institutions; (vi) investments in money
market funds or other regulated investment companies; time deposits
having maturities of not more than 90 days; (vii) repurchase
obligations with respect to direct obligations and guaranteed
obligations of the U.S. entered into with a regulated U.S. financial
institution; and (viii) other investments with a maturity one year
or less, with the requirement that each of the investments listed
have, at the time of the securitization's investment or contractual
commitment to invest therein, a rating of the highest required
investment category.
\1877\ See Allen & Overy (on behalf of Foreign Bank Group); ASF
(Feb. 2012); GE (Feb. 2012); JPMC; RBC; SIFMA (Securitization) (Feb.
2012).
\1878\ See Allen & Overy (on behalf of Foreign Bank Group); ASF
(Feb. 2012); GE (Feb. 2012); JPMC; RBC; SIFMA (Securitization) (Feb.
2012). For example, SIFMA (Securitization) (Feb. 2012) requested
inclusion of third party credit enhancements such as guarantees and
letters of credit. Commenters requested inclusion of the following
examples of credit enhancements: (i) External credit support of
borrower obligations under such loans, including a credit support
facilities, third party or parent guarantee, insurance policy,
letter of credit or other contractual commitment to make payments or
perform other obligations of the borrower under the loans (ASF (Feb.
2012)); and (ii) property guarantees, insurance policies, letters of
credit, or supporting obligations underlying or relating to any of
the loans (RBC).
\1879\ See Allen & Overy (on behalf of Foreign Bank Group); AFME
et al.; ASF (Feb. 2012); Credit Suisse (Williams); GE (Feb. 2012);
GE (Aug. 2012); ICI (Feb. 2012); JPMC; RBC; SIFMA et al. (Covered
Funds) (Feb. 2012); SIFMA (Securitization) (Feb. 2012). Commenters
requested inclusion of the following examples of asset-backed
securities: (i) SUBI certificates (beneficial interests in titling
trusts typically used in lease securitizations) (AFME et al.; ASF
(Feb. 2012); GE (Aug. 2012); SIFMA (Securitization) (Feb. 2012));
(ii) ownership interests and bonds issued by CLOs (JPMC); a broad
array of receivables that support asset-backed commercial paper (ICI
(Feb. 2012)); certain notes, certificates or other instruments
backed by loans or financial assets that are negotiated by the
purchasing asset-backed commercial paper conduit (ASF (Feb. 2012);
GE (Feb. 2012)); municipal securities that are technically ABS,
including revenue bonds that involve the issuance of senior and
subordinate bonds (ASF (Feb. 2012)); ownership interests in credit
funds (as defined in their letter) (SIFMA et al. (Covered Funds)
(Feb. 2012)); any note, bond or security collateralized and payable
from pools of loans, leases (including lease residuals), extensions
of credit or secured or unsecured receivables (RBC); asset-backed
securities issued by intermediate vehicles in a securitization
collateralized predominantly by loans and financial assets, and
other similar instruments (Credit Suisse (Williams)); and asset-
backed securities backed by loans or receivables that are originated
by or owned by the sponsor of such securitization or which are
issued by an entity that is organized under the direction of the
same sponsor as the issuer of the covered fund (ASF (Feb. 2012)).
\1880\ See ICI (Feb. 2012); Vanguard.
\1881\ See Credit Suisse (Williams); SIFMA (Securitization)
(Feb. 2012).
\1882\ See Allen & Overy (on behalf of Foreign Bank Group).
\1883\ See Credit Suisse (Williams).
\1884\ See ASF (Feb. 2012); GE (Feb. 2012); GE (Aug. 2012); RBC.
\1885\ See GE (Aug. 2012).
\1886\ See Allen & Overy (on behalf of Foreign Bank Group);
Credit Suisse (Williams); Japanese Bankers Ass'n.; LSTA (Feb. 2012);
SIFMA (Securitization) (Feb. 2012). Commenters requested inclusion
of the following examples of derivatives: (i) Credit derivatives
(without explanation) as a means of diversifying the portfolio
(Japanese Bankers Association); (ii) synthetic securities that
reference corporate credits or other debt (Credit Suisse (Covered
Fund)); (iii) credit instruments or other obligations that the
banking entity could originate or invest or deal in directly,
including tranched or untranched credit linked notes exposed to the
credit risk of such reference assets through a credit default swap
or other credit derivative entered into by the related ABS Issuer
(SIFMA (Securitization) (Feb. 2012)); (iv) any derivatives
structured as part of the securitization of loans (without
explanation) (Allen & Overy (on behalf of Foreign Bank Group)); (v)
hedge agreements (Credit Suisse (Williams)); and (vi) any
derivative, including a credit default swap, as and to the extent a
banking entity could use such derivative in managing its own
investment portfolio (SIFMA (Securitization) (Feb. 2012)).
\1887\ See ASF (Feb. 2012); Cleary Gottlieb; Credit Suisse
(Williams); GE (Feb. 2012); GE (Aug. 2012); LSTA (Feb. 2012); LSTA
(July 2012).
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In response to comments, the final rule modifies the loan
securitization exclusion from the proposal to identify the types of
contractual rights or assets directly arising from those loans
supporting the asset-backed securities that a loan securitization
relying on such exclusion may hold. Under the final rule, a loan
securitization which is eligible for the loan securitization exclusion
may hold contractual rights or assets (i) designed to assure the
servicing or timely distribution of proceeds to security holders or
(ii) related or incidental to purchasing or otherwise acquiring, and
holding the loans (``servicing assets'').\1888\ The servicing assets
are permissible in an excluded loan securitization transaction only to
the extent that they arise from the structure of the loan
securitization or from the loans supporting a loan securitization. If
such servicing assets are sold and securitized in a separate
transaction, they will not qualify as
[[Page 5690]]
permissible holdings for the loan securitization exclusion.\1889\
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\1888\ See final rule Sec. ----.10(c)(8)(i)(B). The use of the
term ``servicing assets'' is not meant to imply that servicing
assets are limited to those contractual rights or assets related to
the servicer and the performance of the servicer's obligations.
\1889\ For example, under the final rule, mortgage insurance
policies supporting the mortgages in a loan securitization are
servicing assets permissible for purposes of Sec. --
--.10(c)(8)(i)(B). However, a separate securitization of the
payments on those mortgage insurance policies would not qualify for
the loan securitization exclusion.
---------------------------------------------------------------------------
In adopting this approach, the Agencies considered commenters'
concerns and determined to revise the condition to be more consistent
with the definition and treatment of servicing assets in other asset-
backed securitization regulations, such as the exemption from the
definition of ``investment company'' under rule 3a-7 promulgated under
the Investment Company Act.\1890\
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\1890\ The Agencies believe that for purposes of the final rule,
in the context of securitization, such related or incidental assets
in a loan securitization should support or further, and therefore,
be secondary to the loans held by the securitization vehicle.
---------------------------------------------------------------------------
Although the Agencies have revised the proposal in response to
commenters' concerns, the final rule does not permit a loan
securitization to hold as servicing assets a number of instruments
specifically requested by commenters whether in their entirety or as a
percentage of the pool. Under the final rule, servicing assets do not
include securities or derivatives other than as specified in the rule.
Under the final rule, a loan securitization which is eligible for
the loan securitization exclusion may hold securities if those
securities fall into one of three categories.\1891\ First, such loan
securitizations may hold securities that are cash equivalents. For
purposes of the exclusion for loan securitizations, the Agencies
interpret ``cash equivalents'' to mean high quality, highly liquid
short term investments whose maturity corresponds to the
securitization's expected or potential need for funds and whose
currency corresponds to either the underlying loans or the asset-backed
securities.\1892\ Depending on the specific funding needs of a
particular securitization, ``cash equivalents'' might include deposits
insured by the Federal Deposit Insurance Corporation, certificates of
deposit issued by a regulated U.S. financial institution, obligations
backed by the full faith and credit of the United States, investments
in registered money market funds, and commercial paper.\1893\ Second,
such loan securitizations may hold securities received in lieu of debts
previously contracted with respect to the loans supporting the asset-
backed securities. Finally, such loan securitizations may hold
securities that qualify as SUBIs or collateral certificates subject to
the provisions set forth in the rule for such intermediate asset-backed
securities.
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\1891\ See final rule Sec. ----.10(c)(8)(iii).
\1892\ If either the loans supporting the loan securitization or
the asset-backed securities issued by the loan securitization are
denominated in a foreign currency, for purposes of the exclusion a
loan securitization would be permitted to hold foreign currency,
cash equivalents denominated in foreign currency and foreign
exchange derivatives that comply with Sec. ----.10(c)(8)(iv).
\1893\ Servicing assets should not introduce significant
additional risks to the transaction, including foreign currency risk
or maturity risk. For instance, funds on deposit in an account that
is swept on a monthly basis should not be invested in securities
that mature in 90 days.
---------------------------------------------------------------------------
The Agencies have specifically limited the types of securities held
as eligible assets in a loan securitization that may be excluded from
the definition of covered fund under the final rule, even in limited
amounts, in order to assure that the types of securities are cash
equivalents or otherwise related to the loan securitization and to
prevent the possible misuse of the loan securitization exclusion to
circumvent the restrictions on proprietary trading, investments in
covered funds and prohibitions in section 13(f) of the BHC Act.\1894\
The Agencies believe that types of securities other than those
specifically included in the final rule could be misused in such
manner, because without limitations on the types of securities in which
an excluded loan securitization may invest, a banking entity could
structure an excluded loan securitization with provisions to engage in
activities that are outside the scope of the definition of loan as
adopted and also to engage in impermissible proprietary trading.
Further, the Agencies do not believe that the use of thresholds with
respect to such other types of securities as an alternative is
appropriate because similarly, such a securitization would then involve
a securitization of non-loan assets, outside the scope of what the
Agencies believe the rule of construction was intended to cover. By
placing restrictions on the securities permitted to be held by an
excluded loan securitization, the potential for evasion is reduced.
Loan securitizations are intended, as contemplated by the rule of
construction, to permit banks to continue to engage in securitizations
of loans. Including all types of securities within the scope of
permitted assets in an excluded loan securitization would expand the
exclusion beyond the scope of the definition of loan in the final rule
that is intended to implement the rule of construction.
---------------------------------------------------------------------------
\1894\ Commenters expressed concerns about the use of
securitization vehicles for evasion. See, e.g., AFR et al. (Feb.
2012); Occupy; Public Citizen.
---------------------------------------------------------------------------
iii. Derivatives
Under the proposed loan securitization definition, an exempted loan
securitization would be permitted to hold interest rate or foreign
exchange derivatives that materially relate to the terms of any loans
supporting the asset-backed securities and any contractual rights or
assets directly arising from such loans so long as such derivatives are
used for hedging purposes with respect to the securitization
structure.\1895\ The Agencies indicated in the proposing release that
the proposed loan securitization definition would not allow an exempted
loan securitization to use credit default swaps.\1896\
---------------------------------------------------------------------------
\1895\ See Joint Proposal, 76 FR 68,912.
\1896\ Id.
---------------------------------------------------------------------------
Commenters criticized the proposed limitations on the use of
derivatives included in the proposed loan securitization
definition.\1897\ In particular, one commenter indicated that the use
of credit derivatives such as credit default swaps is important in loan
securitizations to provide diversification of assets.\1898\ Another
commenter noted the use of such instruments to manage risks with
respect to corporate loan and debt books by accessing capital from a
broad group of capital markets investors and facilitates making
markets.\1899\ In contrast, two commenters generally supported the
limitations on the use of derivatives under the proposed loan
securitization definition and indicated that excluding credit default
swaps from the loan securitization definition was appropriate.\1900\
---------------------------------------------------------------------------
\1897\ See AFME et al.; Allen & Overy (on behalf of Foreign Bank
Group); ASF (Feb. 2012) (requesting that an excluded loan
securitization be permitted to hold up to 10% of its assets in the
form of synthetic risk exposure to loans); Credit Suisse (Williams);
Japanese Bankers Ass'n.; LSTA (Feb. 2012) (for CLOs); SIFMA
(Securitization) (Feb. 2012).
\1898\ See Japanese Bankers Ass'n. This commenter indicated that
credit derivatives are important in securitizations to provide
diversification when the desired mix of assets cannot be achieved.
\1899\ See ASF (Feb. 2012). This commenter argued that for some
loan securitizations, investors may Seek a broader pool of credit
exposures than the bank has available or can obtain to securitize in
order to achieve risk diversification.
\1900\ See AFR et al. (Feb. 2012); Public Citizen. One of these
commenters stated that the credit default exclusion was appropriate
because ``synthetic securitizations and resecuritizations were a key
contributor to financial contagion during the crisis.'' See AFR et
al. (Feb. 2012). Another commenter argued that the loan
securitization definition should not permit the use of derivatives.
See Occupy. This commenter argued that covered funds should only be
permitted to engage in hedging activity in accordance with the
proposed exemption for hedging activity. This commenter also argued
that the inclusion of derivatives in the loan securitization
definition exceeded the Agencies' statutory authority. Id. Two
senators indicated that ``complex securitizations'' including those
with ``synthetic features'' and ``embedded derivatives'' should not
be allowed to rely on the exclusion for loan securitizations. See
Sens. Merkley & Levin (Feb. 2012).
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[[Page 5691]]
With respect to the use of derivatives, the Agencies are adopting
the loan securitization exclusion substantially as proposed with
certain modifications to reflect a restructuring of this provision in
order to more closely align the permissible uses of derivatives under
the loan securitization exclusion with the loans, the asset-backed
securities, or the contractual rights and other assets that a loan
securitization relying on the loan securitization exclusion may hold.
As adopted, for a loan securitization to be eligible for the loan
securitization exclusion, the loan securitization may hold only
interest rate or foreign exchange derivatives that meet the following
requirements: (i) The written terms of the derivatives directly relate
to either the loans or the asset-backed securities that such loan
securitization may hold under the other provisions of the loan
securitization exclusion; and (ii) the derivatives reduce interest rate
and/or foreign exchange risk with respect to risks related to either
such loans, the asset-backed securities or the contractual rights or
other assets that a loan securitization may hold.\1901\
---------------------------------------------------------------------------
\1901\ See final rule Sec. ----.10(c)(8)(iv).
---------------------------------------------------------------------------
The first requirement that the written terms of the derivatives
``directly relate'' to either the loans or the asset-based securities
themselves is intended to quantitatively and qualitatively limit the
use of derivatives permitted under the loan securitization
exclusion.\1902\ The Agencies would expect that neither the total
notional amount of directly related interest rate derivatives nor the
total notional amount of directly related foreign exchange derivatives
would exceed the greater of either the outstanding principal balance of
the loans supporting the asset-backed securities or the outstanding
principal balance of the asset-backed securities.\1903\ Moreover, under
the loan securitization exclusion, the type of derivatives must be
related to the types of risks associated with the underlying assets and
may not be derivatives designed to supplement income based on general
economic scenarios, income management or unrelated risks.
---------------------------------------------------------------------------
\1902\ Under the final rule, the Agencies expect that a loan
securitization relying on the loan securitization exclusion would
not have a significant amount of interest rate and foreign exchange
derivatives with respect to risks arising from contractual rights or
other assets.
\1903\ For example, a $100 million securitization cannot be
hedged using an interest rate hedge with a notional amount of $200
million.
---------------------------------------------------------------------------
The second requirement that derivatives reduce the interest rate
and/or foreign exchange risks related to either such loans, contractual
rights or other assets, or such asset-backed securities is intended to
permit the use of derivatives to hedge interest rate and/or foreign
exchange risks that result from a mismatch between the loans and the
asset-backed securities.\1904\
---------------------------------------------------------------------------
\1904\ The derivatives permitted in a securitization that may
rely on the loan securitization exclusion would permit a
securitization to hedge the risk resulting from differences between
the income received by the issuing entity and the amounts due under
the terms of the asset-backed securities. For example, fixed rate
loans could support floating rate asset-backed securities; loans
with an interest rate determined by reference to the Prime Rate
could support asset-backed securities with an interest rate
determined by reference to LIBOR; or Euro-denominated loans could
support U.S. Dollar-denominated asset-backed securities.
---------------------------------------------------------------------------
The Agencies believe that the statutory rule of construction should
be implemented in a manner that does not limit or restrict the sale and
securitization of loans. The Agencies further believe that the sale and
securitization of credit exposures other than ``loans'' as defined in
the rule, such as through securities or derivatives, could be abused.
The derivatives that may be held in a loan securitization for purposes
of the exclusion may not be used for speculative purposes. Consistent
with the proposal, the loan securitization exclusion does not permit a
loan securitization relying on such exclusion to hold credit default
swaps or other types of derivatives whether or not they are related
either to the underlying loans or the asset-backed securities.\1905\
Under the final rule, a synthetic securitization in which the asset-
backed securities are supported by cash flow from derivatives, such as
credit default swaps and total return swaps, would not be permitted to
rely on the loan securitization exclusion because such derivatives are
excluded from the final rule's definition of loan specifically, as a
derivative. Similarly, a loan securitization that relies on the loan
securitization exclusion would not be permitted to hold a credit
default swap or total return swap that references a loan that is held
by the loan securitization. Under the final rule as adopted, an
excluded loan securitization would not be able to hold derivatives that
would relate to risks to counterparties or issuers of the underlying
assets referenced by these derivatives because the operation of
derivatives, such as these, that expand potential exposures beyond the
loans and other assets, would not in the Agencies' view be consistent
with the limited exclusion contained in the rule of construction under
section 13(g)(2) of the BHC Act, and could be used to circumvent the
restrictions on proprietary trading and prohibitions in section 13(f)
of the BHC Act. The Agencies believe that the use of derivatives by an
issuing entity for asset-backed securities that is excluded from the
definition of covered fund under the loan securitization exclusion
should be narrowly tailored to hedging activities that reduce the
interest rate and/or foreign exchange risks directly related to the
asset-backed securities or the loans supporting the asset-backed
securities because the use of derivatives for purposes other than
reducing interest rate risk and foreign exchange risks would introduce
credit risk without necessarily relating to or involving a reduction of
interest rate risk or foreign exchange risk.
---------------------------------------------------------------------------
\1905\ Loan securitizations excluded from the covered fund
definition may only hold certain directly related derivatives as
specified in Sec. ----.11(c)(8)(iv) and as discussed in this Part.
---------------------------------------------------------------------------
On the other hand, while the Agencies are not expanding the types
of permitted derivatives to be held in a loan securitization, the
Agencies in the final rule are not restricting the use of all
derivatives under the loan securitization exclusion as requested by
certain commenters. The Agencies believe that a loan securitization
that is excluded from the definition of covered fund should be allowed
to engage in activities that reduce interest rate and foreign exchange
risk because the hedging of such risks is consistent with the prudent
risk management of interest rate and currency risk in a loan portfolio
while at the same time avoiding the potential for additional risk
arising from other types of derivatives.\1906\ The Agencies do not
believe that the exemption for hedging activity applicable to market
making and underwriting under the final rule is the appropriate measure
for permitted derivatives in a loan securitization that would be
excluded from definition of covered fund \1907\ because the hedging
exemptions for market making and underwriting are not tailored to the
hedging requirements of a securitization transaction.\1908\ The
Agencies also do not believe that they lack the statutory authority to
permit a loan securitization
[[Page 5692]]
relying on the loan securitization exclusion to use derivatives, as
suggested by one commenter,\1909\ because the Agencies believe that the
permitted derivatives relate directly to loans that are permitted and
have limited the quality and quantity of derivatives that an excluded
loan securitization is permitted to hold directly to the reduction of
risks that result from the loans and the loan securitization.
---------------------------------------------------------------------------
\1906\ See AFR et al. (Feb. 2012); Occupy; Public Citizen.
\1907\ See Occupy. This commenter argued that covered funds
should only be permitted to engage in hedging activity in accordance
with the proposed exemption for hedging activity.
\1908\ For example, a banking entity may hold an ownership
interest in a covered fund in order to hedge employee compensation
risks. Because securitizations do not have employees, such a hedging
exemption would not be applicable to a securitization structure.
\1909\ See Occupy.
---------------------------------------------------------------------------
While loan securitizations that include non-loan assets are not
excluded from the definition of covered fund, banking entities are not
prohibited from owning interests or sponsoring these covered funds
under the final rule. Under the final rule, these securitizations would
be covered funds, and banking entities engaged with these covered funds
would be subject to the limitations on ownership interests and
relationships with these covered funds imposed by section 13 of the BHC
Act.
iv. SUBIs and Collateral Certificates
Commenters also argued that, under the proposed exemption for loan
securitizations, securitizations that are backed by certain
intermediate asset-backed securities would not satisfy the conditions
for the exemption and therefore would be subject to the covered fund
prohibitions.\1910\ For example, commenters noted that, in a
securitization of leases with respect to equipment where a titling
trust is used to hold ownership of the equipment, a titling trust will
typically own the equipment and the right to payment on the leases, and
then will issue a security or other instrument, often referred to as a
special unit of beneficial interest (SUBI), that represents an
ownership interest in the titling trust to the securitization
issuer.\1911\ As another example, certain securitizations frequently
use a master trust structure allowing the trust to issue more than one
series of asset-backed security collectively backed by a common
revolving pool of assets. In such a structure, a master trust may hold
assets (such as loans) and issue a collateral certificate supported by
those assets to an issuing trust that issues asset-backed securities to
investors. The assets held by the master trust are typically a pool of
revolving accounts that may be paid in full each month (e.g., credit
card receivables) or a revolving pool of short-term loans that are
replaced with new loans as they mature (e.g., floor plan loans).\1912\
One commenter opposed the inclusion of securitizations backed by
intermediate asset-backed securities, arguing that each step should be
viewed separately to ensure compliance to prevent the inclusion of
impermissible assets such as prohibited derivatives.\1913\
---------------------------------------------------------------------------
\1910\ See AFME et al.; Allen & Overy (on behalf of Foreign Bank
Group); ASF (Feb. 2012); Credit Suisse (Williams); GE (Aug. 2012);
PNC; RBC; SIFMA (Securitization) (Feb. 2012).
\1911\ See SIFMA (Securitization) (Feb. 2012).
\1912\ See, e.g., ASF (Feb. 2012). UK RMBS master trusts also
use a master trust structure. See AFME et al.; ASF (Feb. 2012);
SIFMA (Securitization) (Feb. 2012).
\1913\ See Occupy.
---------------------------------------------------------------------------
In response to comments, the Agencies are modifying the proposal to
provide that a securitization backed by certain intermediate asset-
backed securities will qualify for the loan securitization exclusion.
The Agencies recognize that securitization structures that use these
types of intermediate asset-backed securities are essentially loan
securitization transactions, because the intermediate asset-backed
securities in the asset pool are created solely for the purpose of
facilitating a securitization \1914\ and once created, are issued
directly into a securitization vehicle rather than to any third party
investor.
---------------------------------------------------------------------------
\1914\ The use of SUBIs, for example, allows the sponsor to
avoid administrative expenses in retitling the physical property
underlying the leases.
---------------------------------------------------------------------------
Under the final rule, a loan securitization that is excluded from
the definition of covered fund may include SUBIs or collateral
certificates, provided that four conditions are met.\1915\ First, the
special purpose vehicle issuing the SUBI or collateral certificate
itself must meet the conditions of the loan securitization exclusion,
as adopted in the final rule.\1916\ Under this provision, for example,
the special purpose vehicle, in addition to the issuing entity, may
hold an interest rate or foreign exchange derivative or other assets
only if the derivative or asset is permitted to be held in accordance
with the requirements for derivatives in respect of the loan
securitization exclusion. Second, the SUBI or collateral certificate
must be used for the sole purpose of transferring economic risks and
benefits of the loans (and other permissible assets) \1917\ to the
issuing entity for the securitization and may not directly or
indirectly transfer any interest in any other economic or financial
exposures. Third, the SUBI or collateral certificate must be created
solely to satisfy legal requirements or otherwise facilitate the
structuring of the loan securitization. Fourth, the special purpose
vehicle issuing the SUBI or collateral certificate and the issuing
entity for the excluded loan securitization transaction must be
established under the direction of the same entity that initiated the
loan securitization transaction. The Agencies believe that the fourth
condition will ensure that the resecuritizations of asset-backed
securities purchased in the secondary market, which the Agencies do not
believe would constitute a loan securitization, will not be able to use
these special provisions tailored only for transactions utilizing SUBIs
and collateral certificates in order to fall within the loan
securitization exclusion.
---------------------------------------------------------------------------
\1915\ See final rule Sec. ----.10(c)(8)(v).
\1916\ The provision will allow for the existing practice of a
master trust to hold a collateral certificate issued by a legacy
master trust.
\1917\ This would include a collateral certificate issued by a
legacy master trust that meets the requirements of the loan
securitization exclusion.
---------------------------------------------------------------------------
The Agencies believe that these conditions provide that only
securitizations backed by SUBIs and collateral certificates involving
loans--and not other types of securities or other types of assets--will
be able to use the loan securitization exclusion. These conditions are
intended to assure that for purposes of the loan securitization
exclusion that only SUBI and collateral certificates that essentially
represent the underlying loans are included consistent with the terms
and the purpose of section 13 of the BHC Act, while also not adversely
affecting securitization of ``loans'' as defined in the final
rule.\1918\ The Agencies believe that the limitation of the types of
asset-backed securities permitted in an excluded loan securitization
(only SUBIs and collateral certificates) and the restrictions placed on
those SUBIs and collateral certificates that are permitted in an
excluded loan securitization will avoid loan securitizations that
contain other types of assets from being excluded from the definition
of covered fund.
---------------------------------------------------------------------------
\1918\ See, e.g., rule 190 under the Securities Act. See also,
e.g., ASF (Feb. 2012) (noting that certain rules under the
Securities Act and staff interpretations have carved out SUBIs and
collateral certificates from certain disclosure and other
requirements).
---------------------------------------------------------------------------
v. Impermissible Assets
As discussed above, commenters on the loan securitization proposals
argued that various types of assets should be included within the
definition of loan or otherwise permitted to be held by the loan
securitization that would be entitled to rely on the proposed
exemptions.
After considering comments, the Agencies have determined to retain
the narrower scope of the permitted assets in a loan securitization
that is eligible for the loan securitization exclusion.
[[Page 5693]]
The Agencies have revised the language regarding loan securitizations
from the proposal to specify certain types of assets or holdings that a
loan securitization would not be able to hold if it were eligible to
rely on the exclusion from the definition of covered fund for loan
securitizations.\1919\ The Agencies recognize that securitization
structures vary significantly and, accordingly, the loan securitization
exclusion as adopted in the final rule accommodates a wider range of
securitization practices. The Agencies believe that these limitations
provide that only securitizations backed by loans--and not securities,
derivatives or other types of assets--will be able to use the loan
securitization exclusion consistent with the terms and the purpose of
section 13 of the BHC Act.\1920\ The Agencies believe that the
limitation of the types of assets permitted in an excluded loan
securitization will avoid loan securitizations that contain other types
of assets from being excluded from the definition of covered fund.
---------------------------------------------------------------------------
\1919\ See final rule Sec. ----.10(c)(8)(ii).
\1920\ The Agencies discuss earlier in this Part the permissible
assets an excluded loan securitization may hold and the Agencies'
belief that excluding loan securitizations as defined in the final
rule is consistent with the terms and the purpose of section 13 of
the BHC Act, including the rule of construction in section 13(g)(2).
See, e.g., supra note 1866 and accompanying and following text.
---------------------------------------------------------------------------
Under the final rule, in order to be excluded from the definition
of covered fund, a loan securitization may not hold (i) a security,
including an asset-backed security, or an interest in an equity or debt
security (unless specifically permitted, such as with respect to a SUBI
or collateral certificate as described above), (ii) a derivative other
than an interest rate or foreign exchange derivative that meets the
requirements described above,\1921\ or (iii) a commodity forward
contract.\1922\ The Agencies have determined that a loan securitization
relying on the loan securitization exclusion may not include a
commodity forward contract because a commodity forward contract is not
a loan.\1923\
---------------------------------------------------------------------------
\1921\ See final rule Sec. ----.10(c)(8)(iv); See also 7 U.S.C.
27(a)-(b).
\1922\ See the discussion above in Part IV.B.1.c.8 of this
SUPPLEMENTARY INFORMATION.
\1923\ For a discussion of commodity forward contracts, See
Further Definition of ``Swap,'' ``Security-Based Swap,'' and
``Security-Based Swap Agreement;'' Mixed Swaps; Security-Based Swap
Agreement Recordkeeping, 77 FR 48208 (Aug. 13, 2012) (Release Nos.
33-9338 and 34-67453, July 18, 2012).
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9. Asset-Backed Commercial Paper Conduits
Under the proposed rule, certain securitization vehicles, including
ABCP conduits, would not have been covered by the loan securitization
exclusion and, therefore, would have been deemed to be a covered
fund.\1924\ ABCP is a type of liability that is typically issued by a
special purpose vehicle (commonly referred to as a ``conduit'')
sponsored by a financial institution or other entity. The short term
asset-backed securities issued by the conduit are supported by a
managed pool of assets, which may change over the life of the entity.
Depending on the type of ABCP conduit, the securitized assets
ultimately supporting the short term asset-backed securities may
consist of a wide range of assets including automobile loans,
commercial loans, trade receivables, credit card receivables, student
loans, and other loans in addition to asset-backed securities supported
by such assets. The term of ABCP typically is short, and the
liabilities are ``rolled'' (i.e., replaced or refinanced) at regular
intervals. Thus, ABCP conduits generally fund longer-term assets with
shorter-term liabilities.\1925\ In this regard, in the proposing
release, the Agencies requested comment on the proposed rule's
definition of ``covered fund'' with respect to asset-backed securities
and/or securitization vehicles \1926\ and received numerous comments
requesting a variety of exemptions for ABCP conduits.\1927\
---------------------------------------------------------------------------
\1924\ See proposed rule Sec. ----.13(d).
\1925\ Structured investment vehicles (``SIVs'') and securities
arbitrage ABCP programs both purchase securities (rather than
receivables and loans). SIVs typically lack liquidity facilities
covering all of these liabilities issued by the SIV, while
securities arbitrage ABCP programs typically have such liquidity
coverage, though the terms are more limited than those of the ABCP
conduits eligible for the exclusion pursuant to the final rule.
\1926\ See Joint Proposal, 76 FR 68,899.
\1927\ See, e.g., ASF (Feb. 2012); BoA; Capital Group; Eaton
Vance; Fidelity; ICI (Feb. 2012); Japanese Bankers Ass'n.; PNC; RBC.
---------------------------------------------------------------------------
A number of commenters requested that the final rule exclude ABCP
conduits from the definition of covered fund \1928\ or that the
Agencies use their authority under section 13(d)(1)(J) of the BHC Act
\1929\ to similar effect.\1930\ One commenter argued that ABCP conduits
do not have the characteristics of a private equity fund or hedge
fund,\1931\ even though they typically rely on the exemptions set forth
in section 3(c)(1) or 3(c)(7) of the Investment Company Act. Another
commenter argued that the proposed rule's definition of covered fund
would negatively impact asset-backed securitizations (including ABCP
conduits), and suggested that the Agencies define covered funds, in
part, as those that both (i) rely on section 3(c)(1) or 3(c)(7) of the
Investment Company Act and (ii) have the traditional characteristics of
private equity funds or hedge funds.\1932\ Another commenter stated
that the rule of construction set forth in section 13(g)(2) of the BHC
Act \1933\ is a clear indication that section 13 of the BHC Act was not
intended to apply to securitization vehicles such as ABCP
conduits.\1934\ Another commenter stated that the lending that occurs
through ABCP conduits is the type of activity that Congress and the
Executive Branch have urged banks to expand in order to support
economic growth and job creation,\1935\ while another commenter stated
that ABCP conduits provide low cost, reliable financing for registered
investment companies, which poses little risk to the safety and
soundness of banks because federal law requires registered investment
companies to maintain prescribed asset coverage in connection with
borrowings.\1936\
---------------------------------------------------------------------------
\1928\ See, e.g., ICI (Feb. 2012); PNC et al.; SIFMA (May 2012).
\1929\ See 12 U.S.C. 1851(d)(1)(J).
\1930\ See ICI (Feb. 2012).
\1931\ See PNC.
\1932\ See Barclays.
\1933\ See 12 U.S.C. 1851(g)(2).
\1934\ See ICI (Feb. 2012).
\1935\ See Credit Suisse (Williams).
\1936\ See Eaton Vance.
---------------------------------------------------------------------------
Two commenters contended that, while certain issuers of asset-
backed securities may rely on section 3(c)(5) of the Investment Company
Act or rule 3a-7 thereunder, and, therefore, not be brought under the
proposed rule's definition of covered fund, ABCP conduits typically
cannot rely on this section or rule either because to do so would be
too restrictive (in the case of section 3(c)(5)) or because they cannot
meet the rule's requirements.\1937\
---------------------------------------------------------------------------
\1937\ See RBC; ASF (Feb. 2012).
---------------------------------------------------------------------------
One commenter, employing ABCP conduits as an example, stated that
failing to exempt securitization vehicles from the covered fund
prohibitions would preclude banking entities from engaging in
activities that have long been recognized as permissible activities for
banking entities and that are vital to the normal functioning of the
securitization markets, and will have a significant and negative impact
on the securitization markets and on the ability of banking entities
and other companies to provide credit to their customers.\1938\ This
commenter further stated that ABCP conduits are an efficient and
[[Page 5694]]
attractive way for banking entities to lend their own credit-worthiness
to expand the pool of possible lenders willing to finance key economic
activity while maintaining a low cost of funding for consumers, and
because of the liquidity support provided by the sponsoring banking
entity, the sponsoring banking entity to the ABCP conduit has full
exposure to the assets acquired by or securing the amounts lent by the
ABCP conduit and the banking entity subjects those assets and the
obligors to the same analysis as it would engage in if the bank were
lending directly against those assets.\1939\ Another commenter stated
that the provision of credit to companies to finance receivables
through ABCP conduits is an area of traditional banking activity that
should be distinguished from the type of high-risk, conflict-ridden
financial activities that Congress sought to restrict under section 13
of the BHC Act.\1940\
---------------------------------------------------------------------------
\1938\ See Credit Suisse (Williams).
\1939\ Id.
\1940\ See ICI (Feb. 2012). This commenter emphasized the
importance of the ABCP conduit market to money market funds, noting
that as of November 2011, taxable money market funds held $126
billion of the $348.1 billion of securities issued by ABCP conduits
outstanding, which represented approximately 5.4% of taxable money
market funds' total assets. Another commenter noted that
approximately $66.7 billion of automobile loans and leases, $52.1
billion of student loans, $22.3 billion of credit card charges,
$49.4 billion of loans to commercial borrowers and $50.7 billion of
trade receivables were financed by the U.S. ABCP conduit market as
of October 31, 2011, and that the total outstanding amount of
securities sold by ABCP conduits in the U.S. market was $344.5
billion as of January 18, 2012. See ASF (Feb. 2012).
---------------------------------------------------------------------------
To this end, commenters proposed several means to exclude ABCP
conduits from the proposed rule's restrictions and requirements,
including an expansion of the loan securitization exemption to treat
two-step securitization transactions as a single loan
securitization,\1941\ a separate exclusion for ABCP conduits,\1942\ an
expansion of the definition of loan,\1943\ or as part of a broad
exclusion for all issuers of asset-backed securities.\1944\ In order to
allow ABCP conduits to qualify as loan securitizations, commenters
suggested that the loan securitization exclusion should permit a
limited amount of securities purchased in the secondary market.\1945\
Commenters also proposed changes to the permissible assets such as
allowing a loan securitization to hold liquidity and support
commitments, asset-backed securities and certain financial assets in
addition to loans that by their terms convert to cash within a finite
period of time.\1946\ Another commenter argued that the loan
securitization exemption should allow banking entities to sponsor,
control, and invest in ABCP conduits that facilitate the securitization
of customer loans and receivables.\1947\ In contrast, one commenter
supported the restriction of the loan securitization exemption to the
plain meaning of what constitutes a loan and advocated that the
Agencies not include ABCP conduits under the exemption.\1948\
---------------------------------------------------------------------------
\1941\ See AFME et al.; Allen & Overy (on behalf of Foreign Bank
Group); ASF (Feb. 2012); PNC; SIFMA (Securitization) (Feb. 2012).
\1942\ See ASF (Feb. 2012); Capital Group (alleging that ABCP
does not pose the risks that the rule is meant to combat); GE (Feb.
2012). One commenter proposed an exemption for ABCP conduits that
included a requirement of 100% liquidity support from a regulated,
affiliated entity, and such liquidity support may be conditional or
unconditional. See RBC.
\1943\ See Credit Suisse (Williams) (alleging that ABCP conduits
acquire ownership of loans indirectly through the purchase of
variable funding notes, trust certificates, asset-backed securities,
repurchase agreements and other instruments that may be considered
securities, all of which economically are consistent with providing
funding or extensions of credit to customers); ICI (Feb. 2012)
(requesting that the definition of loan include the broad array of
receivables that back ABCP).
\1944\ See AFME et al.; SIFMA (Securitization) (Feb. 2012).
\1945\ See ASF (Feb. 2012) (requesting that ABCP conduits be
permitted to own asset-backed securities purchased on the secondary
market only if the aggregate principal amount of such securities
does not exceed 5% of the aggregate principal or face amount of all
assets held by the ABCP conduit in order to diversify their asset
base and avoid the negative consequences of divestiture of such
assets); RBC (requesting that loan securitizations be permitted to
hold cash equivalents and assets, other than loans, which, by their
terms, convert to cash within a finite period of time so long as
such assets comprise no more than 10% of their total assets based on
book value).
\1946\ See ASF (Feb. 2012) (arguing that the loans, receivables,
leases, or other assets purchased by the ABCP conduit might have fit
the definition of loan in the proposed rules but for the proposal's
express assertion that the definition of loan does not include any
asset-backed security that is issued in connection with a loan
securitization or otherwise backed by loans). See Joint Proposal, 76
FR 68,865; GE (Feb. 2012); RBC.
\1947\ See PNC.
\1948\ See Public Citizen.
---------------------------------------------------------------------------
In addition to the effect the proposed rule's definition of covered
fund would have on ABCP conduits, commenters also noted that section
13(f) of the BHC Act \1949\ would prohibit certain transactions between
a banking entity sponsor and a covered fund securitization.\1950\ Two
commenters requested a specific exemption from Sec. ----.16 of the
proposed rule for ABCP conduits based on the interpretation that the
proposed rule subjects covered funds exempted under the loan
securitization exemption or other exemptions to Sec. ----.16.\1951\
Commenters argued that without liquidity and credit support, ABCP
conduits are not viable,\1952\ cannot effectively operate,\1953\ could
not function,\1954\ or would not be marketable.\1955\ One commenter
argued that prohibiting a banking entity from providing liquidity
facilities to ABCP conduits is tantamount to requiring the banking
entity to wind down the operation of such ABCP conduits.\1956\
---------------------------------------------------------------------------
\1949\ See 12 U.S.C. 1851(f); See also Sec. ----.16 of the
proposed rule.
\1950\ See, e.g., Allen & Overy (on behalf of Foreign Bank
Group); Credit Suisse (Williams); Fidelity; IIB/EBF; JPMC; PNC; RBC;
SIFMA (Securitization) (Feb. 2012).
\1951\ See ICI (Feb. 2012); Fidelity.
\1952\ See JPMC.
\1953\ See ASF (Mar. 2012).
\1954\ See Allen & Overy (on behalf of Foreign Bank Group).
\1955\ See ASF (Feb. 2012); Fidelity.
\1956\ See ASF (Mar. 2012).
---------------------------------------------------------------------------
In response to the comments received and in light of the rule of
construction contained in section 13(g)(2) of the BHC Act, the Agencies
have determined in the final rule to exclude from the definition of
covered fund an ABCP conduit that is a ``qualifying asset-backed
commercial paper conduit'' as defined in the final rule is excluded
from the definition of covered fund.\1957\
---------------------------------------------------------------------------
\1957\ See final rule Sec. ----.10(c)(9)(i). The rule of
construction contained in section 13(g)(2) of the BHC Act provides
that nothing in section 13 of the BHC Act shall be construed to
limit or restrict the ability of a banking entity or nonbank
financial company supervised by the Board to sell or securitize
loans in a manner that is otherwise permitted by law. As noted above
and explained below, a qualifying asset-backed commercial paper
conduit under the final rule is an ABCP conduit that holds only (i)
loans or other assets that would be permissible in a loan
securitization and (ii) asset-backed securities that are supported
solely by assets permissible for a loan securitization and are
acquired by the conduit as part of an initial issuance directly from
the issuer or directly from an underwriter engaged in the
distribution of the securities.
---------------------------------------------------------------------------
Under the final rule, a qualifying asset-backed commercial paper
conduit is an ABCP conduit that holds only (i) loans or other assets
that would be permissible in a loan securitization \1958\ and (ii)
asset-backed securities that are supported solely by assets permissible
for a loan securitization and are acquired by the conduit as part of an
initial issuance directly from the issuer or directly from an
underwriter engaged in the distribution of the securities.\1959\ In
addition, a qualifying asset-backed commercial paper conduit must issue
only asset-backed securities, comprising of a residual and securities
with a term of 397 days or less and in addition, a ``regulated
liquidity provider,'' as defined in the final rule, must provide a
legally binding commitment to provide full and unconditional liquidity
coverage with respect to all the outstanding short term asset-backed
[[Page 5695]]
securities issued by the qualifying asset-backed commercial paper
conduit in the event that funds are required to redeem the maturing
securities.\1960\
---------------------------------------------------------------------------
\1958\ See final rule Sec. ----.10(c)(8).
\1959\ See final rule Sec. ----.10(c)(9)(i)(B).
\1960\ See final rule Sec. ----.10(c)(9)(ii) and (iii).
---------------------------------------------------------------------------
Under the final rule, a regulated liquidity provider is (i) a
depository institution as defined in section 3 of the Federal Deposit
Insurance Act; \1961\ (ii) a bank holding company or a subsidiary
thereof; \1962\ (iii) a savings and loan holding company,\1963\
provided all or substantially all of the holding company's activities
are permissible for a financial holding company,\1964\ or a subsidiary
thereof; (iv) a foreign bank whose home country supervisor as defined
in section 211.21 of the Federal Reserve Board's Regulation K \1965\
has adopted capital standards consistent with the Capital Accord of the
Basel Committee on Banking Supervision, as amended, and that is subject
to such standards, or a subsidiary thereof or (v) a sovereign
nation.\1966\ In order for a sovereign nation to qualify as a regulated
liquidity provider, the liquidity provided must be unconditionally
guaranteed by the sovereign, which would include its departments and
ministries, including the central bank.
---------------------------------------------------------------------------
\1961\ See 12 U.S.C. 1813.
\1962\ See 12 U.S.C. 1841.
\1963\ See 12 U.S.C. 1467a.
\1964\ See 12 U.S. C. 1843(k).
\1965\ See 12 CFR 211.21.
\1966\ See final rule Sec. ----.10(c)(9)(iii).
---------------------------------------------------------------------------
In this regard, under the final rule, the exclusion from the
definition of covered fund in respect of ABCP conduits is only
available to an issuer of short-term asset-backed securities supported
by loans and certain asset-backed securities supported by loans that
were issued or initially sold to the ABCP conduit, and the short term
asset-backed securities issued by the ABCP conduit are supported by a
liquidity facility that provides 100 percent liquidity coverage from a
regulated liquidity provider. The exclusion, therefore, is not
available to ABCP conduits that lack 100 percent liquidity coverage.
The liquidity coverage may be provided in the form of a lending
facility, an asset purchase agreement, a repurchase agreement, or
similar arrangement and 100 percent liquidity coverage means that, in
the event the qualifying asset-backed commercial paper conduit is
unable for any reason to repay maturing asset-backed securities issued
by the issuing entity, the total amount for which the regulated
liquidity provider may be obligated is equal to 100 percent of the
amount of asset-backed securities outstanding plus accrued and unpaid
interest. In addition, amounts due pursuant to the required liquidity
coverage may not be subject to the credit performance of the asset-
backed securities held by the qualifying asset-backed commercial paper
conduit or reduced by the amount of credit support provided to the
qualifying asset-backed commercial paper conduit. Under the final rule,
liquidity coverage that only funds an amount determined by reference to
the amount of performing loans, receivables, or asset-backed securities
will not be permitted to satisfy the liquidity requirement for a
qualifying asset-backed commercial paper conduit.
As discussed above, the final rule defines a qualifying asset-
backed commercial paper conduit as having certain elements. First, a
qualifying asset-backed commercial paper conduit must issue only a
residual interest and short-term asset-backed securities. This
requirement distinguishes ABCP conduits from covered funds that issue
partnership interests and mitigates the potential that a qualifying
ABCP conduit would be used for evasion of the covered fund
prohibitions. The Agencies chose a maximum term of 397 days for these
securities because this time frame corresponds to the maximum maturity
of securities allowed to be purchased by money market funds under Rule
2a-7 of the Investment Company Act.
Second, the asset-backed securities issued by the ABCP conduit must
be supported only by loans and certain asset-backed securities that
meet the requirements of the loan securitization exclusion. By placing
restrictions on the assets permitted to be held by an excluded loan
securitization, the potential for evasion of the covered fund
prohibitions is reduced. The exclusion for qualifying ABCP conduits is
intended, as contemplated by the rule of construction in section
13(g)(2) of the BHC Act, to permit banks to continue to engage in
securitizations of loans. Including all types of securities and other
assets within the scope of permitted assets in a qualifying ABCP
conduit, as with loan securitizations, would expand the exclusion
beyond the scope of the definition of loan in the final rule that is
intended to implement the rule of construction.
Third, the asset-backed securities supporting a qualifying asset-
backed commercial paper conduit must be purchased as part of the
initial issuance of such asset-backed securities. Asset-backed
securities purchased by an ABCP conduit in the secondary market will
not be permitted because such a purchase would not be part of an
initial issuance and the banking entity that established and manages
the ABCP conduit would not have participated in the negotiation of the
terms of such asset-backed securities. Without a more direct connection
between the banking entity and the ABCP conduit, the purchase of such
asset-backed securities in the secondary market would resemble
investments in securities.
Fourth, under the final rule, the ABCP conduit exclusion will not
be available to ABCP conduits that lack 100 percent liquidity coverage.
The Agencies believe that the 100 percent liquidity coverage
requirement distinguishes the conduits eligible for the exemption,
which sometimes hold and securitize a customer's loans through an
intervening special-purpose vehicle instead of holding the loans
directly, and are supported by a 100 percent liquidity guarantee, from
other types of conduits with partial liquidity guarantees (such as
structured investment vehicles) that have sometimes been operated by
banking entities for the purpose of financing portfolios of securities
acquired or retained as part of their activities in the securities
markets.
The Agencies recognize that ABCP conduits that do not satisfy the
elements of the ABCP conduit exclusion may be covered funds and
therefore would be subject to section 13(f) of the BHC Act.\1967\ As a
result of section 13(f) of the BHC Act, which prohibits certain
transactions between banking entities and a covered fund securitization
that the banking entity sponsors or for which it provides investment
management services, the banking entity would be prohibited from
providing liquidity support for the ABCP conduit.
---------------------------------------------------------------------------
\1967\ See 12 U.S.C. 1851(f); See also Sec. ----.16 of the
proposed rule.
---------------------------------------------------------------------------
Similarly, while some commenters requested that the loan
securitization exclusion permit the holding of a limited amount of
securities purchased in the secondary market, the final rule does not
provide for this in the context of ABCP conduits. The Agencies believe
that the limitations on the types of securities that a qualifying
asset-backed commercial paper conduit may invest in are needed to avoid
the possibility that a banking entity could use a qualifying asset-
backed commercial paper conduit to securitize non-loan assets or to
engage in proprietary trading of such securities prohibited under the
final rule. Thus this limitation reduces the potential for evasion of
the covered fund provisions of section 13 of the BHC Act. In developing
the exclusion from the definition of covered fund for qualifying asset-
backed commercial paper conduits
[[Page 5696]]
in the final rule, the Agencies considered the factors set forth in
sections 13(g)(2) and 13(h)(2) of the BHC Act. The final rule includes
conditions designed to ensure that an ABCP conduit established and
managed by a banking entity serves as a means of facilitating that
banking entity's loan securitization activity rather than financing
that banking entity's capital market investments. The final rule
distinguishes between qualifying asset-backed commercial paper conduits
and other ABCP conduits in order to adhere to the tenets of section 13
of the BHC Act while accommodating the market practices discussed by
the commenters by facilitating reasonable access to credit by consumers
and businesses through the issuance of ABCP backed by consumer and
business receivables. As discussed above, the Agencies understand that
some existing ABCP conduits may need to be restructured to conform to
the requirements of the ABCP conduit exclusion.
To the extent that the definition of covered fund, the loan
securitization exclusion and the ABCP conduit exclusion do not
eliminate the applicability of the final rule provisions to certain
covered funds, there may be adverse effects on the provision of capital
to customers,\1968\ to securitization markets,\1969\ and to the
creation of new securitization products to meet investor demands that
Congress may not have contemplated. \1970\ However, financial
institutions that are not banking entities and therefore are not
subject to the restrictions on ownership can continue to engage in
activities relating to securitization, including those securitizations
that fall under the definition of covered fund. Furthermore, new
securitizations may be structured so as to qualify for the loan
securitization exclusion or other exclusions under the final rule. For
these reasons, the impact on securitizations that are not excluded
under the final rule may be mitigated.
---------------------------------------------------------------------------
\1968\ See, e.g., ASF (Feb. 2012).
\1969\ See Credit Suisse (Williams) (employing ABCP conduits as
an example); ASF (Feb. 2012) (describing the constriction of the
market for asset-backed securities if banking entities are
restricted from owning debt classes of new asset backed securities).
\1970\ See RBC; ASF (Feb. 2012).
---------------------------------------------------------------------------
The Agencies believe that the final rule excludes from the
definition of covered fund typical structures used in the most common
loan securitizations representing a significant majority of the current
securitization market, such as residential mortgages, commercial
mortgages, student loans, credit card receivables, auto loans, auto
leases and equipment leases. Additionally, the Agencies believe that
esoteric asset classes supported by loans may also be able to rely on
the loan securitization exclusion, such as time share loans, container
leases and servicer advances.
10. Covered Bonds
Several commenters called for covered bond structures to be
excluded from the definition of covered fund.\1971\ They indicated that
the proposed rule may interfere with and restrict non-U.S. banks'
ability to establish or issue covered bonds. As described by several
commenters, covered bonds are full recourse debt instruments typically
issued by a non-U.S. entity that are fully secured or ``covered'' by a
pool of high-quality collateral (e.g., residential or commercial
mortgage loans or public sector loans).\1972\ Certain of these covered
bond structures utilize a special purpose vehicle (``SPV'') that holds
a collateral pool. As such, under the proposed rule, an SPV could be a
covered fund that relies on the exclusion in section 3(c)(1) or 3(c)(7)
of the Investment Company Act.
---------------------------------------------------------------------------
\1971\ See Allen & Overy (on behalf of Foreign Bank Group);
UKRCBC; FSA (Apr. 2012); ASF (Feb. 2012).
\1972\ See AFME et al.; Allen & Overy (on behalf of Foreign Bank
Group); ASF (Feb. 2012); FSA (Apr. 2012); UKRCBC.
---------------------------------------------------------------------------
According to one commenter, the majority of covered bonds are
issued under specific legislative frameworks which define permitted
characteristics for covered bond issuances, including the kinds and
quality of collateral that may be included in cover pools, the specific
legal framework for issuance of covered bonds, and the procedures for
resolution in the event that the issuer becomes insolvent.\1973\ Some
commenters expressed concern about the possibility that certain covered
bond structures could fall within the definition of covered fund, as
proposed. In particular, commenters expressed concern about covered
bond structures in the United Kingdom that also would be relevant in
principle with respect to covered bond structures used in other
European Union (``EU'') jurisdictions (e.g., the Netherlands and Italy)
and certain non-EU jurisdictions (e.g., Canada, Australia, and New
Zealand).\1974\ Another commenter indicated that covered bonds issued
by certain French entities that hold a revolving pool of loans may be
impacted by the proposed rule.\1975\
---------------------------------------------------------------------------
\1973\ See UKRCBC. For example, a commenter indicated that in
the European Union, Article 52(4) of the EU UCITS Directive sets out
the defining characteristics of covered bonds, and this directive is
implemented by specific legislative frameworks.
\1974\ See UKRCBC; FSA (Apr. 2012). One commenter argued that
there are two main models used for covered bond structures in
Europe--the integrated model (where the collateral pool continues to
be owned directly by the bank issuer and is segregated by special
legislation) and the structured model (where the pool is transferred
to a special purpose vehicle and is segregated by operation of legal
principles). See UKRCBC.
\1975\ See Allen & Overy (on behalf of Foreign Bank Group).
---------------------------------------------------------------------------
Certain commenters argued that in order to achieve the intended
economic effect of providing recourse to both the bank issuing covered
bonds and to the collateral pool, the issuing bank may enter into a
number of agreements with the SPV that holds the collateral. This
includes transactions where the bank takes on credit exposure to the
SPV (e.g., through derivatives and securities lending, provision of
loans, and/or investments in securities of the SPV).\1976\ The issuing
bank typically also provides asset and liability management services to
the SPV and may also repurchase certain assets from the SPV.\1977\
Commenters also contended that under certain legislative frameworks,
the SPV issues the covered bonds and holds the collateral, and a
sponsoring bank lends money to the SPV.\1978\ According to commenters,
the broad definition of covered fund in the proposed rule could capture
an SPV that holds the collateral, so transactions between an SPV and
the issuing bank or sponsor bank may be prohibited.\1979\ These
commenters argued that including covered bond structures in the
definition of covered fund is inconsistent with the legislative intent
of the rule, would have a negative and disproportionate effect on
foreign banks, markets and economies and would give rise to potential
conflicts with such foreign legislative frameworks.\1980\
---------------------------------------------------------------------------
\1976\ See FSA (Apr. 2012).
\1977\ See UKRCBC.
\1978\ See Allen & Overy (on behalf of Foreign Bank Group).
\1979\ See Allen & Overy (on behalf of Foreign Bank Group);
UKRCBC; FSA (Apr. 2012).
\1980\ See Allen & Overy (on behalf of Foreign Bank Group);
UKRCBC; FSA (Apr. 2012); ASF (Feb. 2012); AFME et al. For a
discussion of possible economic effects, See FSA (Feb. 2012);
UKRCBC; Allen & Overy (on behalf of Foreign Bank Group).
---------------------------------------------------------------------------
According to certain commenters, SPVs whose sole function is as
part of an offering of covered bonds should be excluded from the
definition of covered fund in the final rule. These commenters provided
that the proposed rule was not clear on whether these SPVs, which
effectively function as collateral devices for the covered bond, would
be excluded from the definition of covered fund.\1981\ One commenter
indicated that the key concern was primarily due to the wide definition
of
[[Page 5697]]
covered fund in the proposed rule.\1982\ Other commenters indicated
that the final rule should not apply to covered bond transactions
because they are not traditionally recognized or regulated as asset-
backed securities transactions, and they are not the type of
transactions that the rule was intended to address.\1983\
---------------------------------------------------------------------------
\1981\ See ASF (Feb. 2012); AFME et al.; UKRCBC.
\1982\ See UKRCBC.
\1983\ See, e.g., AFME et al.
---------------------------------------------------------------------------
As a result of comments received on covered bond vehicles, the
final rule specifically excludes from the definition of covered fund
certain entities that own or hold a dynamic or fixed pool of assets
that covers the payment obligations of covered bonds. In order to
qualify for the exclusion, the assets or holdings in the cover pool
must satisfy the conditions in the loan securitization exclusion,
except for the requirement that the securities they issue are asset-
backed securities (the ``permitted cover pool'').\1984\ The Agencies
believe this approach is consistent with the rule of construction
contained in section 13(g)(2) of the BHC Act. The rule of construction
in section 13(g)(2) of the BHC Act specifically refers to the ``sale
and securitization of loans'' and the Agencies would not want a banking
entity to use an excluded cover pool to engage in proprietary trading
of such securities prohibited under the final rule. The Agencies
believe this restriction reduces the potential for evasion of the final
rule.
---------------------------------------------------------------------------
\1984\ See final rule Sec. ----.10(c)(10).
---------------------------------------------------------------------------
By placing restrictions on the assets permitted to be held by a
cover pool, the potential for evasion of the covered fund prohibitions
is reduced. The exclusion for cover pools is intended, as contemplated
by the rule of construction in section 13(g)(2) of the BHC Act, to
permit banking entities to continue to engage in lending activities and
the financing those lending activities. Including all types of
securities and other assets within the scope of permitted assets in a
cover pools would expand the exclusion beyond the scope of the
definition of loan in the final rule that is intended to implement the
rule of construction. Additionally, because the exclusion for cover
pools is only available to foreign banking organizations, allowing such
cover pools to hold securities would provide unequal treatment of
covered bonds as compared to a loan securitization sponsored by a U.S.
banking entity.
Under the definition of covered bond in the final rule, the debt
obligation may be issued directly by a foreign banking organization or
by an entity that owns a permitted cover pool. In both cases, the
payment obligations of the debt obligation must be fully and
unconditionally guaranteed. If the debt obligation is issued by a
foreign banking organization, such debt obligation will be a ``covered
bond'' under the final rule if the payment obligations are fully and
unconditionally guaranteed by an entity that owns a permitted cover
pool.\1985\ If the debt obligation is issued by an entity that owns a
permitted cover pool, such debt obligation will be a ``covered bond''
under the final rule if (i) the payment obligations are fully and
unconditionally guaranteed by a foreign banking organization and (ii)
the issuer of the debt obligation is a wholly-owned subsidiary (as
defined) by such foreign banking organization.\1986\ Thus, under the
final rule, a covered bond structure in which an entity holds the cover
pool and issues securities that are fully and unconditionally
guaranteed by a foreign banking organization may also be able to rely
on the loan securitization exclusion if it meets all of the
requirements of that exclusion.
---------------------------------------------------------------------------
\1985\ See final rule Sec. ----.10(c)(10)(ii)(A).
\1986\ See final rule Sec. ----.10(c)(10)(ii)(B). As discussed
above in the section describing the wholly-owned subsidiary
exclusion from the definition of covered fund, the Agencies are
permitting 0.5 of a wholly-owned subsidiary to be owned by an
unaffiliated party for the purpose of establishing corporate
separateness or addressing bankruptcy, insolvency, or similar
concerns.
---------------------------------------------------------------------------
The Agencies recognize that many covered bond programs may involve
foreign covered bond programs (and their related cover pools) that are
permitted by their respective laws to own residential mortgage-backed
securities and other non-loan assets. As a result, the exclusion for
covered bonds in the final rule may not be available to many of the
existing cover pools that support outstanding covered bonds. The
Agencies recognize that this approach may not exclude all foreign
covered bond programs. Although certain commenters argued that
including covered bond structures in the definition of covered fund is
inconsistent with the legislative intent of the rule,\1987\ the
Agencies believe that the exclusion for qualifying covered bonds,
including the limitations on the types of securities that a loan
securitization can hold, is consistent with the rule of construction
contained in section 13(g)(2) of the BHC Act and appropriate for the
reasons discussed directly above and under ``Definition of Loan.'' The
Agencies also recognize that commenters argued that including covered
bonds as covered funds could have a negative and disproportionate
effect on foreign banks, markets and economies and would give rise to
potential conflicts with such foreign legislative frameworks.\1988\ The
Agencies note that, although they do not know the composition of the
cover pools, the Agencies believe that foreign banking organizations
should be able to look at the composition of their cover pools to
evaluate how to meet the requirements of the exclusion--and thus to
avoid or mitigate the adverse effects commenters asserted would occur--
as they determine appropriate.
---------------------------------------------------------------------------
\1987\ See supra note 1980 and accompanying text.
\1988\ Id.
---------------------------------------------------------------------------
11. Certain Permissible Public Welfare and Similar Funds
Section 13(d)(1)(E) of the BHC Act permits a banking entity to make
and retain: (i) investments in one or more small business investment
companies (``SBICs''), as defined in section 103(3) of the Small
Business Investment Act of 1958 (SBA) (15 U.S.C. 662) \1989\; (ii)
investments that are designed primarily to promote the public welfare,
of the type permitted under paragraph (11) of section 5136 of the
Revised Statutes of the United States (12 U.S.C. 24); and (iii)
investments that are qualified rehabilitation expenditures with respect
to a qualified rehabilitated building or certified historic structure,
as such terms are defined in section 47 of the Internal Revenue Code of
1986 or a similar State historic tax credit program.\1990\ The proposed
rule permitted banking entities to invest in and act as sponsor \1991\
to these entities, but did not explicitly exclude them from the
definition of covered fund.\1992\
---------------------------------------------------------------------------
\1989\ The Agencies note that section 13(d)(1)(E) of the BHC Act
incorrectly provides that the term ``small business investment
company'' is defined in section 102 of the SBA, while the definition
is in fact contained in section 103(3) of the SBA as codified at 15
U.S.C. 662. The statute includes the correct citation to 15 U.S.C.
662. The Agencies are correcting this technical error in the final
rule by updating the reference to section 102 to section 103(3).
\1990\ See 12 U.S.C. 1851(d)(1)(E).
\1991\ The proposal implemented a proposed determination by the
Agencies under 13(d)(1)(J) ``that a banking entity may not only
invest in such entities as provided under section 13(d)(1)(E) of the
BHC Act, but also may sponsor an entity described in that paragraph
and that such activity, since it generally would facilitate
investment in small businesses and support the public welfare, would
promote and protect the safety and soundness of banking entities and
the financial stability of the United States.'' Joint Proposal, 76
FR 68,908 n.292.
\1992\ See proposed rule Sec. ----.13(a).
---------------------------------------------------------------------------
Commenters generally supported the proposed exemption for
investments in and sponsorship of funds designed to promote the public
welfare, SBICs, and other tax credit funds given the valuable funding
and assistance these investments provide in facilitating community and
economic priorities and
[[Page 5698]]
the role these investments play in the ability of banking entities,
especially community and regional banks, to achieve their financial and
Community Reinvestment Act (``CRA'') goals. However, commenters raised
some issues with respect to the proposed exemption and sought
clarification on its application to specific investments.\1993\ Of
primary concern to commenters was the impact of the prohibition in
section 13(f) of the BHC Act on the ability of a banking entity
sponsoring a tax credit fund or its affiliate to guarantee certain
obligations of the fund in order to provide assurance to investors that
the investment has been properly structured to enable the investor to
receive the tax benefits on which the investment are sold.\1994\ Some
commenters noted that failure to address this issue in the final rule
would damage a large segment of this market and therefore urged the
Agencies to exempt these investments from the application of section
13(f) or, in the alternative, from the definition of covered
fund.\1995\
---------------------------------------------------------------------------
\1993\ See Novogradac (LIHTC); Novogradac (NMTC); Novogradac
(RETC); PNC; Raymond James; SIFMA et al. (Covered Funds) (Feb.
2012); SBIA.
\1994\ See AHIC; Novogradac (LIHTC); Novogradac (NMTC);
Novogradac (RETC); SBIA; Union Bank; U.S. Bancorp.
\1995\ See ABA (Keating); Lone Star; Novogradac (LIHTC);
Novogradac (NMTC); Novogradac (RETC); SVB; U.S. Bancorp.
---------------------------------------------------------------------------
In addition, commenters requested clarification that specific types
of public welfare, SBIC, and other tax credit investments would be
eligible for the exemption, including Low Income Housing Tax Credits,
Renewable Energy Tax Credits, New Markets Tax Credits, and Rural
Business Investment Companies.\1996\ One commenter requested that
applicants for an SBIC license that have received permission from the
Small Business Administration to file a formal SBIC license application
be viewed the same as an SBIC.\1997\ Other commenters sought coverage
of investments in non-SBIC funds that provide capital to small and
middle-market companies,\1998\ investments in any state administered
tax credit program,\1999\ and investments outside the United States
that are of the type permitted under paragraph (11) of section 5136 of
the Revised Statutes of the United States (12 U.S.C. 24).\2000\
---------------------------------------------------------------------------
\1996\ See NCHSA; SBIA; Novogradac (LIHTC); Novogradac (NMTC);
Novogradac (RETC).
\1997\ See SBIA; See also SEC Rule 3c-2.
\1998\ See ABA (Keating); PNC.
\1999\ See USAA.
\2000\ See JPMC; SIFMA et al. (Covered Funds) (Feb. 2012).
---------------------------------------------------------------------------
In light of the comments received, the final rule excludes from the
definition of covered fund an issuer that is an SBIC (or that has
received from the Small Business Administration notice to proceed to
qualify for a license as an SBIC, which notice or license has not been
revoked) or the business of which is to make investments that are: (i)
designed primarily to promote the public welfare, of the type permitted
under paragraph (11) of section 5136 of the Revised Statutes of the
United States (12 U.S.C. 24), including the welfare of low- and
moderate-income communities or families (such as providing housing,
services, or jobs); or (ii) qualified rehabilitation expenditures with
respect to a qualified rehabilitated building or certified historic
structure, as such terms are defined in section 47 of the Internal
Revenue Code of 1986 or a similar State historic tax credit
program.\2001\
---------------------------------------------------------------------------
\2001\ See final rule Sec. ----.10(c)(11). This provision would
cover any issuer that engages in the business of making tax credit
investments (e.g., Low Income Housing Tax Credit, New Markets Tax
Credit, Renewable Energy Tax Credit, Rural Business Investment
Company) that are either designed to promote the public welfare of
the type permitted under 12 U.S.C. 24(Eleventh) or are qualified
rehabilitation expenditures with respect to a qualified
rehabilitated building or certified historic structure, as provided
for under Sec. ----.10(c)(11).
---------------------------------------------------------------------------
By excluding SBICs and other public interest funds from the
definition of covered fund--rather than provide a permitted activity
exemption as proposed--the Agencies addressed commenters' concerns
regarding the burdens imposed by section 13(f). The Agencies believe
that excluding these investments from the definition of covered fund
addresses the issues many commenters raised with respect to the
application of section 13(f) of the BHC Act, and gives effect to the
statutory exemption of these investments in a way that appropriately
facilitates national community and economic development objectives. The
Agencies believe that permitting a banking entity to sponsor and invest
in these types of public interest entities will result in banking
entities being able to provide valuable expertise and services to these
entities and to provide funding and assistance to small businesses and
low- and moderate-income communities. The Agencies believe that
providing the exclusion will also allow banking entities to continue to
provide capital to community-improving projects and in some instances
promote capital formation.
12. Registered Investment Companies and Excluded Entities
The proposed rule did not specifically include registered
investment companies (including mutual funds) or business development
companies within the definition of covered fund.\2002\ As explained
above, the statute references funds that rely on section 3(c)(1) or
3(c)(7) of the Investment Company Act. Registered investment companies
and business development companies do not rely on either section
3(c)(1) or 3(c)(7) of the Investment Company Act and are instead
registered or regulated in accordance with the Investment Company Act.
---------------------------------------------------------------------------
\2002\ See proposed rule Sec. ----.10(b)(1).
---------------------------------------------------------------------------
Many commenters argued that registered investment companies and
business development companies would be treated as covered funds under
the proposed definition if commodity pools are treated as covered
funds.\2003\ A few commenters argued that the final rule should
specifically provide that all SEC-registered funds are excluded from
the definition of covered fund (and the definition of banking entity)
to avoid any uncertainty about whether section 13 applies to these
types of funds.\2004\
---------------------------------------------------------------------------
\2003\ See, e.g., Arnold & Porter; BoA; Goldman (Covered Funds);
ICI (Feb. 2012); Putnam; TCW; Vanguard. According to these
commenters, a registered investment company may use security or
commodity futures, swaps, or other commodity interests in various
ways to manage its investment portfolio and be swept into the broad
definition of ``commodity pool'' contained in the Commodity Exchange
Act.
\2004\ See Arnold & Porter; Goldman (Covered Funds); See also
SIFMA et al. (Covered Funds) (Feb. 2012); SIFMA et al. (Mar. 2012);
ABA (Keating); BoA; ICI (Feb. 2012); JPMC (requesting clarification
that registered investment companies are not banking entities); TCW.
---------------------------------------------------------------------------
Commenters also requested that the final rule exclude from the
definition of covered fund entities formed to establish registered
investment companies during the seeding period. These commenters
contended that, during the early stages of forming and seeding a
registered investment company, an entity relying on section 3(c)(1) or
(3)(c)(7) may be created to facilitate the development of a track
record for the registered investment company so that it may be marketed
to unaffiliated investors.\2005\
---------------------------------------------------------------------------
\2005\ See ICI (Feb. 2012); TCW.
---------------------------------------------------------------------------
Section 13's definition of private equity fund and hedge fund by
reference to section 3(c)(1) and 3(c)(7) of the Investment Company Act
appears to reflect Congress' concerns about banking entities' exposure
to and relationships with investment funds that explicitly are excluded
from SEC
[[Page 5699]]
regulation as investment companies. The Agencies do not believe it
would be appropriate to treat as a covered fund registered investment
companies and business development companies, which are regulated by
the SEC as investment companies. The Agencies believe that the proposed
rule's inclusion of commodity pools would have resulted in some
registered investment companies and business development companies
being covered funds, a result the Agencies did not intend. The
Agencies, in addition to narrowing the commodity pools that will be
included as covered funds as discussed above, have also modified the
final rule to exclude SEC-registered investment companies and business
development companies from the definition of covered fund.\2006\
---------------------------------------------------------------------------
\2006\ See final rule Sec. ----.10(c)(12).
---------------------------------------------------------------------------
The Agencies also recognize that an entity that becomes a
registered investment company or business development company might,
during its seeding period, rely on section 3(c)(1) or 3(c)(7). The
Agencies have determined to exclude these seeding vehicles from the
covered fund definition for the same reasons the Agencies determined to
exclude entities that are operating as registered investment companies
or business development companies as discussed above.
In order to prevent banking entities from purporting to use this
exclusion for vehicles that the banking entity does not reasonably
expect to become a registered investment company or business
development company, the exclusion is available only with respect to a
vehicle that the banking entity operates (i) pursuant to a written
plan, developed in accordance with the banking entity's compliance
program, that reflects the banking entity's determination that the
vehicle will become a registered investment company or business
development company within the time period provided by the final rule
for seeding a covered fund; (ii) consistently with the leverage
requirements under the Investment Company Act of 1940 that are
applicable to registered investment companies and SEC-regulated
business development companies.\2007\ A banking entity that seeds a
covered fund for any purpose other than to register it as an investment
company or establish a business development company must comply with
the requirements of section 13(d)(1)(G) of the BHC Act and Sec. --
--.11 of the final rule as described above. The Agencies will monitor
this seeding activity for attempts to use this exclusion to evade the
requirements governing the ownership of and relationships with covered
funds under section 13 of the BHC Act and the final rule.\2008\
---------------------------------------------------------------------------
\2007\ See final rule Sec. Sec. ----.10(c)(12)(i);
10(c)(12)(iii); ----.20(e).
\2008\ The Agencies also note that banking entities with more
than $10 billion in total consolidated assets as reported on
December 31 of the previous two calendar years must maintain records
that include, among other things, documentation of the exclusions or
exemptions other than sections 3(c)(1) and 3(c)(7) of the Investment
Company Act of 1940 relied on by each fund sponsored by the banking
entity in determining that such fund is not a covered fund. See
final rule Sec. ----.20(e).
---------------------------------------------------------------------------
13. Other Excluded Entities
Section 13(h)(2) permits the Agencies to include similar funds
within the definition of covered fund, but the proposal did not contain
a process for excluding from the definition of covered fund other
entities that do not engage in the investment activities contemplated
by section 13. Many commenters argued that the breadth of entities that
may be required to rely on the exclusions in section 3(c)(1) or 3(c)(7)
of the Investment Company Act could result in additional unidentified
entities becoming subject to the definition of covered fund.\2009\ In
order to ensure that the final rule effectively addresses the full
scope of entities that may inadvertently be included within the
definition of covered fund, a number of commenters urged that the final
rule include a mechanism to exclude other entities from the term
``covered fund'' by rule or order if the Agencies determine such an
exclusion is appropriate.\2010\
---------------------------------------------------------------------------
\2009\ See also FSOC study.
\2010\ See SIFMA et al. (Covered Funds) (Feb. 2012); Credit
Suisse (Williams); GE (Feb. 2012).
---------------------------------------------------------------------------
As evidenced by the extensive comments discussed above identifying
the many types of corporate structures and other vehicles (not just
investment funds) that rely on sections 3(c)(1) and 3(c)(7) but do not
engage in investment activities of the type contemplated by section 13,
the scope of an overly broad definition of covered fund may impose
significant burdens on banking entities that are in conflict with the
purposes of section 13 of the BHC Act. In response to commenters'
concerns and to address the potential that the final rule's definition
of covered fund might encompass entities that do not engage in the
investment activities contemplated by section 13, the final rule
includes a provision that provides that the Agencies may jointly
determine to exclude an issuer from the definition of covered fund if
the exclusion is consistent with the purposes of section 13 of the BHC
Act.\2011\
---------------------------------------------------------------------------
\2011\ See final rule Sec. ----.10(c)(14).
---------------------------------------------------------------------------
As noted above, the statute permits the Agencies to act by rule to
modify the definition of covered fund. After issuing the proposed rule
and receiving comment on it, the final rule provides that the Agencies
may act jointly to provide an exclusion.\2012\ The Agencies are working
to establish a process within which to evaluate requests for exclusions
and expect to provide additional guidance on this matter as the
Agencies gain experience with the final rule.\2013\ As a result, the
definition of covered fund would remain unified and consistent. The
final rule also provides that a determination by the Agencies to
exclude an entity from the definition of covered fund will be promptly
made public in order to ensure that both banking entities and the
public may understand what entities are and are not included within the
definition of covered fund.
---------------------------------------------------------------------------
\2012\ As discussed above, the Agencies also may determine
jointly that an entity excluded from the definition of covered fund
under Sec. ----.10(c) is in fact a covered fund, and consequently
banking entities' investments in and transactions with such fund
would be subject to limitations and/or divestiture. The Agencies
intend to utilize this authority to monitor for and address, as
appropriate, instances of evasion. See, e.g., 12 U.S.C. 1851(e)(2).
\2013\ A joint determination specified under Sec. --
--.10(c)(14) may take a variety of forms.
---------------------------------------------------------------------------
d. Entities Not Specifically Excluded From the Definition of Covered
Fund
In addition to the entities identified above which are excluded
from the definition of covered fund under the final rule, commenters
argued that a number of other entities such as financial market
utilities, venture capital funds, credit funds, cash management
vehicles or cash collateral pools may also be an investment company but
for the exclusion contained in section 3(c)(1) or 3(c)(7) of the
Investment Company Act and requested that these entities expressly be
excluded from the final rule's definition of covered fund. The Agencies
have considered carefully the comments received on each of these
entities but, for the reasons explained below, have declined to provide
a separate exclusion for them from the definition of covered fund at
this time. As discussed below, some of these entities are not covered
funds for various reasons or may, with relatively little cost, conform
to the terms of an exclusion or exemption from the definition of
covered fund. As noted above, to the extent that one of these entities
qualifies for one or more of the
[[Page 5700]]
other exclusions from the definition of covered fund, that entity would
not be a covered fund under the final rule. Any entity that would be a
covered fund would still be able to rely on the conformance period in
order to come into compliance with the requirements of section 13 and
the final rule.
A number of commenters requested that certain existing covered
funds be either excluded from the definition of covered fund or
grandfathered and not be subject to the limitations of section 13 of
the BHC Act.\2014\ The Agencies note, however, that section 13
specifically addresses a banking entity's preexisting investments in
covered funds by providing a conformance period, which banking entities
may use to bring their activities and investments into compliance with
the requirements of section 13 and the final rule. To the extent that
section 13 could be interpreted to permit the Agencies to take a
different approach, despite addressing banking entities' preexisting
covered fund investments directly, the Agencies believe it would be
inconsistent with the purposes of section 13 to permit banking entities
to continue to hold ownership interests in covered funds beyond the
conformance period provided by the statute. Section 13's prohibition on
banking entities' investments in and relationships with covered funds
and the requirement that banking entities divest or conform these
investments appear to reflect the statutory purpose that banking
entities be limited in their ability to continue to be exposed to these
investments outside of the statutorily-provided conformance period. The
Agencies believe that permitting banking entities to hold ownership
interests indefinitely beyond the conformance period provided by the
statute appears inconsistent with this purpose.
---------------------------------------------------------------------------
\2014\ See, e.g., PNC; SVB; SIFMA (Securitization) (Feb. 2012);
AFME et al.; BoA. See also, e.g., Credit Suisse (Williams).
---------------------------------------------------------------------------
1. Financial Market Utilities
Several commenters contended that financial market utilities
(``FMUs'') could be covered funds because they might rely on section
3(c)(1) or 3(c)(7) for an exclusion from the definition of investment
company under the Investment Company Act and may not qualify for an
alternative exemption.\2015\ These commenters argued that banking
entities have long been investors in domestic and foreign FMUs, such as
securities clearing agencies, derivatives clearing organizations,
securities exchanges, derivatives boards of trade and alternative
trading systems. These commenters expressed concern that, unless FMUs
are expressly excluded from the definition of covered fund, banking
entities could be prohibited from entering into any new covered
transactions with related FMUs and would be required to divest their
investments in FMUs, thereby disrupting the operations of those FMUs
and financial markets generally.
---------------------------------------------------------------------------
\2015\ See SIFMA et al. (Covered Funds) (Feb. 2012); Credit
Suisse (Williams).
---------------------------------------------------------------------------
After carefully considering commenters' concerns, the Agencies
believe that FMUs are not investment vehicles of the type section 13 of
the BHC Act was designed to address, but rather entities that generally
engage in other activities, including acting as central counterparties
that reduce counterparty risk in clearing and settlement activities.
Congress recognized, in the Payment, Clearing, and Settlement
Supervision Act of 2010 (title VIII of the Dodd-Frank Act),\2016\ that
properly designed, operated, and supervised financial market utilities
as defined in that Act mitigate systemic risk and promote financial
stability.\2017\
---------------------------------------------------------------------------
\2016\ 12 USC 5461 et seq.
\2017\ See id.
---------------------------------------------------------------------------
However, the Agencies have not provided an exclusion from the
covered fund definition for FMUs because these kinds of entities do not
generally appear to rely on section 3(c)(1) or 3(c)(7) of the
Investment Company Act, and therefore do not appear to need an
exclusion. For example, section 3(b)(1) of the Investment Company Act
excludes from the definition of investment company--and thus from the
definition of a covered fund--entities primarily engaged in a business
other than that of an investment company.\2018\ If an FMU is primarily
engaged in a business other than those that would make it an investment
company, for example, if the FMU is primarily engaged in transferring,
clearing, or settling payments, securities, or other financial
transactions among or between financial institutions,\2019\ the FMU
could rely on the exclusion to the definition of investment company
provided by section 3(b)(1) and would not need to rely on section
3(c)(1) or 3(c)(7) and, as such, would not be a covered fund.
---------------------------------------------------------------------------
\2018\ Section 3(b)(1) of the Investment Company Act excludes
from the definition of investment company ``[a]ny issuer primarily
engaged, directly or through a wholly-owned subsidiary or
subsidiaries, in a business or businesses other than that of
investing, reinvesting, owning, holding, or trading in securities.''
\2019\ See 12 U.S.C. 1562(6); 12 CFR Part 234.
---------------------------------------------------------------------------
2. Cash Collateral Pools
Some commenters expressed concern that cash collateral pools, which
are part of securities lending programs, could be included in the
definition of covered fund.\2020\ According to these commenters,
banking entities, including bank custodians acting as lending agent for
customer's securities lending activities, typically manage these pools
as fiduciaries for their customers.\2021\ These commenters argued that
collateral pools are part of a banks' traditional custody and advisory
services and have been an integral part of any lending agent's role
(whether custodial or non-custodial) for years.\2022\
---------------------------------------------------------------------------
\2020\ See RMA; State Street (Feb. 2012); See also BNY Mellon et
al.
\2021\ See RMA; State Street (Feb. 2012).
\2022\ See RMA; BNY Mellon et al. (citing Comptroller's
Handbook: Custody Services (Jan. 2002)).
---------------------------------------------------------------------------
Cash collateral pools are typically formed when, as part of a
securities lending program, a customer of a bank authorizes the bank to
take securities from the customer's account and lend them in the open
market. The agent bank then lends those securities and receives
collateral in return from the borrower; a securities lending customer
of a bank typically elects to have cash collateral provided by a
borrower pooled by the agent bank with other cash collateral provided
to other clients.\2023\ These investment pools may exist in the form of
trusts, partnerships, limited liability companies, or separate accounts
maintained by more than one party and these structures may rely on
sections 3(c)(1) and 3(c)(7) of the Investment Company Act to avoid
being an investment company.\2024\ While their ownership interest may
be nominal in amount, the agent banks may hold a general partnership,
limited liability company membership or trustee interest in the cash
collateral pool.\2025\ As part of these arrangements, custodian banks
routinely offer borrower default indemnifications to the securities
lender in a securities lending transactions.
---------------------------------------------------------------------------
\2023\ See RMA.
\2024\ See RMA.
\2025\ See RMA.
---------------------------------------------------------------------------
Commenters raised concerns that these indemnification agreements
could be considered a covered transaction prohibited by section 13(f)
of the BHC Act.\2026\ Since some cash collateral
[[Page 5701]]
pools are established outside of the United States, commenters
requested that the final rule permit banking entities to have interests
in and relationships with both U.S. and non-U.S. cash collateral
pools.\2027\ These commenters suggested that cash collateral pools be
excluded from the definition of covered fund or, in the alternative,
that the Agencies make clear that cash collateral pools managed by
agent banks qualify for the exemption in Sec. ----.11 of the proposed
rule for organizing and offering a covered fund and that the prime
brokerage exemption from the restrictions of section 13(f) would permit
the indemnification and income or settlement services agent banks
typically provide to the pools.\2028\ These commenters also suggested
that the Agencies use their authority under section 13(d)(1)(J) to
provide an exemption for banking entities to continue to have interests
in and provide services to these types of pools.\2029\
---------------------------------------------------------------------------
\2026\ See State Street; RMA. Commenters also argued that as
part of offering pooled cash collateral management, agent banks have
traditionally provided short-term extensions of credit and
contractual income and settlement services to lending clients and
cash collateral pools to facilitate trade settlement and related
cash collateral investment activities. See RMA. One commenter
further argued that if banks are required to ``outsource'' cash
collateral pools and/or the related short-term credit services
provided to the pools, ``participation in securities lending
programs would only be cost effective for the largest lending
clients'' and, as a result, ``many small and intermediate securities
lending clients would be denied the incremental revenue securities
lending can provide''; ``securities lending programs could lose
significant diversification in lending clients, lendable assets,
borrowers and agent banks''; and, as a result of lost revenues,
``the actual costs of [] custodial or other services provided to
clients that no longer participate in lending would increase.'' Id.
\2027\ See RMA.
\2028\ See RMA.
\2029\ See RMA.
---------------------------------------------------------------------------
After carefully considering comments received, the final rule does
not provide a specific exclusion from the definition of covered fund
for cash collateral pools. The Agencies have determined to provide
specific exclusions for entities that do not function as investment
funds, consistent with the intent of section 13's restrictions, or in
response to other unique considerations (e.g., to provide consistent
treatment for certain foreign and domestic pension plans). These
considerations do not support a separate exclusion for cash collateral
pools.
The Agencies note, however, that some cash collateral pools may not
be covered funds because they rely on an exclusion from the definition
of investment company other than those contained in section 3(c)(1) or
3(c)(7) of the Investment Company Act.\2030\ Banking entities may
determine to register cash collateral pools with the SEC as investment
companies or to operate them as separate accounts to exclude the pools
from the covered fund definition or, if the pools remain covered funds,
to organize and offer them in compliance with the requirements of Sec.
----.11 of the final rule.
---------------------------------------------------------------------------
\2030\ For instance, the Agencies understand that a banking
entity may set up a cash collateral pool in reliance on the
exclusion contained in section 3(c)(3) of the Investment Company
Act, or may be able to structure these pools as SEC-registered money
market funds operated in accordance with rule 2a-7 under the
Investment Company Act.
---------------------------------------------------------------------------
In response to comments received on the proposal, the Agencies note
that the provision of a borrower default indemnification by a banking
entity to a lending client in connection with securities lending
transactions involving a covered fund is not a covered transaction
subject to 13(f) or a guarantee of the performance or obligations of a
covered fund prohibited under Sec. ----.11 of the final rule. Those
restrictions apply to transactions with the covered fund or guarantees
of the covered fund's performance. Borrower default indemnifications
are provided to the bank's securities lending customer, not to the cash
collateral pool.
3. Pass-through REITS
Some banking entities may issue real estate investment trust
(``REIT'') preferred securities to the public directly from a
subsidiary that qualifies for the exclusion in section 3(c)(5) or
section 3(c)(6) of the Investment Company Act. These entities would not
be considered a ``covered fund'' because they may rely on an exclusion
from the definition of an investment company other than the exclusion
in section 3(c)(1) or 3(c)(7) of the Investment Company Act.\2031\
However, in order to meet the demands of customers and avoid
undesirable tax consequences, some banking entities structure their
REIT offerings by using a passive, pass-through statutory trust between
the banking entity and the REIT to issue REIT preferred securities to
the public.\2032\ Because the pass-through trust holds the preferred
securities of the underlying REIT (which would itself not be a covered
fund), as well as provides administrative and ministerial functions for
the REIT (including passing through dividends from the underlying
REIT), the pass-through trust may not itself rely on the exclusion
contained in section 3(c)(5) or 3(c)(6) and, thus, typically relies on
section 3(c)(1) or 3(c)(7).\2033\
---------------------------------------------------------------------------
\2031\ See PNC.
\2032\ See PNC.
\2033\ See ABA (Keating); PNC.
---------------------------------------------------------------------------
Some commenters urged the Agencies to provide an exclusion for
pass-through REITS from the definition of covered fund.\2034\ These
commenters argued that because the pass-through trust exists as a
corporate convenience as part of issuing REIT preferred securities to
the banking entity and its customers, it is not the type of entity that
the covered fund prohibition in section 13 of the BHC Act was intended
to address. These commenters also argued that pass-through REITs enable
banking entities to offer preferable tax treatment to holders of the
REIT preferred securities and that if pass-through REITs were included
as covered funds, because of the limitations on covered transactions
contained in section 13(f), the minority interests in the preferred
securities issued by the REIT would no longer be able to be included in
a banking entity's tier 1 capital, thereby negatively impacting the
safety and soundness of the banking entity.\2035\
---------------------------------------------------------------------------
\2034\ See ABA (Keating); PNC.
\2035\ See PNC; ABA (Keating). These commenters argued that most
REIT preferred securities contain a conditional exchange provision
that allows the primary regulator to direct that the preferred
securities be automatically exchanged for preferred shares of the
bank or parent BHC upon occurrence of a conditional exchange event.
Because this arrangement involves the purchase of securities issued
by an affiliate or the purchase of assets, it would be prohibited
under section 13(f) of the BHC Act if the pass-through REIT were a
covered fund.
---------------------------------------------------------------------------
The Agencies are not providing a specific exclusion from the
definition of covered fund for pass-through REITs because the Agencies
are concerned that such an exclusion could enable banking entities to
structure non-loan securitization transactions using a pass-through
entity in a manner inconsistent with the final rule's treatment of
similar vehicles that invest in securities. Furthermore, banking
entities have alternative manners in which they may issue or hold REIT
preferred securities, including through REITs directly, which do not
raise the same concerns about evasion.\2036\
---------------------------------------------------------------------------
\2036\ The Agencies recognize that banking entities may have
relied on pass-through REIT structures to issue preferred securities
in the past and prohibiting such transactions may pose
inefficiencies. Furthermore, it may not be possible to unwind or
conform past issuances without significant effort by the banking
entity and negotiation with the holders of the preferred securities.
As noted above, in these circumstances, section 13 provides a
conformance period which banking entities may take advantage of in
order to bring their activities and investments into compliance with
the requirements of section 13 and the final rule.
---------------------------------------------------------------------------
4. Municipal Securities Tender Option Bond Transactions
The Agencies received a number of comments addressing how the final
rule should treat municipal securities tender option bond vehicles. A
number of commenters argued that issuers of municipal securities tender
option bonds would fall under the definition of covered fund in the
proposed rule because these issuers typically rely on the exclusion
contained in section
[[Page 5702]]
3(c)(1) or 3(c)(7) of the Investment Company Act.\2037\ According to
commenters, a typical tender option bond transaction consists of the
deposit of a single issue of highly-rated, long-term municipal bonds in
a trust and the issuance by the trust of two classes of securities: A
floating rate, puttable security (the ``floaters''), and an inverse
floating rate security (the ``residual'') with no tranching involved.
According to commenters, the holders of the floaters have the right,
generally on a daily or weekly basis, to put the floaters for purchase
at par. The put right is supported by a liquidity facility delivered by
a highly-rated provider (in many cases, the banking entity sponsoring
the trust) and allows the floaters to be treated as a short-term
security. The floaters are in large part purchased and held by money
market mutual funds. The residual is held by a longer-term investor (in
many cases the banking entity sponsoring the trust, or an insurance
company, mutual fund, or hedge fund). According to commenters, the
residual investors take all of the market and structural risk related
to the tender option bonds structure, with the investors in floaters
taking only limited, well-defined insolvency and default risks
associated with the underlying municipal bonds generally equivalent to
the risks associated with investing in the municipal bonds directly.
According to commenters, the structure of tender option bond
transactions is governed by certain provisions of the Internal Revenue
Code in order to preserve the tax-exempt treatment of the underlying
municipal securities.
---------------------------------------------------------------------------
\2037\ See, e.g., Ashurst; SIFMA (Municipal Securities) (Feb.
2012); Citigroup (Jan. 2012); Cadwalader (Municipal Securities);
Vanguard; ICI (Feb. 2012); ASF (Feb. 2012); Fidelity; Wells Fargo
(Covered Funds). Commenters also noted that tender option bond
programs as currently structured may not meet the requirements of
section 3(a)(5) of the Investment Company Act or rule 3a-7
thereunder, or any other exclusion or exemption under the Investment
Company Act. See Ashurst; RBC; ASF (Feb. 2012).
---------------------------------------------------------------------------
Many commenters requested a specific exclusion for municipal tender
option bond vehicles from the definition of a covered fund.\2038\ These
commenters argued that, without an exclusion from the definition of
covered fund, banking entities would be prohibited from owning or
sponsoring tender option bonds and from providing credit enhancement,
liquidity support, remarketing, and other services required in
connection with a tender option bond program.\2039\ Commenters argued
that tender option bond vehicles should be excluded because section
13(d)(1)(A) of the BHC Act already allows banking entities to own and
dispose of municipal securities directly,\2040\ tender option bonds are
economically similar to repurchase agreements, which are expressly
excluded from the proprietary trading restrictions of the proposed
rule, and, because they are safe and low risk are similar to the types
of transactions that the proposed rule would have exempted.\2041\
Commenters also argued that tender option bonds are different from
other covered funds that rely on the exclusion contained in section
3(c)(1) or 3(c)(7) of the Investment Company Act \2042\ and play an
important role in the municipal bond markets.\2043\ Commenters
requested that the Agencies use their authority under section
13(d)(1)(J) of the BHC Act to exclude tender option bonds because they
argued that tender option bonds promote the safety and soundness of
banking entities and the financial stability of the United States by
providing for a deeper, richer pool of potential investors, a larger
and more liquid market for municipal securities that results in lower
borrowing costs for municipalities and other issuers of municipal
securities, and greater efficiency and risk diversification.\2044\
Commenters also suggested a number of other ways to exclude tender
option bonds, including defining ownership interest to exclude any
interest in a tender option bond transaction; \2045\ defining banking
entity to exclude tender option bond issuers; \2046\ expanding the loan
securitization exclusion to include tender option bond issuers; \2047\
and revising the definition of sponsor to exclude sponsors of tender
option bond vehicles.\2048\ One commenter urged the Commission to
consider amending the exemption under rule 3a-7 under the Investment
Company Act or providing formal guidance regarding the status of tender
option bond programs.\2049\ In addition, some commenters requested an
exclusion for tender option bond transactions from the provisions of
section 13(f) of the BHC Act.\2050\
---------------------------------------------------------------------------
\2038\ See, e.g., ASF (Feb. 2012); BDA (Feb. 2012); Eaton Vance;
Fidelity; ICI (Feb. 2012); RBC; SIFMA (Municipal Securities) (Feb.
2012); SIFMA (May 2012); State Street (Feb. 2012); Vanguard.
\2039\ See Ashurst; ASF (Feb. 2012).
\2040\ See ASF (Feb. 2012); SIFMA (Municipal Securities) (Feb.
13, 2012); Citigroup (Jan. 2012). See also Cadwalader (Municipal
Securities) (alleging that the legislative history of section 13 of
the BHC Act suggests that the exemption relating to municipal
securities should not be construed to apply only to the section of
the rule pertaining to the proprietary trading prohibitions); BDA
(Feb. 2012) (arguing that any fund or trust the assets of which are
entirely invested in any of the obligations that are excluded from
the proprietary trading prohibitions should also be excluded from
the definition of covered fund).
\2041\ See, e.g., Ashurst; Cadwalader (Municipal Securities);
Eaton Vance; Nuveen Asset Mgmt.; SIFMA (Municipal Securities) (Feb.
13, 2012); State Street (Feb. 2012); Vanguard; Wells Fargo (Covered
Funds); Citigroup (Jan. 2012).
\2042\ See, e.g., ASF (Feb. 2012); State Street (Feb. 2012);
Citigroup (Jan. 2012); Vanguard; Wells Fargo (Covered Funds);
Cadwalader (Municipal Securities); Ashurst.
\2043\ See Cadwalader (Municipal Securities); ICI (Feb. 2012);
Ashurst; ASF (Feb. 2012).
\2044\ See Cadwalader (Municipal Securities).
\2045\ See RBC.
\2046\ See ICI (Feb. 2012).
\2047\ See ASF (Feb. 2012).
\2048\ See RBC.
\2049\ See Ashurst.
\2050\ See, e.g., RBC; ASF (Mar. 2012); ASF (Feb. 2012).
---------------------------------------------------------------------------
After carefully considering the comments received, the final rule
does not provide a specific exclusion from the definition of covered
fund or from the prohibitions and requirements of the final rule for
tender option bond vehicles.\2051\ The Agencies have determined to
provide specific exclusions for entities that they believe fall within
the rule of construction contained in section 13(g)(2) of the BHC Act,
which expressly relates to the sale and securitization of loans,\2052\
do not function as investment funds, consistent with the intent of
section 13's restrictions, or in response to other unique
considerations. The Agencies do not believe that these considerations
support a separate exclusion for tender option bond vehicles, which
have municipal securities as underlying assets and not loans.
---------------------------------------------------------------------------
\2051\ The Agencies received a variety of requests requesting
specific treatment of tender option bond transactions. See, e.g.,
supra notes 2045-2050. As discussed above, the Agencies believe
that, in light of the comments received, tender option bond vehicles
do not fall within the rule of construction contained in section
13(g)(2) of the BHC Act and, as a result, the final rule does not
provide such treatment.
\2052\ See 12 U.S.C. 1851(g)(2).
---------------------------------------------------------------------------
The Agencies recognize commenters' concerns about the treatment of
tender option bonds under the final rule, as discussed above. However,
as there is no corresponding rule of construction in section 13 of the
BHC Act for financial instruments other than loans, the Agencies do not
believe that the resecuritization of municipal debt instruments should
be treated differently than the resecuritization of other debt
instruments.\2053\ Notwithstanding the statutory treatment of municipal
securities for purposes of the proprietary trading restrictions, the
Agencies also do not believe that tender option bond vehicles fall
within the rule
[[Page 5703]]
of construction contained in section 13(g)(2) of the BHC Act, because,
in light of commenters' descriptions of these vehicles, tender option
bond vehicles are more in the nature of other types of bond repackaging
securitizations and other non-excluded securitization vehicles.\2054\
The final rule, however, does not prevent a banking entity from owning
or otherwise participating in a tender option bond vehicle; it requires
that these activities be conducted in the same manner as with other
covered funds.
---------------------------------------------------------------------------
\2053\ For these same reasons, and based on the definitions of
sponsor and banking entity in section 13, the Agencies have not
modified those definitions in the final rule to exclude sponsors of
tender options bonds and tender bond issuers, respectively, as some
commenters requested. See supra notes 2046 and 2048 and accompanying
text.
\2054\ Commenters also argued that to the extent tender option
bond programs are not excluded from the definition of covered fund,
the definition of ownership interest should exclude any interest in
a tender option bond program (See RBC) or that where a third party
owns the residual, the banking entity should not be treated as
having an ownership interest, even when it owns a small interest for
tax purposes or becomes the owner through liquidity or remarketing
agreements (See Cadwalader (Municipal Securities)). The definition
of ownership interest in the final rule focuses on the attributes of
the interest, as discussed below, and not the particular type of
covered fund involved. The Agencies are not providing separate
definitions of or exclusions from the ownership interest definition
based on the type of vehicle or financing involved. See infra note
2098 and preceding and following text. Banking entities will need to
evaluate whether the interests they may acquire are ownership
interests as defined under the final rule.
---------------------------------------------------------------------------
In this regard, under the final rule, a banking entity would need
to evaluate whether a tender option bond vehicle is a covered fund as
defined in the final rule. If a tender option bond vehicle is a covered
fund and an exclusion from that definition is not available, then
banking entities sponsoring such a vehicle will be subject to the
prohibitions in Sec. ----.14 of the final rule and the provisions of
section 13(f) of the BHC Act.\2055\
---------------------------------------------------------------------------
\2055\ See 12 U.S.C. 1851(f).
---------------------------------------------------------------------------
As tender option bond vehicles are considered issuers of asset-
backed securities subject to the risk retention requirements of section
15G of the Exchange Act, banking entities may look to the provisions of
the final rule governing the limits applicable to banking entities'
interests in and relationships with those funds. Under the final rule,
as in the statute, a banking entity that conducts the activities
described in section 13(f) of the BHC Act is subject to the
restrictions on transactions with a tender option bond vehicle,
including guaranteeing or insuring the performance of the tender option
bond vehicle, contained in section 13(f) of the BHC Act. As a result, a
banking entity is not permitted to provide credit enhancement,
liquidity support, and other similar services if it serves in a
capacity covered by section 13(f) with the tender option bond
program.\2056\ An unaffiliated third party may provide such services if
it does not have a relationship with the tender option bond vehicle
that triggers application of section 13(f). The extent to which the
final rule causes a disruption to the securitization of, and market
for, municipal tender option bonds may also affect the economic burden
and effects on the municipal bond market and its participants,
including money market mutual funds \2057\ and issuers of municipal
securities. The Agencies recognize that a potential economic burden may
be an increase in financing costs to municipalities as a result of a
decrease in demand for the types of municipal securities customarily
included in municipal tender option bond vehicles \2058\ and therefore
potential effects on the depth and liquidity of the market for certain
types of municipal securities.\2059\
---------------------------------------------------------------------------
\2056\ As discussed above, while commenters requested treatment
of municipal tender option bond vehicles that would cause section
13(f) of the BHC Act not to apply to them, the final rule does not
exclude these vehicles from the definition of covered fund or the
prohibitions relating to covered funds. As a result, section 13(f)
of the BHC Act will apply to a banking entity that is sponsoring a
tender option bond vehicle.
\2057\ See ASF (Feb. 2012); Nuveen Asset Mgmt.
\2058\ See Ashurst.
\2059\ See Eaton Vance.
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5. Venture Capital Funds
Some private equity funds that make investments in early-stage
start-up companies or other companies with significant growth potential
(``venture capital funds'') would be investment companies but for the
exclusion contained in section 3(c)(1) or 3(c)(7) of the Investment
Company Act. Venture capital funds would therefore qualify as a covered
fund under the proposal. The proposal specifically requested comment on
whether venture capital funds should be excluded from the definition of
``covered fund.''
Some commenters argued that venture capital funds should be treated
differently than other covered funds and excluded from the definition.
These commenters argued that, unlike conventional hedge funds and
private equity funds, venture capital funds do not possess high
leverage and do not engage in risky trading activities of the type
section 13 of the BHC Act was designed to address.\2060\ These
commenters contended that investments and relationships by banking
entities in venture capital funds would be consistent with safety and
soundness; provide important funding and expertise and other services
to start-up companies; and provide positive benefits to employment,
GDP, growth, and innovation.\2061\ These commenters argued that
restricting banking entities' ability to invest in or sponsor venture
capital funds would have a negative impact on companies and the U.S.
economy generally.\2062\ Some commenters asserted that bank investments
in venture capital funds are important to the success of venture
capital,\2063\ with some citing a consulting firm's data indicating
that approximately 7 percent of all venture capital is provided by
banks.\2064\ One commenter argued, therefore, that ``preventing banks
from investing in venture thus could depress U.S. GDP by roughly 1.5%
(or $215 billion annually) and eliminate nearly 1% of all U.S. private
sector employment over the long term,'' and the funding gap that would
result if banks could not invest in venture capital funds would not be
met by other market participants if bank investments in venture capital
were restricted.\2065\ Several commenters recommended that venture
capital funds be excluded if they: (i) Do not fundamentally engage in
proprietary trading; (ii) do not use leverage to increase investment
returns; and (iii) typically invest in high-growth start-up companies
as compared to more mature publicly traded companies.\2066\
---------------------------------------------------------------------------
\2060\ See SVB; NVCA; Rep. Eshoo; Sen. Boxer; Rep. Goodlatte;
Rep. Schweikert; Rep. Speier; Rep. Honda; Rep. Lofgren; Rep. Peters
et. al.
\2061\ See, e.g., NVCA; SVB; Scale.
\2062\ See, e.g., SVB; Scale; Sen. Boxer; SIFMA et al. (Covered
Funds) (Feb. 2012) (citing a colloquy between Sen. Dodd and Sen.
Boxer supporting an exemption for venture capital funds (156 Cong.
Rec. H5226 (daily ed., June 30, 2010)).
\2063\ See River Cities; Scale. See also Sofinnova; Canaan
(Young); Canaan (Ahrens); Canaan (Kamra); Mohr Davidow; ATV;
BlueRun; Westly; Charles River; Flybridge; SVB.
\2064\ See, e.g., SVB.
\2065\ See SVB.
\2066\ See, e.g., SVB (arguing that the definition of ``venture
capital fund'' in section 203(l)-1 of the Investment Advisers Act
and the SEC's Form PF reporting requirements for investment advisers
to private funds would be instructive for defining an exclusion for
venture capital funds for purposes of section 13 of the BHC Act).
---------------------------------------------------------------------------
Conversely, one commenter alleged that there was no credible way to
exclude venture capital funds without providing a means to circumvent
the requirements of section 13 and the final rule.\2067\ Another
commenter argued that venture capital funds do in fact engage in risky
activities and that, instead of making investments in venture capital
funds, banking entities may directly extend credit to start-up
[[Page 5704]]
companies in a safe and sound manner.\2068\
---------------------------------------------------------------------------
\2067\ See Occupy.
\2068\ See Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------
The final rule does not provide an exclusion for venture capital
funds. The Agencies believe that the statutory language of section 13
does not support providing an exclusion for venture capital funds from
the definition of covered fund. Congress explicitly recognized and
treated venture capital funds as a subset of private equity funds in
various parts of the Dodd-Frank Act and accorded distinct treatment for
venture capital fund advisers by exempting them from registration
requirements under the Investment Advisers Act.\2069\ This indicates
that Congress knew how to distinguish venture capital funds from other
types of private equity funds when it desired to do so.\2070\ No such
distinction appears in section 13 of the BHC Act. Because Congress
chose to distinguish between private equity and venture capital in one
part of the Dodd-Frank Act, but chose not to do so for purposes of
section 13, the Agencies believe it is appropriate to follow this
Congressional determination.
---------------------------------------------------------------------------
\2069\ See S. Rep. No. 111-176, at 71-3 (2010) (``S. Rep. No.
111-176''); H. Rep. No. 111-517, at 866 (2010) (``H. Rep. No. 111-
517''). H. Rep. No. 111-517 contains the conference report
accompanying the version of H.R. 4173 that was debated in
conference. See S. Rep. No. 111-176, at 74 (``The Committee believes
that venture capital funds, a subset of private investment funds
specializing in long-term equity investment in small or start-up
businesses, do not present the same risks as the large private funds
whose advisers are required to register with the SEC under this
title.''). Compare Restoring American Financial Stability Act of
2010, S. 3217, 111th Cong. Sec. 408 (2010) (as passed by the
Senate) with The Wall Street Reform and Consumer Protection Act of
2009, H.R. 4173, 111th Cong. (2009) (as passed by the House) (``H.R.
4173'') and Dodd-Frank Act (2010).
\2070\ But See Rep. Honda.
---------------------------------------------------------------------------
In addition to the language of the statute, it appears to the
Agencies that the activities and risk profiles for banking entities
regarding sponsorship of, and investment in, venture capital funds and
private equity funds are not readily distinguishable. Many key
structural and operational characteristics of venture capital funds are
substantially similar to those of hedge funds and private equity funds,
thereby making it difficult to define venture capital funds in a manner
that would not provide banking entities with an opportunity to evade
the restrictions of section 13 of the BHC Act.
For instance, in addition to relying on the same exemptions under
the Securities Act,\2071\ venture capital funds, private equity funds
and hedge funds all rely on the exclusion in section 3(c)(1) or 3(c)(7)
from the definition of investment company under the Investment Company
Act. Moreover, like private equity funds, venture capital funds pool
funds from multiple investors and invest those funds in interests of
portfolio companies for the purpose of profiting from the resale of
those interests. Indeed, funds that are called ``venture capital
funds'' may invest in the very same entities and to the same extent as
do funds that call themselves private equity funds. Venture capital
funds, like private equity funds, also typically charge incentive
compensation to fund investors based on the price appreciation achieved
on the investments held by the fund and provide a return of principal
plus gains at specific times during the limited life of the fund. Not
including venture capital funds in the definition of covered fund,
therefore, could allow banking entities, either directly or indirectly,
to engage in the type of activities section 13 was designed to address.
---------------------------------------------------------------------------
\2071\ These funds all typically offer their shares on an
unregistered basis in reliance on section 4(a)(2) of the Securities
Act of 1933 or Regulation D thereunder.
---------------------------------------------------------------------------
While the final rule does not provide a separate exclusion for
venture capital funds from the definition of covered fund, the Agencies
recognize that certain venture capital investments by banking entities
provide capital and funding to nascent or early-stage companies and
small businesses and also may provide these companies expertise and
other services.\2072\ Other provisions of the final rule or the statute
may facilitate, or at least not impede, other forms of investing that
may provide the same or similar benefits. For example, in addition to
permitting a banking entity to organize and offer a covered fund in
section 13(d)(1)(G), section 13 of the BHC Act does not prohibit a
banking entity, to the extent otherwise permitted under applicable law,
from making a venture capital-style investment in a company or business
so long as that investment is not through or in a covered fund, such as
through a direct investment made pursuant to merchant banking authority
\2073\ or through business development companies which are not covered
funds and, like venture capital funds, often invest in small, early-
stage companies.\2074\
---------------------------------------------------------------------------
\2072\ As noted above, some commenters quantified the importance
of banking entities to the provision of venture capital by providing
information indicating that approximately 7 percent of all venture
capital is provided by banks. See, e.g., SVB (citing The Venture
Capital Industry: A Preqin Special Report, published by Preqin, Ltd.
(Oct. 2010)). The 7% estimate commenters identified includes
information on investors based in North America, Europe, and Asia;
thus, although potentially indicative of the extent of venture
capital investing by banking entities in venture capital funds, the
estimate does not specifically address the proportion of investment
by banking entities in venture capital funds that are covered funds,
as those terms are defined in the final rule.
\2073\ See 12 U.S.C. 1843(k)(4)(H); 12 CFR 225.170 et seq.
\2074\ See 15 U.S.C. 80a-54. Companies that have elected to be
treated as a business development company are subject to limits
under the Investment Company Act, including: (i) Limits on how much
debt the business development company may incur; (ii) prohibitions
on certain affiliated transactions; (iii) regulation and examination
by the SEC; and (iv) registration and filing requirements.
---------------------------------------------------------------------------
Thus, to the extent that banking entities are required to reduce
their investments in venture capital funds, certain of these
investments may be redirected to the types of entities in which venture
capital funds invest through alternative means. To the extent that
banking entities may reduce their investments in venture capital funds
that are covered funds, the potential funding gap for venture capital
funds may also be offset, in whole or in part, by investments from
firms that are not banking entities and thus not subject to section
13's restrictions.
6. Credit Funds
Several commenters requested that the final rule explicitly exclude
from the definition of covered fund entities that are generally formed
as partnerships with third-party capital and invest in loans or make
loans or otherwise extend the type of credit that banks are authorized
to undertake on their own balance sheet (``credit funds'').\2075\ Two
commenters contended that the language of section 13(g)(2) indicates
that Congress did not intend section 13 of the BHC Act to limit a
banking entity's ability to extend credit.\2076\ They argued that
lending is a fundamental banking activity, whether accomplished through
direct loans or through a fund structure. These commenters argued that
credit funds functioned like syndicated loans that enable borrowers to
secure credit during periods of market distress and reduce the
concentration of risk for both individual banking entities and the
banking system as a whole.
---------------------------------------------------------------------------
\2075\ See, e.g., Goldman (Covered Funds); ABA (Keating); Credit
Suisse (Williams); Comm. on Capital Markets Regulation; Chamber
(Feb. 2012).
\2076\ See ABA (Keating); Goldman (Covered Funds).
---------------------------------------------------------------------------
Commenters suggested different approaches for excluding credit
funds from the definition of covered fund. One commenter recommended
excluding an entity that would otherwise be a covered fund if more than
50 percent of its assets consist of loans.\2077\ Another
[[Page 5705]]
commenter proposed defining a credit fund as an entity that met a
number of criteria designed to ensure the entity only held loans or
otherwise engaged in prudent lending activity.\2078\ Another commenter
requested that the Agencies use their authority under section
13(d)(1)(J) to permit a banking entity to sponsor, invest in, or enter
into covered transactions with related credit funds that are covered
funds.\2079\
---------------------------------------------------------------------------
\2077\ See Credit Suisse (Williams).
\2078\ See Goldman (Covered Funds).
\2079\ See SIFMA et al. (Covered Funds) (Feb. 2012); See also.
ABA (Keating); Chamber (Feb. 2012).
---------------------------------------------------------------------------
The Agencies, however, are unable effectively to distinguish credit
funds from other types of private equity funds or hedge funds in a
manner that would give effect to the language and purpose of section 13
and not raise concerns about banking entities being able to evade the
requirements of section 13. Moreover, the Agencies also believe that
the final rule largely addresses commenters' concerns in other ways
because some credit funds may be able to rely on another exclusion from
the definition of covered fund in the final rule such as the exclusion
for joint ventures or the exclusion, discussed above, for loan
securitizations. To the extent that a credit fund may rely on another
exclusion from the definition of covered fund, it would not be a
covered fund under section 13 of the BHC Act.
7. Employee Securities Companies
Several commenters argued that employee securities companies
(``ESCs'') should be explicitly excluded from the definition of covered
fund.\2080\ One commenter alleged that, though many ESCs could qualify
for the exemption in section 6(b) of the Investment Company Act, they
often opt to rely on section 3(c)(1) or 3(c)(7) instead due to the fact
that the section 6(b) exemption is available only upon application to
the SEC.\2081\ According to this commenter, the limitations contained
in section 13 on employee investments and intercompany transactions
with covered funds would severely limit the ability of a banking entity
to design competitive employee compensation arrangements.\2082\ This
commenter also argued that an exclusion should be provided for any
investment vehicle that satisfies the definition of an ESC under
section 2(a)(13) of the Investment Company Act.
---------------------------------------------------------------------------
\2080\ See, e.g., ABA (Keating), Credit Suisse (Williams),
Arnold & Porter (as it relates to commodity pools). Section 2(a)(13)
of the Investment Company Act generally defines an ESC as ``any
investment company or similar issuer all of the outstanding
securities of which (other than short-term paper) are beneficially
owned'' by employees and certain related persons (e.g., employees'
immediate family members).
\2081\ Section 6(b) of the Investment Company Act provides, in
part, that ``[u]pon application by any employees' security company,
the Commission shall by order exempt such company from the
provisions of this title and of the rules and regulations hereunder,
if and to the extent that such exemption is consistent with the
protection of investors.''
\2082\ See Credit Suisse (Williams).
---------------------------------------------------------------------------
After considering carefully the comments received on the proposed
rule, the final rule does not provide a specific exclusion for ESCs
because the Agencies believe that these vehicles may avoid being a
covered fund by either complying with the conditions of another
exclusion from the definition of covered fund or seeking and receiving
an exemption available under section 6(b) of the Investment Company
Act. As such, the Agencies believe a banking entity has a reasonable
alternative to design competitive employee compensation arrangements.
The Agencies recognize that preparing an application under section 6(b)
of the Investment Company Act or modifying an ESC's activities to meet
the terms of another exclusion from the covered fund definition is not
without costs, but have determined to provide specific exclusions for
entities that do not function as investment funds, consistent with the
purpose of section 13, or in response to other unique considerations
(e.g., to provide consistent treatment for certain foreign and domestic
pension plans). These considerations do not support a separate
exclusion for ESCs.
The Agencies also note that non-qualified plans are not exempt from
the Investment Company Act under 3(c)(11) and thus would be covered
funds if they are operating in reliance on section 3(c)(1) or 3(c)(7)
of the Investment Company Act. Some of these non-qualified plans may be
formed as employees' securities companies, however, and could qualify
for an exemption under section 6(b) of the Investment Company Act for
employees' securities companies as discussed above.
e. Definition of ``Ownership Interest''
The proposed rule defined ``ownership interest'' in a covered fund
to mean any equity, partnership, or other similar interest (including,
without limitation, a share, equity security, warrant, option, general
partnership interest, limited partnership interest, membership
interest, trust certificate, or other similar instrument) in a covered
fund, whether voting or nonvoting, as well as any derivative of such an
interest.\2083\ This definition focused on the attributes of the
interest and whether it provided a banking entity with economic
exposure to the profits and losses of the covered fund, rather than its
form. The proposal thus would also have included a debt security or
other interest in a covered fund as an ownership interest if it
exhibited substantially the same characteristics as an equity or other
ownership interest (e.g., provides the holder with voting rights, the
right or ability to share in the covered fund's profits or losses, or
the ability, directly or pursuant to a contract or synthetic interest,
to earn a return based on the performance of the fund's underlying
holdings or investments).\2084\ As described further below, the
proposed rule excluded carried interest (termed ``restricted profit
interest'' in the final rule) from the definition of ownership
interest.
---------------------------------------------------------------------------
\2083\ See proposed rule Sec. ----.10(b)(3).
\2084\ See Joint Proposal, 76 FR 68,897.
---------------------------------------------------------------------------
Many commenters argued that the proposed definition of ownership
interest was too broad and urged excluding one or more types of
interests from the definition. A number of commenters raised concerns
regarding the difficulty of applying the ownership interest definition
to securitization structures and questioned whether the definition of
ownership interest might apply to a debt security issued by, or a debt
interest in, a covered fund that has some characteristics similar to an
equity or other ownership interest.\2085\ One commenter argued that the
ownership interest definition should not include debt instruments with
equity features unless the Agencies determine with respect to a
particular debt instrument, after appropriate notice and opportunity
for hearing, that the equity features are so pervasive that the debt
instrument is the functional equivalent of an equity interest or
partnership interest and was structured to evade the prohibitions and
[[Page 5706]]
restrictions in the proposal.\2086\ Several commenters argued that the
Agencies should explicitly exclude certain debt instruments with equity
features from the ownership interest definition.\2087\ Finally, certain
commenters argued that, because the application of the ownership
interest definition to securitization structures was problematic,
alternative regulatory treatment was appropriate.\2088\
---------------------------------------------------------------------------
\2085\ See AFME et al.; AFR et al. (Feb. 2012); ASF (Feb. 2012);
BoA; Cadwalader (Municipal Securities); Credit Suisse (Williams);
Deutsche Bank (Repackaging Transactions); Occupy; RBC; SIFMA et al.
(Covered Funds) (Feb. 2012); SIFMA (Securitization) (Feb. 2012);
TCW. For example, securitization structures generally provide that
either the most senior or the most junior tranche notes have
controlling voting rights. One commenter argued that under the
proposed ownership interest definition, a banking entity could be
deemed to have an ownership interest in an entity it does not own or
sponsor simply due to its obtaining voting rights. See ASF (Feb.
2012). As a further example, one commenter alleged that
securitization structures generally are not viewed as providing
economic exposure to the profits and losses of the issuer in the
same manner as equity interests in hedge funds and private equity
funds. This commenter argued that the ownership interest definition
should include only those interests that permit the banking entity
to share without limit in the profits and losses or that earn a
return that is based on the performance of the underlying assets.
See SIFMA (Securitization) (Feb. 2012).
\2086\ See SIFMA et al. (Covered Funds) (Feb. 2012).
\2087\ See AFME et al.; ASF (Feb. 2012); BoA; Cadwalader
(Municipal Securities); RBC; SIFMA (Securitization) (Feb. 2012).
These commenters argued that the ownership interest definition
should not include tender option bond programs and other debt asset-
backed securities. Two of these commenters argued that debt asset-
backed securities should not be viewed as ownership interests
because: (i) They are not typically viewed as having economic
exposure to profits and losses of an ABS Issuer; (ii) they have a
limited life, periodic fixed or fluctuating cumulative payments, and
are senior to equity of the issuer should the issuer fail; (iii)
they do not have perpetual life with broad voting rights,
appreciation in the market value of the issuer and non-cumulative
dividends, and subordination to the claims of debt holders if the
issuer fails; and (iv) their limited voting rights (such as the
rights to replace a servicer or manager) and such rights are
protective in nature and similar to voting rights that accompany
securities traditionally classified by the Agencies as debt
securities (including securities formally structured as equity). See
AFME et al.; SIFMA (Securitization) (Feb. 2012). One of these
commenters argued that the ownership interest definition should be
limited to those interests that share in the profits or losses of
the relevant entity on an unlimited basis or that otherwise earn a
return that is specifically based upon the performance of the
underlying assets because the senior tranche in an asset-based
securities transaction often has substantial voting rights and
banking entities should not be penalized for requiring or otherwise
obtaining voting rights that protect their interests. This commenter
also expressed the view that banking entities should not be
restricted from owning debt classes of new asset-backed securities
because ``doing so would substantially constrict the market for
asset-backed securities.'' See ASF (Feb. 2012).
\2088\ See AFR et al. (Feb. 2012); Credit Suisse (Williams);
Occupy. One of these commenters argued that any general statement
about what instruments would be considered an ``ownership interest''
for purposes of securitization structures would be problematic and
easy to evade because transaction documents underlying
securitization structures are not standardized. This commenter
suggested as an alternative using a safe harbor for standardized,
pre-specified securitization structures. See AFR et al. (Feb. 2012).
Another of these commenters argued that ``it is difficult to
characterize holders of ABS securities in most securitization
structures as having `ownership interests' in any common
understanding of the term'' and the concept of ownership interest is
a ``poor fit for the securitization market, underscoring the
benefits of excluding securitization issuers from the definition of
covered fund entirely.'' See Credit Suisse (Williams).
---------------------------------------------------------------------------
One commenter expressed concern over the proposal's inclusion of
``derivatives'' of ownership interests in the definition of ownership
interest and recommended certain derivative interests of ownership
interests in hedge funds and private equity funds not be included
within the definition of ownership interest.\2089\ This commenter also
recommended that the Agencies expressly exclude from the definition of
ownership interest lending arrangements with a covered fund that
contain protective covenants linking the interest rate on the loan to
the profits of the borrowing fund.\2090\
---------------------------------------------------------------------------
\2089\ See Credit Suisse (Williams).
\2090\ See Credit Suisse (Williams) (arguing that such
arrangements are a fundamental part of a bank's lending activities).
---------------------------------------------------------------------------
As discussed in detail below, the Agencies are adopting the
definition of ``ownership interest'' largely as proposed but clarifying
the scope of that definition, including with respect to the inclusion
of interests that are linked to profits and losses of a covered fund
and the exclusion for a restricted profit interest in a covered
fund.\2091\ The definition is centered on equity interests, partnership
interests, membership interests, trust certificates, and similar
interests, and would not generally cover typical extensions of credit
the terms of which provide for payment of stated principal and interest
calculated at a fixed rate or at a floating rate based on an index or
interbank rate. However, as under the proposal, to the extent that a
debt security or other interest in a covered fund exhibits specified
characteristics that are similar to those of equity or other ownership
interests (e.g., provides the holder with the ability to participate in
the election or removal of a party with investment discretion, the
right or ability to share in the covered fund's profits or losses, or
the ability, directly or pursuant to a contract or synthetic interest,
to earn a return based on the performance of the fund's underlying
holdings or investments), the instrument would be an ownership interest
under the final rule.
---------------------------------------------------------------------------
\2091\ See final rule Sec. ----.10(d)(6). The concept of a
restricted profit share was referred to as ``carried interest'' in
the proposed rule, a term that is often used as a generic reference
to performance-based allocations or compensation. The Agencies have
instead used the term ``restricted profit interest'' in the final
rule to avoid any confusion that could result from using a term that
is also used in other contexts. The final rule focuses only on
whether a profit interest is excluded from the definition of
ownership interest under section 13, and the final rule does not
address in any way the treatment of such profit interests under
other laws, including under Federal income tax law.
---------------------------------------------------------------------------
In response to commenters and in order to provide clarity about the
types of interests that would be considered within the scope of
ownership interest, the Agencies have revised the definition of
``ownership interest'' to define the term more clearly. The Agencies
are not explicitly excluding or including debt securities, instruments
or interests with equity features as requested by some commenters, but
are instead identifying certain specific characteristics that would
cause a particular interest, regardless of the name or legal form of
that interest, to be included within the definition of ownership
interest. The Agencies believe that this elaboration on the
characteristics of an ownership interest will enable parties, including
securitization structures, to more easily analyze whether their
interest is an ownership interest, regardless of the type of legal
entity or the name of the particular interest.
As adopted, the final rule provides that an ownership interest
would be any interest in or security issued by a covered fund that
exhibits any of the following features or characteristics on a current,
future, or contingent basis: \2092\
---------------------------------------------------------------------------
\2092\ Each of these factors are designed to clarify the
interests identified in the proposed definition of ownership
interest as noted above.
---------------------------------------------------------------------------
Has the right to participate in the selection or removal
of a general partner, managing member, member of the board of directors
or trustees, investment manager, investment adviser, or commodity
trading advisor of the covered fund. For purposes of the rule, this
would not include the rights of a creditor to exercise remedies upon
the occurrence of an event of default or similar rights arising due to
an acceleration event;
has the right under the terms of the interest to receive a
share of the income, gains or profits of the covered fund. This would
apply regardless of whether the right is pro rata with other owners or
holders of interests; \2093\
---------------------------------------------------------------------------
\2093\ This characteristic exists for both multi-class and
single-class covered funds. In the context of an entity that issues
shares, this right could cover, for example, common shares, as well
as preferred shares the dividend payments of which are determined by
reference to the performance of the covered fund.
---------------------------------------------------------------------------
has the right to receive the underlying assets of the
covered fund, after all other interests have been redeemed and/or paid
in full (commonly known as the ``residual'' in securitizations). For
purposes of the rule, this would not include the rights of a creditor
to exercise remedies upon the occurrence of an event of default or
similar rights arising due to an acceleration event;
has the right to receive all or a portion of excess spread
(the positive difference, if any, between the aggregate interest
payments received from the underlying assets of the covered fund and
the aggregate interest paid to the
[[Page 5707]]
holders of other outstanding interests); \2094\
---------------------------------------------------------------------------
\2094\ The reference to ``all or a portion of excess spread'' is
meant to include within the definition of ownership interest the
right to receive any excess spread which remains after the excess
spread is used to pay expenses, maintain credit enhancement such as
overcollateralization or is otherwise reduced.
---------------------------------------------------------------------------
provides that the amounts payable by the covered fund with
respect to the interest could, under the terms of the interest, be
reduced based on losses arising from the underlying assets of the
covered fund, such as allocation of losses, write-downs or charge-offs
of the outstanding principal balance, or reductions in the amount of
interest due and payable on the interest; \2095\
---------------------------------------------------------------------------
\2095\ This characteristic does not refer to any reduction in
the stated claim to principal or interest of a holder of an interest
that occurs either as a result of a bona fide subsequent
renegotiation of the terms of an interest or as a result of a
bankruptcy, insolvency, or similar proceeding.
---------------------------------------------------------------------------
receives income on a pass-through basis from the covered
fund, or has a rate of return that is determined by reference to the
performance of the underlying assets of the covered fund.\2096\ This
provision would not include an interest that is entitled to receive
dividend amounts calculated at a fixed or at a floating rate based on
an index or interbank rate such as LIBOR; or
---------------------------------------------------------------------------
\2096\ This provision is not intended to encompass derivative
transactions entered into in connection with typical prime brokerage
activities of banking entities. However, the activities of banking
entities are subject to the anti-evasion provisions.
---------------------------------------------------------------------------
any synthetic right to have, receive or be allocated any
of the rights above. This provision would not permit banking entities
to obtain synthetic or derivative exposure to any of the
characteristics identified above in order to avoid being considered to
have an ownership interest in the covered fund.
This definition of ``ownership interest'' is intended to address
commenters' concerns regarding the applicability of the ownership
interest definition to different types of interests. The Agencies
believe defining ``ownership interest'' in this way will allow existing
as well as potential holders of interests in covered funds, including
securitizations, to effectively determine whether they have an
ownership interest. As an example, this definition would include
preferred stock, as well as a lending arrangement with a covered fund
in which the interest or other payments are calculated by reference to
the profits of the fund. As a contrasting example, the Agencies believe
that a loan that provides for a step-up in interest rate margin when a
covered fund has fallen below or breached a NAV trigger or other
negotiated covenant would not generally be an ownership interest.
Banking entities will be expected to evaluate the specific terms of
their interests to determine whether any of the specified
characteristics exist. In this manner, the Agencies believe that the
definition of ownership interest in the final rule is clearer than
under the proposal and thus should be less burdensome for banking
entities in their determination of whether certain rights would cause
an interest to be an ownership interest for purposes of compliance with
the rule.
As indicated above, many commenters on securitizations under the
proposed rule made arguments regarding the difficulty of applying the
proposal's definition of ownership interest to securitization
structures, contending that the definition should not include debt
instruments with equity features, or that the final rule should provide
a safe harbor under which the use of a standardized, pre-specified
securitization structure would not give rise to an ownership
interest.\2097\ The Agencies are not adopting a separate definition of
ownership interest for securitization transactions, providing for
differing treatment of financial instruments, or providing a safe
harbor as requested by some commenters. The revised definition of
ownership interest will apply regardless of the type of legal entity or
the name or legal form of the particular interest. The determination of
whether an interest is an ownership interest under the final rule will
depend on the features and characteristics of the particular interest,
including the rights the particular interest provides its holder,
including not only voting rights but also the right to receive a share
of the income, gains, or profits of a covered fund, the right to
receive a residual, the right to receive excess spread, and any
synthetic or derivative that would provide similar rights. While some
commenters argued that securities issued in asset-backed securities
transactions and by tender option bond issuers should not be viewed as
ownership interests due to the nature of the securities issued or the
possible lack of exposure to profits and losses,\2098\ the Agencies do
not believe that the type of covered fund involved or the type of
security issued is an appropriate basis for determining whether there
is an ownership interest for purposes of the restrictions contained in
section 13(a)(1)(B) of the BHC Act. The Agencies believe that making
distinctions in the definition of ownership interest based on the type
of entity or the type of security, in which many of the same rights
exist as for other types of ownership interests, would not be
consistent with the statutory restrictions on ownership. Similarly,
while some commenters argued that including a safe harbor for
standardized securitization structures would be more effective in
identifying an ownership interest in securitizations, the Agencies
believe that the type of interest and the rights associated with the
interest are more appropriate to determine whether an interest is an
ownership interest and is necessary to avoid potential evasion of the
ownership restrictions contained in section 13 of the BHC Act.
The Agencies understand that the definition of ownership interest
in the final rule may include interests in a covered fund that might
not be considered an ownership interest or equity interest in other
contexts. For instance, it may include loans with an interest rate
determined by reference to the performance of a covered fund or senior
debt interests issued in a securitization. While the definition of
ownership interest may affect the ability of a banking entity to hold
such interests, whether existing or in the future, the Agencies believe
that the definition of ownership interest as adopted in the final rule
is more effective in preventing possible evasion of section 13 by
capturing interests that may be characterized as debt but confer
benefits of ownership, including voting rights and/or the ability to
participate in profits or losses of the covered fund.
---------------------------------------------------------------------------
\2097\ See supra note 2085.
\2098\ See supra note 2087.
---------------------------------------------------------------------------
The definition of ownership interest in the final rule, like the
proposed rule, includes derivatives of the interests described above.
Derivatives of ownership interests provide holders with economic
exposure to the profits and losses of the covered fund or an ability to
earn a return based on the performance of the fund's underlying
holdings or investments in a manner substantially similar to an
ownership interest. The Agencies believe the final rule's approach
appropriately addresses the statutory purpose to limit a banking
entity's economic exposure to covered funds, irrespective of the legal
form, name, or issuer of that ownership interest.
As noted above, the proposed definition of ownership interest did
not include carried interest (termed ``restricted profit interest'' in
the final rule). The proposal recognized that many banking entities
that serve as investment adviser or provide other services to a covered
fund are routinely
[[Page 5708]]
compensated for services they provide to the fund through receipt of
carried interest. As a result, the proposed rule provided that an
ownership interest with respect to a covered fund did not include an
interest held by a banking entity (or an affiliate, subsidiary or
employee thereof) in a covered fund for which the banking entity (or an
affiliate, subsidiary or employee thereof) served as investment
manager, investment adviser, or commodity trading advisor, so long as
certain enumerated conditions were met.\2099\
---------------------------------------------------------------------------
\2099\ See proposed rule Sec. ----.10(b)(3)(ii).
---------------------------------------------------------------------------
The enumerated conditions contained in the proposal were designed
to narrow the scope of the exclusion of carried interest from the
definition of ``ownership interest'' so as to distinguish between an
investor's economic risks and a service provider's performance-based
compensation. This was designed to limit the ability of a banking
entity to structure carried interest in a manner that would evade
section 13's restriction on the amount of ownership interests a banking
entity may have as an investment in a covered fund.
Commenters disagreed over whether the definition of ownership
interest should exclude carried interest. For instance, some commenters
did not support excluding carried interest from the definition of
ownership interest, arguing that such an exclusion was too permissive
and inconsistent with the statute because, for instance, carried
interest derives its value in part by tracking gains on price movements
of investments by the fund.\2100\ One commenter argued that, despite
the fact that carried interest is typically provided as compensation
for services provided to a fund, carried interest is a form of
investment and therefore should be included as an ownership
interest.\2101\ Another commenter argued that permitting banking
entities to hold an unrestricted amount of carried interest could
create an indirect and undesirable link between prohibited proprietary
trading and covered fund activities.\2102\ These commenters also argued
that treating carried interest as compensation for providing services
would be inconsistent with the manner in which carried interest is
treated for tax purposes.\2103\
---------------------------------------------------------------------------
\2100\ See, e.g., Occupy; AFR et al. (Feb. 2012).
\2101\ See Public Citizens; See also Occupy.
\2102\ See AFR et al. (Feb. 2012).
\2103\ See Occupy; Public Citizens; AFR et al. (Feb. 2012).
---------------------------------------------------------------------------
Other commenters, however, supported excluding carried interest
from the definition of an ownership interest and argued the exclusion
was consistent with the words and purpose of section 13.\2104\ One
commenter argued that carried interest is readily distinguished from an
investment in a covered fund because carried interest normally does not
expose a banking entity to a covered fund's losses (other than in
limited instances such as when a ``clawback'' provision is
triggered).\2105\ Another commenter argued that permitting a banking
entity to receive carried interest without being subject to the
requirements of section 13 regarding ownership interests better aligns
the interest of the investment manager with that of the fund and its
investors.\2106\ Another commenter supported expanding the definition
of carried interest to include an interest received by a banking entity
in return for qualifying services (e.g., lending, placement,
distribution, or equity financing) provided to the investment manager
of the fund, but not directly provided to the fund itself.\2107\
---------------------------------------------------------------------------
\2104\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012); TCW;
Credit Suisse (Williams); SVB.
\2105\ See Credit Suisse (Williams).
\2106\ See TCW.
\2107\ See Credit Suisse (Williams).
---------------------------------------------------------------------------
The proposal established four criteria that must be met in order
for carried interest to be excluded from the definition of ownership
interest. First, the proposal required that carried interest have the
sole purpose and effect of permitting the banking entity or an employee
thereof to share in the covered fund's profits as performance
compensation for services provided to the fund. While most commenters
did not object to this criterion, one commenter argued that the wording
of this approach would appear to prohibit an employee of the banking
entity from retaining a carried interest after the employee has changed
employment.\2108\ This commenter argued that the determination of the
carried interest's purpose should be made only at the time the interest
is granted, thereby enabling an employee to retain the carried interest
if and when the employee no longer provides investment management,
investment advisory, or similar services to the fund or is no longer
employed at the banking entity.
---------------------------------------------------------------------------
\2108\ See TCW.
---------------------------------------------------------------------------
Second, the proposal required that carried interest, once
allocated, be distributed to the banking entity promptly after it is
earned or, if not so distributed, not share in the subsequent profits
and losses of the covered fund. One commenter urged the Agencies to
allow the ``reserve'' portion of carried interest that for tax purposes
is allocated to the investment manager or investment adviser, but
invested alongside the fund and not formally allocated or distributed
by the fund, also to qualify for the exclusion as carried
interest.\2109\ This commenter also suggested that this criterion
should not affect the common European structure in which allocated
carried interest may share in the subsequent losses, but not the
profits, of the fund.
---------------------------------------------------------------------------
\2109\ See Credit Suisse (Williams).
---------------------------------------------------------------------------
Third, under the proposal a banking entity (including its
affiliates or employees) was not permitted to provide funds to the
covered fund in connection with receiving a carried interest. The
proposal specifically requested comment on whether the exemption for
carried interest, including this requirement, was consistent with the
current tax treatment and requirements of carried interest
arrangements.\2110\ Commenters urged the Agencies to relax or amend
this criterion so that banking entities, including their affiliates and
employees, whether directly or indirectly through a fund vehicle, would
be permitted to make minimal capital contributions to the fund
(typically less than 1 percent) in connection with the receipt of
carried interest to the extent that such contributions provide the
basis for treating the interest as carried interest for tax
purposes.\2111\ However, these commenters supported the proposal's
requirement that any amount contributed by a banking entity in
connection with receiving a carried interest should be aggregated with
the banking entity's ownership interests for purposes of the 3 percent
investment limits.
---------------------------------------------------------------------------
\2110\ Joint Proposal, 76 FR 68,899.
\2111\ See TCW; SIFMA (Covered Funds) (Feb. 2012); Credit Suisse
(Williams).
---------------------------------------------------------------------------
Fourth, the proposal provided that carried interest may not be
transferable by the banking entity (or the affiliate, subsidiary or
employee thereof) except to another affiliate or subsidiary of the
banking entity. Commenters generally urged removing the proposal's
limitations on transferability and argued, among other things, that
this criterion could prevent a banking entity (or its affiliate or
employee) from transferring the carried interest in connection with
selling or otherwise transferring the provision of advisory or other
services that gave rise to the carried interest.\2112\ Similarly, one
commenter argued that the final rule should not require carried
interest to be
[[Page 5709]]
re-characterized as an ownership interest if it is transferred among
employees, family members of employees or to estate planning vehicles
upon an employee's death.\2113\
---------------------------------------------------------------------------
\2112\ See ASF (Feb. 2012); See also Credit Suisse (Williams);
SVB.
\2113\ See TCW.
---------------------------------------------------------------------------
After considering carefully comments received on the proposal, the
Agencies have determined to retain in the final rule the exclusion from
the definition of ``ownership interest'' for a restricted profit
interest (termed ``carried interest'' in the proposed rule\2114\)
largely as provided in the proposed rule. The final rule, like the
proposal, recognizes that banking entities that serve as investment
adviser or provide other services to a covered fund are routinely
compensated for such services through receipt of a restricted profit
interest. The final rule, also like the proposal, generally excludes
restricted profit interest from the definition of ownership interest
subject to conditions designed to distinguish restricted profit
interest, which serves as a form of compensation, from an investment in
the fund prohibited (or limited) by section 13. As explained in detail
below, the definition of restricted profit interest in the final rule
has been modified from the proposal in several aspects to respond to
commenters' concerns and to more effectively capture the types of
compensation that is often granted in exchange for services provided to
a fund. However, like the proposal, the final rule continues to contain
a number of requirements designed to ensure that restricted profit
interest functions as compensation for providing certain services to a
covered fund and does not permit a banking entity to evade the
investment limitations or other requirements of section 13.
---------------------------------------------------------------------------
\2114\ See supra note 2091 and accompanying text.
---------------------------------------------------------------------------
Under the final rule, restricted profit interest is defined to
include an interest held by an entity (or employee or former employee
thereof) that serves as investment manager, investment adviser,
commodity trading advisor, or other service provider so long as:
(i) The sole purpose and effect of the interest is to allow the
entity (or an employee or former employee thereof) to share in the
profits of the covered fund as performance compensation for the
investment management, investment advisory, commodity trading
advisory, or other services provided to the covered fund by the
entity (or employee or former employee thereof), provided that the
entity (or employee or former employee thereof) may be obligated
under the terms of such interest to return profits previously
received;
(ii) all such profit, once allocated, is distributed to the
entity (or employee or former employee thereof) promptly after being
earned or, if not so distributed, is retained by the covered fund
for the sole purpose of establishing a reserve amount to satisfy
contractual obligations with respect to subsequent losses of the
covered fund and such undistributed profit of the entity (or
employee or former employee thereof) does not share in subsequent
investment gains of the covered fund;
(iii) any amounts invested in the covered fund, including any
amounts paid by the entity (or employee or former employee thereof)
in connection with obtaining the restricted profit interest, are
within the investment limitations of Sec. ----.12; and
(iv) the interest is not transferable by the entity (or employee
or former employee thereof) except to an affiliate thereof (or an
employee of the banking entity or affiliate), to immediate family
members, or through the intestacy of the employee or former
employee, or in connection with a sale of the business that gave
rise to the restricted profit interest by the entity (or employee or
former employee thereof) to an unaffiliated party that provides
investment management, investment advisory, commodity trading
advisory, or other services to the fund.\2115\
---------------------------------------------------------------------------
\2115\ See final rule Sec. ----.10(d)(6)(ii).
The final rule, like the proposal, permits any entity (or the affiliate
or employee thereof) to receive or hold restricted profit interest if
the entity (or the affiliate or employee thereof) serves as investment
manager, investment adviser, commodity trading advisor, or other
service provider to the covered fund. For example, an entity that
provides services to the covered fund in a capacity as sub-adviser or
placement agent would be eligible to receive or hold restricted profit
interest.
As requested by commenters, the first condition in the final rule,
in contrast to the proposal, permits an employee or former employee to
retain a restricted profit interest after a change in employment status
so long as the restricted profit interest was originally received as
compensation for qualifying services provided to the covered fund.
Also in response to issues raised by commenters, the second
condition in the final rule has been modified to permit so-called
``clawback'' features whereby restricted profit interest that has been
provided to an investment manager, investment adviser, commodity
trading advisor, or similar service provider may be taken back if
certain subsequent events occur, such as if the fund fails to achieve a
specified preferred rate of return or if liabilities or subsequent
losses are incurred by the fund. Under these circumstances, the
Agencies believe it is appropriate to allow the allocated but
undistributed profits to be clawed back from the service provider's
performance compensation, and the final rule has been amended to allow
this practice. The final rule makes clear, however, that the
undistributed profits may only be held in the fund in connection with
such a clawback arrangement. Undistributed profits that remain in the
covered fund after they have been allocated without connection to such
an arrangement would be deemed to be an investment in the fund and
would be an ownership interest under the final rule. Importantly, the
final rule also retains the limitation in the proposal that
undistributed profit may not share in subsequent investment gains of
the covered fund. This limitation (together with the limited
circumstances under which the undistributed profit may be retained in
the fund) appears necessary in order to distinguish restricted profit
interest, which functions as performance compensation and is not
intended to be a form of investment, from an ownership interest, which
is designed to be an investment. The Agencies believe that this
approach achieves an appropriate balance between accommodating receipt
of restricted profit interest, including such amounts held in
``reserve,'' \2116\ and limiting the ability of a banking entity to
evade the investment limitations of section 13. The Agencies expect to
review restricted profit interests to ensure banking entities do not
use the exclusion for restricted profit interest in a manner that
functions as an evasion of section 13.
---------------------------------------------------------------------------
\2116\ The Agencies believe that this addresses a commenter's
concern regarding the ``reserve'' portion of carried interest
discussed above; however such amounts may not share in subsequent
investment gains of the covered fund for the reasons also discussed
above.
---------------------------------------------------------------------------
As noted above, the Agencies understand that entities that provide
investment management, investment advisory, commodity trading advisory
or other services to a covered fund may, in connection with receiving
restricted profit interest, be required to hold a small amount of
ownership interests in a fund to provide the basis for desired tax
treatment of restricted profit interest. Accordingly, the third
condition of the final rule allows an entity that provides qualifying
services to a fund to contribute funds to, and have an ownership
interest in, the fund in connection with receiving restricted profit
interest. As under the proposal, the amount of the contribution must be
counted toward the investment limits under section 13(d)(4) and Sec.
----.12 of the final rule. This would include attribution to the
banking entity of sums invested by employees in connection with
obtaining a restricted profit interest. Thus, the final rule permits a
[[Page 5710]]
banking entity that provides investment management, investment
advisory, or commodity trading advisory services to have both an
ownership interest in, and receive restricted profit interest from, the
covered fund, so long as the aggregate of the sums invested in all
ownership interests acquired or retained by the banking entity
(including a general partnership interest), either in connection with
receiving the restricted profit interest or as an investment, are
within the investment limitations in section 13(d)(4) and Sec. ----.12
of the final rule. The Agencies believe this more appropriately
implements the requirements of section 13 of the BHC Act by permitting
banking entities to continue to provide customer-driven investment
management services through organizing and offering covered funds,
while also abiding by the investment limitations of section 13.
In response to comments, the fourth condition of the final rule
permits the transfer of a restricted profit interest in connection with
a sale to an unaffiliated party that provides investment management,
investment advisory, commodity trading advisory, or other services to
the fund. In response to comments, the final rule also permits the
transfer of a restricted profit interest to immediate family members of
the banking entity's employees or former employees that provide
investment management, investment advisory, commodity trading advisory,
or other services to the covered fund, or in connection with the death
of such employee. Also in response to comments, the final rule permits
the transfer of a restricted profit interest to an affiliate or
employee that provides investment management, investment advisory,
commodity trading advisory, or other services to the covered fund.
However, the final rule, like the proposed rule, would treat a
restricted profit interest as an ownership interest if the restricted
profit interest is otherwise transferable. This remaining restriction
recognizes that a freely transferable restricted profit interest has
the same economic benefits as an ownership interest and is essential to
differentiating a restricted profit interest from an ownership
interest.
f. Definition of ``Resident of the United States''
Section 13(d)(1)(I) of the BHC Act provides that a foreign banking
entity may acquire or retain an ownership interest in or act as sponsor
to a covered fund, but only if that activity is conducted according to
the requirements of the statute, including that no ownership interest
in the covered fund is offered for sale or sold to a ``resident of the
United States.'' The statute does not define this term.
Under the proposed rule, the term ``resident of the United States''
was used in the context of the exemptions for covered trading and
covered fund activities. As proposed, the definition of resident of the
United States was similar, but not identical, to the SEC's definition
of U.S. person in Regulation S, which governs offerings of securities
outside of the United States.\2117\ The Agencies proposed this approach
in order to promote consistency and understanding among market
participants that have experience with the concept from the SEC's
Regulation S.
---------------------------------------------------------------------------
\2117\ See proposed rule Sec. ----.2(t); 17 CFR 230.901-
230.905.
---------------------------------------------------------------------------
Some commenters supported the proposed definition of resident of
the United States.\2118\ One commenter suggested that the proposed rule
defined resident of the United States too broadly and inappropriately
precluded investments in U.S. funds by foreign banking entities.\2119\
---------------------------------------------------------------------------
\2118\ See, e.g., Occupy.
\2119\ See Sens. Merkley & Levin (Feb. 2012) (citing 156 Cong.
Rec. S5897 (daily ed. July 15, 2010) (statement of Sen. Merkley)).
---------------------------------------------------------------------------
Other commenters generally argued that the final rule should adopt
the definition of ``U.S. person'' under the SEC's Regulation S without
the modifications in the proposed rule.\2120\ According to many
commenters, market participants are familiar with and rely upon the
body of law interpreting U.S. Person under Regulation S.\2121\ They
argued that, to the extent that the definitions of ``resident of the
United States'' under section 13 and ``U.S. person'' under Regulation S
differ, this would create unnecessary uncertainty and increase
compliance burdens associated with monitoring multiple
definitions.\2122\ Other commenters urged the Agencies not to depart
from the treatment of international parties and organizations (e.g.,
the International Monetary Fund and the World Bank) under the SEC's
Regulation S.\2123\
---------------------------------------------------------------------------
\2120\ See, e.g., Union Asset; EFAMA; BVI; AFME et al.; IIB/EBF;
Credit Suisse (Williams); Hong Kong Inv. Funds Ass'n.; PEGCC; UBS;
Allen & Overy (on behalf of Canadian Banks); Allen & Overy (on
behalf of Foreign Bank Group); AFG.
\2121\ See PEGCC; Allen & Overy (on behalf of Canadian Banks);
Allen & Overy (on behalf of Foreign Bank Group); ICI (Feb. 2012);
Credit Suisse (Williams).
\2122\ See IIB/EBF; Credit Suisse (Williams); ICI (Feb. 2012);
ICI Global; PEGCC.
\2123\ See IIB/EBF; ICI Global; Credit Suisse (Williams).
---------------------------------------------------------------------------
Many commenters contended that, because the definition of resident
of the United States in the proposal was generally broader than the
definition of U.S. person under Regulation S, many additional types of
persons, entities and investors would be deemed residents of the United
States for purposes of the foreign activity exemptions. Commenters
argued that this would limit the potential for foreign banking entities
to effectively use those statutorily provided exemptions. A few
commenters noted that using a definition in the foreign fund exemption
that differs from the definition in Regulation S loses the advantage of
using a term that is already understood by market participants and that
avoids confusion and limits compliance costs.\2124\
---------------------------------------------------------------------------
\2124\ See Allen & Overy (on behalf of Foreign Bank Group); IIB/
EBF; PEGCC; Union Asset.
---------------------------------------------------------------------------
Other commenters suggested that defining resident of the United
States as proposed presented problems for investment funds managed by
U.S. investment advisers, even those without U.S. investors.\2125\ Some
commenters argued that, under the proposed definition, a foreign fund
managed by a U.S. investment adviser or sub-adviser that is not
otherwise subject to section 13 might be deemed a resident of the
United States, thereby disqualifying the fund from relying on the
foreign funds exemption, a result inconsistent with the purpose of
section 13 and the statutory exemption in section 13(d)(1)(I).\2126\
---------------------------------------------------------------------------
\2125\ See, e.g., MFA; TCW.
\2126\ See AFG; BVI. See also MFA; TCW. Similarly, these
commenters argued that although treated as a non-U.S. person under
Regulation S, a non-U.S. fund organized as a trust in accordance
with local law with a limited number of U.S. investors would have
been a resident of the United States. Under the proposal, this
foreign fund could not invest in another foreign covered fund
Seeking to rely on the exemption for covered fund activities or
investments that occur solely outside of the United States.
---------------------------------------------------------------------------
Commenters also argued that the proposed definition raised issues
for compensation plans of international organizations that are subject
to section 13 of the BHC Act. Several commenters argued that U.S.
employees of a foreign banking entity should not be considered
residents of the United States if they invest in a non-U.S. covered
fund pursuant to a bona fide employee investment, retirement or
compensation program.\2127\ The Agencies have carefully considered the
comments received on the definition of resident of the United States,
and have determined to modify the final rule as discussed below. The
term ``resident of the United States'' is not defined in the statute
and is used by the statute to clarify when
[[Page 5711]]
foreign activity or investment of a foreign banking entity qualifies
for the foreign funds exemption in section 13(d)(1)(I). The purpose of
this exemption is to enable foreign banking entities to continue to
engage in foreign funds activities and investments that do not have a
sufficient nexus to the United States so as to present risk to U.S.
investors or the U.S. financial system.\2128\ The purpose of Regulation
S is to provide a safe harbor from the registration provisions under
the Securities Act for offerings that take place outside of the United
States.\2129\
---------------------------------------------------------------------------
\2127\ See IIB/EBF; Credit Suisse (Williams); UBS; JPMC.
\2128\ See 156 Cong. Reg. S.5894-5895 (daily ed. July 15, 2010)
(statement of Sen. Merkley).
\2129\ Offers and Sales, Securities Act Release No. 6863 (Apr.
24, 1990), 55 FR 18,306 (May 2, 1990).
---------------------------------------------------------------------------
The Agencies believe that, because the covered funds provisions of
the final rule involve sponsoring covered funds and offering and
selling securities issued by funds (as compared to counterparty
transactional relationships), the securities law framework reflected in
Regulation S would most effectively achieve the purpose of the foreign
funds exemption. As noted by commenters and discussed above, market
participants are familiar with and rely upon the body of law
interpreting U.S. Person under Regulation S, and differing definitions
under section 13 and Regulation S could create uncertainty and increase
compliance burdens associated with monitoring multiple definitions. The
Agencies therefore have defined the term ``resident of the United
States'' in the final rule to mean a ``U.S. person'' as defined in
Regulation S.\2130\
---------------------------------------------------------------------------
\2130\ See final rule Sec. ----.10(d)(8).
---------------------------------------------------------------------------
In addition, as explained in detail below in Part IV.B.4.b.3. of
this SUPPLEMENTARY INFORMATION, the final rule provides that an
ownership interest is offered for sale or sold to a resident of the
United States if it is sold in an offering that ``targets'' residents
of the United States.\2131\ As explained in more detail in that
section, this approach is consistent with Regulation S.
---------------------------------------------------------------------------
\2131\ See infra Part IV.B.4.b.3.
---------------------------------------------------------------------------
g. Definition of ``Sponsor''
Section 13(h)(5) of the BHC Act defines ``sponsor'' to mean: (i)
Serving as a general partner, managing member, or trustee of a covered
fund; (ii) in any manner selecting or controlling (or to have
employees, officers, or directors, or agents who constitute) a majority
of the directors, trustees, or management of a covered fund; or (iii)
sharing with a covered fund, for corporate, marketing, promotional, or
other purposes, the same name or a variation of the same name.\2132\
Sponsor is a key definition because it defines, in part, the scope of
activities to which the prohibition in section 13(a)(1) applies.\2133\
---------------------------------------------------------------------------
\2132\ See 12 U.S.C. 1851(h)(5).
\2133\ See 12 U.S.C. 1851(a)(1).
---------------------------------------------------------------------------
Under the proposal, the term sponsor would have been defined
largely as in the statute.\2134\ Nearly all commenters who addressed
the definition of sponsor argued that the definition was too broad and
suggested various ways to narrow or limit the definition.\2135\
Commenters generally expressed concerns that a sponsor to a covered
fund became subject to the restrictions of section 13(f), limiting the
relationships of the banking entity with the covered fund. Commenters
argued this would prevent banking entities from providing many
customary services to covered funds.\2136\
---------------------------------------------------------------------------
\2134\ See proposed rule ----.10(b)(5).
\2135\ A number of comments received regarding the definition of
sponsor relate to securitization structures and are addressed below.
There also were a few comments urging that insurance companies not
be considered to sponsor their separate accounts. See Sutherland (on
behalf of Comm. of Annuity Insurers); Nationwide. The Agencies
believe these concerns should be addressed by the exclusion of
separate accounts from the definition of covered fund, as discussed
in Part IV.B.1.c.6. of this SUPPLEMENTARY INFORMATION.
\2136\ See, e.g., ASF (Feb. 2012); BNY Mellon et al.; Credit
Suisse (Williams).
---------------------------------------------------------------------------
The proposal excluded from the definition of ``trustee'' as used in
the term sponsor a trustee that does not exercise investment discretion
with respect to a covered fund, including a directed trustee, as that
term is used in section 403(a)(1) of the Employee's Retirement Income
Security Act (``ERISA'') (29 U.S.C. 1103(a)(1)).\2137\ On the other
hand, the proposal provided that any banking entity that directs a
directed trustee, or that possesses authority and discretion to manage
and control the assets of a covered fund for which a directed trustee
serves as trustee, would be considered a trustee of the covered fund.
---------------------------------------------------------------------------
\2137\ See proposed rule Sec. ----.10(b)(6); See also 29 U.S.C.
1103(a)(1).
---------------------------------------------------------------------------
Commenters generally supported the exception for directed trustees
in the proposed rule but argued that the exception was too narrow
because it only referred to directed trustees under section 403(a)(1)
of the ERISA and did not include other similar custodial or
administrative arrangements that may not meet those requirements or be
subject to ERISA.\2138\ These commenters argued that banking entities
that serve as trustees or custodians of covered funds may provide a
limited range of ministerial services or exercise limited fiduciary
duties that, while not subject to ERISA or beyond those permitted for a
directed trustee under ERISA, nevertheless do not involve the exercise
of investment discretion or control over the operations of the covered
fund in the same manner as a general partner or managing member. Some
of these commenters advocated defining ``directed trustee'' more
expansively to include any situation in which a banking entity serves
solely in a directed, fiduciary, or administrative role where a third-
party and not the banking entity exercises investment discretion.
---------------------------------------------------------------------------
\2138\ See, e.g., Arnold & Porter; Ass'n. of Global Custodians;
BNY Mellon et al.; SIFMA et al. (Covered Funds) (Feb. 2012); State
Street (Feb. 2012); See also Fin. Services Roundtable (June 14,
2011) (recommending the definition of directed trustee under the
Board's Regulation R be used, which defines directed trustee to mean
``a trustee that does not exercise investment discretion with
respect to the account'').
---------------------------------------------------------------------------
In particular, some commenters also argued that a trustee should
not be viewed as having investment discretion, and therefore should not
be treated as a sponsor, if it possesses only the authority to
terminate an investment adviser to a covered fund and to appoint
another unaffiliated investment adviser in order to fulfill a
demonstrable legal or contractual obligation of the trustee, or the
formal but unexercised power to make investment decisions for a covered
fund in circumstances where one or more unaffiliated investment
advisers have been appointed to manage fund assets. Some commenters
argued in favor of excluding trustees serving under non-U.S. trust
arrangements pursuant to which they may have legal or contractual
authority to, but in fact do not, exercise investment discretion (i.e.,
the entity has the formal authority to appoint an investment adviser to
a trust but does so only in extraordinary circumstances such as
appointing a successor investment adviser).\2139\
---------------------------------------------------------------------------
\2139\ See BNY Mellon et al. (providing proposed rule text or
suggesting in the alternative clarification regarding the phrase
``exercise investment discretion'' in the final rule preamble);
Ass'n. of Global Custodians; ICI Global; State Street (Feb. 2012).
---------------------------------------------------------------------------
A few commenters requested confirmation that a banking entity
acting as a custodian should not be considered a sponsor of a covered
fund.\2140\ One commenter argued that traditional client trust accounts
for which a bank serves as discretionary trustee should not, by
implication, themselves become ``covered funds'' that are ``sponsored''
by the bank.\2141\
---------------------------------------------------------------------------
\2140\ See Ass'n. of Global Custodians; SIFMA et al. (Covered
Funds) (Feb. 2012); ABA (Keating); AFG; AFTI; BNY Mellon et al.;
EFAMA; IMA; State Street (Feb. 2012).
\2141\ See Arnold & Porter. To the extent that a client trust
account would not be an investment company but for the exclusion
contained in section 3(c)(1) or 3(c)(7) of the Investment Company
Act, such as the exclusion for common trust funds under section
3(c)(3) of that Act, it would not be a covered fund regardless of
whether a banking entity acts as trustee.
---------------------------------------------------------------------------
[[Page 5712]]
One commenter argued that any person performing similar functions
to a directed trustee (such as a fund management company established
under Irish law), regardless of its formal title or position, also
should be excluded if the person does not exercise investment
discretion.\2142\ Some commenters argued more generally for an
exclusion from the definition of trustee (and therefore from the
definition of sponsor) for entities that act as service providers (such
as custodians, trustees, or administrators) to non-U.S. regulated
funds, arguing that European laws already impose significant
obligations on entities serving in these roles.\2143\
---------------------------------------------------------------------------
\2142\ See BNY Mellon et al.
\2143\ See EFAMA; F&C; IRSG; Union Asset.
---------------------------------------------------------------------------
Under both section 13 of the BHC Act and the proposal, the
definition of sponsor also included the ability to select or control
(or to have employees, officers, directors, or agents who constitute) a
majority of the directors, trustees or management of a covered fund.
Some commenters argued that an entity should not be treated as a
sponsor of a covered fund when it selects a majority of the initial
directors, trustees or management of a covered fund that are
independent of the banking entity, so long as the banking entity may
not remove or replace the directors, trustees, or management and
directors are subsequently either chosen by others or self-
perpetuating.\2144\ One of these commenters argued similarly that a
banking entity should not be deemed to sponsor a covered fund if it
selects an independent general partner, managing member or trustee of a
new fund, so long as the general partner, managing member or trustee
may not be terminated and replaced by the banking entity.\2145\
Commenters argued that initial selection of these parties was
inherently part of, and necessary to allow, the formation of a covered
fund and would not provide a banking entity with ongoing control over
the fund to a degree that the banking entity should be considered to be
a sponsor.
---------------------------------------------------------------------------
\2144\ See SIFMA et al. (Covered Funds) (Feb. 2012)
(recommending the Agencies adopt independence guidelines similar to
the FDIC's guidelines for determining whether audit committee
members of insured depository institutions are ``independent'' of
management); Credit Suisse (Williams).
\2145\ See Credit Suisse (Williams) (arguing that such an
approach would be consistent with the existing BHC Act concept of
control with respect to funds).
---------------------------------------------------------------------------
The statute and proposed rule also defined the term sponsor to
include an entity that shares, for corporate, marketing, promotional,
or other purposes, the same name or a variation of the same name, with
a covered fund. One commenter argued in favor of a narrower
interpretation of this statutory provision.\2146\ This commenter argued
that a covered fund should be permitted to share the name of the asset
manager that advises the fund without the asset manager becoming a
sponsor so long as the asset manager does not share the same name as an
affiliated insured depository institution or the ultimate parent of an
affiliated insured depository institution.\2147\ Another commenter
argued that the proposal would put U.S. banking entities at a
competitive disadvantage relative to non-banking entities and foreign
banks.\2148\ These commenters argued that the costs of rebranding
covered funds or an asset manager would far outweigh any potential
benefit in terms of reducing the risk that a banking entity may be
pressured to ``bail out'' a covered fund with a name similar to its
investment manager.\2149\ One commenter also requested clarification
that the name sharing prohibition does not apply in the context of
offering documents that carry the names of the manager, sponsor,
distributor, as well as the name of the fund itself.\2150\ This
commenter also advocated that, because of the costs associated with
changing a fund name, the Agencies give specific guidance regarding how
similar a name may be so as not to be a ``variation of the same name''
for purposes of the definition of sponsor and the activities permitted
under section 13(d)(1)(G) and Sec. ----.11 of the rule.
---------------------------------------------------------------------------
\2146\ A number of comments were also received regarding the
restriction on name sharing that is one of the requirements of
section 13(d)(1)(G) and Sec. ----.11 of the proposed rule. These
comments are discussed in Part IV.B.2.a.5. of this SUPPLEMENTARY
INFORMATION.
\2147\ See Credit Suisse (Williams); See also ABA (Keating);
BlackRock; Goldman (Covered Funds); SIFMA et al. (Covered Funds)
(Feb. 2012); TCW (proposing similarly to limit the name-sharing
restriction to the insured depository institution in context of
section 13(d)(1)(G)).
\2148\ See Goldman (Covered Funds).
\2149\ See Credit Suisse (Williams); See also Goldman (Covered
Funds).
\2150\ See Credit Suisse (Williams).
---------------------------------------------------------------------------
The Agencies have carefully considered comments received in light
of the terms of the statute. Section 13(h)(5) of the BHC Act
specifically defines the term ``sponsor'' for purposes of section 13.
The Agencies recognize that the broad definition of sponsor in the
statute will result in some of the effects commenters identified, as
discussed above.
The final rule generally retains the definition of ``sponsor'' in
the statute and the proposed rule, although with certain modifications
and clarifications to respond to comments received regarding the
exclusion for ``directed trustees.'' As in the proposed rule, the
definition of sponsor in the final rule covers an entity that (i)
serves as general partner, managing member, or trustee of a covered
fund, or that serves as a commodity pool operator of a covered fund as
defined in Sec. ----.10(b)(1)(ii) of the final rule, (ii) in any
manner selects or controls (or has employees, officers, or directors,
or agents who constitute) a majority of the directors, trustees, or
management of a covered fund, or (iii) shares with a covered fund, for
corporate, marketing, promotional, or other purposes, the same name or
a variation of the same name.\2151\
---------------------------------------------------------------------------
\2151\ See final rule Sec. ----.10(d)(9). Some commenters
asserted that custodians and service providers should not treated as
sponsors under the final rule. The Agencies note, however, that a
banking entity is not a sponsor under the final rule unless it
serves in one or more of the capacities specified in the definition;
controls or makes up the fund's board of directors or management as
described in the final rule; or shares the same name or a variation
of the same name with the fund as described in the final rule. See,
e.g., supra note 2151 and accompanying text. See also infra note
2155.
---------------------------------------------------------------------------
While commenters urged the Agencies to provide an exemption from
the definition of sponsor for a banking entity that selects the initial
directors, trustees, or management of a fund,\2152\ the final rule has
not been modified in this manner because the initial selection of the
directors, trustees or management of a fund is an action characteristic
of a sponsor and is essential to the creation of a covered fund. The
Agencies note, however, that the statute and the final rule allow
banking entities to sponsor covered funds, including selecting the
initial board of directors, trustees and management, so long as the
banking entity observes certain requirements and conforms any initial
investment in the covered fund to the limits in the statute and
regulation during the relevant conformance period as discussed in Part
IV.B.3.b. of this SUPPLEMENTARY INFORMATION.\2153\ Moreover, a banking
entity that does not continue to select or control a majority of the
board of directors would not be considered to be a sponsor under this
part of the definition once that role or control terminates. In the
case of a covered fund that will have a self-perpetuating board
[[Page 5713]]
of directors or a board selected by the fund's shareholders, this would
not be considered to have occurred until the board has held its first
re-selection of directors or first shareholder vote on directors
without selection or control by the banking entity.
---------------------------------------------------------------------------
\2152\ See supra note 2144 and accompanying text.
\2153\ Similarly, a banking entity may share the same name or a
variation of the same name with a covered fund so long as the
banking entity does not organize and offer the covered fund in
accordance with section 13(d)(1)(G) and Sec. ----.11.
---------------------------------------------------------------------------
As explained below, the Agencies believe that, in context, the term
trustee in the definition of the term sponsor refers to a trustee with
investment discretion. Consistent with this view, commenters urged the
Agencies to exclude from the definition of sponsor certain trustees and
parties commenters asserted acted in a similar capacity, as discussed
above.\2154\ The final rule therefore has been modified to exclude from
the definition of trustee: (i) a trustee that does not exercise
investment discretion with respect to a covered fund, including a
trustee that is subject to the direction of an unaffiliated named
fiduciary who is not a trustee pursuant to section 403(a)(1) of the
Employee's Retirement Income Security Act (29 U.S.C. 1103(a)(1)); or
(ii) a trustee that is subject to fiduciary standards imposed under
foreign law that are substantially equivalent to those described in
paragraph (i).\2155\ Under the final rule, a trustee would be excluded
if the trustee does not have any investment discretion, but is required
to ensure that the underlying assets are appropriately segregated for
the benefit of the trust. Similarly, a trustee would be excluded if the
trustee has no investment discretion but is authorized to replace an
investment adviser with an unaffiliated party when the investment
adviser resigns. With respect to an issuing entity of asset-backed
securities and as explained below, a directed trustee excluded from the
definition of sponsor would include a person that conducts their
actions solely in accordance with directions prepared by an
unaffiliated party.
---------------------------------------------------------------------------
\2154\ See, e.g., supra notes 2138-2139 and accompanying text.
See also supra note 2151.
\2155\ See final rule Sec. ----.10(d)(10). With respect to the
concept of a ``directed trustee'' under foreign law, commenters
generally requested changes only if non-U.S. mutual fund equivalents
were not excluded from the definition of covered fund. As discussed
above, the final rule explicitly excludes foreign public funds from
the definition of covered fund, which should address these
commenters concerns. See final rule Sec. ----.10(c)(1).
---------------------------------------------------------------------------
The Agencies believe that this exclusion is appropriate because the
relevant prong of the definition of sponsor (i.e., serving as general
partner, managing member, or trustee) specifies entities that have the
ongoing ability to exercise control over a fund; directed trustees
excluded from definition of sponsor in the final rule do not appear to
have this ability and thus do not appear to be the type of entity that
this prong of the definition of sponsor was intended to capture. If a
trustee were itself to assume the role of investment adviser, or have
the ability to exercise investment discretion with respect to the
covered fund, the trustee would not qualify for this exclusion. The
final rule does not include within the definition of sponsor custodians
or administrators of covered funds unless they otherwise meet the
definitional qualifications set forth in section 13 and the final rule.
The definition of sponsor will continue to cover entities that
share the same name or variation of the same name of a covered fund for
corporate, marketing, promotional, or other purposes, consistent with
the definition of sponsor in section 13(h)(5). The Agencies recognize
that some commenters urged the Agencies to modify this aspect of the
definition of sponsor, and that the name-sharing prohibition included
in the definition of sponsor (and in the conditions for the organize
and offer exemption) will require some banking entities to rebrand
their covered funds, which may prove expensive and will limit the
extent to which banking entities may continue to benefit from brand
equity they have developed.\2156\ The costs a banking entity would
incur to rebrand its covered funds would depend on the cost to rebrand
the banking entity's current funds, as well as the banking entity's
ability to attract new investor capital to its current and future
covered funds. The total burden per banking entity, therefore, would
depend on the brand equity as well as the number of covered funds that
share a similar name.\2157\ One commenter argued that, as a result,
banking entities subject to section 13 may be at a competitive
disadvantage to other firms that are not subject to these or similar
restrictions.\2158\ The Agencies believe that the final rule addresses
some commenters' concerns to an extent by adopting a more tailored
definition of covered, including a focused definition of foreign funds
that will be covered funds and an exclusion for foreign public
funds.\2159\ In addition, to the extent that a banking entity would
otherwise come under pressure for reputational reasons to directly or
indirectly assist a covered fund under distress that bears the banking
entity's name, the name-sharing prohibition could reduce the risk to
the banking entity this assistance could pose.
---------------------------------------------------------------------------
\2156\ See supra notes 2146-2150 and accompanying text.
\2157\ See infra note 2159.
\2158\ See supra note 2148 and accompanying text.
\2159\ For example, one commenter argued that it would need to
rebrand approximately 500 established funds under the rule proposal
if the final rule was not modified to exclude established and
regulated funds in foreign jurisdictions. See Goldman (Covered
Funds).
---------------------------------------------------------------------------
B. Definition of Sponsor With Respect to Securitizations
Commenters on the definition of sponsor in the context of
securitization vehicles generally argued that the proposed definition
of sponsor was too broad and requested clarification that various roles
that banking entities might serve within a securitization structure
would be excluded from the definition of sponsor, including servicers;
\2160\ backup servicers and master servicers; \2161\ collateral agents
and administrators; \2162\ custodians; \2163\ indenture trustees;
\2164\ underwriters, distributors, placement agents; \2165\ arrangers,
structuring agents; \2166\ originators, depositors, securitizers;
\2167\ ``sponsors'' under the SEC's Regulation AB; \2168\
administrative agents; \2169\ and securities administrators and
remarketing agents.\2170\ Commenters argued that these parties should
not be included in the definition of sponsor because such parties have
clearly defined and extremely limited authority and discretion,\2171\
do not have the right to control the decision-making and operational
functions of the issuer,\2172\
[[Page 5714]]
and would not have ``control'' under BHC Act control precedent.\2173\
Conversely, one commentator supported defining sponsor under the
proposed rule to include the Regulation AB sponsor, the servicer and
the investment manager.\2174\ Commenters also made arguments regarding
the potential detrimental effects to securitization and credit markets
if banking entities are prohibited from acting as sponsors of
securitizations.\2175\
---------------------------------------------------------------------------
\2160\ See Allen & Overy (on behalf of Foreign Bank Group); ASF
(Feb. 2012); Credit Suisse (Williams); SIFMA (Securitization) (Feb.
2012); Wells Fargo (Covered Funds). One of these commenters argued
that servicers will not have the right to control the decision-
making and operational functions of the issuer. See SIFMA
(Securitization) (Feb. 2012). Another commenter stated that
servicers do not have the authority to select assets or make
investment decisions on behalf of investors. See PNC.
\2161\ See ASF (Feb. 2012).
\2162\ Id.
\2163\ See Allen & Overy (on behalf of Foreign Bank Group); ASF
(Feb. 2012).
\2164\ Id.
\2165\ See Cleary Gottlieb; Credit Suisse (Williams); SIFMA
(Securitization) (Feb. 2012); Wells Fargo (Covered Funds). One of
these commentators argued that placement agents and underwriters
will not have the right to control the decision-making and
operational functions of the issuer. See SIFMA (Securitization)
(Feb. 2012).
\2166\ See Cleary Gottlieb (``party that structures the asset-
backed securities''); SIFMA (Securitization) (Feb. 2012).
\2167\ See Credit Suisse (Williams); Wells Fargo (Covered
Funds).
\2168\ See SIFMA (Securitization) (Feb. 2012) (arguing that
Regulation AB sponsors will not have the right to control the
decision-making and operational functions of the issuer after they
deposit the assets).
\2169\ See Credit Suisse (Williams).
\2170\ See ASF (Feb. 2012); Wells Fargo (Covered Funds).
\2171\ See Allen & Overy (on behalf of Foreign Bank Group).
\2172\ See SIFMA (Securitization) (Feb. 2012).
\2173\ See Credit Suisse (Williams).
\2174\ See Occupy.
\2175\ See ASF (Feb. 2012); Credit Suisse (Williams).
---------------------------------------------------------------------------
Commenters disagreed as to whether or not a sponsor under the final
rule should include a party with any investment discretion, some
investment discretion or complete investment discretion. Some
commenters argued that certain parties should not be considered a
sponsor because they were not an investment advisor or did not have
investment discretion.\2176\ Other commenters argued that an entity
should not be considered a sponsor even though it has limited
investment discretion,\2177\ while others argued that investment
advisers and parties with investment discretion should not be included
in the definition of sponsor.\2178\
---------------------------------------------------------------------------
\2176\ See ASF (Feb. 2012) (arguing that service providers,
including trustees, custodians, collateral agents, servicers, master
servicers, backup servicers, securities administrators, remarketing
agents and collateral administrators, should not be considered the
sponsor or investment manager of a fund under section 13 of the BHC
Act because they have roles that are principally ministerial in
nature and do not generally involve investment discretion or
management and control activities); PNC (arguing that a banking
entity should not be deemed a sponsor simply by serving as
underwriter, distributor, placement agent, originator, depositor,
investment adviser, servicer, administrative agent, securitizer or
similar role because these parties do not have the authority to
select assets or make investment decisions on behalf of investors).
\2177\ See Allen & Overy (on behalf of Foreign Bank Group); ASF
(Feb. 2012); SIFMA (Securitization) (Feb. 2012). One commenter
argued that the limited discretion that a servicer, trustee or
custodian may have to either invest funds within certain parameters,
liquidate assets following a default on the asset or the
securitization default, or mitigate losses subject to a servicing
standard, should not be considered a sponsor because these entities
do not exercise the level of management and control exercised by the
general partner or managing member of a hedge fund or private equity
fund. Another commenter argued that to the extent that any of these
parties exercises discretion, such discretion (A) involves decisions
made after another party defaults (e.g., post-event of default
collateral sale), (B) prescribed by the transaction documents (e.g.,
choosing among a limited number of eligible investments) and (C)
governed by standards of care (e.g., the servicing standards). See
ASF (Feb. 2012). Another commenter requested clarification that the
exclusion of trustees that do not exercise investment discretion
would also cover trustees that (A) direct investment of amounts in
accordance with the applicable transaction documents, (B) act as
servicer pending the appointment of a successor or (C) liquidate
collateral. See SIFMA (Securitization) (Feb. 2012). One commenter
argued that the definition of sponsor should not include an
investment manager unless the investment manager (A) serves in one
of the capacities designated in the definition of sponsor and can be
replaced at the discretion of one or more entities serving in such
capacity or with or without cause by the security holders or (B) has
the ``discretion to acquire or dispose of assets in the
securitization for the primary purpose of recognizing gains or
decreasing losses resulting from market value changes.'' Id.
\2178\ See Credit Suisse (Williams); SIFMA (Securitization)
(Feb. 2012); TCW (arguing that the investment manager is typically
unaffiliated with the general partner or equivalent of such fund,
does not control the board of directors, is not responsible for the
operations or books and records of the fund and generally does not
perform any other significant function for the fund, such as acting
as transfer agent).
---------------------------------------------------------------------------
After considering comments received and the language and purpose of
section 13, the Agencies have determined not to adopt a separate
definition of sponsor for issuers of covered funds that are issuers of
an asset-backed security. As described above and consistent with the
statute, the definition of sponsor only includes parties that: (i)
Serve as a general partner, managing member, or trustee (other than a
directed trustee) of a covered fund; (ii) have the right to select or
control a majority of the directors, trustees, or management of a
covered fund; or (iii) share with a covered fund, for corporate,
marketing, promotional, or other purposes, the same name or a variation
of the same name. If the parties that commenters described do not serve
in those capacities for a covered fund, do not have those rights with
respect to a covered fund or do not share a name with a covered fund,
such parties would not be a sponsor for purposes of the final rule,
and, therefore, they would not be subject to the restrictions
applicable to the sponsor of a covered fund, including the restrictions
contained in section 13(f).\2179\
---------------------------------------------------------------------------
\2179\ As discussed above, commenters argued that that various
roles that banking entities might serve within a securitization
structure should be excluded from the definition of sponsor. See
supra notes 2160-2170 and accompanying text.
---------------------------------------------------------------------------
Additionally, the Agencies believe that the exclusion of loan
securitizations from the definition of covered fund under the final
rule addresses many of the commenters' concerns about the sponsor
definition because this exclusion limits the types of securitizations
that are covered funds and subject to the final rule. Similarly, the
exclusion of certain ABCP conduits from the definition of covered fund
will mean that the restrictions under section 13(f) will not apply to
qualifying asset-backed commercial paper conduits.
As with any other covered fund under the final rule, the term
sponsor would include a trustee that has the right to exercise any
investment discretion for the securitization. For issuers of asset-
backed securities, this would generally not include a trustee that
executes decision-making, including investment of funds prior to the
occurrence of an event of default, solely according to the provisions
of a written contract or at the written direction of an unaffiliated
party. In addition, under the rule as adopted a trustee with investment
discretion may avoid characterization as a sponsor if it irrevocably
delegates all of its investment discretion to another unaffiliated
party with respect to the covered fund. The Agencies believe that these
considerations regarding when a trustee is a sponsor responds to
commenters' concerns regarding the roles of trustees in
securitizations.\2180\
---------------------------------------------------------------------------
\2180\ The Agencies also note that, while the entities
commenters identified may not fall into the definition of sponsor,
the ability of a banking entity to acquire and retain an interest in
a securitization that is a covered fund will depend on whether it
conducts its activity in a manner permitted under one of the
exemptions contained in section 13(d)(1) of the BHC Act, such as the
exemption for organizing and offering a covered fund.
---------------------------------------------------------------------------
2. Section ----.11: Activities Permitted in Connection With Organizing
and Offering a Covered Fund
Section 13(d)(1)(G) of the BHC Act permits a banking entity to make
investments in and sponsor covered funds within certain limits in
connection with organizing and offering the covered fund.\2181\ Section
----.11 of the final rule implements this statutory exemption, and
includes several changes from the proposed rule in response to concerns
raised by commenters as described in detail below.\2182\
---------------------------------------------------------------------------
\2181\ 156 Cong. Rec. S5889 (daily ed. July 15, 2010) (statement
of Sen. Hagan) (arguing that section 13 permits a banking entity to
engage in a certain level of traditional asset management business).
\2182\ See final rule Sec. ----.11; proposed rule Sec. --
--.11.
---------------------------------------------------------------------------
a. Scope of Exemption
Section ----.11 of the proposed rule described the conditions that
must be met in order to qualify for the exemption provided by section
13(d)(1)(G) for covered fund activities conducted in connection with
organizing and offering a covered fund.\2183\ These conditions
generally mirrored section 13(d)(1)(G) of the statute, and included:
(i) The banking entity must provide bona fide trust, fiduciary,
investment advisory, or commodity trading advisory services; \2184\
(ii) the covered fund must
[[Page 5715]]
be organized and offered only in connection with the provision of bona
fide trust, fiduciary, investment advisory, or commodity trading
advisory services and only to persons that are customers of such
services of the banking entity; (iii) the banking entity may not
acquire or retain an ownership interest in the covered fund except in
accordance with the limitations on amounts and value of those interests
as permitted under subpart C of the proposed rule; (iv) the banking
entity must comply with the restrictions governing relationships with
covered funds under Sec. ----.16 of the proposed rule; (v) the banking
entity may not, directly or indirectly, guarantee, assume, or otherwise
insure the obligations or performance of the covered fund or of any
covered fund in which such covered fund invests; (vi) the covered fund,
for corporate, marketing, promotional, or other purposes, may not share
the same name or a variation of the same name with the banking entity
(or an affiliate or subsidiary thereof), and may not use the word
``bank'' in its name; (vii) no director or employee of the banking
entity may take or retain an ownership interest in the covered fund,
except for any director or employee of the banking entity who is
directly engaged in providing investment advisory or other services to
the covered fund; (viii) the banking entity must clearly and
conspicuously disclose, in writing, to any prospective and actual
investor in the covered fund (such as through disclosure in the covered
fund's offering documents) the enumerated disclosures contained in
Sec. ----.11(h) of the proposed rule; and (ix) the banking entity must
comply with any additional rules of the appropriate Agency or Agencies,
designed to ensure that losses in such covered fund are borne solely by
investors in the covered fund and not by the banking entity.\2185\
---------------------------------------------------------------------------
\2183\ See proposed rule Sec. Sec. ----.11(a)-(h).
\2184\ While section 13(d)(1)(G) of the BHC Act does not
explicitly mention ``commodity trading advisory services,'' the
Agencies proposed to treat commodity trading advisory services in
the same way as investment advisory services because the proposed
rule would have included commodity pools within the definition of
``covered fund.'' One commenter argued that a covered banking entity
should not be permitted to qualify for the exemption in section
13(d)(1)(G) based on providing commodity trading advisory services.
See Occupy. The Agencies believe that commodity trading advisors
provide services to commodity pools that are similar to the services
an investment adviser provides to a hedge fund or private equity
fund. Because certain commodity pools are included within the
definition of covered fund, banking entities may organize and offer
these commodity pools as a means of providing these services to
customers.
\2185\ See proposed rule Sec. Sec. ----.11(a)-(h).
---------------------------------------------------------------------------
Commenters raised concern that the proposed rule could be read to
extend the prohibition on covered fund activities beyond the scope
intended by the statute.\2186\ Because the proposed exemption was
applicable to banking entities engaged in ``organizing and offering'' a
covered fund, commenters were concerned that the proposed rule might be
interpreted to prohibit a banking entity from engaging in activities
that are part of organizing and offering a covered fund but that are
not prohibited under the covered fund prohibition. In this regard,
commenters contended that the activity of ``organizing and offering'' a
covered fund would include serving as investment adviser, distributor,
broker, and other activities not prohibited by section 13 of the BHC
Act and not involving the acquisition or retention of an ownership
interest in or sponsorship of a covered fund as those terms are defined
in section 13.\2187\
---------------------------------------------------------------------------
\2186\ See, e.g., Arnold & Porter.
\2187\ See Arnold & Porter; F&C.
---------------------------------------------------------------------------
The Agencies have modified the final rule to address this concern,
which reflects a reading of the proposal not intended by the Agencies.
Section 13(d)(1)(G) of the BHC Act by its terms provides an exemption
from section 13(a) of the BHC Act, which prohibits a banking entity
from acquiring or retaining an equity, partnership or other ownership
interest in or sponsoring a covered fund. To the extent that an
activity is not prohibited by section 13(a), no exemption to that
statutory prohibition is needed to conduct that activity. However, it
is common for prohibited and non-prohibited activities to be conducted
together in connection with offering and organizing a covered fund. For
example, an entity that provides investment advisory services to a
covered fund (an activity not itself prohibited by section 13(a)(1)(B)
of the BHC Act) often acquires an ownership interest in a covered fund
and/or appoints a majority of management of the covered fund (which is
included in the definition of sponsor under the statute), both of which
are covered by the statutory prohibition in section 13(a)(1)(B). In
that case, the banking entity may engage in the prohibited activity as
part of organizing and offering a covered fund only if the prohibited
activity is conducted in accordance with the requirements in the
exemption in section 13(d)(1)(G) or some other exemption.
The final rule reflects this view in that it permits a banking
entity to invest in or sponsor a covered fund in connection with
organizing and offering the fund, which may involve activities that are
not prohibited by section 13. Under the final rule, a banking entity
that serves as an investment adviser to a covered fund (including a
sub-adviser), for example, may permissibly invest in the covered fund
to the extent the banking entity complies with the requirements of
section 13(d)(1)(G) of the Act. An entity that serves only as
investment adviser, without making any investment or conducting any
activity covered by the prohibition in section 13(a), would not be
covered by the prohibition in section 13(a) and thus would not need to
rely on section 13(d)(1)(G) and Sec. ----.11 of the final rule to
conduct that investment advisory activity.
As described in more detail below, a number of commenters expressed
concern about applying the requirements of section 13(d)(1)(G) and the
final rule outside of the United States, including with respect to
foreign public funds organized and offered by foreign banking entities,
particularly in situations where requirements in foreign jurisdictions
may conflict with the requirements of section 13 of the BHC Act and
implementing regulations.\2188\ The Agencies believe that many of the
concerns raised with respect to applying section 13(d)(1)(G) and the
proposed rule outside the United States have been addressed through the
revised definition of covered fund described above and revisions to the
exemption provided for activities conducted solely outside the United
States. In particular, the revised definition of covered fund makes
clear that a foreign fund offered outside the United States is only a
covered fund under specified circumstances with respect to a banking
entity that is, or is controlled directly or indirectly by a banking
entity that is, located in or organized or established under the laws
of the United States or of any State.\2189\ Furthermore, foreign public
funds are excluded from the definition of covered fund in the final
rule.\2190\ Consequently, a foreign banking entity may invest in or
organize and offer a variety of funds outside of the United States
without becoming subject to the requirements of section 13(d)(1)(G) and
Sec. ----.11 of the final rule, such as the name-sharing restriction
or limitations on director and employee investments.
---------------------------------------------------------------------------
\2188\ See, e.g., EFAMA; ICI Global; JPMC.
\2189\ See final rule Sec. ----.10(b)(1)(iii).
\2190\ See final rule Sec. ----.10(c)(1).
---------------------------------------------------------------------------
1. Fiduciary Services
In order to qualify for the exemption for activities related to
organizing and offering a covered fund, section 13(d)(1)(G) generally
requires that a banking entity provide bona fide trust, fiduciary,
investment advisory, or
[[Page 5716]]
commodity trading advisory services, that the covered fund be organized
and offered in connection with providing these services, and that the
banking entity providing those services offer the covered fund only to
persons that are customers of those services of the banking
entity.\2191\ These requirements were largely mirrored in the proposed
rule. Requiring a customer relationship in connection with organizing
and offering a covered fund helps to ensure that a banking entity is
engaging in the covered fund activity for others and not on the banking
entity's own behalf.\2192\
---------------------------------------------------------------------------
\2191\ See 12 U.S.C. 1851(d)(1)(G)(i); proposed rule Sec. --
--.11(a).
\2192\ See 156 Cong. Rec. at S5897 (daily ed. July 15, 2010)
(statement of Sen. Merkley).
---------------------------------------------------------------------------
As noted in the proposal, section 13(d)(1)(G)(ii) of the BHC Act
does not explicitly require that the customer relationship be pre-
existing. Accordingly, the Agencies explained in the proposal that the
customer relationship may be established through or in connection with
the banking entity's organization and offering of a covered fund, so
long as that fund is a manifestation of the provision by the banking
entity of bona fide trust, fiduciary, investment advisory, or commodity
trading advisory services to the customer. This application of the
customer requirement is consistent with the manner in which these
services are provided by banking entities. The proposed rule also
required that a banking entity relying on the authority contained in
Sec. ----.11 adopt a credible plan or similar documentation outlining
how the banking entity intended to provide advisory or similar services
to its customers through organizing and offering such fund.
Several commenters indicated support for this customer requirement
and, in particular, the Agencies' view that the customer relationship
need not be a preexisting one.\2193\ A few commenters contended that
the statute required that a banking entity have a pre-existing customer
relationship, and may not solicit investors outside of its existing
asset management customers.\2194\ One of these commenters argued that
this would place banking entities at a competitive disadvantage
compared to investment advisers that are not banking entities (and thus
not subject to the requirements of section 13 and the final rule), but
argued that this is a necessary result of section 13.\2195\
---------------------------------------------------------------------------
\2193\ See Ass'n of Institutional Investors (Feb. 2012); SIFMA
et al. (Covered Funds) (Feb. 2012); JPMC.
\2194\ See Sens. Merkley & Levin (Feb. 2012); AFR et al. (Feb.
2012); Occupy; Public Citizen.
\2195\ See Sens. Merkley & Levin.
---------------------------------------------------------------------------
The final rule adopts the language largely as proposed, and the
Agencies continue to believe that the customer relationship required
under section 13(d)(1)(G) and the final rule may be established through
or in connection with the banking entity's organization and offering of
a covered fund, so long as that fund is a manifestation of the
provision by the banking entity of bona fide trust, fiduciary,
investment advisory, or commodity trading advisory services to the
customer.\2196\ The final rule requires that a covered fund be
organized and offered pursuant to a written plan or similar
documentation outlining how the banking entity (or an affiliate
thereof) intends to provide advisory or similar services to its
customers through organizing and offering the fund. As part of this
requirement, the plan must be credible and indicate that the banking
entity has conducted reasonable analysis to show that the fund is
organized and offered for the purpose of providing bona fide trust,
fiduciary, investment advisory, or commodity trading advisory services
to customers of the banking entity (or an affiliate thereof) and not to
evade the restrictions of section 13 of the BHC Act.
---------------------------------------------------------------------------
\2196\ See final rule Sec. ----.11(a)(1)-(2). See Part
IV.B.2.b. below for a discussion of these requirements in the
context of a banking entity that organizes and offers a covered fund
that is an issuing entity of asset-backed securities.
---------------------------------------------------------------------------
The language of the final rule also adopts the statutory
requirements (and modifications related to commodity pools as discussed
above) that the banking entity provide bona fide trust, fiduciary,
investment advisory, or commodity trading advisory services, and that
the covered fund be organized and offered only in connection with the
provision of those services. Banking entities provide a wide range of
customer-oriented services which may qualify as bona fide trust,
fiduciary, investment advisory, or commodity trading advisory
services.\2197\ Historically, banking entities have used covered funds
as a method of providing these services to customers in a manner that
is both cost efficient for the customer and allows customers to benefit
from access to advice and services that might not otherwise be
available to them. These benefits apply to long-established customers
as well as individuals or entities that have no pre-existing
relationship with the banking entity but choose to obtain the benefit
of trust, fiduciary, investment advisory, or commodity trading advisory
services through participation in the covered fund. Covered funds also
allow customers to gauge the historical record of the banking entity in
providing these services by reviewing the funds' past performance.
---------------------------------------------------------------------------
\2197\ See, e.g., 12 U.S.C. 1843(c)(4), (c)(8), (K), 12 CFR
225.28(b)(5) and (6), 12 CFR 225.86, 12 CFR 225.125 (with respect to
a bank holding company); 12 U.S.C. 24 (Seventh), 92a, 12 CFR Part 9
(with respect to a national bank); 12 U.S.C. Part 362 (with respect
to a state non-member bank).
---------------------------------------------------------------------------
The statute does not require that a covered fund be offered only to
pre-existing customers of the banking entity, and the Agencies believe
that imposing such a requirement would not improve the quality of the
trust, fiduciary, investment advisory, or commodity trading advisory
service, enhance the safety and soundness of the banking entity, or
reduce the risks to the customers or the banking entity. In each case,
the banking entity provides trust, fiduciary or advisory services to a
covered fund for the benefit of the banking entity's customers, and the
statute recognizes that organizing and offering a covered fund is a
legitimate method for providing that service. In addition, the banking
entity must abide by all the statutory and prudential requirements
imposed by section 13 and the entity's supervisors on the provision of
those services. The Agencies do not believe that a pre-existing
customer relationship requirement would be meaningful because it could
easily be satisfied by a prospective customer seeking to invest in a
covered fund by first establishing an account with a banking entity or
purchasing another product (e.g., a brokerage account or shares of a
mutual fund).
2. Compliance With Investment Limitations
Section 13(d)(1)(G)(iii) of the BHC Act limits the ability of a
banking entity that organizes and offers a covered fund to acquire or
retain an ownership interest in that covered fund as an
investment.\2198\ Both the proposed rule and the final rule implement
this provision by requiring that a banking entity limit its investments
in a covered fund that the banking entity organizes and offers as
provided in Sec. ----.12.\2199\ Comments received on investment
limitations in the proposed rule, and modifications made to the final
rule implementing these limitations, are described in Part IV.B.3.
below.
---------------------------------------------------------------------------
\2198\ See 12 U.S.C. 1851(d)(1)(G)(iii).
\2199\ See proposed rule and final rule Sec. ----.12.
---------------------------------------------------------------------------
3. Compliance With Section 13(f) of the BHC Act
Section ----.11(d) of the proposed rule required that the banking
entity comply with the limitations on
[[Page 5717]]
relationships with covered funds imposed by section 13(f) of the BHC
Act.\2200\ The final rule adopts this requirement and provides that the
banking entity (and its affiliates) must comply with the requirements
of Sec. ----.14. Section 13(f) of the BHC Act prohibits certain
transactions or relationships that would be covered by section 23A of
the Federal Reserve Act, and provides that any permitted transaction is
subject to section 23B of the Federal Reserve Act, in each instance as
if such banking entity were a member bank and such covered fund were an
affiliate thereof.\2201\ These limitations apply in several contexts,
and are contained in Sec. ----.14 of the final rule, discussed in
detail below in Part IV.B.5.
---------------------------------------------------------------------------
\2200\ 12 U.S.C. 1851(d)(1)(G)(iv); proposed rule Sec. --
--.11(d).
\2201\ See Part IV.B.5. below. The comments received on section
13(f) and Sec. ----.16 of the proposed rule are described below.
---------------------------------------------------------------------------
4. No Guarantees or Insurance of Fund Performance
Section ----.11(e) of the proposed rule prohibited a banking entity
that organizes and offers a covered fund from, directly or indirectly,
guaranteeing, assuming or otherwise insuring the obligations or
performance of the covered fund or any covered fund in which such
covered fund invests.\2202\ This prong implemented section
13(d)(1)(G)(iv) of the BHC Act and was intended to prevent a banking
entity from engaging in bailouts of a covered fund in which the banking
entity has an interest.\2203\
---------------------------------------------------------------------------
\2202\ 12 U.S.C. 1851(d)(1)(G)(v); proposed rule Sec. --
--.11(e).
\2203\ See 156 Cong. Rec. S5897 (daily ed. July 15, 2010)
(statement of Sen. Merkley).
---------------------------------------------------------------------------
There were only a few comments received on this aspect of the
proposal. One commenter supported the restriction on guarantees as
effective and consistent with the statute.\2204\
---------------------------------------------------------------------------
\2204\ See Occupy.
---------------------------------------------------------------------------
One commenter argued that the final rule should not prohibit
borrower default indemnification services (i.e., the guarantee of
collateral sufficiency upon a securities borrower's default) provided
to lending clients by agent banks in connection with securities lending
transactions involving a covered fund.\2205\ This commenter argued that
borrower default indemnification services guarantee only the deficit
between the mark to market value of cash collateral received and the
amount of any borrower default, and are therefore different from and
more limited than the type of general investment performance or
obligation guarantee that section 13 was designed to prevent.
---------------------------------------------------------------------------
\2205\ See RMA.
---------------------------------------------------------------------------
The Agencies believe that the statute does not permit either full
or partial guarantees of the obligations of a covered fund that the
banking entity organizes and offers. Accordingly, the final rule, like
the proposed rule, continues to mirror the statutory restriction on
direct or indirect guarantees of the obligations or performance of a
covered fund by a banking entity in connection with reliance on the
exemption provided in section 13(d)(1)(G) of the BHC Act. However, in
response to comments received on the proposal, the Agencies note that
the provision of a borrower default indemnification by a banking entity
to a lending client in connection with securities lending transactions
involving a covered fund is not prohibited. This type of
indemnification is not a guarantee of the performance or obligations of
a covered fund because it represents a guarantee to the customer or
borrower of the obligation of the counterparty to perform and not a
guarantee of the performance or underlying obligations of the covered
fund. The requirement of the final rule that a banking entity and its
affiliates not guarantee the obligations or performance of a covered
fund that it organizes and offers therefore does not prohibit a banking
entity from providing borrower default indemnifications to customers.
5. Limitation on Name Sharing With a Covered Fund
Section ----.11(f) of the proposed rule prohibited the covered fund
from sharing the same name or a variation of the same name with the
banking entity that relies on the exemption in section 13(d)(1)(G) of
the BHC Act.\2206\ The proposed rule also prohibited the covered fund
from using the word ``bank'' in its name.\2207\
---------------------------------------------------------------------------
\2206\ 12 U.S.C. 1851(d)(1)(G)(vi); proposed rule Sec. --
--.11(f).
\2207\ Similar restrictions on a fund sharing the same name, or
variation of the same name, with an insured depository institution
or company that controls an insured depository institution or having
the word ``bank'' in its name, have been used previously in order to
prevent customer confusion regarding the relationship between such
companies and a fund. See, e.g., Bank of Ireland, 82 Fed. Res. Bull.
1129 (1996).
---------------------------------------------------------------------------
The name-sharing restriction was one of the most commented upon
aspects of Sec. ----.11. A number of commenters on this section
expressed the view that the name-sharing restriction in section
13(d)(1)(G)(vi) of the BHC Act and the proposed rule was too strict. In
particular, a number of commenters argued that the name-sharing
restriction should allow an asset manager to share its name with a
sponsored covered fund so long as the covered fund does not share the
name of the insured depository institution or its affiliated holding
company or use the word ``bank.'' \2208\
---------------------------------------------------------------------------
\2208\ See ABA (Keating); Ass'n of Institutional Investors (Feb.
2012); Blackrock; EFAMA; SIFMA et al. (Covered Funds) (Feb. 2012);
TCW; Katten (on behalf of Int'l Clients); Union Asset.
---------------------------------------------------------------------------
Commenters argued that the name-sharing restriction as proposed
would impose significant business and branding burdens on the industry
without providing incremental benefit to the public.\2209\ These
commenters argued that it would be unduly burdensome and costly for
funds currently affiliated with banking entities or managers that are
themselves banking entities to change the name of their affiliated
funds and that many of these funds have developed a reputation in the
marketplace based on the current name of the fund and/or fund manager.
Some of these commenters argued that the name-sharing restriction would
place asset managers and funds affiliated with banking entities at a
competitive disadvantage to other asset managers and funds.\2210\
---------------------------------------------------------------------------
\2209\ See, e.g., ABA (Keating); Ass'n of Institutional
Investors (Feb. 2012); Blackrock; See also SVB; Katten (on behalf of
Int'l Clients); SIFMA et al. (Covered Funds) (Feb. 2012); UBS.
\2210\ See Ass'n of Institutional Investors (Feb. 2012); Katten
(on behalf of Int'l Clients); SIFMA et al. (Covered Funds) (Feb.
2012).
---------------------------------------------------------------------------
A few commenters argued that the rationale for the name-sharing
restriction (i.e., to discourage bailing out funds) was already
addressed under other restrictions of section 13(d)(1)(G) and the
proposed rule that prohibit a banking entity from, directly or
indirectly, guaranteeing, assuming or otherwise insuring the
obligations or performance of the covered fund or of any covered fund
in which such covered fund invested and that require disclosure that
investments in the covered fund are not insured by the Federal Deposit
Insurance Corporation.\2211\ These commenters questioned the necessity
for the name-sharing restriction when a prohibition on bailing out
funds is already in place and where there is disclosure that investors
bear the risk of loss in the fund. Some of these commenters contended
it was unlikely that investors in a covered fund with an SEC-registered
investment adviser that has a name unrelated to the name of an insured
depository institution would be
[[Page 5718]]
misled to believe that the fund would be backed in any way by a related
insured depository institution or the Federal Deposit Insurance
Corporation.\2212\ One of these commenters argued that the name-sharing
restriction should not apply to organizations where insured depository
institutions represent a de minimis component of the organization's
operations.\2213\
---------------------------------------------------------------------------
\2211\ See Ass'n of Institutional Investors (Feb. 2012); SIFMA
et al. (Covered Funds) (Feb. 2012); T. Rowe Price; TCW.
\2212\ See TCW; Union Asset.
\2213\ See T. Rowe Price.
---------------------------------------------------------------------------
Other commenters recommended that the name-sharing restriction not
be applied to covered funds that rely on the exemption for covered fund
activities and investments that occur solely outside of the United
States.\2214\ A few commenters expressed concern that the name-sharing
restriction could be incompatible with regulatory requirements in
certain foreign jurisdictions that a covered fund's name must indicate
the fund's connection with the fund sponsor.\2215\ One commenter argued
that it is common practice in Germany to disclose the designation of
the sponsoring investment manager in the fund name in order to provide
transparency to investors, while a few commenters contended that
European jurisdictions, including the U.K., require an authorized fund
to have a name representative of the authorized investment manager to
avoid misleading fund investors.\2216\ Commenters also argued that the
name-sharing restriction was inconsistent with the laws of Ireland and
Hong Kong.\2217\ Certain commenters argued that the impact of the name-
sharing restriction would be particularly unfair to non-U.S. retail
funds like European UCITS if such funds are not allowed to use the name
of the bank while U.S. mutual funds would not be subject to the same
restriction.\2218\
---------------------------------------------------------------------------
\2214\ See, e.g., UBS.
\2215\ See Credit Suisse (Williams); EFAMA; JPMC; Katten (on
behalf of Int'l Clients); Union Asset; IAA; ICI Global; UBS; SIFMA
et al. (Covered Funds) (Feb. 2012) (citing Directive 2004/39/EC of
the European Parliament and Council).
\2216\ See BVI; EFAMA; JPMC; UBS; Union Asset; ICI Global; IAA.
\2217\ See UBS; Union Asset; ICI Global.
\2218\ See, e.g., AFG; ICI Global; JPMC.
---------------------------------------------------------------------------
By contrast, some commenters supported the name-sharing
restriction. For example, one commenter indicated that the use of the
word ``bank'' or a shared name in the fund's name was already strongly
discouraged by prior guidance.\2219\ Another commenter supported the
name-sharing restriction but argued it did not go far enough because it
did not apply to funds that a banking entity was permissibly allowed to
sponsor and invest in under other provisions of section 13.\2220\
According to this commenter, covered funds permitted under other
exemptions should not be allowed to share the same name with the
banking entity.\2221\
---------------------------------------------------------------------------
\2219\ See Arnold & Porter (citing SEC Division of Investment
Management, Letter to Registrants (May 13, 1993); Memorandum to SEC
Chairman Breeden from Division of Investment Management (May 6,
1993); FDIC, Board, OCC, OTS, Interagency Statement on Retail Sales
of Non-Deposit Investment Products (Feb. 14, 1994)).
\2220\ See Occupy the SEC at 165.
\2221\ See id.
---------------------------------------------------------------------------
After carefully considering comments and the express terms of the
statute, the final rule includes the name-sharing restriction as
proposed.\2222\ The name-sharing restriction is imposed by the statute
and prohibits a banking entity from sharing the same name or variation
of the same name with a covered fund. The statute also defines the
scope of the prohibition by defining the term ``banking entity'' to
generally include any affiliate or subsidiary of an insured depository
institution or any company that controls an insured depository
institution.\2223\
---------------------------------------------------------------------------
\2222\ See final rule Sec. ----.11(f).
\2223\ See 12 U.S.C. 1851(d)(1)(G)(vi) & (h)(1).
---------------------------------------------------------------------------
However, the Agencies believe that many of the concerns raised by
commenters with respect to this provision should be addressed through
the revised definition of covered fund in the final rule, and
modifications to the exemption for covered fund activities and
investments that occur solely outside of the United States.\2224\ For
example, as discussed in greater detail above in Part IV.B.1.c.1.,
foreign public funds sold outside the United States are excluded from
the definition of covered fund.\2225\ In addition, pursuant to the
definition of covered fund in the final rule, a foreign fund only
becomes a covered fund with respect to a U.S. banking entity (including
a foreign affiliate of that U.S. banking entity) that acts as sponsor
to, or has an ownership interest in, the fund. Moreover, numerous funds
operate successfully with names that differ from the name of the fund
sponsor or adviser.
---------------------------------------------------------------------------
\2224\ For example, one commenter alleged that it would need to
rebrand approximately 500 established funds if the final rule was
not modified to exclude established and regulated funds in foreign
jurisdictions. See Goldman (Covered Funds).
\2225\ See final rule Sec. Sec. ----.10(b)(1)(ii) & (c)(1).
---------------------------------------------------------------------------
The Agencies recognize, however, that the statutory name-sharing
restriction may affect some entities that will be covered funds and
that cannot rely on another permitted activity exemption under section
13(d)(1) and the final rule. The name-sharing restriction may result in
certain costs and other economic burdens for banking entities that
advise these funds, as discussed in greater detail in Part IV.B.1.g.
above.\2226\ However, as the Agencies also note above, to the extent
that the restriction results in a banking entity not otherwise coming
under pressure for reputational reasons to directly or indirectly
assist a covered fund under distress that shares the banking entity's
name, the name-sharing prohibition could reduce the risk to the banking
entity that this assistance might pose. The Agencies also expect that
the conformance period, both for compliance with section 13 of the BHC
Act generally and for funds that are illiquid funds, should be
sufficient to allow covered funds to take the steps necessary to comply
with the name-sharing restriction in the statute and final rule.
---------------------------------------------------------------------------
\2226\ See Part IV.B.1.g.
---------------------------------------------------------------------------
6. Limitation on Ownership by Directors and Employees
Section ----.11(g) of the proposed rule implemented section
13(d)(1)(G)(vii) of the BHC Act. That statutory provision prohibits any
director or employee of the banking entity from acquiring or retaining
an ownership interest in the covered fund, except for any director or
employee of the banking entity who is directly engaged in providing
investment advisory or other services to the covered fund.\2227\ This
allows an individual employed by a banking entity, who also acts as
fund manager or adviser (for example), to acquire or retain an
ownership interest in a covered fund that aligns the manager or
adviser's incentives with those of the banking entity's
customers.\2228\
---------------------------------------------------------------------------
\2227\ See 12 U.S.C. 1851(d)(1)(G)(vii); proposed rule Sec. --
--.11(g).
\2228\ See 156 Cong. Rec. S5897 (daily ed. July 15, 2010)
(statement of Sen. Merkley).
---------------------------------------------------------------------------
One commenter argued that only employees or directors who provide
investment advisory services should be allowed to make an investment in
the fund and that the rule should not allow employees or directors who
provide other, unspecified services to invest in a fund.\2229\ This
commenter argued that the proposed rule would allow non-adviser banking
entity employees who have no need to maintain ``skin in the game'' to
earn profit on the fund's performance. According to another commenter,
fiduciary clients of banking organizations often are less interested in
whether the fund manager or other service providers have money in the
fund than whether the client's own account manager, and those
individuals
[[Page 5719]]
above him/her who are responsible for investment decisions, have
allocated his or her own assets in the same way and into the same
general asset classes and funds as the client's fiduciary account is
being allocated.\2230\
---------------------------------------------------------------------------
\2229\ See Occupy.
\2230\ See Arnold & Porter.
---------------------------------------------------------------------------
The more prevalent view among commenters was that the proposed rule
should be revised and expanded to permit investments in a sponsored
fund by a broader group of banking entity directors, officers, and
employees, directly or indirectly through employee benefit programs or
trust and fiduciary accounts, regardless of whether the individual
provides services to the covered fund.\2231\ Some commenters argued
that narrowly limiting permissible director and employee investments
could put asset managers affiliated with an insured depository
institution at a competitive disadvantage relative to managers that are
not affiliated with an insured depository institution,\2232\ as well as
make it more difficult for banking entities to offer their U.S. and
non-U.S. employees similar choices in retirement plans.\2233\
---------------------------------------------------------------------------
\2231\ See Arnold & Porter; BOK, Credit Suisse (Williams); Fin.
Services Roundtable (Jun. 14, 2011); PEGCC; T. Rowe Price.
\2232\ See Credit Suisse (Williams).
\2233\ See T. Rowe Price.
---------------------------------------------------------------------------
Two commenters urged that the supervisors of a fund's portfolio
managers or investment advisers should be permitted to invest.\2234\
These commenters also argued that individuals who provide support
services to the fund, including administrative, oversight and risk
management, legal compliance, regulatory, product structuring, deal
sourcing and origination, deal evaluation and diligence, investor
relations, sales and marketing, tax, accounting, valuation and other
operational support services, should be permitted to invest in the
fund. These commenters also requested confirmation that any director,
including an individual serving on the board or investment committee of
a fund or its manager, should be permitted to invest.\2235\ Another
commenter argued that employees and directors should be permitted to
make their own individual investment decisions independently without
regard to whether they provide services to the covered fund.\2236\ One
commenter contended that a grandfathering approach is necessary to
address situations where a pre-existing covered fund already has
investments from directors and employees who do not directly provide
services to the fund because the fund may be unable to force those
individuals out of the fund.\2237\
---------------------------------------------------------------------------
\2234\ See Credit Suisse (Williams); Fin. Services Roundtable
(Jun. 14, 2011).
\2235\ See Credit Suisse (Williams); Fin. Services Roundtable
(Jun. 14, 2011).
\2236\ See BOK (citing proposed rule at Sec. ----.17); Arnold &
Porter.
\2237\ See SVB.
---------------------------------------------------------------------------
A number of commenters argued that, if defined too narrowly, this
restriction may conflict with the laws of other jurisdictions that
require advisers and/or their directors and employees to invest in the
funds they manage.\2238\ For example, several commenters argued that
this requirement will directly conflict with the European Alternative
Investment Fund Managers Directive.\2239\ Two commenters contended that
certain jurisdictions, including the Netherlands, require directors and
other personnel of fund managers to hold fund units or shares of funds
managed by the fund manager as part of their pensions.\2240\
---------------------------------------------------------------------------
\2238\ See EFAMA; BVI; IAA; ICI Global; JPMC; Union Asset.
\2239\ See Annex II para. 1(m). Directive 2011/61/EU of the
European Parliament and the Council of 8 June 2011 on Alternative
Investment Fund Managers.
\2240\ See EFAMA; Union Asset.
---------------------------------------------------------------------------
The final rule retains the requirement limiting the ownership of a
covered fund by directors and employees of a banking entity (or an
affiliate thereof) relying on the exemption in section 13(d)(1)(G) of
the BHC Act.\2241\ This limitation is imposed by statute on banking
entities that rely on this exemption. If a director or employee does
not provide services to the fund, they may not invest in that fund. As
in the statute, the final rule allows employees who provide services to
the fund other than investment advisory services to invest in the fund.
Under the final rule, directors or employees who provide investment
advice or investment management services to the fund may invest in that
fund. Similarly, directors or employees who provide services that
enable the provision of investment advice or investment management,
such as oversight and risk management, deal origination, due diligence,
administrative or other support services, may also invest in the fund.
In response to comments, the final rule has been modified to make clear
that a former director or employee may retain an interest in a covered
fund if the director or employee acquired the interest while serving as
a director or employee of the banking entity and providing investment
advisory or other services to the covered fund.
---------------------------------------------------------------------------
\2241\ See final rule Sec. ----.11(g).
---------------------------------------------------------------------------
The Agencies believe that many of the concerns raised by commenters
regarding the effects of this limitation on foreign funds are addressed
through the scope of foreign funds that will be covered funds, and
revisions to the exemption provided for covered fund activities and
investments that occur solely outside of the United States. Moreover,
the final rule excludes foreign public funds and broad-based foreign
pension funds from the definition of covered fund and they are thus not
subject to the restrictions of section 13 or the final rule.\2242\
---------------------------------------------------------------------------
\2242\ See final rule Sec. Sec. ----.10(c)(1) and --
--.10(c)(5).
---------------------------------------------------------------------------
Section 13 clearly contemplates investments by certain employees
and directors of the banking entity.\2243\ However, the Agencies
continue to believe that certain director or employee investments in a
covered fund may provide an opportunity for a banking entity to evade
the limitations regarding the amount or value of ownership interests a
banking entity may acquire or retain in a covered fund or funds
contained in section 13(d)(4) of the BHC Act and the final rule. In
order to address this concern, the final rule attributes an ownership
interest in a covered fund acquired or retained by a director or
employee to a banking entity for purposes of the investment limits in
section 13(d)(4) under certain circumstances. This attribution is
discussed in detail below in Part IV.B.3.f.
---------------------------------------------------------------------------
\2243\ See 12 U.S.C. 1851(d)(1)(G)(vii).
---------------------------------------------------------------------------
7. Disclosure Requirements
Section ----.11(h) of the proposed rule required that, in
connection with organizing and offering a covered fund, the banking
entity clearly and conspicuously disclose, in writing, to prospective
and actual investors in the covered fund that any losses in the covered
fund will be borne solely by investors in the covered fund and not by
the banking entity and its affiliates or subsidiaries; and that the
banking entity's and its affiliates' or subsidiaries' losses in the
covered fund will be limited to losses attributable to the ownership
interests in the covered fund held by the banking entity and its
affiliates or subsidiaries in their capacity as investors in the
covered fund. In addition, the proposed rule required that a banking
entity disclose, in writing: (i) That each investor should read the
fund offering documents before investing in the covered fund; (ii) that
the ownership interests in the covered fund are not insured by the
FDIC, and are not deposits, obligations of, or
[[Page 5720]]
endorsed or guaranteed in any way, by any banking entity (unless that
happens to be the case); and (iii) the role of the banking entity and
its affiliates, subsidiaries, and employees in sponsoring or providing
any services to the covered fund. The proposed rule also required
banking entities to comply with any additional rules of the appropriate
Agency designed to ensure that losses in any covered fund are borne
solely by the investors in the covered fund and not by the banking
entity.\2244\ In proposing the rule, the Agencies indicated that a
banking entity may satisfy these disclosure requirements by making the
required disclosures in the covered fund's offering documents.\2245\
---------------------------------------------------------------------------
\2244\ 12 U.S.C. 1851(d)(1)(G)(viii); proposed rule Sec. --
--.11(h).
\2245\ To the extent that any additional rules are issued to
ensure that losses in a covered fund are borne solely by the
investors in the covered fund and not by the banking entity, a
banking entity would be required to comply with those as well in
order to satisfy the requirements of section 13(d)(1)(G)(viii) of
the BHC Act.
---------------------------------------------------------------------------
A few commenters supported the disclosure requirement as effective
and consistent with the statute.\2246\ One commenter stated that the
disclosures required in section 13(d)(1)(G)(viii) of the Act and the
proposed rule are consistent with disclosures in the banking agencies'
February 1994 ``Interagency Statement on Retail Sales of Non-deposit
Investment Products'' and other FINRA and SEC guidance.\2247\ One
commenter suggested that the rule include a requirement that the
disclosures be issued in plain English.\2248\
---------------------------------------------------------------------------
\2246\ See, e.g., Occupy.
\2247\ See Arnold& Porter.
\2248\ See Occupy.
---------------------------------------------------------------------------
Another commenter argued that the Agencies should revise the
disclosure requirements under the proposal so that offering materials
of non-U.S. funds provided to non-U.S. investors outside the United
States need not include the specified disclosures nor refer to the FDIC
or other specific U.S. agencies.\2249\ This commenter argued that a
non-U.S. person investing in a non-U.S. fund offered or sponsored by a
non-U.S. banking entity has no expectation that the fund or its
interests would be insured by the FDIC. The Agencies believe this
concern is addressed through the revised definition of covered fund,
which generally provides that a foreign fund offered outside of the
United States will only be a covered fund with respect to a U.S.
banking entity (including a foreign affiliate of the U.S. banking
entity) that acts as sponsor to, or invests in, the fund.\2250\
---------------------------------------------------------------------------
\2249\ See Katten (on behalf of Int'l Clients).
\2250\ See final rule Sec. ----.10(b)(1)(iii).
---------------------------------------------------------------------------
The final rule adopts the proposed disclosure requirements
substantially as proposed. As explained above, these disclosures are
largely required by the statute.\2251\ The proposed requirement to
disclose that ownership interests in a covered fund are not insured by
the FDIC, and are not deposits, obligations of, or endorsed or
guaranteed in any way, by any banking entity (unless that happens to be
the case) is not expressly required by the statute. However, section
13(d)(1)(G)(iii) permits the Agencies to impose additional rules
designed to ensure that losses in a covered fund are borne solely by
investors in the fund and not by a banking entity. The Agencies believe
that requiring a banking entity to make this disclosure as part of
organizing and offering a covered fund furthers this purpose by
removing the potential for misperception that a covered fund sponsored
by a banking entity (which by definition must be affiliated with a
depository institution insured by the FDIC) is guaranteed by that
insured institution or the FDIC. Moreover, as noted above, this
disclosure is already commonly provided by banking entities.
---------------------------------------------------------------------------
\2251\ See 12 U.S.C. 1851(d)(1)(G)(viii).
---------------------------------------------------------------------------
b. Organizing and Offering an Issuing Entity of Asset-Backed Securities
To the extent that an issuing entity of asset-backed securities is
a covered fund, the investment limitations contained in section
13(d)(4) of the BHC Act also would limit the ability of a banking
entity to acquire or retain an investment in that issuer. Section 941
of the Dodd-Frank Act added a new section 15G of the Exchange Act (15
U.S.C. 78o-11) which requires a banking entity to retain and maintain a
certain minimum interest in certain asset-backed securities.\2252\ In
order to give effect to this separate requirement under the Dodd-Frank
Act, Sec. ----.14(a)(2) of the proposed rule permitted a banking
entity that is a ``securitizer'' or ``originator'' under the provisions
of that Act to acquire or retain an ownership interest in an issuer of
asset-backed securities, in an amount (or value of economic interest)
required to comply with the minimum requirements of section 15G of the
Exchange Act and any implementing regulations issued thereunder.\2253\
The proposal also permitted a banking entity to act as sponsor to the
securitization.
---------------------------------------------------------------------------
\2252\ The relevant agencies issued a proposed rule to implement
the requirements of section 15G of the Exchange Act, as required
under section 941 of the Dodd-Frank Act. See Credit Risk Retention,
76 FR 24,090 (Apr. 29, 2011). Those agencies recently issued a re-
proposal of the risk-retention requirements. See Credit Risk
Retention, 78 FR 57,928 (Sept. 20, 2013).
\2253\ See proposed rule Sec. ----.14(a)(2)(iii).
---------------------------------------------------------------------------
Commenters expressed a variety of views on the treatment of
interests in securitizations held under risk retention pursuant to the
proposed rule. Some commenters argued that the proposal was effective
as written and represented a reasonable way to reconcile the two
sections of the Dodd-Frank Act consistent with the risk-reducing
objective of section 13 of the BHC Act.\2254\ Other commenters also
supported the proposal's recognition that banking entities may be
required to hold a certain amount of risk in a securitization that
would also be a covered fund, but argued that the proposed exemption
was too narrow.\2255\
---------------------------------------------------------------------------
\2254\ See Sens. Merkley & Levin (Feb. 2012); Alfred Brock.
\2255\ See, e.g., AFME et al.; SIFMA (Securitization) (Feb.
2012); JPMC; BoA.
---------------------------------------------------------------------------
After carefully considering the comments received on the proposal,
as well as the language and purpose of section 13 of the BHC Act, the
final rule provides an exemption that permits a banking entity to
organize and offer a covered fund that is an issuing entity of asset-
backed securities.\2256\ The Agencies have determined to provide this
exemption in order to address the unique circumstances and ownership
structures presented by securitizations.\2257\ Under the final rule, a
banking entity may permissibly organize and offer a covered fund that
is an issuing entity of asset-backed securities so long as the banking
entity (and its affiliates) comply with all of the requirements of
Sec. ----.11(a)(3) through (a)(8).\2258\ As discussed above, the
requirements of Sec. ----.11(a)(3) through ----.11(a)(8) are that: (i)
The banking entity and its affiliates do not acquire or retain an
ownership interest in the covered fund except as permitted under Sec.
----.12 of the final rule; \2259\ (ii) the
[[Page 5721]]
banking entity and its affiliates comply with the requirements of Sec.
----.14 of the final rule; (iii) the banking entity and its affiliates
do not, directly or indirectly, guarantee, assume, or otherwise insure
the obligations or performance of the covered fund or of any covered
fund in which such covered fund invests; (iv) the covered fund, for
corporate, marketing, promotional, or other purposes, does not share
the same name or variation of the same name with the banking entity (or
an affiliate thereof) and does not use the word ``bank'' in its name;
(v) no director or employee of the banking entity (or an affiliate
thereof) takes or retains an ownership interest in the covered fund
except under the limited circumstances noted in the final rule; and
(vi) the banking entity complies with the disclosure requirements
regarding covered funds in the final rule.
---------------------------------------------------------------------------
\2256\ See final rule Sec. ----.11(b).
\2257\ As used in this Supplementary Information, the term
``securitization'' means a transaction or series of transactions
that result in the issuance of asset-backed securities.
\2258\ See final rule Sec. ----.11(b) (providing the
requirements for a banking entity that is organizing and offering a
covered fund that is an issuing entity of asset-backed securities by
reference to the requirements of Sec. ----.11(a), as discussed
above).
\2259\ As explained in detail below in Part IV.B.3. addressing
the limitations on investments in covered funds by a banking entity,
the final rule permits a banking entity to acquire and retain
ownership interests in a covered fund in order to comply with
section 15G of the Exchange Act (15 U.S.C.78o-11) in an amount that
does not exceed the amount required to comply with the banking
entity's chosen method of compliance under section 15G and the
implementing regulations issued thereunder.
---------------------------------------------------------------------------
The Agencies believe that the requirements of the exemption for
organizing and offering a covered fund that is an issuing entity of
asset-backed securities, which are in most aspects consistent with the
exemption for organizing and offering a covered fund in section
13(d)(1)(G), provide limitations on a banking entity's securitization
activities involving covered funds that are consistent with the
limitations imposed with respect to organizing and offering a covered
fund that is not an issuing entity of asset-backed securities. For
instance, a banking entity may not share the same name as a covered
fund that is an issuing entity of asset-backed securities and is
prohibited from guaranteeing or otherwise ``bailing out'' a covered
fund that is an issuing entity of asset-backed securities, including
being required to comply with section 13(f) of the BHC Act regarding
covered transactions with the covered fund. Furthermore, like a banking
entity's investment in any covered fund, the final rule limits the
ability of a banking entity to invest in a covered fund that is an
issuing entity of asset-backed securities unless it meets the
requirements of Sec. ----.12.
Unlike many other covered funds, the Agencies understand that
banking entities might not act in a fiduciary capacity when they
organize and offer a covered fund that is a securitization vehicle. For
instance, as part of organizing and offering a securitization vehicle,
one or more parties may typically organize and initiate the
securitization by selling or transferring assets, either directly or
indirectly, to an issuing entity of asset-backed securities. An entity
that provides these services typically does so as a service to provide
investors and the entity's customers with the ability to invest in the
assets in a manner and to a degree that they may otherwise be unable to
do. In order to identify certain activities that would be included as
organizing and offering a securitization, the final rule provides that
organizing and offering an issuing entity of asset-backed securities
means acting as the securitizer, as that term is used in section
15G(a)(3) of the Exchange Act, for the issuer, or acquiring or
retaining an ownership interest in the issuer in compliance with the
implementing regulations issued under section 15G of that Act.
The final rule reflects, as discussed above, that one or more
parties that organize and offer an issuing entity of asset-backed
securities may not provide any of the services identified in Sec. --
--.11(a)(1). In this case the banking entity is not required to comply
with Sec. ----.11(a)(1) or (a)(2). Section ----.11(b) of the final
rule is designed to address situations where, as discussed above, a
banking entity does not act in a fiduciary capacity when it organizes
and offers a covered fund that is a securitization vehicle. With
respect to any securitization vehicle that retains a collateral manager
for investment advice regarding the assets of the securitization
vehicle, such a collateral manager would be required to comply with all
of the provisions of Sec. ----.11(a) to acquire and retain an
ownership interest in such securitization vehicle.
The final rule therefore both identifies certain activities that
would be included as organizing and offering a securitization and
modifies the requirements of Sec. ----.11 to reflect differences
between securitizations and other types of covered funds, as discussed
above. The Agencies believe, therefore, that the final rule
appropriately addresses the type of activity that is usually associated
with organizing and offering a securitization and also comports with
the manner in which Congress chose to define the type of parties
engaged in activities that merit special attention related to issuing
entities of asset-backed securities in another part of the Dodd-Frank
Act.
The Agencies have determined to provide this exemption by using
their authority in section 13(d)(1)(J) of the BHC Act and believe that
this exemption promotes and protects the safety and soundness of
banking entities and the financial stability of the United States. Many
companies and other entities utilize securitization transactions to
efficiently manage, allocate and distribute risks throughout the
markets in a manner consistent with meeting the demands of their
investors. Companies also utilize securitizations in order to help
provide liquidity to certain asset classes or portions of the market
that, absent this liquidity, may experience decreased liquidity and
increased costs of funding. For instance, if banking entities were not
permitted to organize and offer a securitization, the Agencies believe
this would result in increased costs of funding or credit for many
businesses of all sizes that are engaged in activities that section 13
of the BHC Act was not designed to address. Additionally, this
exemption enables banking entities to acquire and retain ownership
interests in a covered fund to comply with section 15G of the Exchange
Act, which requires certain parties to a securitization transaction to
retain a minimum amount of risk in a securitization, a requirement not
applicable to covered funds that are not securitizations. The Agencies
therefore have determined that this exemption will promote and protect
the safety and soundness of banking entities and the financial
stability of the United States by facilitating the benefits
securitizations can provide as discussed above, and also by enabling
banking entities to comply with section 15G of the Exchange Act.
The Agencies believe it would not be consistent with the safety and
soundness of banking entities or the financial stability of the United
States to prevent banking entities from acquiring or retaining
ownership interests in securitizations as part of the permitted
activity of organizing and offering securitizations or from meeting any
applicable requirements related to securitizations, including those
imposed under section 15G of the Exchange Act. The Agencies note that
the exemption for organizing and offering a securitization does not
relieve banking entities of any requirements that they may be subject
to with respect to their investments in or relationships with a
securitization, such as any applicable requirements regarding conflicts
of interest relating to certain securitizations under section 27B of
the Securities Act of 1933.
c. Underwriting and Market Making for a Covered Fund
Section 13(d)(1)(B) permits a banking entity to purchase and sell
securities and other instruments described in 13(h)(4) in connection
with certain underwriting or market making-related activities.\2260\
The proposal did not
[[Page 5722]]
discuss how this exemption applied in the context of underwriting or
market making of ownership interests in covered funds.
---------------------------------------------------------------------------
\2260\ See 12 U.S.C. 1851(d)(1)(B).
---------------------------------------------------------------------------
Commenters argued that the scope of the permitted activities under
sections 13(d)(1)(B), (D) and (F), which respectively set out permitted
activities of underwriting and market making-related activities,
activities on behalf of customers, and activities by a regulated
insurance company, apply to all of the activities prohibited under
section 13(a), whether those activities would involve proprietary
trading or ownership of or acting as a sponsor to covered funds.\2261\
Commenters argued that the statutory exemption for underwriting and
market making-related activities is applicable to both proprietary
trading and covered fund activities, and recommended that the final
rule allow banking entities to hold ownership interests and other
securities of covered funds for the purpose of underwriting and
engaging in market making-related activities.\2262\ Commenters noted
that many structured finance vehicles rely on sections 3(c)(1) and
3(c)(7) of the Investment Company Act, and argued that, without a
market making exemption for securities of covered funds, banking
entities would be unable to engage in customer-driven underwriting and
market making activity with respect to securities issued by entities
such as collateralized loan obligation issuers and non-U.S. exchange-
traded funds.\2263\
---------------------------------------------------------------------------
\2261\ See Cleary Gottlieb et al.; JPMC; Credit Suisse
(Williams).
\2262\ See BoA; Cleary Gottlieb; Credit Suisse (Williams); SIFMA
et al. (Covered Funds) (Feb. 2012); See also Deutsche Bank (Fund-
Linked Products); SIFMA (Securitization) (Feb. 2012). Other
commenters argued that application of Section 13(f) of the BHC Act
would prohibit the underwriting and market making by a banking
entity of the securities of a covered fund that such banking entity
sponsors, organizes and offers or provides investment management
advice or services because Section 13(f) of the BHC Act prohibits
the purchase of securities by a banking entity from such a covered
fund. See, e.g., ASF (Feb. 2012); Cleary Gottlieb; Credit Suisse
(Williams); SIFMA (Securitization) (Feb. 2012); FSA (Feb. 2012).
\2263\ See JPMC; Cleary Gottlieb.
---------------------------------------------------------------------------
After careful review of the comments in light of the statutory
provisions, the final rule has been modified to provide a covered fund
specific provision for underwriting and market making-related
activities of ownership interests in covered funds. These underwriting
and market making activities are within the scope of permitted
activities under the final rule so long as:
The banking entity conducts the activities in
accordance with the requirements of Sec. ----.4(a) or Sec. --
--.4(b), respectively;
With respect to any banking entity (or an affiliate
thereof) that: Acts as a sponsor, investment adviser or commodity
trading advisor to a particular covered fund or otherwise acquires
and retains an ownership interest in such covered fund in reliance
on Sec. ----.11(a); acquires and retains an ownership interest in
such covered fund and is either a securitizer, as that term is used
in section 15G(a)(3) of the Exchange Act, or is acquiring and
retaining an ownership interest in such covered fund in compliance
with section 15G of that Act and the implementing regulations issued
thereunder each as permitted by Sec. ----.11(b); or, directly or
indirectly, guarantees, assumes, or otherwise insures the
obligations or performance of the covered fund or of any covered
fund in which such fund invests, then in each such case any
ownership interests acquired or retained by the banking entity and
its affiliates in connection with underwriting and market making
related activities for that particular covered fund are included in
the calculation of ownership interests permitted to be held by the
banking entity and its affiliates under the limitations of Sec. --
--.12(a)(2)(ii) and Sec. ----.12(d); and
With respect to any banking entity, the aggregate value
of all ownership interests of the banking entity and its affiliates
in all covered funds acquired and retained under Sec. ----.11,
including all covered funds in which the banking entity holds an
ownership interest in connection with underwriting and market making
related activities under Sec. ----.11(c), are included in the
calculation of all ownership interests under Sec. --
--.12(a)(2)(iii) and Sec. ----.12(d).\2264\
---------------------------------------------------------------------------
\2264\ See final rule Sec. --.11(c).
The Agencies believe that providing a separate provision relating
to permitted underwriting and market making-related activities for
ownership interests in covered funds is supported by section
13(d)(1)(B) of the BHC Act.\2265\ The exemption for underwriting and
market making-related activities under section 13(d)(1)(B), by its
terms, is a statutorily permitted activity and exemption from the
prohibitions in section 13(a), whether on proprietary trading or on
covered fund activities. Applying the statutory exemption in this
manner accommodates the capital raising activities of covered funds and
other issuers in accordance with the underwriting and market making
provisions under the statute.
---------------------------------------------------------------------------
\2265\ A discussion of the implementation of section 13(d)(1)(D)
and (F) with regard to the final rule's limitations on covered fund
investments and activities is provided in the section that relates
to permitted covered fund interests and activities by a regulated
insurance company and Sec. ----.13(c) of the final rule.
---------------------------------------------------------------------------
The final rule provides that a banking entity must include any
ownership interests that it acquires or retains in connection with
underwriting and market making-related activities for a particular
covered fund for purposes of the per-fund limitation under Sec. --
--.12(a)(2)(ii) if the banking entity: (i) Acts as a sponsor,
investment adviser or commodity trading advisor to the covered fund;
(ii) otherwise acquires and retains an ownership interest in the
covered fund as permitted under Sec. ----.11(a); (iii) acquires and
retains an ownership interest in the covered fund and is either a
securitizer, as that term is used in section 15G(a)(3) of the Exchange
Act, or is acquiring and retaining an ownership interest in the covered
fund in compliance with section 15G of that Act and the implementing
regulations issued thereunder each as permitted by Sec. ----.11(b); or
(iv) directly or indirectly guarantees, assumes, or otherwise insures
the obligations or performance of the covered fund or of any covered
fund in which such fund invests. This is designed to prevent any
unintended expansion of ownership of covered funds by banking entities
that are subject to the per fund limitations under Sec. ----.12.
These banking entities will have a limited ability to engage in
underwriting or market making-related activities for a covered fund for
which the banking entity's investments are subject to the per-fund
limitations in Sec. ----.12 as discussed above. Such a banking entity
will have more flexibility to underwrite and make a market in the
ownership interests of such a covered fund in connection with
organizing and offering the covered fund during the fund's seeding
period, since during the seeding period a banking entity may own in
excess of three percent of the covered fund, subject to the other
requirements in Sec. ----.12.
The final rule also provides that all banking entities that engage
in underwriting and market-making related activities in covered funds
are required to include the aggregate value of all ownership interests
of the banking entity in all covered funds acquired and retained under
Sec. ----.11, including in connection with underwriting and market
making-related activities under Sec. ----.11(c), in the calculation of
the aggregate covered fund ownership interest limitations under Sec.
----.12(a)(2)(iii) (and make the associated deduction from tier one
capital for purposes of calculating compliance with applicable
regulatory capital requirements).\2266\
---------------------------------------------------------------------------
\2266\ See final rule Sec. ----.11(c)(3).
---------------------------------------------------------------------------
Some commenters asked that the Agencies permit banking entities to
engage in market making and underwriting in non-sponsored covered fund
interests.\2267\ The final rule permits
[[Page 5723]]
a banking entity that does not hold an ownership interest in the
covered fund in reliance on Sec. Sec. ----.11(a) or ----.11(b) of the
final rule, is not a sponsor of the covered fund, is not an investment
adviser or commodity trading advisor to the covered fund, and does not,
directly or indirectly, guarantee, assume, or otherwise insure the
obligations or performance of the covered fund or of any covered fund
in which such fund invests to rely on the market-making and
underwriting exemption in Sec. ----.11(c) provided that the banking
entity meets all of the requirements of that exemption. These
conditions include the aggregate funds limitation and the capital
deduction contained in Sec. ----.12 after including all ownership
interest held by the banking entity and its affiliates under Sec. --
--.11, including ownership interests acquired or retained under the
exemption for underwriting and market making-related activities in
Sec. ----.11(c). In accordance with section 13(d)(1) of the BHC Act,
the Agencies have determined that these restrictions on reliance on the
market-making and underwriting exemption provided by section
13(d)(1)(B) are appropriate to address the purposes of section 13 of
the BHC Act, which is aimed at assuring that banking entities do not
bail-out a covered fund and maintain sufficient capital against the
risks of ownership of covered funds. The Agencies note, however, that
the guarantee restriction is not intended to prevent a banking entity
from entering into arrangements with a covered fund that are not
entered into for the purpose of guaranteeing the obligations or
performance of the covered fund. For example, this restriction is not
intended to prohibit a banking entity from entering into or providing
liquidity facilities or letters of credit for covered funds; however,
it would apply to arrangements such as a put of the ownership interest
in the covered fund to the banking entity. The determination of whether
an arrangement would fall within this guarantee restriction would
depend on the facts and circumstances.
---------------------------------------------------------------------------
\2267\ See Cleary Gottlieb; Credit Suisse (Williams).
---------------------------------------------------------------------------
The Agencies emphasize that any banking entity that engages in
underwriting or market making-related activities in covered funds must
comply with all of the conditions applicable to such activity as set
forth in section Sec. Sec. ----.4(a) and ----.4(b).\2268\ Thus,
holdings of a single covered fund would be subject to limitations on
risk as well as length of holding period, among other applicable
limitations and requirements. These requirements are designed
specifically to address a banking entity's underwriting and market
making-related activities and to prohibit holding exposures in excess
of reasonably expected near term demand of clients, customers and
counterparties.
---------------------------------------------------------------------------
\2268\ See final rule Sec. ----.11(c)(1).
---------------------------------------------------------------------------
3. Section ----.12: Permitted Investment in a Covered Fund
a. Proposed Rule
Section ----.12 of the proposed rule implemented section 13(d)(4)
of the BHC Act and described the limited circumstances under which a
banking entity may acquire or retain an ownership interest in a covered
fund that the banking entity (which includes its subsidiaries and
affiliates) organizes and offers.\2269\ Section 13(d)(4)(A) of the BHC
Act permits a banking entity to acquire and retain an ownership
interest in a covered fund that the banking entity organizes and offers
for the purpose of: (i) establishing the 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 fund, subject to several limitations. Section 13(d)(4)(B) of the
BHC Act requires that investments by a banking entity in a covered fund
must, not later than one year after the date of establishment of the
fund, be reduced to an amount that is not more than three percent of
the total outstanding ownership interests of the fund. Consistent with
the statute, Sec. .----12 of the proposal provided that, after
expiration of the seeding period, a banking entity's investment in a
single covered fund may not represent more than three percent of the
total outstanding ownership interests in the covered fund (the ``per-
fund limitation'').\2270\ In addition, as provided in the statute, the
proposal provided that the total amount invested by a banking entity in
all covered funds may not exceed three percent of the tier 1 capital of
the banking entity (the ``aggregate funds limitation'').\2271\
---------------------------------------------------------------------------
\2269\ 12 U.S.C. 1851(d)(4); proposed rule Sec. ----.12.
\2270\ See proposed rule Sec. Sec. ----.12(a)(1)(i);--
--.12(a)(2)(i)(A) and (B); ----.12(b).
\2271\ See id. at Sec. Sec. ----.12(a)(1)(ii); --
--.12(a)(2)(ii); ----.12(c).
---------------------------------------------------------------------------
b. Duration of Seeding Period for New Covered Funds
Commenters argued that it is essential to serving their customers
efficiently that a banking entity be permitted to acquire and retain an
ownership interest in a covered fund that it organizes and offers as a
de minimis investment or for the purpose of establishing the fund. A
number of commenters contended that a banking entity typically invests
a limited amount of its own capital in a fund (``seed capital'') as
part of organizing the fund to produce investment performance as a
record of the fund's investment strategy (``track record'').\2272\ Once
a track record for the fund is established, the banking entity markets
the fund to unaffiliated investors.
---------------------------------------------------------------------------
\2272\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012); SSgA
(Feb. 2012); T. Rowe Price; Credit Suisse (Williams); Allen & Overy
(on behalf of Canadian Banks);TCW.
---------------------------------------------------------------------------
Commenters argued that the one-year seeding period provided in the
proposed rule would be too short to establish a track record for many
types of covered funds. Commenters argued that the duration of the
track record investors typically demand before investing in a new fund
depends on a number of factors (e.g., the type of fund, investment
strategy, and potential investors). According to commenters, an
inability to demonstrate a track record over multiple years may reduce
the allocation of capital by investors who are unable to gain an
understanding of the investment strategy, risk profile, and potential
performance of the fund.\2273\
---------------------------------------------------------------------------
\2273\ See et al. (Covered Funds) (Feb. 2012); See also Ass'n of
Institutional Investors (Feb. 2012); Bank of Montreal et al. (Jan.
2012); Allen & Overy (on behalf of Canadian Banks); Credit Suisse
(Williams); Japanese Bankers Ass'n; SSgA (Feb. 2012); T. Rowe Price;
Union Asset. One commenter argued that this limitation would
constrain portfolio composition of a covered fund due to an
inability of a fund to raise sufficient capital to make larger
investments. See Credit Suisse (Williams).
---------------------------------------------------------------------------
Commenters provided alternative suggestions regarding how to define
the start of the seeding period for purposes of applying the statutory
exception for investments during the seeding period. For example, two
commenters recommended that the Agencies treat a private equity fund as
being established on the date on which the fund begins its asset-
acquisition phase and is closed to new investors, and a hedge fund as
established on the date on which the fund has reached its target amount
of funding and begins investing according to the fund's stated
investment objectives.\2274\ Another commenter suggested that the
permitted seeding period begin on the date on which third-party
investors are first admitted to the fund.\2275\
---------------------------------------------------------------------------
\2274\ See AFG; Union Asset.
\2275\ See SIFMA (Mar. 2012); See also Credit Suisse (Williams).
---------------------------------------------------------------------------
Several commenters expressed concern that the per-fund limitation
could be subject to evasion unless the Agencies require that the
seeding period begin at the time funds are first invested
[[Page 5724]]
by the banking entity in the fund.\2276\ Some of these commenters
suggested the Agencies impose a dollar cap of $10 million on the seed
capital that a banking entity may provide to a newly organized covered
fund in addition to the statutory limits based on the amount of the
fund's shares and the amount of the banking entity's tier 1
capital.\2277\ These commenters argued that an explicit quantitative
limit better accounted for the size of some banking entities, which
otherwise made the potential amount of capital placed in covered funds
quite large.\2278\
---------------------------------------------------------------------------
\2276\ See AFR et al. (Feb. 2012); Occupy; Public Citizen; Sens.
Merkley & Levin (Feb. 2012).
\2277\ See Occupy; Sens. Merkley & Levin (Feb. 2012); See also
156 Cong. Rec. S5897 (daily ed. July 15, 2010) (statement of Sen.
Merkley).
\2278\ See, e.g., Public Citizen.
---------------------------------------------------------------------------
The Agencies have considered carefully the comments on the proposal
and have made several modifications to the final rule to more clearly
explain how the limitations apply during the seeding period. The final
rule continues to provide that a banking entity may invest in a covered
fund that it organizes and offers either in connection with
establishing the fund, or as a de minimis investment.\2279\
Importantly, the statute does not permit a banking entity to invest in
a covered fund unless the banking entity organizes or offers the
covered fund or qualifies for another exemption. As explained more
fully in the discussion of Sec. ----.11 above, a wide variety of
activities are encompassed in organizing and offering a covered fund.
Under the statute, which generally prohibits investments in covered
funds, a banking entity may invest in a covered fund under the
exemptions provided in section 13(d)(1) of the BHC Act, including
section 13(d)(1)(G) and the provisions of section 13(d)(4), only if the
banking entity engages in one or more of these permitted activities
with regard to that covered fund and complies with all applicable
limitations under the final rule regarding investments in a covered
fund.
---------------------------------------------------------------------------
\2279\ See final rule Sec. ----.12(a)(1).
---------------------------------------------------------------------------
As noted above, the statute allows a banking entity to acquire and
hold all of the ownership interests in a covered fund for the purpose
of establishing the fund and providing the fund with sufficient initial
equity for investment to permit the fund to attract unaffiliated
investors.\2280\ However, the statute also imposes a limit on the
duration of an investment made in connection with seeding a covered
fund. At the end of that period, the investment must conform to the
limits on de minimis investments set by the statute. In keeping with
the terms of the statute, the final rule, like the proposal, allows
banking entities a seeding period of one-year for all covered funds.
The statute also allows the Board to extend that period, upon an
application by a banking entity, for two additional years if the Board
finds an extension to be consistent with safety and soundness and in
the public interest.\2281\ As explained below, the final rule, like the
proposal, incorporates this process and sets forth the factors the
Board will consider when determining whether to allow an extended
seeding period. The Board and the Agencies will monitor these extension
requests to ensure that banking entities do not seek extensions for the
purpose of evading the restrictions on covered funds or to engage in
prohibited proprietary trading.
---------------------------------------------------------------------------
\2280\ 12 U.S.C. 1851(d)(4).
\2281\ See id. at 1851(d)(4)(C).
---------------------------------------------------------------------------
As noted above, the proposal did not specify ``date of
establishment,'' and commenters suggested a variety of dates that could
serve as the date of establishment for purposes of determining the
duration of the seeding period and the per-fund limitations on
ownership interests in a covered fund.\2282\ After considering comments
received on the proposal, the Agencies have modified the final rule to
include a definition of ``date of establishment'' for a covered fund.
In general, the date of establishment is the date on which an
investment adviser or similar party begins to make investments that
execute an investment or trading strategy for the covered fund. The
Agencies perceive the act of making investments to execute an
investment or trading strategy as demonstrating that the fund has begun
its existence and is no longer simply a plan or proposal. In order to
account for the unique circumstances and manner in which
securitizations are established, for a covered fund that is an issuing
entity of asset-backed securities, the date of establishment under the
final rule is the date on which the assets are initially transferred
into the issuing entity of the asset-backed securities. This is the
date that the entity is formed and the securities are generally sold
around this time. The Agencies believe this is the appropriate time for
the date of establishment for securitizations because this is the date
that the securitization risks are transferred to the owners of the
securitization vehicle. Once the assets have been transferred, the
securitization has been established and securities of the issuer may
typically be priced in support of organizing and offering the issuer.
Setting a later time, such as when the fund becomes fully subscribed or
the assets have been fully assembled, could permit a banking entity to
engage in prohibited proprietary trading under the guise of waiting for
investors that may never materialize.\2283\
---------------------------------------------------------------------------
\2282\ See SIFMA et al. (Mar. 2012); Credit Suisse (Williams);
EFAMA: Hong Kong Inv. Funds Ass'n; AFG; Union Asset.
\2283\ Importantly, the statute recognizes that a banking entity
may need more than the automatic one-year Seeding period to build a
track record and/or market its interests to unaffiliated investors;
therefore, a banking entity may apply for an extension of the
Seeding period as provided in ----.12(e) of the final rule as
discussed below in Part IV.B.3.h.
---------------------------------------------------------------------------
The statute also requires a banking entity to actively seek
unaffiliated investors to reduce or dilute the entity's ownership
interest to the amount permitted under the statute. This requirement is
included in the final rule, and underscores the nature of covered fund
activities under section 13(d)(1)(G) as a method to provide investment
advisory, trust and fiduciary services to customers rather than allow
the banking entity to engage in prohibited proprietary trading. To
effectuate the requirements of the statute, under the final rule,
banking entities that organize and offer a covered fund must develop
and document a plan for offering shares in the covered fund to other
investors and conforming the banking entity's investments to the de
minimis limits to help monitor and ensure compliance with this
requirement.
While certain commenters requested that the final rule include a
quantitative dollar limit on the amount of funds a banking entity may
use to organize and offer a covered fund, the Agencies have declined to
add this limitation in the final rule. This type of limit is not
required by statute. Moreover, the Agencies believe that imposing a
strict dollar limit may not adequately permit banking entities to
employ trading or investment strategies that will attract unaffiliated
investors, thereby precluding banking entities from meeting the demands
of customers contrary to the purpose of section 13.
c. Limitations on Investments in a Single Covered Fund (``Per-Fund
Limitation'')
Section 13(d)(4)(B) imposes limits on the amount of ownership
interest a banking entity may have in any single covered fund at the
end of the one year period (subject to limited extension) after the
date of establishment of the fund (the ``seeding period''). In
recognition of the fact that a covered
[[Page 5725]]
fund may have multiple classes or types of ownership interests with
different characteristics or values, the proposal required that a
banking entity apply the limits to both the total value of and total
amount of the banking entity's ownership interest in a covered fund.
The proposed rule required a banking entity to calculate the per-
fund limitation using two methods. First, a banking entity was required
to calculate the value of its investments and capital contributions
made with respect to any ownership interest in a single covered fund as
a percentage of the value of all investments and capital contributions
made by all persons in that covered fund. Second, a banking entity was
required to determine the total number of ownership interests held by
the banking entity in a single covered fund as a percentage of the
total number of ownership interests held by all persons in that covered
fund.\2284\ Both calculations were required to be done without regard
to committed funds not yet called for investment. The proposed rule
also required the banking entity to calculate the value and amount of
its ownership interest in each covered fund in the same manner and
according to the same standards utilized by the covered fund for
determining the aggregate value of the fund's assets and ownership
interests.\2285\ These calculations were designed to ensure that the
banking entity's investment in a covered fund could not result in more
than three percent of the losses of the covered fund being allocated to
the banking entity's investment.\2286\
---------------------------------------------------------------------------
\2284\ See proposed rule Sec. ----.12(b)(2).
\2285\ See proposed rule Sec. ----.12(b)(4).
\2286\ See Joint Proposal, 76 FR 68,904.
---------------------------------------------------------------------------
Commenters did not generally object to calculating the per-fund
limitation based on both number and value of ownership interests.
Several commenters urged the Agencies to allow a banking entity to
value its investment in a covered fund based on the acquisition cost of
the investment, instead of fair market value, notwithstanding the
manner in which the covered fund accounts for or values investments for
its shareholders generally.\2287\ One commenter suggested that the
Agencies allow a banking entity to choose between acquisition cost and
fair value so long as the chosen valuation method is applied
consistently to both the numerator and denominator when calculating the
per-fund limitation.\2288\
---------------------------------------------------------------------------
\2287\ See ABA (Keating); BoA; Arnold & Porter; BOK; Scale; SVB.
\2288\ See ABA (Keating) (alleging that this is similar to the
SEC's approach to the definition of venture capital fund for the
purposes of being exempt from investment advisor registration).
---------------------------------------------------------------------------
To the extent that an issuer of an asset-backed security is a
covered fund, the investment limitations contained in section 13(d)(4)
of the BHC Act also would limit the ability of a banking entity to
acquire or retain an investment in that issuer. Section 941 of the
Dodd-Frank Act added a new section 15G of the Exchange Act (15 U.S.C.
78o-11) which requires certain parties to a securitization transaction,
including banking entities, to retain and maintain a certain minimum
interest in certain issuers or asset-backed securities.\2289\ In order
to give effect to this separate requirement under the Dodd-Frank Act,
Sec. ----.14(a)(2) of the proposed rule permitted a banking entity
that is a ``securitizer'' or ``originator'' under that provisions of
the Act to acquire or retain an ownership interest in an issuer of
asset-backed securities, in an amount (or value of economic interest)
required to comply with the minimum requirements of section 15G of the
Exchange Act and any implementing regulations issued thereunder.\2290\
The proposal also permitted a banking entity to act as sponsor to the
securitization.
---------------------------------------------------------------------------
\2289\ The relevant agencies issued a proposed rule to implement
the requirements of section 15G of the Exchange Act, as required
under section 941 of the Dodd-Frank Act. See Credit Risk Retention,
76 FR 24,090 (Apr. 29, 2011). Those agencies recently issued a re-
proposal of the risk-retention requirements. See Credit Risk
Retention, 78 FR 57,928 (Sept. 20, 2013).
\2290\ See proposed rule Sec. ----.14(a)(2)(iii).
---------------------------------------------------------------------------
Commenters expressed a variety of views on the treatment of
interests in securitizations held under risk retention pursuant to the
proposed rule. Some commenters argued that the proposal was effective
as written and represented a reasonable way to reconcile the two
sections of the Dodd-Frank Act consistent with the risk-reducing
objective of section 13 of the BHC Act.\2291\ Other commenters also
supported the proposal's recognition that banking entities may be
required to hold a certain amount of risk in a securitization that
would also be a covered fund, but argued that the proposed exemption
was too narrow.\2292\ Some commenters argued that the exemption should
be broadened to permit a banking entity to hold in excess of the
minimum amount required under section 15G of the Exchange Act instead
of allowing only the minimum amount required by that section.\2293\ One
commenter requested that the final rule permit a banking entity to hold
an amount of risk in a securitization that is commensurate with what
investors demand rather than the minimum required by section 15G.\2294\
Some commenters argued that banking entities may be subject to similar
generally applicable requirements to hold risk in securitizations under
foreign law, such as Article 122a of the Capital Requirements Directive
issued by the European Union, and that the final rule should permit
banking entities to comply with these foreign legal requirements.\2295\
---------------------------------------------------------------------------
\2291\ See Sens. Merkley & Levin (Feb. 2012); Alfred Brock.
\2292\ See, e.g., AFME et al.; SIFMA (Securitization) (Feb.
2012); JPMC; BoA.
\2293\ See AFME et al.; SIFMA (Securitization) (Feb. 2012);
JPMC; BoA.
\2294\ See BoA.
\2295\ See AFME et al.; Allen & Overy (on behalf of Foreign Bank
Group); SIFMA (Securitization) (Feb. 2012);BoA.
---------------------------------------------------------------------------
Conversely, a few commenters objected to the proposed rule's
exemption for risk-retention as unclear and argued that if the
exemption was retained, the Agencies should provide that any amounts
held by a banking entity in a securitization that exceed the minimum
required to satisfy section 15G of the Exchange Act should count
towards the aggregate funds limitation of the banking entity.\2296\ One
commenter argued that the final rule should impose higher capital
charges for interests held in these securitizations due to concerns
that securitizations involve heightened risks due to the complexity of
their ownership structure.\2297\
---------------------------------------------------------------------------
\2296\ See Occupy.
\2297\ See Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------
The Agencies have carefully considered the comments received and
are adopting the calculation requirements for the per-fund limitation
as proposed with several modifications, including modifications
designed to address the unique characteristics and ownership structure
of securitizations. The final rule, like the proposal, requires that a
banking entity calculate its per-fund investment limit in covered funds
that are not issuing entities of asset-backed securities based on both
the value of its investments and capital contributions in and to each
covered fund and the total number of ownership interests it has in each
covered fund. A banking entity's investment (including investments by
its affiliates) may not exceed either three percent of the value of the
covered fund or three percent of the number of ownership interests in
the covered fund at the end of the seeding period. The Agencies
continue to believe that requiring the per-fund limitation to be
calculated based on these two measures best effectuates the terms and
purpose of the per-fund
[[Page 5726]]
limitation in the statute. Together, these measures ensure that a
banking entity's exposure to and ownership of each covered fund is
limited. Each measure alone could provide a distorted view of the
banking entity's ownership interest and could be more easily
manipulated, for example by issuing ownership interests with high value
or special governance provisions. As discussed in more detail below,
the final rule contains a separate method for calculating the value of
investments in issuing entities of asset-backed securities due to the
fact that these entities do not have a single class of security and
thus, the valuation of the ownership interests cannot be made on a per
interest or single class basis.
The per-fund limitation on ownership interests must be measured
against the total ownership interests of the covered fund, as defined
in Sec. ----.10 of the final rule and as discussed above in Part
IV.B.1.e. In determining the amount of ownership interests held by the
banking entity and its affiliates, the banking entity must include an
ownership interest permitted under Sec. Sec. ----.4 and ----.11 of the
final rule.\2298\ Additionally, any banking entity that acts as
underwriter or market-maker for ownership interests of a covered fund
must do so in compliance with the limitations of Sec. Sec. ----.4(a)
and ----.4(b) of the final rule, including the limits on the amount,
types, and risk of the underwriting position or market-maker inventory
as well as in compliance with the per-fund limitation, as applicable,
and the aggregate funds limitations and capital deduction in the final
rule. The Agencies expect to monitor these activities to ensure that a
banking entity does not engage in underwriting or market making-related
activity in a manner that is inconsistent with the limitations of the
statute and the final rule.\2299\
---------------------------------------------------------------------------
\2298\ As discussed above in Part IV.B.2.c., the per-fund
limitation does not apply to ownership interests held by a banking
entity that acts as market maker or underwriter in accordance with
Sec. ----.11(c) of the final rule, so long as the banking entity
does not also organize and offer, or act as sponsor, investment
adviser or commodity trading advisor to, the fund, or, with respect
to ownership interests in issuing entities of asset-backed
securities, is not a securitizer who continues to own ownership
interests or is not an entity that holds ownership interests in
compliance with Section 15G of the Exchange Act and the implementing
regulations adopted thereunder; however, the banking entity that is
acting as market maker or underwriter that is not subject to the
per-fund limitation must still comply with the other requirements
set forth in Sec. Sec. ----.4(a) and ----.4(b), respectively, and
any other applicable requirements set out in Sec. ----.11(c).
\2299\ The Agencies note that if a banking entity acts as
investment adviser or commodity trading advisor to a covered fund
and shares the same name or variation of the same name with the
fund, then that banking entity would be a sponsor and therefore
subject to the limitations of section 13(f).
---------------------------------------------------------------------------
The final rule requires that the value of the ownership interests
and contributions made by a banking entity in each covered fund (that
is not an issuing entity of an asset-backed security) be the fair
market value of the interest or contribution. The Agencies have
determined to use fair market value as the measurement of value for the
per-fund value limitation in order to ensure comparability with the
investments made in the covered fund by others and limit the potential
that the valuation measure can be manipulated (for example by altering
the percentage of gains and losses that are associated with a
particular ownership interest). A banking entity should determine fair
market value for purposes of the final rule, including the calculation
of both the per-fund and aggregate funds limitations, in a manner that
is consistent with its determination of the fair market value of its
assets for financial statement purposes and that fair market value
would be determined in a manner consistent with the valuations reported
by the relevant covered fund unless the banking entity determines
otherwise for purposes of its financial statements and documents the
reason for any disparity. If fair market value cannot be determined,
then the value shall be the historical cost basis of all investments
and capital contributions made by the banking entity to the covered
fund. The final rule also requires that, once a valuation method is
chosen, the banking entity calculate the value of its investments and
the investments of all others in the covered fund for purposes of the
per-fund limitation in the same manner and according to the same
standards.\2300\ This approach is intended to ensure that, for purposes
of calculating the per-fund limitation, a banking entity does not
calculate its investment in a covered fund in a manner more favorable
to the banking entity than the method used by the covered fund for
valuing the investments made by others. Under the final rule and as
explained in more detail below, any ownership interest acquired or
retained by an employee or director of the banking entity is attributed
to the banking entity for purposes of the per-fund limitation if the
banking entity financed the purchase of the ownership interest.
Additionally, any amount contributed or paid by a banking entity or its
employee to obtain an ownership interest in connection with obtaining
the restricted profit interest must be included in calculating
compliance with the per-fund and aggregate funds limitations (See Part
IV.B.1.e. above).\2301\
---------------------------------------------------------------------------
\2300\ In the context of securitizations, the final rule
similarly provides that the valuation methodology used to calculate
the fair market value of the ownership interests must be the same
for both the ownership interests held by a banking entity and the
ownership interests held by all other investors in the covered fund
in the same manner and according to the same standards.
\2301\ See Part IV.B.1.e.
---------------------------------------------------------------------------
In determining the per-fund limitation for purposes of Sec. --
--.12 of the final rule, the banking entity should use the same
methodology for valuing its investments and capital contributions as
the banking entity uses to prepare its financial statements and
regulatory reports.\2302\ In particular, the fair market value of a
banking entity's investments and any capital contributions made to a
covered fund should be the same for purposes of Sec. ----.12 of the
final rule as reported on the banking entity's financial statements and
regulatory reports. Similarly, if fair market value of all investments
in and capital contributions cannot be determined for purposes of Sec.
----.12 of the final rule, then the banking entity should use the same
methodology to calculate the historical cost basis of the investments
and any capital contributions as the banking entity uses to prepare its
financial statements and regulatory reports. The Agencies will review
carefully the methodology that a banking entity uses to calculate the
value of its investments in and capital contributions made to covered
funds as part of the process to monitor compliance with the final rule.
---------------------------------------------------------------------------
\2302\ For example, a depository institution or bank holding
company should use the same methodology as used in the Report of
Condition and Income (Call Report) for depository institutions and
the Consolidated Financial Statements for Holding Companies (FR Y-
9C) for bank holding companies, respectively.
---------------------------------------------------------------------------
The Agencies expect that for the majority of covered funds, the
party that organizes and offers the fund or otherwise exercises control
over the fund will provide a standard methodology for valuing interests
in the fund. However, the Agencies understand that for some covered
funds, including issuing entities of asset backed securities, there may
be multiple parties that organize and offer the fund that each utilize
a different methodology or standard for calculating the value of
ownership interests of the fund. Going forward, the Agencies expect
that in these circumstances the parties that organize and offer the
covered fund will work together or select a responsible party to
determine a single standard by
[[Page 5727]]
which all ownership interests in the covered fund will be valued.
One commenter suggested the Agencies count both invested funds and
committed funds not yet called for investment towards the per-fund
limitation.\2303\ This commenter argued that a banking entity has
already contractually allocated committed-yet-uncalled funds to the
covered fund and that depositors face a risk of loss for such funds if
the covered fund fails.
---------------------------------------------------------------------------
\2303\ See Occupy.
---------------------------------------------------------------------------
The final rule, like the proposal, does not count committed-yet-
uncalled funds towards the per-fund limitation; instead, it counts
funds once they are invested. This approach reflects the fact that
these funds may never be called while at the same time ensuring that
the banking entity must comply with the per-fund limitation once the
funds are called. The Agencies note that a banking entity is prohibited
from guaranteeing or bailing out a covered fund that the banking entity
or one of its affiliates organizes and offers by the terms of the
statute and the final rule and, accordingly, would not be permitted to
provide committed funds to a covered fund in a manner inconsistent with
the limitations in the statute and final rule.
After carefully considering the comments received on the proposal,
as well as the language and purpose of section 13 of the BHC Act, the
final rule provides that, for purposes of applying the per-fund
limitation to an investment in a covered fund that is an issuing entity
of an asset-backed security, the ownership interest held by the banking
entity and its affiliates generally may not exceed three percent of the
fair market value of the ownership interests of the fund as measured in
accordance with Sec. ----.12(b)(3), unless a greater percentage is
retained by the banking entity and its affiliates in compliance with
the requirements of section 15G of the Exchange Act and the
implementing regulations issued thereunder, in which case the
investment by the banking entity and its affiliates in the covered fund
may not exceed the amount, number, or value of ownership interests of
the fund required under section 15G of the Exchange Act and the
implementing regulations issued thereunder. A banking entity may rely
on any of the options available to it in order to meet the requirements
of section 15G, but for purposes of section 13 of the BHC Act and this
rule, the amount held by the banking entity may not exceed the amount
required under the chosen option. Under the final rule, if a banking
entity's investment in a covered fund is held pursuant to the
requirements of section 15G of the Exchange Act, the banking entity
must calculate the amount and value of its ownership interest for
purposes of the per-fund limitation as of the date and according to the
same valuation methodology applicable pursuant to the requirements of
that section and the implementing regulations issued thereunder.
While the amount retained in compliance with section 15G of the
Exchange Act and the implementing regulations issued thereunder may
permit a banking entity to own more than three percent of the ownership
interests in a securitization that is a covered fund, this approach is
appropriate to reconcile the competing policies of section 13 of the
BHC Act and section 15G of the Exchange Act which requires that a
securitizer of certain securitizations retain a minimum of five percent
of the risk of the securitization. Congress enacted these two
apparently conflicting provisions in the same Act, and the Agencies
believe the more specific section regarding risk retention in
securitizations was intended to prevail over the more general
restriction on ownership of covered funds (which applies to a broader
range of entities). The Agencies believe that the risk limitation goals
of section 13 of the BHC Act are met by satisfying the minimum
requirement of an applicable option under section 15G of the Exchange
Act as the maximum initial investment limit, and applying the other
limitations discussed in this section governing aggregate investment in
covered funds and capital deductions.
As under the proposal, if a banking entity does not have a minimum
risk retention requirement, that banking entity would remain subject to
the limitations of section 13(d)(4) of the BHC Act and Sec. ----.12 on
the amount of ownership interests it may hold in an issuing entity of
asset-backed securities. A banking entity may not combine the amounts
under these provisions to acquire or retain ownership interests in a
securitization that exceed the aggregate permissible amounts.
Some commenters requested that the Agencies coordinate
implementation of any exemption for risk-retention requirements under
section 13 of the BHC Act with the issuance of rules implementing
section 15G of the Exchange Act. The Agencies note that rules
implementing section 15G have been proposed but not yet finalized, but
the Agencies will review the interaction between the rules promulgated
under section 13 of the BHC Act and section 15G of the Exchange Act
once the rules under section 15G are finalized. Regardless of any
action that may be taken regarding rules implementing section 15G, the
final rule permits banking entities to own ownership interests in and
sponsor covered funds as discussed above.
Some commenters also requested that the final rule provide an
exemption to permit banking entities to comply with any risk retention
requirement imposed under foreign law that is similar to section 15G of
the Exchange Act. The Agencies are not revising the rule to permit
banking entities to own ownership interests required to be retained
pursuant to risk retention-type requirements under foreign law. The
Agencies are providing the exemption for the required ownership arising
from the risk retention provisions under section 15G of the Exchange
Act in order to reconcile the requirements under the Dodd-Frank Act
applicable to ownership of securitization interests; however, the
Agencies do not believe at this time that such reconciliation is
appropriate with respect to foreign law risk retention-type
requirements and those requirements should not prevail over the purpose
of section 13 of the BHC Act to reduce banking entities' exposure to
risks from investments in covered funds.
The Agencies also note that the definition of covered fund has been
modified to exclude certain foreign public funds and also any foreign
fund that is not owned or sponsored by a U.S. banking entity. Moreover,
the final rule permits foreign banking entities to engage in covered
fund activities and investments that occur solely outside of the United
States without regard to the investment limitations of section 13(d)(4)
of the BHC Act and Sec. ----.12 of the final rule, which may include
retaining risk in a securitization to the extent required under foreign
law. In these manners, the final rule permits foreign banking entities
to comply with requirements under foreign law that govern their
securitization activities or investments abroad. However, as noted
above, section 13 of the BHC Act applies to the global operations of
U.S. banking entities and, as such, U.S. banking entities' investments
in foreign securitizations that are covered funds would remain subject
to the investment limitations of section 13(d)(4) and Sec. ----.12 of
the final rule.
The proposed rule provided that a banking entity must comply with
both measures of the per-fund limitation at all times. The preamble to
the proposal explained that the Agencies expected a banking entity to
calculate its per-fund limitation no less frequently than the
[[Page 5728]]
frequency with which the fund performs such calculation or issues or
redeems interests, and in no case less frequently than quarterly.\2304\
---------------------------------------------------------------------------
\2304\ See proposed rule Sec. ----.12(b); Joint Proposal, 76 FR
68,904.
---------------------------------------------------------------------------
Several commenters requested that the Agencies modify the frequency
of this calculation and monitoring requirement to a standard quarterly
basis.\2305\ These commenters argued that, although some covered funds
may provide daily liquidation and redemption rights to investors,
monitoring the per-fund limitation on a continuous basis would be
costly and burdensome and would not provide a significant offsetting
benefit.
---------------------------------------------------------------------------
\2305\ See, e.g., ABA (Keating); Credit Suisse (Williams); JPMC.
---------------------------------------------------------------------------
The Agencies continue to believe that for covered funds other than
issuing entities of asset-backed securities the per-fund limitations
apply to investments in covered funds at all times following the end of
the seeding period. However, to relieve burden and costs, while also
setting a minimum recordkeeping standard, the final rule has been
modified to require that a banking entity calculate the amount and
value of its ownership interests in covered funds other than issuing
entities of asset-backed securities quarterly.\2306\ The Agencies
believe that this change will assist in reducing unnecessary costs and
burdens in connection with calculating the per-fund limitation,
particularly for smaller banking entities, and will also facilitate
consistency with the calculation for the aggregate funds limitation
(which is also determined on a quarterly basis). Nevertheless, should a
banking entity become aware that it has exceeded the per-fund
limitation for a given fund at any time, the Agencies expect the
banking entity to take steps to ensure that the banking entity complies
promptly with the per-fund limitation.\2307\
---------------------------------------------------------------------------
\2306\ See final rule Sec. --.12(b)(2)(i) and (ii). For covered
funds that are an issuing entity of asset-backed securities,
recalculation of the banking entity's permitted ownership for
purposes of the per-fund limitation is not required unless the
covered fund sells additional securities.
\2307\ See 12 U.S.C. 1851(d)(4)(B)(ii)(I).
---------------------------------------------------------------------------
The Agencies have also modified the timing and methodology of the
per-fund limitation as it applies to securitizations to address the
unique circumstances and ownership structure presented by
securitizations, which typically wind down over time. Unlike many other
covered funds, securitizations do not generally experience increases in
the amount of investors or value of ownership interests during the life
of the securitization; rather, they generally experience only a
contraction of the investor base and reduction in the total outstanding
value of ownership interests on an aggregate basis, and may do so at
different rates under the terms of the transaction agreements, meaning
that the percentage of ownership represented by a particular ownership
interest may increase as the fund amortizes but without the banking
entity adding any funds. The manner in which securitizations are
organized and offered, as well as the amortization of securitizations,
differs from many other covered funds; section 15G of the Exchange Act
also requires that certain parties to securitization transactions,
which may include banking entities, retain a minimum amount of risk in
a securitization, a requirement not applicable to covered funds that
are not securitizations. Therefore, for purposes of calculating a
banking entity's per-fund limitation with respect to a securitization,
the calculation of the per-fund limitation shall be based on whether
section 15G applies and the implementing regulations are effective. In
the case of an ownership interest in an issuing entity of an asset-
backed security that is subject to section 15G of the Exchange Act and
for which effective implementing regulations have been issued, the
calculation of the per-fund limitation shall be made as of the date and
pursuant to the methodology applicable pursuant to the requirements of
section 15G of the Exchange Act and the implementing regulations
issued. For securitizations executed after the effective date of the
final rule and prior to the adoption and implementation of the rules
promulgated under section 15G of the Exchange Act and for
securitizations for which a fair valuation calculation is not required
by the implementing rules promulgated under section 15G of the Exchange
Act, the per fund limitation is calculated as of the date on which the
assets are initially transferred into the issuing entity of the asset-
backed securities or such earlier date on which the transferred assets
have been valued for purposes of transfer to the covered fund.\2308\
This calculation for issuers of asset backed securities is only
required to be performed once on the date noted above, and thereafter
only upon the date on which the price of additional securities of the
covered fund to be sold to third parties is determined.
---------------------------------------------------------------------------
\2308\ In addition, although some commenters requested that
banking entities be able to hold more than the minimum required by
section 15G, the Agencies are not revising the per fund limitation
in that manner. One of the purposes of section 13 of the BHC Act is
to reduce banking entities' exposure to risks from investments in
covered funds, and the Agencies believe at this time that permitting
banking entities to retain risk exposure to the covered fund in
excess of the minimum required to be retained would contradict the
purposes of section 13 of the BHC Act.
---------------------------------------------------------------------------
As noted above, the per-fund limitations for ownership interests in
issuing entities of asset-backed securities are calculated based only
on the value of the ownership interest in relation to the value of all
ownership interests in the issuing entity of the asset-backed security
and are not calculated on a class by class, or tranche by tranche
basis. For purposes of the valuation, the aggregate value of all the
assets that are transferred to the issuing entity of the asset-backed
securities, and any assets otherwise held by the issuing entity, are
determined based on the valuation methodology used for determining the
value of the assets for financial statement purposes. This valuation
will be the value of the ownership interests in the issuing entity for
purposes of the calculation. A banking entity will need to determine
its percentage ownership in the issuing entity based on the its
contributions to the entity in relation to the contributions of all
parties and after taking into account the value of any residual
interest in the issuing entity. In addition, for purposes of the final
rule, the asset valuation is as of the date of establishment (the date
of the asset transfer to the issuing entity of the asset-backed
securities).
d. Limitation on Aggregate Permitted Investments in all Covered Funds
(``Aggregate Funds Limitation'')
In addition to the per-fund limitation, section 13(d)(4) of the BHC
Act provides that the aggregate of a banking entity's investments in
all covered funds may not exceed three percent of the tier 1 capital of
the banking entity (referred to above as the ``aggregate funds
limitation'').\2309\ To implement this limitation, the proposed rule
required a banking entity to determine the aggregate value of the
banking entity's investments in covered funds by calculating the sum of
the value of each investment in a covered fund, as determined in
accordance with applicable accounting standards. This amount was then
measured as a percentage of the tier 1 capital of the banking entity
for purposes of determining compliance with the aggregate funds
limitation. For purposes of applying the limit, a banking entity that
is subject to regulatory capital requirements was required under the
proposed rule to measure tier 1 capital
[[Page 5729]]
in accordance with those regulatory capital requirements; a banking
entity that is not a subsidiary of a reporting banking entity and that
is not itself required to report capital in accordance with the risk-
based capital rules of a Federal banking agency was required by the
proposed rule to calculate its tier 1 capital based on the total amount
of shareholders' equity of the top-tier entity as of the last day of
the most recent calendar quarter, as determined under applicable
accounting standards.
---------------------------------------------------------------------------
\2309\ See 12 U.S.C. 1851(d)(4)(B)(ii)(II).
---------------------------------------------------------------------------
Commenters expressed a variety of views regarding the aggregate
funds limitation. One commenter argued that basing the aggregate funds
limitation on the size of tier 1 capital of a banking entity provides
an advantage to the largest institutions with large absolute capital
bases and disadvantages smaller banks that are well capitalized but
have a smaller absolute capital base.\2310\ This commenter urged the
Agencies to permit all banking entities to invest in covered funds in
an amount that is, in the aggregate, the greater of $1 billion (subject
to prudential investment limitations and safety and soundness
concerns), or three percent of tier 1 capital.\2311\
---------------------------------------------------------------------------
\2310\ See ABA (Abernathy).
\2311\ See, e.g., ABA (Abernathy).
---------------------------------------------------------------------------
In contrast, other commenters urged the Agencies to decrease the
statutory limit in order to prevent the largest banking entities from
investing amounts that, while within the statutory limit, could be very
large in absolute terms.\2312\ One commenter argued that a loss of
three percent of tier 1 capital would be a material loss reflected in a
change in stock price.\2313\ Another commenter suggested the Agencies
consider whether the investment supports a large flow of management
fees linked to market volatility or has significant embedded
leverage.\2314\
---------------------------------------------------------------------------
\2312\ See AFR et al. (Feb. 2012); Public Citizen.
\2313\ See Public Citizen.
\2314\ See AFR et al. (Feb. 2012).
---------------------------------------------------------------------------
Some commenters argued that the final rule should calculate the
value of covered fund investments based on acquisition cost instead of
fair market value.\2315\ These commenters argued that using fair value
to calculate the aggregate funds limitation penalizes banking entities
for organizing and investing in successful funds and, conversely, would
allow banking entities to increase investments in unsuccessful funds
(the value of which would decline relative to the capital of the
banking entity).
---------------------------------------------------------------------------
\2315\ See ABA(Keating); BoA; Arnold & Porter; BOK; Scale; SVB.
---------------------------------------------------------------------------
In contrast, another commenter argued that valuation of a covered
fund investment should include any mark-to-market increase in a banking
entity's aggregate investments in order to keep pace with increases in
the capital of the banking entity.\2316\
---------------------------------------------------------------------------
\2316\ See Occupy.
---------------------------------------------------------------------------
Some commenters discussing the frequency of the calculation of the
aggregate funds limitation supported determining the aggregate funds
limitation on the last day of each calendar quarter as required in the
proposal.\2317\ Other commenters argued that the statute requires
compliance at all times rather than periodic calculations of
compliance.\2318\
---------------------------------------------------------------------------
\2317\ See ABA (Keating).
\2318\ See AFR et al. (Feb. 2012); Occupy.
---------------------------------------------------------------------------
After consideration of the comments in light of the statutory
provisions, the Agencies have adopted the requirements for calculating
the aggregate funds limitation as proposed with several modifications
as explained below. Under the final rule, the aggregate value is the
sum of all amounts paid or contributed by the banking entity in
connection with acquiring or retaining an ownership interest in each
covered fund (together with any amounts paid by the entity (or employee
thereof) in connection with obtaining a restricted profit interest
under Sec. ----.10(d)(6)(ii)), as measured on a historical cost basis.
This aggregate value is measured against the total applicable tier 1
capital for the banking entity as explained below.
For purposes of determining the aggregate funds limitation, the
final rule requires that the value of investments made by a banking
entity be calculated on a historical cost basis. This approach limits
the aggregate amount of funds a banking entity may provide to covered
funds as a percentage of the banking entity's capital as required by
statute. At the same time, this approach does not permit a banking
entity to increase its exposure to covered funds in the event any
investment in a particular covered fund declines in value as a result
of the fund's investment activities. Permitting a banking entity to
increase its aggregate investments as covered funds lose value would
permit the banking entity both to increase its exposure to covered
funds at the same time the covered funds it already owns are losing
value and to effectively bail-out investors by providing additional
capital to troubled covered funds. Neither of these actions is
consistent with the purposes of section 13 of the BHC Act. Moreover and
as explained below, because the final rule requires that the banking
entity deduct from the entity's capital the greater of historical cost
(plus earnings) or fair market value of its investments in covered
funds, the deduction accounts for any profits resulting from
investments in covered funds.
Historical cost basis means, with respect to a banking entity's
ownership interest in a covered fund, the sum of all amounts paid or
contributed by the banking entity to a covered fund in connection with
acquiring or retaining an ownership interest (together with any amounts
paid by the entity (or employee thereof) in connection with obtaining a
restricted profit interest)), less any amounts received as a
redemption, sale or distribution of such ownership interest or
restricted profit interest. Under the final rule, any reduction of the
historical cost would not generally include gains or losses, fees,
income, expenses or similar items. However, as noted above, the final
rule also requires that a banking entity deduct any earnings from its
tier 1 capital even if it values its ownership interests in a covered
fund pursuant to historical cost.
The concern expressed by commenters that the aggregate funds
limitation should account for increases in the fair market value of
covered funds is addressed in other ways under the final rule. In
particular, the final rule requires that for purposes of calculating
compliance with regulatory capital requirements the banking entity
deduct from the entity's capital the greater of fair market value (or
historical cost plus earnings) of its investment in each covered fund;
thus, profits resulting from investments in covered funds will not
inflate the capital of the banking entity for regulatory compliance
purposes. Moreover, as explained above, the per-fund limitation is
generally based on fair market value, which maintains the relative
level of a banking entity's investment in each covered fund.
As noted above, the aggregate funds limitation applies to all
investments by a banking entity in a covered fund that the banking
entity or an affiliate thereof holds under Sec. Sec. ----.4 and --
--.11 of the final rule. The limitation would also apply to investments
by a banking entity made or held during the seeding period as part of
organizing and offering a covered fund, including ownership interests
held in order to satisfy the requirements of section 15G of the
Exchange Act, as well as ownership interests held by a banking entity
in the capacity of acting as underwriter or market-maker.
As under the proposal, this calculation must be made as of the last
day of each calendar quarter, consistent with when tier 1 capital is
reported by banking entities to the Agencies.
[[Page 5730]]
Because compliance with the aggregate funds limitations is calculated
based on tier 1 capital, the Agencies believe it is more appropriate to
require the calculation to be performed on the same schedule as tier 1
capital is reported. While the aggregate funds limitation must be
calculated on a quarterly basis, the Agencies expect banking entities
to monitor investments in covered funds regularly and remain in
compliance with the limitations on covered fund investments throughout
the quarter. The Agencies intend, through their respective supervisory
processes, to monitor covered fund investment activity to ensure that a
banking entity is not attempting to evade the requirements of section
13.
The Agencies recognize that banks with large absolute capital bases
will be able to place a greater amount of capital in covered funds
compared to banks with small absolute capital bases. However, the
amount of risk exposure to a covered fund, despite their different
investment strategies, will be relatively similar across banking
entities, which is consistent with the language and risk-limiting
purpose of section 13.
e. Capital Treatment of an Investment in a Covered Fund
Section 13(d)(4)(B)(iii) of the BHC Act provides that, for purposes
of determining compliance with applicable capital standards under
section 13(d)(3) of that Act, the aggregate amount of outstanding
investments by a banking entity under section 13(d)(4), including
retained earnings, must be deducted from the assets and tangible equity
of the banking entity, and the amount of the deduction must increase
commensurate with the leverage of the covered fund.\2319\ Section
13(d)(3) authorizes the Agencies, by rule, to impose additional capital
requirements and quantitative limitations, including diversification
requirements on any of the activities permitted under section 13 of the
BHC Act if the Agencies determine that such additional capital and
quantitative limitations are appropriate to protect the safety and
soundness of banking entities engaged in such activities.\2320\
---------------------------------------------------------------------------
\2319\ See 12 U.S.C. 1851(d)(4)(B)(iii).
\2320\ Id. at 1851(d)(3).
---------------------------------------------------------------------------
The proposed rule implemented the capital deduction provided for
under section 13(d)(4)(B)(iii) of the BHC Act by requiring a banking
entity to deduct the aggregate fair value of its investments in covered
funds, including any attributed profits, from tier 1 capital. As in the
statute, the proposed rule applied the capital deduction to ownership
interests in covered funds held as an investment by a banking entity
pursuant to the provisions of section 13(d)(4) of the BHC Act, and not
to ownership interests acquired under other permitted authorities, such
as a risk-mitigating hedge under section 13 of the BHC Act. The
proposed rule required the deduction to be calculated consistent with
the method for calculating other deductions under the applicable risk-
based capital rules. The proposed rule did not otherwise adopt
additional capital requirements and quantitative limitations under
section 13(d)(3) of the BHC Act.
Some commenters supported the proposed dollar-for-dollar deduction
from tier 1 capital of a banking entity's aggregate investments in
covered funds and asserted it is consistent with the statute.\2321\ One
of these commenters urged the Agencies to rely on their authority under
section 13(d)(3) of the BHC Act to apply the capital deduction to other
permitted ownership interests in covered funds to protect the safety
and soundness of the banking entity.\2322\ In contrast, other
commenters urged the Agencies to eliminate the capital deduction for
investments in covered funds and questioned the Agencies' statutory
authority to impose the capital deduction.\2323\ These commenters
argued that the statute does not authorize or require the Agencies to
require banking entities to deduct their investments in covered funds
for purposes of calculating capital pursuant to the applicable capital
rules. According to these commenters, section 13 only requires
deductions for purposes of determining compliance with applicable
capital standards under section 13 and argued the Agencies did not make
the necessary safety and soundness findings under section 13(d)(3) to
impose additional capital requirements on any activities permitted
under section 13(d)(1).\2324\ One commenter urged the Agencies to make
any capital adjustment as part of the banking agencies' broader efforts
to implement the Basel III capital framework.\2325\ Another commenter
urged the Agencies to apply the capital deduction only for purposes of
determining a banking entity's compliance with the aggregate funds
limitation and not for other regulatory capital purposes.\2326\ This
commenter also argued that a capital deduction is normally not required
for assets reflected on a bank's consolidated balance sheet, and that
the Agencies should not require a deduction for a covered fund
investment that is not consolidated with the banking entity for
financial reporting purposes under GAAP.\2327\ Some commenters urged
the Agencies to apply the capital deduction only to a banking entity's
investment in a covered fund that the banking entity organizes and
offers and not to ownership interests otherwise permitted to be held
under section 13 of the BHC Act.\2328\
---------------------------------------------------------------------------
\2321\ See Occupy.
\2322\ See Occupy.
\2323\ See ABA (Keating); BNY Mellon et al.; PNC; SIFMA et al.
(Covered Funds) (Feb. 2012); SVB.
\2324\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012).
\2325\ Id.
\2326\ See ABA (Keating).
\2327\ See ABA (Keating); See also letter from PNC.
\2328\ See Arnold & Porter; SVB.
---------------------------------------------------------------------------
Several commenters addressed the manner for valuing an investment
subject to the deduction. One commenter urged the Agencies to permit a
banking entity to calculate the deduction based on the acquisition
cost, instead of the fair market value, of the banking entity's
ownership interest in the covered fund.\2329\ This commenter emphasized
that valuing the investment at fair market value would penalize a
banking entity if the covered fund performs well by reducing the amount
of capital available for additional covered fund investments but reduce
the capital charge against troubled investments. One commenter argued
that the Agencies did not perform an appropriate cost-benefit analysis
of the deduction in the proposed rules.\2330\
---------------------------------------------------------------------------
\2329\ See SIFMA et al. (Covered Funds) (Feb. 2012).
\2330\ Id.
---------------------------------------------------------------------------
Other commenters sought clarification on how the capital deduction
would apply to a foreign banking organization. Several commenters
argued that the capital deduction should not apply to a foreign banking
entity that calculates its tier 1 capital under the standards of its
home country.\2331\ These commenters argued that imposing a capital
deduction requirement on foreign banks would not be consistent with
past practices on the application of U.S. risk-based capital
requirements to foreign banking organizations.
---------------------------------------------------------------------------
\2331\ See IIB/EBF.
---------------------------------------------------------------------------
The Agencies have carefully considered the comments in light of the
statutory provisions requiring a capital deduction. The statute
requires that the aggregate amount of outstanding investments by a
banking entity, including retained earnings, be deducted from the
assets and tangible equity of the banking entity.\2332\ This
requirement is independent of the minimum regulatory capital
[[Page 5731]]
requirements in the final capital rule published by the Federal Banking
agencies in 2013 (``regulatory capital rule'').\2333\
---------------------------------------------------------------------------
\2332\ See 12 U.S.C. 1851(d)(4)(B)(iii).
\2333\ See 78 FR 62,018, 62,072 (Oct. 11, 2013) (Board/OCC/FDIC
Basel III Final Rule); 78 FR 55,340, 55,391 (Sept. 10, 2013) (FDIC
Basel III interim final rule).
---------------------------------------------------------------------------
The Federal Banking agencies recognize that the regulatory capital
rule imposes risk weights and deductions that do not correspond to the
deduction for covered fund investments imposed by section 13 of the BHC
Act. The Federal Banking agencies intend to review the interaction
between the requirements of this rule and the requirements of the
regulatory capital rule and expect to propose steps to reconcile the
two rules.
At the same time, the Agencies believe that the dollar-for-dollar
deduction of the fair market value of a banking entity's investment in
a covered fund is appropriate to protect the safety and soundness of
the banking entity, as provided in section 13(d) of the BHC Act. This
approach ensures that a banking entity can withstand the failure of a
covered fund without causing the banking entity to breach the minimum
regulatory capital requirements. Consistent with the language and
purpose of section 13 of the BHC Act, this deduction will help provide
that a banking entity has sufficient capital to absorb losses that may
occur from covered fund investments without endangering the safety and
soundness of the banking entity or the financial stability of the
United States.
Accordingly, under the final rule, a banking entity must, for
purposes of determining compliance with applicable regulatory capital
requirements, deduct the greater of (i) the sum of all amounts paid or
contributed by the banking entity in connection with acquiring or
retaining an ownership interest (together with any amounts paid by the
entity (or employee thereof) in connection with obtaining a restricted
profit interest under Sec. ----.10(b)(6)(ii)), on a historical cost
basis, including earnings or (ii) the fair market value of the sum of
all amounts paid or contributed by the banking entity in connection
with acquiring or retaining an ownership interest (together with any
amounts paid by the entity (or employee thereof) in connection with
obtaining a restricted profit interest under Sec. ----.10(b)(6)(ii)),
if the banking entity accounts for the profits (or losses) of the fund
investment in its financial statements.\2334\ This deduction must be
made whenever the banking entity calculates its tier 1 capital, either
quarterly or at such other time at which the appropriate Federal
banking agency may request such a calculation. Requiring a banking
entity to deduct the greater of historical cost or fair market value of
all covered fund investments made by a banking entity from the entity's
tier 1 capital should result in an appropriate deduction that is
consistent with the manner in which the banking entity accounts for its
covered fund investments. For instance, if a banking entity accounts
for its investments in covered funds using fair market value, then any
changes in the fair market value of the banking entity's investment in
a covered fund should similarly be reflected in the banking entity's
tier 1 capital. Thus, this deduction should not unduly penalize banking
entities for making successful investments or allow more investments in
troubled covered funds.
---------------------------------------------------------------------------
\2334\ See 12 CFR part 208, subpart D and appendixes A, B, E,
and F; 12 CFR part 217 (to be codified), and 12 CFR part 225,
appendixes A, D, E, and G; See also 12 CFR 240.15c3-1 (net capital
requirements for brokers or dealers).
---------------------------------------------------------------------------
The final rule does not require a foreign banking entity that makes
a covered fund investment in the United States, either directly or
through a branch or agency, to deduct the aggregate value of the
investment from the foreign bank's tier 1 capital calculated under
applicable home country standards. However, any U.S. subsidiary of a
foreign banking entity that is required to calculate tier 1 capital
under U.S. risk based capital regulations must deduct the aggregate
value of investment held through that subsidiary from its tier 1
capital.
While some commenters requested that additional capital charges be
imposed on banking entity's interests in securitizations, the Agencies
have declined to do so at this time. Under the final rule, the banking
entity must deduct the value of its investment in a securitization that
is a covered fund from its tier 1 capital for purposes of determining
compliance with the applicable regulatory capital requirements. This
requirement already requires the banking entity to adjust its capital
for the possibility of losses on the full amount of its investment. The
Agencies do not believe that it is appropriate to impose additional
capital charges on these securitizations because it would act as a
disincentive to retain risk in securitizations for which the banking
entity acts as issuer or sponsor, a result that would contradict the
purpose of section 15G of the Exchange Act. Additionally and as noted
in the proposal, permitting a banking entity to retain the minimum
level of economic interest and risk in a securitization will incent
banking entities to engage in more careful and prudent underwriting and
evaluation of the risks and obligations that may accompany asset-backed
securitizations, which would promote and protect the safety and
soundness of banking entities and the financial stability of the United
States.
The Agencies have also declined to impose additional quantitative
limitations or diversification requirements on covered fund investments
at this time. The Agencies believe that the per-fund and aggregate
funds limitations, as well as the capital deduction required by the
rule, acting together with the other limitations on covered fund
activities, establish an appropriate framework for ensuring that the
covered fund investments and activities of banking entities are
conducted in a manner that is safe and sound and consistent with
financial stability. The Agencies will continue to monitor these
activities and investments to determine whether other limitations are
appropriate over time.
f. Attribution of Ownership Interests to a Banking Entity
The proposed rule attributed an ownership interest to a banking
entity based on whether or not the banking entity held the interest
through a controlled entity. The proposed rule required that any
ownership interest held by any entity that is controlled, directly or
indirectly, by a banking entity be included in the amount and value of
the banking entity's permitted investments in a single covered fund.
The proposed rule required that the pro rata share of any ownership
interest held by any covered fund that is not controlled by the banking
entity, but in which the banking entity owns, controls, or holds with
the power to vote more than 5 percent of the voting shares, be included
in the amount and value of the banking entity's permitted investments
in a single covered fund.
Many commenters expressed concerns regarding the proposed
attribution requirements.\2335\ These commenters argued that the
proposed pro rata attribution requirements are not required or
permitted by the statute, have unintended and inconsistent consequences
for covered fund investments, impose heavy compliance costs on banking
entities, and would impede the ability of funds sponsored by banking
entities to invest in third-party funds for the benefit of clients.
[[Page 5732]]
Some commenters argued that the costs and complexity of determining
whether a banking entity ``controls'' another banking entity under the
BHC Act and the Board's precedent are high and urged the Agencies to
adopt a simpler test.\2336\ For example, some commenters urged that
shares of a company be attributed to a banking entity only when the
banking entity maintains ownership of 25 percent or more of voting
shares of the company.\2337\
---------------------------------------------------------------------------
\2335\ See ABA (Keating); Arnold & Porter; SIFMA et al. (Covered
Funds) (Feb. 2012); SSgA (Feb. 2012).
\2336\ See SIFMA et al. (Covered Funds) (Feb. 2012); BlackRock;
Arnold & Porter.
\2337\ See ABA (Keating); Arnold & Porter.
---------------------------------------------------------------------------
Several commenters maintained that applying the attribution
requirements to fund-of-funds structures and parallel or master-feeder
structures would be unworkable.\2338\ Commenters contended that the
proposed attribution rules could result in a banking entity calculating
the per-fund limitation in a way that exceeds the banking entity's
actual loss exposure if the attribution rule for controlled investments
is interpreted to require that 100 percent of all investments made by
controlled entities be attributed to the banking entity.\2339\
---------------------------------------------------------------------------
\2338\ See BoA; SIFMA et al. (Covered Funds) (Feb. 2012); SSgA
(Feb. 2012). These commenters argued that banking entities
traditionally utilize a fund-of-funds structure to offer customers
the opportunity to invest indirectly in a portfolio of other funds
(including some funds sponsored and managed by one or more third
parties) and that these structures provide customers with certain
risk-mitigating benefits and allow customers to gain exposure to a
diverse portfolio without having to satisfy the minimum investment
requirements of each fund directly. They also argued that parallel
and feeder entities are established for a variety of client-driven
reasons, including to accommodate tax needs of clients and that
these entities should be viewed as a single investment program in
which the master fund holds and manages investments in portfolio
assets and the feeder fund typically makes no investments other than
in the master fund.
\2339\ See SIFMA et al. (Covered Funds) (Feb. 2012); BoA; Arnold
& Porter; SSgA (Feb. 2012).
---------------------------------------------------------------------------
In addition, several commenters argued that the pro rata
attribution of investments held through non-controlled structures is
not consistent with the Board's rules and practices for purposes of the
activity and investment limits in other sections of the BHC Act.
Commenters also maintained that this pro rata attribution for non-
controlled entities would be impracticable because a banking entity has
only a limited ability to monitor, direct, or restrain investments of a
covered fund that it does not control.\2340\
---------------------------------------------------------------------------
\2340\ See SIFMA et al. (Covered Funds) (Feb. 2012).
---------------------------------------------------------------------------
Conversely, one commenter supported the pro rata attribution
requirement in the proposal. This commenter argued that this
requirement reduced opportunities for evasion through subsidiaries,
affiliates or related entities.\2341\
---------------------------------------------------------------------------
\2341\ See Occupy.
---------------------------------------------------------------------------
The final rule has been modified in light of the comments. Under
the final rule, a banking entity must account for an investment in a
covered fund for purposes of the per-fund and aggregate funds
limitations only if the investment is made by the banking entity or
another entity controlled by the banking entity. Accordingly, the final
rule does not generally require that a banking entity include the pro
rata share of any ownership interest held by any entity that is not
controlled by the banking entity, and thus reduces the potential
compliance costs of the final rule. The Agencies believe that this
concept of attribution is more consistent with how the Board has
historically applied the concept of ``control'' under the BHC Act for
purposes of determining whether a company subject to that Act is
engaged in an activity or whether to attribute an investment to that
company. Furthermore, because a banking entity does not control a non-
affiliate and typically has less access to information about the
holdings of a non-affiliate, this change is unlikely to present
opportunity for circumvention of the per-fund and aggregate funds
limitations. The Agencies will monitor these limitations for practices
that appear to be attempts to circumvent them.\2342\
---------------------------------------------------------------------------
\2342\ The Agencies note that other provisions of the BHC Act
and Savings and Loan Holding Company Act would prohibit a banking
entity that is a bank holding company or savings and loan holding
company from acquiring 5 percent or more of a covered fund that is
itself a bank holding company or a savings and loan holding company,
respectively, without regulatory approval. See 12 U.S.C. 1842(a); 12
U.S.C. 1467a(e).
---------------------------------------------------------------------------
Whether a banking entity controls another entity under the BHC Act
may vary depending on the type of entity in question. As noted above in
Part IV.B.1.b.3., the Board's regulations and orders have long
recognized that the concept of control is different for funds than for
operating companies.\2343\ In contrast to the proposal, the final rule
incorporates these different concepts of control in part by providing
that, for purposes of section 13 of the BHC Act and the final rule, a
registered investment company, SEC-regulated business development
company, and a foreign public fund as described in Sec. ----.10(c)(1)
of the final rule will not be considered to be an affiliate of the
banking entity if the banking entity owns, controls, or holds with the
power to vote less than 25 percent of the voting shares of the company
or fund, and provides investment advisory, commodity trading advisory,
administrative, and other services to the company or fund only in a
manner that complies with other limitations under applicable
regulation, order, or other authority.\2344\
---------------------------------------------------------------------------
\2343\ See, e.g., First Union Letter.
\2344\ Id. See final rule Sec. ----.12(b)(1)(ii).
---------------------------------------------------------------------------
In response to commenter concerns regarding the workability of the
proposed rule, the final rule has been modified to address how
ownership interests would be attributed to a banking entity when those
interests are held in a fund-of-funds or multi-tiered fund structures.
For instance, banking entities may use a variety of structures to
satisfy operational needs or meet the investment needs of customers of
their trust, fiduciary, investment advisory or commodity trading
advisory services.
First, except as explained for purposes of calculating a banking
entity's permitted investment in multi-tier fund structures, the final
rule does not generally attribute to a banking entity ownership
interests held by a covered fund so long as the banking entity's
investment in the covered fund meets the per-fund limitation in the
final rule.\2345\ Absent unusual circumstances or structures, a banking
entity would not control a covered fund in which the banking entity has
an ownership interest that conforms to the per-fund and aggregate funds
limitations contained in the final rule. Thus, the interests held by
that covered fund would not be attributed to the banking entity for the
reasons discussed above.
---------------------------------------------------------------------------
\2345\ See final rule Sec. ----.12(b)(1)(iii).
---------------------------------------------------------------------------
The final rule also explains how the investment limitations apply
to investments of a banking entity in multi-tier fund structures. The
Agencies believe that master-feeder fund structures typically
constitute a single investment program in which the master fund holds
and manages investments and the feeder funds typically make no
investments other than in the master fund and exist as a convenience
for customers of the trust, fiduciary, investment advisory, or
commodity trading advisory services of the banking entity. Similarly,
trust, fiduciary, or advisory customers of a banking entity may desire
to obtain diversified exposure to a variety of funds or investments
through investing in a fund-of-funds structure that the banking entity
organizes and offers.
In order to meet the demands of these customers, the final rule
provides that if the principal investment strategy of a covered fund
(the ``feeder fund'') is to invest substantially all of its assets in
another single covered fund (the ``master fund''), then for purposes of
the
[[Page 5733]]
per-fund limitation the banking entity's permitted investment shall be
measured only at the master fund. However, in order to appropriately
capture the banking entity's amount of investment in the master fund, a
banking entity must include in this calculation any investment held by
the banking entity in the master fund, as well as the banking entity's
pro-rata share of any ownership interest of the master fund that is
held through the feeder fund.\2346\
---------------------------------------------------------------------------
\2346\ See final rule Sec. ----.12(b)(34).
---------------------------------------------------------------------------
Similarly, regarding fund-of-funds structures, the final rule
provides that if a banking entity organizes and offers a covered fund
pursuant to Sec. ----.11 for the purpose of investing in other covered
funds (a ``fund of funds'') and that fund of funds itself invests in
another covered fund that the banking entity organizes and offers, then
the banking entity's permitted investment in that other covered fund
shall include any investment held by the banking entity in that other
fund, as well as the banking entity's pro-rata share of any ownership
interest of the other fund that is held through the fund of funds. The
banking entity's investment in the fund of funds must also meet the
investment limitations contained in Sec. ----.12. In these manners,
the final rule permit a banking entity to meet the demands of customers
of their trust, fiduciary, or advisory services while also limiting the
ability of a banking entity to be exposed to more than the amount of
risk of a covered fund contemplated by section 13.
As described above in the discussion of organizing and offering a
covered fund, other provisions of section 13 contemplate investments by
employees and directors of the banking entity that provide qualifying
services to a covered fund.\2347\ The Agencies recognized in the
proposal that employee and director investments in a covered fund may
provide an opportunity for a banking entity to evade the limitations
regarding the amount or value of ownership interests a banking entity
may acquire in a covered fund.\2348\ In order to address this concern,
the proposal attributed an ownership interest in a covered fund
acquired or retained by a director or employee to the person's
employing banking entity if the banking entity either extends credit
for the purposes of allowing the director or employee to acquire the
ownership interest, guaranteed the director or employee's purchase, or
guarantees the director or employee against loss on the investment.
---------------------------------------------------------------------------
\2347\ See 12 U.S.C. 1851(d)(1)(G)(vii); final rule Sec. --
--.11(g).
\2348\ See Joint Proposal, 76 FR 68,902.
---------------------------------------------------------------------------
One commenter supported the way the proposal addressed evasion
concerns by attributing an ownership interest in a covered fund
acquired or retained by a director or employee to a banking
entity.\2349\ A different commenter urged the Agencies to attribute any
employee investments in a covered fund to the banking entity itself,
regardless of the source of funds.\2350\ Another commenter argued that
the statute prohibits a banking entity from guaranteeing an investment
by an employee or director.\2351\
---------------------------------------------------------------------------
\2349\ See Ass'n. of Institutional Investors (Feb. 2012).
\2350\ See Occupy.
\2351\ See Arnold & Porter.
---------------------------------------------------------------------------
After considering the comments and the language of the statute, the
Agencies have determined to retain the requirement that all director or
employee investments in a covered fund be attributed to the banking
entity for purposes of the per-fund limitation and the aggregate funds
limitation whenever the banking entity provides the employee or
director funding for the purpose of acquiring the ownership interest.
Specifically, under the final rule, an investment by a director or
employee of a banking entity who acquires an ownership interest in his
or her personal capacity in a covered fund sponsored by the banking
entity will be attributed to the banking entity if the banking entity,
directly or indirectly, extends financing for the purpose of enabling
the director or employee to acquire the ownership interest in the fund
and the financing is used to acquire such ownership interest in the
covered fund.\2352\ It is also important to note that the statute
prohibits a banking entity from guaranteeing the obligations or
performance of a covered fund in which it acts as investment adviser,
investment manager or sponsor, or organizes and offers.\2353\
---------------------------------------------------------------------------
\2352\ See final rule Sec. ----.12(b)(1)(iv).
\2353\ See 12 U.S.C. 1851(f)(1).
---------------------------------------------------------------------------
As discussed above in the definition of ownership interest, the
final rule also attributes to the banking entity any amounts
contributed by an employee or director when made in order to receive a
restricted profit interest, whether or not funded or guaranteed by the
banking entity. This approach ensures that all funding provided by the
banking entity--whether directly or through its employees or
directors--and all exposures of the banking entity--whether directly or
through a guarantee provided to or on behalf of an employee or
director--is counted against the limits on exposure contained in the
statute and final rule. At the same time, this approach recognizes that
employees and directors may use their own resources, not protected by
the banking entity, to invest in a covered fund. Employees of
investment advisers in particular often invest their own resources in
covered funds they advise, both by choice and as a method to align
their personal financial interests with those of other investors in the
covered fund. So long as these investments are truly with personal
resources, and are not funded by the banking entity, these personal
investments would not expose the banking entity to loss and would not
be attributed by the final rule to the banking entity. This approach is
also consistent with the terms of the statute, which expressly
contemplates investments by directors or employees of a banking entity
in their individual capacity.\2354\
---------------------------------------------------------------------------
\2354\ See 12 U.S.C. 1851(d)(1)(G)(vii).
---------------------------------------------------------------------------
The Agencies intend to monitor investments by directors and
employees of a banking entity to ensure that employee ownership
interests are not used to circumvent the per-fund and aggregate funds
limitations in section 13. Among the factors the Agencies will
consider, in addition to financing and guarantee arrangements, are
whether the benefits of the acquisition and retention, such as
dividends, inure to the benefit of the director or employee and not the
banking entity; the voting or control of the ownership interests is
subject to the direction of, or otherwise controlled by, the banking
entity; and the employee or director, rather than the banking entity,
determines whether the employee or director should make the investment.
The proposed rule contained a provision intended to curb potential
evasion of the per-fund limitation and aggregate limitation through
parallel investments by banking entities that were not otherwise
subject to section 13 of the BHC Act. Specifically, the proposed rule
provided that, to the extent that a banking entity is contractually
obligated to invest in, or is found to be acting in concert through
knowing participation in a joint activity or parallel action toward a
common goal of investing in, one or more investments with a covered
fund that is organized and offered by the banking entity (whether or
not pursuant to an express agreement), such investment must be included
in the calculation of a banking entity's per-fund limitation.
Several commenters objected to this requirement and argued that it
was not consistent with the statute. These commenters argued that
section 13 of
[[Page 5734]]
the BHC Act restricts a banking entity's investments in covered funds,
and not direct investments by a banking entity in individual companies
under other authorities, such as the merchant banking investment
authority in section 4(k)(4)(H) of the BHC Act.\2355\ Some commenters
argued that prohibiting or limiting direct investments could cause a
conflict between a banking entity's fiduciary duty to its clients to
manage their covered fund investments and the banking entity's duty to
its shareholders to pursue legitimate merchant banking
investments.\2356\ Some commenters urged the Agencies not to attribute
any parallel co-investment alongside a covered fund to a banking entity
unless there is a pattern of evasion, and some requested that there be
prior notice and an opportunity for a hearing to determine whether such
a pattern has occurred.\2357\ Another commenter recommended the
Agencies provide a safe harbor for situations where a bank trustee is
acting on behalf of customers.\2358\
---------------------------------------------------------------------------
\2355\ See 12 U.S.C. 1843(k)(4)(H); 12 CFR 225.170 et seq. See
ABA (Keating); BoA; BOK; SIFMA et al. (Covered Funds) (Feb. 2012);
SVB.
\2356\ See ABA (Keating).
\2357\ See BOK; SVB; ABA (Keating); BoA; SIFMA et al. (Covered
Funds) (Feb. 2012).
\2358\ See BOK.
---------------------------------------------------------------------------
In contrast, other commenters contended that the risks of direct
investments, such as those made under merchant banking authority, are
similar to those of many investments in covered funds. These commenters
urged the Agencies to restrict direct investments in the underlying
holdings or assets of a covered fund in the same manner as direct
investments in covered funds.\2359\
---------------------------------------------------------------------------
\2359\ See Public Citizen; Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------
After carefully considering the comments and the language of the
statute, the Agencies have determined not to adopt the proposed
prohibition on parallel investments in the final rule. As illustrated
by commenters, banking entities rely on a number of investment
authorities and structures to meet the needs of their clients and make
investments under a variety of authorities that are not coordinated
with investments made by covered funds owned or advised by the banking
entity. The Agencies believe that many investments made by banking
entities are made for the purpose of serving the legitimate needs of
customers and shareholders, and not for the purpose of circumventing
the per-fund and aggregate funds limitations in section 13.
Nevertheless, the Agencies continue to believe that the potential
for evasion of these limitations may be present where a banking entity
coordinates its direct investment decisions with the investments of
covered funds that it owns or sponsors. For instance, the Agencies
understand that it is relatively common for the sponsor of a covered
fund in connection with a privately negotiated investment to offer
investors co-investment opportunities when the general partner or
investment manager for the covered fund determines that the covered
fund does not have sufficient capital available to make the entire
investment in the target portfolio company or determines that it would
not be suitable for the covered fund to take the entire available
investment. In such circumstances, a banking entity that sponsors the
covered fund should not itself make any additional side by side co-
investment with the covered fund in a privately negotiated investment
unless the value of such co-investment is less than 3% of the value of
the total amount co-invested by other investors in such investment.
Further, if the co-investment is made through a co-investment vehicle
that is itself a covered fund (a ``co-investment fund''), the sum of
the banking entity's ownership interests in the co-investment fund and
the related covered fund should not exceed 3% of the sum of the
ownership interests held by all investors in the co-investment fund and
related covered fund. Finally, the Agencies note that if a banking
entity makes investments side by side in substantially the same
positions as the covered fund, then the value of such investments shall
be included for purposes of determining the value of the banking
entity's investment in the covered fund.
g. Calculation of Tier 1 Capital
The proposal explained that tier 1 capital is a banking law concept
that, in the United States, is calculated and reported by certain
depository institutions and bank holding companies in order to
determine their compliance with regulatory capital standards.
Accordingly, the proposed rule clarified that for purposes of the
aggregate funds limitation in Sec. ----.12, a banking entity that is a
bank, a bank holding company, a company that controls an insured
depository institution that reports tier 1 capital, or uninsured trust
company that reports tier 1 capital (each a ``reporting banking
entity'') needed to use the reporting banking entity's tier 1 capital
as of the last day of the most recent calendar quarter that has ended,
as reported to the relevant Federal banking agency.
The proposal also recognizes that not all entities subject to
section 13 of the BHC Act calculate and report tier 1 capital. In order
to provide a measure of equality related to the aggregate funds
limitation contained in section 13(d)(4)(B)(ii)(II) of the BHC Act and
Sec. ----.12(c) of the proposed rule, the proposed rule clarified how
the aggregate funds limitation should be calculated for entities that
are not required to calculate and report tier 1 capital in order to
determine compliance with regulatory capital standards. Under the
proposed rule, with respect to any banking entity that is not
affiliated with a reporting banking entity and not itself required to
report capital in accordance with the risk-based capital rules of a
Federal banking agency, the banking entity's tier 1 capital for
purposes of the aggregate funds limitation was the total amount of
shareholders' equity of the top-tier entity within such organization as
of the last day of the most recent calendar quarter that has ended, as
determined under applicable accounting standards.\2360\ For a banking
entity that was not itself required to report tier 1 capital but was a
subsidiary of a reporting banking entity that is a depository
institution (e.g., a subsidiary of a national bank), the aggregate
funds limitation was the amount of tier 1 capital reported by such
depository institution.\2361\ For a banking entity that was not itself
required to report tier 1 capital but was a subsidiary of a reporting
banking entity that is not a depository institution (e.g., a nonbank
subsidiary of a bank holding company), the aggregate funds limitation
was the amount of tier 1 capital reported by the top-tier affiliate of
such banking entity that holds and reports tier 1 capital under the
proposal.\2362\
---------------------------------------------------------------------------
\2360\ See proposed rule Sec. ----.12(c)(2)(ii)(B)(2).
\2361\ See proposed rule Sec. ----.12(c)(2)(ii)(A).
\2362\ See proposed rule Sec. ----.12(c)(1)(B(2)(ii)(B)(1).
---------------------------------------------------------------------------
Commenters did not generally object to the proposed approach for
determining the applicable tier 1 capital for banking entities. One
commenter advocated calculating the aggregate funds limitation based on
the tier 1 capital of the banking entity making the covered fund
investment instead of the tier 1 capital of the consolidated banking
entity.\2363\ In addition, the commenter urged the Agencies to require
banking entities to divest any portions of the investment that exceeds
3 percent of that entity's tier 1 capital.
---------------------------------------------------------------------------
\2363\ See Occupy.
---------------------------------------------------------------------------
The final rule provides that any banking entity that is required to
[[Page 5735]]
calculate and report tier 1 capital (a ``reporting banking entity'')
must calculate the aggregate funds limitation using the tier 1 capital
amount reported by the entity as of the last day of the most recent
calendar quarter as reported to the relevant Federal banking agency. A
non-depository institution subsidiary of a reporting banking entity may
rely on the consolidated tier 1 capital of the reporting banking entity
for purposes of calculating compliance with the aggregate funds
limitation. In the case of a depository institution that is itself a
reporting banking entity and that is also a subsidiary or affiliate of
a reporting banking entity, the aggregate of all investments in covered
funds held by the depository institution (including the investments by
its subsidiaries) may not exceed three percent of either the tier 1
capital of the depository institution or of the top-tier reporting
banking entity that controls such depository institution. The final
rule also provides that any banking entity that is not itself required
to report tier 1 capital but is a subsidiary of a reporting banking
entity that is a depository institution (e.g., a subsidiary of a
national bank) may compute compliance with the aggregate funds
limitations using the amount of tier 1 capital reported by such
depository institution.
Several commenters argued that foreign banking organizations should
be permitted to use the consolidated tier 1 capital at the top-tier
foreign banking organization level, as calculated under applicable home
country capital standards, to calculate compliance with the aggregate
funds limitation.\2364\ One commenter noted that the tier 1 capital of
a banking entity may fluctuate based on specific conditions relevant
only to the banking entity, and urged the Agencies to consider an
alternative measure of capital, although this commenter did not suggest
any alternative.\2365\
---------------------------------------------------------------------------
\2364\ See Credit Suisse (Williams); IIB/EBF.
\2365\ See Japanese Bankers Ass'n.
---------------------------------------------------------------------------
After considering the comments received and that purpose and
language of section 13 of the BHC Act, the Agencies have determined
that for foreign banking organizations, the aggregate funds limitation
would be based on the consolidated tier 1 capital of the foreign
banking organization, as calculated under applicable home country
standards. However, a U.S. bank holding company or U.S. savings and
loan holding company that is controlled by a foreign banking entity
must separately meet the per-fund and aggregate funds limitations for
each and all (respectively) covered fund investments made by the U.S.
holding company, based on the tier 1 capital of the U.S. bank holding
company or U.S. savings and loan holding company. The Federal banking
agencies may revisit this approach in light of the manner in which the
Board implements the enhanced prudential standards and early
remediation requirements for foreign banking organizations and foreign
nonbank financial companies, including the proposed U.S. intermediate
holding company requirements under that rule.\2366\
---------------------------------------------------------------------------
\2366\ See Enhanced Prudential Standards and Early Remediation
Requirements for Foreign Banking Organizations and Foreign Nonbank
Financial Companies, 77 FR 76,628, 76,637 (Dec. 28, 2012).
---------------------------------------------------------------------------
h. Extension of Time to Divest Ownership Interest in a Single Fund
The proposed rule provided that the Board may, upon application by
a banking entity, extend the period of time that a banking entity may
have to conform an investment to the 3 percent per-fund limitation. As
in the statute, the proposed rule permitted the Board to grant up to an
additional two years if the Board finds that an extension would be
consistent with safety and soundness and not detrimental to the public
interest. The proposal required a banking entity to submit an
application for extension to the Board, and set forth the factors that
the Board would consider in reviewing an application for extension,
including a requirement that the Board consult with the primary federal
supervisory agency for the banking entity prior to acting on an
application.
Some commenters argued that the final rule should be modified to
extend automatically the one-year statutory period for complying with
the per-fund limitation by an additional two years without application
or approval on a case-by-case basis and to apply the extended
conformance period to the aggregate funds limitations.\2367\ Some of
these commenters suggested that Congress explicitly recognized the need
for a banking entity to have a sufficient seeding period following
establishment of a fund, and that funds often require more than one
year to attract enough unaffiliated investors to enable the sponsoring
banking entity to reduce its ownership interests in the fund to the
level required by section 13(d)(4).
---------------------------------------------------------------------------
\2367\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012); SSgA
(Feb. 2012); TCW; Credit Suisse (Williams).
---------------------------------------------------------------------------
Other commenters argued that the amount of a banking entity's own
capital involved in seeding a fund is typically ``small'' and suggested
that, in order to prevent banking entities from engaging in prohibited
proprietary trading through a fund, the Board should condition the
ability of a banking entity to qualify for an extension of the one-year
statutory period on several requirements, including a requirement that
the banking entity not have provided more than $10 million in seed
capital as part of establishing the covered fund.\2368\
---------------------------------------------------------------------------
\2368\ See, e.g., Occupy; Sens. Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------
The Agencies have carefully considered comments received on the
proposal and have determined instead to adopt the process and standards
governing requests for extensions of time to divest an ownership
interest in a single covered fund largely as proposed. The Agencies
believe that this approach is consistent with the process and standards
set out under the statute.
As under the proposal, the final rule requires any banking entity
that seeks an extension of the conformance period provided for the per-
funds limitation to submit a written request to the Board. Any such
request must be submitted to the Board at least 90 days prior to the
expiration of the applicable time period and provide the reasons why
the banking entity believes the extension should be granted. In
addition, the request must explain the banking entity's plan for
reducing the permitted investment in a covered fund through redemption,
sale, dilution or other methods to the limits imposed by the final
rule. To allow the Board to assess the factors provided in the statute,
the final rule provides that any extension request by a banking entity
must address: (i) Whether the investment would result, directly or
indirectly, in a material exposure by the banking entity to high-risk
assets or high-risk trading strategies; (ii) the contractual terms
governing the banking entity's interest in the covered fund; (iii) the
total exposure of the covered banking entity to the investment and the
risks that disposing of, or maintaining, the investment in the covered
fund may pose to the banking entity and the financial stability of the
United States; (iv) the cost to the banking entity of divesting or
disposing of the investment within the applicable period; (v) whether
the investment or the divestiture or conformance of the investment
would involve or result in a material conflict of interest between the
banking entity and unaffiliated parties, including clients, customers
or counterparties to which it owes a duty; (vi) the banking entity's
prior efforts to reduce through redemption, sale, dilution, or other
methods its ownership
[[Page 5736]]
interests in the covered fund, including activities related to the
marketing of interests in such covered fund; (vii) market conditions;
and (viii) any other factor that the Board believes appropriate. In
contrast to the proposal, the final rule does not require information
on whether the extension would pose a threat to safety and soundness of
the covered banking entity or to financial stability of the United
States. The categories of information in final rule have been modified
in order to eliminate redundancies.
The final rule continues to permit the Board to impose conditions
on granting any extension granted if the Board determines conditions
are necessary or appropriate to protect the safety and soundness of
banking entities or the financial stability of the United States,
address material conflicts of interest or otherwise unsound practices,
or to otherwise further the purposes of section 13 of the BHC Act and
the final rule. In cases where the banking entity is primarily
supervised by another Agency, the Board will consult with such Agency
both in connection with its review of the application and, if
applicable, prior to imposing conditions in connection with the
approval of any request by the banking entity for an extension of the
conformance period. While some commenters requested that the Board
modify the final rule to permit a banking entity to have covered fund
investments in excess of the aggregate funds limitation,\2369\ the
final rule does not contain such a provision. As noted in the release
for the proposed rule, the statutory grant of authority to provide
extensions of time to comply with the investment limits refers
specifically and only to the period for conforming a seeding investment
to the per-fund limitation.\2370\
---------------------------------------------------------------------------
\2369\ See ABA (Keating).
\2370\ See 12 U.S.C. 1851(d)(4)(C).
---------------------------------------------------------------------------
As noted in the proposed rule, the Agencies recognize the potential
for evasion of the restrictions contained in section 13 of the BHC Act
through misuse of requests for extension of the seeding period for
covered funds. Therefore, the Board and the Agencies will monitor
requests for extensions of the seeding period for activity in covered
funds that is inconsistent with the requirements of section 13 of the
BHC Act.
4. Section ----.13: Other Permitted Covered Fund Activities
a. Permitted Risk-Mitigating Hedging Activities
Section 13(d)(1)(C) of the BHC Act provides an exemption for
certain risk-mitigating hedging activities.\2371\ In the context of
covered fund activities, the proposed rule implemented this authority
narrowly and permitted a banking entity to acquire or retain an
ownership interest in a covered fund as a risk-mitigating hedge only in
two situations: (i) When acting as intermediary on behalf of a customer
that is not itself a banking entity to facilitate exposure by the
customer to the profits and losses of the covered fund; and (ii) with
respect to a compensation arrangement with an employee of the banking
entity that directly provides investment advisory or other services to
that fund.\2372\ The proposed rule imposed specific requirements on a
banking entity seeking to rely on this exemption.\2373\
---------------------------------------------------------------------------
\2371\ See 12 U.S.C. 1851(d)(1)(C).
\2372\ See proposed rule Sec. ----.13(b)(1)(i)(A) and (B).
\2373\ These requirements were substantially similar to the
requirements for the risk-mitigating hedging exemption for trading
activities contained in proposed Sec. ----.5. In addition, proposed
Sec. ----.13(b) also required that: (i) The hedge represent a
substantially similar offsetting exposure to the same covered fund
and in the same amount of ownership interest in that covered fund
arising out of the transaction to accommodate a specific customer
request or directly connected to the banking entity's compensation
arrangement with an employee; and (ii) the banking entity document,
at the time the transaction is executed, the hedging rationale for
all hedging transactions involving an ownership interest in a
covered fund.
---------------------------------------------------------------------------
The Agencies received a range of comments on the proposed risk-
mitigating hedging exemption for ownership interests in covered funds.
Some commenters objected to the limited applicability of the statutory
risk-mitigating hedging exemption in the covered funds context and
urged the Agencies to allow ownership interests in covered funds to be
used in any appropriate risk-mitigating hedging.\2374\ In contrast,
other commenters urged the Agencies to delete one or both of the risk-
mitigating hedging exemptions as the commenters argued they were
inconsistent with the statute or otherwise inappropriate.\2375\
Commenters also argued that a separate risk-mitigating hedging
exemption for covered funds is unnecessary because the statute provides
a single risk-mitigating hedging exemption.\2376\
---------------------------------------------------------------------------
\2374\ See BoA; Credit Suisse (Williams); Deutsche Bank (Fund-
Linked Products); ISDA (Feb. 2012); SIFMA et al. (Covered Funds)
(Feb. 2012).
\2375\ See AFR et al. (Feb. 2012); Occupy; Public Citizen; Sens.
Merkley & Levin (Feb. 2012).
\2376\ See BoA.
---------------------------------------------------------------------------
Some commenters argued that the proposed rule would impede banking
entities from offering covered-fund linked products to customers,
including hedging these products, and would, in particular, impair the
ability of banking entities to hedge the risks of fund-linked
derivatives with fund-linked swaps or shares of covered funds
referenced in fund-linked products.\2377\ These commenters argued this
limitation would increase risks at banking entities and was
inconsistent with the purpose of the risk-mitigating hedging exemption.
Commenters also proposed modifying the proposal to permit risk-
mitigating hedging activities that facilitate a customer's exposure to
profits and/or losses of the covered fund, to permit portfolio or
dynamic hedging strategies involving covered fund interests, and to
eliminate the proposed condition that a customer would not itself be a
banking entity.\2378\ Some commenters also urged the Agencies to
grandfather existing risk-mitigating hedging activities with respect to
any covered-fund linked products that comply with the hedging
requirements for proprietary trading under Sec. ----.5 of the proposed
rule.\2379\
---------------------------------------------------------------------------
\2377\ See ISDA (Feb. 2012); BoA; Credit Suisse (Williams);
Deutsche Bank (Fund-Linked Products); ISDA (Feb. 2012); SIFMA et al.
(Covered Funds) (Feb. 2012).
\2378\ See, e.g., BoA; SIFMA et al. (Covered Funds) (Feb. 2012);
Deutsche Bank (Fund-Linked Products).
\2379\ See SIFMA et al. (Covered Funds) (Feb. 2012); BoA.
---------------------------------------------------------------------------
In contrast, other commenters objected to the exemption for hedging
covered fund-linked products sold to customers. These commenters
asserted that this activity would authorize investment in covered funds
in a manner that would not be subject to the three percent per-fund
limitation; \2380\ or would be inconsistent with the statutory
requirement that a banking entity actively seek additional investors
for a fund.\2381\
---------------------------------------------------------------------------
\2380\ See Sens. Merkley & Levin (Feb. 2012).
\2381\ See AFR et al. (Feb. 2012).
---------------------------------------------------------------------------
Some commenters urged the Agencies to expand the hedging exemption
to allow banking entities to invest in covered funds in order to hedge
obligations relating to deferred compensation plans for employees who
do not directly provide services to the covered fund for which the
hedge relates.\2382\ Another commenter argued that banking entities
should be permitted to hedge compensation investment accounts for
executive officers who are not involved in the management of the
investment accounts.\2383\ In contrast, other commenters objected to
the hedging exemption for compensation arrangements, arguing that it
may increase risk to banking entities,\2384\ is
[[Page 5737]]
unnecessary,\2385\ or may provide banking entities with an opportunity
to evade the limitations on the amount of ownership interests they may
have as an investment in a covered fund.\2386\
---------------------------------------------------------------------------
\2382\ See Arnold & Porter.
\2383\ See BOK.
\2384\ See Occupy.
\2385\ See AFR et al. (Feb. 2012); Public Citizen.
\2386\ See Occupy.
---------------------------------------------------------------------------
After review of the comments, the Agencies believe at this time
that permitting only limited risk-mitigating hedging activities
involving ownership interests in covered funds is consistent with the
safe and sound conduct of banking entities, and that increased use of
ownership interests in covered funds could result in exposure to higher
risks.\2387\
---------------------------------------------------------------------------
\2387\ See 12 U.S.C. 1851(d)(2).
---------------------------------------------------------------------------
In particular, the Agencies have determined that transactions by a
banking entity to act as principal in providing exposure to the profits
and losses of a covered fund for a customer, even if hedged by the
entity with ownership interests of the covered fund, is a high risk
strategy that could threaten the safety and soundness of the banking
entity. These transactions expose the banking entity to the risk that
the customer will fail to perform, thereby effectively exposing the
banking entity to the risks of the covered fund. Furthermore, a
customer's failure to perform may be concurrent with a decline in value
of the covered fund, which could expose the banking entity to
additional losses. Accordingly, the Agencies believe that these
transactions pose a significant potential to expose banking entities to
the same or similar economic risks that section 13 of the BHC Act
sought to eliminate, and have not adopted the proposed exemption for
using ownership interests in covered funds to hedge these types of
transactions in the final rule.
As argued by some commenters, modifying the proposal to eliminate
the exemption for permitting banking entities to acquire covered fund
interests in connection with customer facilitation may impact banking
entities ability to hedge the risks of fund-linked derivatives through
the use of fund-linked swaps or shares of covered funds referenced by
fund-linked products.\2388\ Some commenters on the proposal argued that
innovation of financial products may potentially be reduced if the
final rule does not permit this type of activity related to fund-linked
products.\2389\ The Agencies recognize that U.S. banking entities may
no longer be able to participate in offering certain customer
facilitation products relating to covered funds, but believe it is
consistent with the purposes of section 13 to restrict these
activities.
---------------------------------------------------------------------------
\2388\ See ISDA (Feb. 2012); BoA; Credit Suisse (Williams);
Deutsche Bank (Fund-Linked Products); SIFMA et al. (Covered Funds)
(Feb. 2012).
\2389\ See SIFMA et al. (Covered Funds) (Feb. 2012); Credit
Suisse (Williams).
---------------------------------------------------------------------------
The final rule maintains the proposed exemption for hedging
employee compensation arrangements with several changes. To ensure that
exempt hedging activities are designed to reduce one or more specific
risks, as required by section 13(d)(1)(C) of the BHC Act, the proposed
rule required that permitted hedging activity be designed to reduce the
specific risks to the banking entity in connection with and related to
its obligations or liabilities. The final rule permits a banking entity
to acquire or retain an ownership interest in a covered fund provided
that the ownership interest is designed to demonstrably reduce or
otherwise significantly mitigate the specific, identifiable risks to
the banking entity in connection with a compensation arrangement with
an employee who directly provides investment advisory or other services
to the covered fund. Under the final rule, a banking entity may not use
as a hedge ownership interests of a covered fund for which the employee
does not provide services. The requirement under the final rule that
the hedging activity be designed to demonstrably reduce or otherwise
significantly mitigate the specific, identifiable risks to the banking
entity is consistent with the requirement in Sec. ----.5 of the final
rule, as discussed above in Part IV.A.4. The final rule permits a
banking entity to hedge its exposures to price and other risks based on
fund performance that arise from restricted profit interest and other
performance based compensation arrangements with its investment
managers.
Section 13(a)(2) of the final rule describes the criteria a banking
entity must meet in order to rely on the risk-mitigating hedging
exemption for covered funds. These requirements, which are based on the
requirements for the risk-mitigating hedging exemption for trading
activities under Sec. ----.5 of the final rule and which are discussed
in detail above in Part IV.A.4, have been modified from the proposal to
reflect the more limited scope of this section.\2390\ In particular,
the final rule permits a banking entity to engage in risk-mitigating
hedging activities involving ownership interests in a covered fund only
if the banking entity has established and implements, maintains and
enforces an internal compliance program that is reasonably designed to
ensure the covered banking entity's compliance with the requirements of
the hedging exemption, including reasonably designed written policies
and procedures and internal controls and ongoing monitoring and
authorization procedures, and has acquired or retained the ownership
interest in accordance with these written policies, procedures and
internal controls. Furthermore, the acquisition or retention of an
ownership interest must demonstrably reduce or otherwise significantly
mitigate, at the inception of the hedge, one or more specific,
identifiable risks arising in connection with the compensation
arrangement with an employee that directly provides investment advisory
or other services to the covered fund. The acquisition or retention
also may not, at the inception of the hedge, result in any significant
new or additional risk that is not itself hedged contemporaneously in
accordance with the hedging exemption, and the hedge must be subject to
continuing review, monitoring and management by the banking entity.
---------------------------------------------------------------------------
\2390\ See final rule Sec. ----.13(a)(2).
---------------------------------------------------------------------------
The final rule also permits a banking entity to engage in risk-
mitigating hedging activities in connection with a compensation
arrangement, subject to the conditions noted above, only if the
compensation arrangement relates solely to the covered fund in which
the banking entity or any affiliate thereof has acquired an ownership
interest and the losses on such ownership interest are offset by
corresponding decreases in the amounts payable in connection with the
related employee compensation arrangement.\2391\
---------------------------------------------------------------------------
\2391\ See final rule Sec. ----.13(a)(2)(iii).
---------------------------------------------------------------------------
b. Permitted Covered Fund Activities and Investments Outside of the
United States
Section 13(d)(1)(I) of the BHC Act \2392\ permits foreign banking
entities to acquire or retain an ownership interest in, or act as
sponsor to, covered funds, so long as those activities and investments
occur solely outside the United States and certain other conditions are
met (the ``foreign fund
[[Page 5738]]
exemption'').\2393\ As described in the proposal, the purpose of this
statutory exemption appears to be to limit the extraterritorial
application of the statutory restrictions on covered fund activities
and investments, while preserving national treatment and competitive
equality among U.S. and foreign banking entities within the United
States.\2394\ The statute does not explicitly define what is meant by
``solely outside of the United States.''
---------------------------------------------------------------------------
\2392\ Section 13(d)(1)(I) of the BHC Act permits a banking
entity to acquire or retain an ownership interest in, or have
certain relationships with, a covered fund notwithstanding the
restrictions on investments in, and relationships with, a covered
fund, if: (i) Such activity or investment is conducted by a banking
entity pursuant to paragraph (9) or (13) of section 4(c) of the BHC
Act; (ii) the activity occurs solely outside of the United States;
(iii) no ownership interest in such fund is offered for sale or sold
to a resident of the United States; and (iv) the banking entity is
not directly or indirectly controlled by a banking entity that is
organized under the laws of the United States or of one or more
States. See 12 U.S.C. 1851(d)(1)(I).
\2393\ This section's discussion of the concept ``solely outside
of the United States'' is provided solely for purposes of the final
rule's implementation of section 13(d)(1)(I) of the BHC Act, and
does not affect a banking entity's obligation to comply with
additional or different requirements under applicable securities,
banking, or other laws.
\2394\ See 156 Cong. Rec. S5897 (daily ed. July 15, 2010)
(statement of Sen. Merkley). (``Subparagraphs (H) and (I) recognize
rules of international regulatory comity by permitting foreign
banks, regulated and backed by foreign taxpayers, in the course of
operating outside of the United States to engage in activities
permitted under relevant foreign law. However, these subparagraphs
are not intended to permit a U.S. banking entity to avoid the
restrictions on proprietary trading simply by setting up an offshore
subsidiary or reincorporating offshore, and regulators should
enforce them accordingly. In addition, the subparagraphs Seek to
maintain a level playing field by prohibiting a foreign bank from
improperly offering its hedge fund and private equity fund services
to U.S. persons when such offering could not be made in the United
States.'').
---------------------------------------------------------------------------
The proposed rule allowed foreign banking entities that met certain
qualifications to engage in covered fund activities, including owning,
organizing and offering, and sponsoring funds outside the United
States. The proposed rule defined both the type of foreign banking
entity that is eligible for the exemption and when an activity or
investment would occur ``solely outside of the United States.'' The
proposed rule allowed a qualifying foreign banking entity to acquire or
retain an ownership interest in, or act as sponsor to, a covered fund
under the exemption only if no subsidiary, affiliate or employee of the
banking entity that's incorporated or physically located in the United
States engaged in offering or selling the covered fund. The proposed
rule also implemented the statutory requirement that prohibited an
ownership interest in the covered fund from being offered for sale or
sold to a resident of the United States.
Commenters generally expressed support for an exemption to allow
foreign banking entities to conduct foreign covered fund activities and
make investments outside the United States.\2395\ A number of
commenters also expressed concerns that the proposed foreign fund
exemption was too narrow and would not be effective in permitting
foreign banking entities to engage in covered fund activities and
investments outside of the United States. For instance, many commenters
argued that several of the proposal's restrictions on the exemption
were not required by statute and were inconsistent with congressional
intent to limit the extraterritorial impact of section 13 of the BHC
Act.\2396\ These commenters argued that the foreign funds exemption
should focus on whether a prohibited activity, such as sponsoring or
investing in a covered fund, involves principal risk taken or held by
the foreign banking entity that poses risk to U.S. banking entities or
the financial stability of the United States.\2397\ Commenters also
argued that a broader exemption would better recognize the regulation
and supervision of the home country supervisor of the foreign banking
entity and of its covered fund activities.\2398\
---------------------------------------------------------------------------
\2395\ See, e.g., IIB/EBF; SIFMA et al. (Covered Funds) (Feb.
2012); See also Occupy.
\2396\ See Ass'n. of German Banks; BVI; Allen & Overy (on behalf
of Canadian Banks); EFAMA; F&C; HSBC; IIB/EBF; ICSA; PEGCC;
Soci[eacute]t[eacute] G[eacute]n[eacute]rale; Union Asset; Ass'n. of
Banks in Malaysia; EBF; Credit Suisse (Williams); Cadwalader (on
behalf of Thai Banks).
\2397\ See IIB/EBF; EBF; Allen & Overy (on behalf of Canadian
Banks); Credit Suisse (Williams); Katten (on behalf of Int'l
Clients).
\2398\ See Credit Suisse (Williams); PEGCC; See also
Commissioner Barnier.
---------------------------------------------------------------------------
Some commenters contended that the proposal represented an improper
extraterritorial application of U.S. law that could be found to violate
international treaty obligations of the United States, such as those
under the North American Free Trade Agreement, and might result in
retaliation by foreign countries in their treatment of U.S. banking
entities abroad.\2399\ Commenters also alleged that the proposal would
impose significant compliance costs on the foreign operations of
foreign banking entities conducting activity pursuant to this
exemption.\2400\ These commenters argued that foreign banking entities
relying on the foreign fund exemption should not be subject to the
compliance program requirements contained in Appendix C with respect to
their non-U.S. operations.\2401\
---------------------------------------------------------------------------
\2399\ See e.g., Norinchukin; Cadwalader (on behalf of Thai
Banks); Barclays; EBF; Ass'n. of German Banks; Soci[eacute]t[eacute]
G[eacute]n[eacute]rale; Chamber (Feb. 2012).
\2400\ See BaFin/Deutsche Bundesbank; Norinchukin; IIF; Allen &
Overy (on behalf of Canadian Banks); ICFR; BoA. As discussed below
in Part IV.C.1, other parts of the final rule address commenters'
concerns regarding the compliance burden on foreign banking
entities.
\2401\ See AFG; Ass'n. of German Banks; BVI; Comm. on Capital
Markets Regulation; IIB/EBF; Japanese Bankers Ass'n.; Norinchukin;
Union Asset. As discussed in greater detail below in Part IV.C.1,
activities and investments of a foreign bank that are conducted
under the foreign funds exemption are generally not subject to the
specific requirements of Sec. ----.20 and Appendices A and B. The
U.S. operations of foreign banking entities are expected to have
policies and procedures in place to ensure that they conduct
activities under this part in full compliance with this part.
---------------------------------------------------------------------------
Several commenters argued that the restrictions of section 13(f),
which limits transactions between a banking entity and certain covered
funds, would not apply to activities and investments made in reliance
on the foreign fund exemption.\2402\ Some commenters argued that the
Agencies should grandfather all existing foreign covered funds and
argued that failure to provide relief for existing relationships could
cause substantial disruption to foreign covered funds and significantly
harm investors in existing funds without producing a clear offsetting
benefit.\2403\
---------------------------------------------------------------------------
\2402\ See Australian Bankers Ass'n.; AFMA; Allen & Overy (on
behalf of Foreign Bank Group); British Bankers' Ass'n.; F&C; French
Banking Fed'n.; IIB/EBF; Japanese Bankers Ass'n; Katten (on behalf
of Int'l Clients); Union Asset. See also infra Part IV.B.5.
\2403\ See BVI; Credit Suisse (Williams); EFAMA; IIB/EBF; PEGCC;
Union Asset. See supra Part II for a discussion regarding the
conformance period.
---------------------------------------------------------------------------
In response to comments received on the proposal, the final rule
contains a number of modifications to more effectively implement the
foreign fund exemption in light of the language and purpose of the
statute. Importantly, as explained in the section defining covered
funds, the Agencies also believe that the more circumscribed definition
of covered fund, including the exclusion for foreign public funds,
should alleviate many of the concerns raised and potential burdens
identified by commenters with respect to the funds activities of
foreign banking entities.\2404\
---------------------------------------------------------------------------
\2404\ For instance, many commenters raised concerns regarding
the treatment of foreign public funds such as UCITS. As discussed in
greater detail above in Part IV.B.1, the definition of covered fund
under the final rule has been modified from the proposal and
tailored to include only the types of foreign funds that the
Agencies believe are intended to be the focus of the statute (e.g.,
certain foreign funds that are established by U.S. banking
entities). Foreign public funds are also excluded from the
definition of covered fund under the final rule. The modifications
in the final rule in part address commenters' request that foreign
funds be grandfathered. To the extent that an entity qualifies for
one or more of the exclusions from the definition of covered fund,
that entity would not be a covered fund under the final rule.
Moreover, any entity that would be a covered fund would still be
able to rely on the conformance period in order to come into
compliance with the requirements of section 13 and the final rule.
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1. Foreign Banking Entities Eligible for the Exemption
The statutory language of section 13(d)(1)(I) provides that, in
order to be eligible for the foreign funds exemption, the banking
entity must not be directly or indirectly controlled by a banking
[[Page 5739]]
entity that is organized under the laws of the United States or of one
or more States. Consistent with this statutory language, the proposed
rule limited the scope of the exemption to banking entities that are
organized under foreign law and, as applicable, controlled only by
entities organized under foreign law.
The Agencies did not receive substantive comment on this aspect of
the proposal related to the foreign fund exemption, though some
commenters offered suggestions to clarify various parts of the wording
of the scope of the definition of banking entities that may qualify for
the exemption. The final rule makes only minor, technical changes to
more fully carry out the purposes of the statute.
Consistent with the statutory language and purpose of section
13(d)(1)(I) of the BHC Act, the final rule provides that the exemption
is available only if the banking entity is not organized under \2405\
or directly or indirectly controlled by a banking entity that is
organized under the laws of the United States or of one or more States.
As noted above, section 13(d)(1)(I) of the BHC Act specifically
provides that its exemption is available only to a banking entity that
is not ``directly or indirectly'' controlled by a banking entity that
is organized under the laws of the United States or of one or more
States.\2406\ Because of this express statutory requirement, a foreign
subsidiary controlled, directly or indirectly, by a banking entity
organized under the laws of the United States or one of its States, and
a foreign branch office of a banking entity organized under the laws of
the United States or one of the States, may not take advantage of this
exemption.
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\2405\ The final rule clarifies the eligibility requirements for
banking entities Seeking to rely on the foreign fund exemption.
Section 13(d)(1)(I) of the BHC Act and Sec. ----.13(c)(1)(i) of the
proposal require that a banking entity Seeking to rely on the
foreign fund exemption not be directly or indirectly controlled by a
banking entity that is organized under the laws of the United States
or of one or more states. For clarification purposes, in addition to
the eligibility requirement in Section 13(d)(1)(I) of the BHC Act
and the proposal, the final rule also expressly requires that the
banking entity not itself be organized under the laws of the United
States.
\2406\ See 12 U.S.C. 1851(d)(1)(I).
---------------------------------------------------------------------------
Like the proposal, the final rule incorporates the statutory
requirement that the banking entity conduct its sponsorship or
investment activities pursuant to sections 4(c)(9) or 4(c)(13) of the
BHC Act. The final rule retains the tests in the proposed rule for
determining when a banking entity would meet that requirement. The
final rule also provides qualifying criteria for both a banking entity
that is a qualifying foreign banking organization under the Board's
Regulation K and a banking entity that is not a foreign banking
organization for purposes of Regulation K.\2407\
---------------------------------------------------------------------------
\2407\ Section ----.13(b)(2) only addresses when a transaction
will be considered to have been conducted pursuant to section
4(c)(9) of the BHC Act. Although the statute also references section
4(c)(13) of the BHC Act, the Board has to date applied the general
authority contained in that section solely to the foreign activities
of U.S. banking organizations which, by the express terms of section
13(d)(1)(I) of the BHC Act, are unable to rely on the foreign funds
exemption.
---------------------------------------------------------------------------
Section 4(c)(9) of the BHC Act applies to any company organized
under the laws of a foreign country the greater part of whose business
is conducted outside the United States, if the Board by regulation or
order determines that the exemption would not be substantially at
variance with the purposes of the BHC Act and would be in the public
interest.\2408\ The Board has implemented section 4(c)(9) as part of
subpart B of the Board's Regulation K,\2409\ which specifies a number
of conditions and requirements that a foreign banking organization must
meet in order to act pursuant to that authority.\2410\ The qualifying
conditions and requirements include, for example, that the foreign
banking organization demonstrate that more than half of its worldwide
business is banking and that more than half of its banking business is
outside the United States.\2411\ Under the final rule a banking entity
that is a qualifying foreign banking organization for purposes of the
Board's Regulation K, other than a foreign bank as defined in section
1(b)(7) of the International Banking Act of 1978 that is organized
under the laws of any commonwealth, territory, or possession of the
United States, will qualify for the foreign fund exemption.\2412\
---------------------------------------------------------------------------
\2408\ See 12 U.S.C. 1843(c)(9).
\2409\ See 12 CFR 211.20 et seq.
\2410\ Some commenters argued that the Board's Regulation K
contains a number of limitations that may not be appropriate to
include as part of the requirements of the foreign fund exemption.
For example, subpart B of the Board's Regulation K includes various
approval requirements and interstate office location restrictions.
See Allen & Overy (on behalf of Foreign Bank Group); HSBC Life. The
final rule does not retain the proposal's requirement that the
activity be conducted in compliance with all of subpart B of the
Board's Regulation K (12 CFR 211.20 through 211.30). However, the
foreign fund exemption in section 13(d)(1)(I) of the BHC Act and the
final rule operates as an exemption and is not a separate grant of
authority to engage in an otherwise impermissible activity. To the
extent a banking entity is a foreign banking organization, it
remains subject to the Board's Regulation K and must, as a separate
matter, comply with any and all applicable rules and requirements of
that regulation.
\2411\ See 12 CFR 211.23(a), (c), and (e). The proposed rule
only referenced the qualifying test under section 211.23(a) of the
Board's Regulation K; however, because there are two other methods
by which a foreign banking organization may meet the requirements to
be considered a qualified foreign banking organization, the final
rule incorporates a reference to those provisions as well.
\2412\ This modification to the definition of foreign banking
organization from the proposed definition is necessary because,
under the International Banking Act and the Board's Regulation K,
depository institutions that are located in, or organized under the
laws of a commonwealth, territory, or possession of the United
States, are foreign banking organizations. However, for purposes of
the Federal securities laws and certain banking statutes, such as
section 2(c)(1) of the BHC Act and section 3 of the FDI Act, these
same entities are defined to be and treated as domestic entities.
For instance, these entities act as domestic broker-dealers under
U.S. securities laws and their deposits are insured by the FDIC.
Because one of the purposes of section 13 is to protect insured
depository institutions and the U.S. financial system from the
perceived risks of proprietary trading and covered fund activities,
the Agencies believe that these entities should be considered to be
located within the United States for purposes of section 13. The
final rule includes within the definition of State any State, the
District of Columbia, the Commonwealth of Puerto Rico, Guam,
American Samoa, the United States Virgin Islands, and the
Commonwealth of the Northern Mariana Islands.
---------------------------------------------------------------------------
Section 13 of the BHC Act also applies to foreign companies that
control a U.S. insured depository institution but that are not subject
to the BHC Act generally or to the Board's Regulation K--for example,
because the foreign company controls a savings association or an FDIC-
insured industrial loan company. Accordingly, the final rule also
provides that a foreign banking entity that is not a foreign banking
organization would be considered to be conducting activities ``pursuant
to section 4(c)(9)'' for purposes of the foreign fund exemption \2413\
if the entity, on a fully-consolidated basis \2414\, meets at least two
of three requirements that evaluate the extent to which the foreign
banking entity's business is conducted outside the United States, as
measured by assets, revenues, and income.\2415\ This test largely
mirrors the qualifying foreign banking organization test that is made
applicable under section 4(c)(9) of the BHC Act and Sec. 211.23(a),
(c), or (e) of the Board's Regulation K, except that the test does not
require the foreign
[[Page 5740]]
entity to demonstrate that more than half of its banking business is
outside the United States.\2416\ This difference reflects the fact that
foreign entities subject to section 13 of the BHC Act, but not the BHC
Act generally, are likely to be, in many cases, predominantly
commercial firms. A requirement that such firms also demonstrate that
more than half of their banking business is outside the United States
would likely make the exemption unavailable to such firms and subject
their global activities to the restrictions on covered fund activities
and investments, a result that the Agencies do not believe was
intended.
---------------------------------------------------------------------------
\2413\ This clarification would be applicable solely in the
context of section 13(d)(1) of the BHC Act. The application of
section 4(c)(9) to foreign companies in other contexts is likely to
involve different legal and policy issues and may therefore merit
different approaches.
\2414\ For clarification purposes, the final rule has been
modified from the proposal to provide that the requirements for this
provision must be met on a fully-consolidated basis.
\2415\ See final rule Sec. ----.13(b)(2)(ii)(B). For purposes
of determining whether, on a fully consolidated basis, it meets the
requirements under Sec. ----.13(b)(2)(ii)(B), a foreign banking
entity that is not a foreign banking organization should base its
calculation on the consolidated global assets, revenues, and income
of the top-tier affiliate within the foreign banking entity's
structure.
\2416\ See 12 U.S.C. 1843(c)(9); 12 CFR 211.23(a), (c), and (e);
final rule Sec. ----.13(b)(2)(ii)(B).
---------------------------------------------------------------------------
2. Activities or Investments Solely Outside of the United States
As noted above, the proposed rule adopted a transaction-based
approach to implementing the foreign fund exemption and focused on the
extent to which the foreign fund transactions occur within, or are
carried out by personnel, subsidiaries or affiliates within, the United
States. In particular, Sec. ----.13(c)(3) of the proposed rule
provided that a transaction or activity be considered to have occurred
solely outside of the United States only if: (i) the transaction or
activity is conducted by a banking entity that is not organized under
the laws of the United States or of one or more States; (ii) no
subsidiary, affiliate, or employee of the banking entity that is
involved in the offer or sale of an ownership interest in the covered
fund is incorporated or physically located in the United States; and
(iii) no ownership interest in such covered fund is offered for sale or
sold to a resident of the United States.
Commenters suggested that, like the foreign trading exemption, the
foreign fund exemption should focus on the location of activities that
a banking entity engages in as principal.\2417\ These commenters argued
that the location of sales activities of a fund should not determine
whether a banking entity has sponsored or acquired an ownership
interest in a covered fund solely outside of the United States.
Commenters also argued that foreign banking entities typically locate
marketing and sales personnel for foreign funds in the United States in
order to serve customers, including those that are not residents of the
United States, and that the proposal would needlessly force all covered
fund sales activities to shift outside of the United States. These
commenters alleged that the restrictions under the proposal would cause
foreign banking entities to relocate their personnel from the United
States to overseas, diminishing U.S. jobs with no concomitant
benefit.\2418\
---------------------------------------------------------------------------
\2417\ See Credit Suisse (Williams); IIB/EBF; Katten (on behalf
of Int'l Clients).
\2418\ See Allen & Overy (on behalf of Foreign Bank Group);
Ass'n. of German Banks; Credit Suisse (Williams); IIB/EBF;
Soci[eacute]t[eacute] G[eacute]n[eacute]rale; Union Asset.
---------------------------------------------------------------------------
Many commenters requested removal of the proposal's prohibition on
a U.S. subsidiary, affiliate, or employee of the foreign banking entity
offering or selling fund interests in order to qualify for the foreign
fund exemption.\2419\ Commenters argued that this limitation was not
included in the statute and that the limited involvement of persons
located in the U.S. in the distribution of ownership interests in a
foreign covered fund should not, by itself, disqualify the banking
entity from relying on the foreign fund exemption so long as the fund
is offered only outside the United States.\2420\ These commenters
argued that organizing and offering a fund is not a prohibited activity
so long as it is not accompanied by ownership or sponsorship of the
covered fund. One commenter urged that the final rule permit U.S.
personnel of a foreign banking entity to engage in non-selling
activities related to a covered fund, including acting as investment
advisor, establishing fund vehicles, conducting back-office functions
such as day-to-day management and deal sourcing tax structuring,
obtaining licenses, interfacing with regulators, and other related
activities that do not involve U.S. sales activity.\2421\
---------------------------------------------------------------------------
\2419\ See Allen & Overy (on behalf of Foreign Bank Group);
Ass'n. of German Banks; Credit Suisse (Williams); IIB/EBF; Katten
(on behalf of Int'l Clients); TCW; Union Asset.
\2420\ See IIB/EBF; Soci[eacute]t[eacute]
G[eacute]n[eacute]rale; TCW; Union Asset; Credit Suisse (Williams);
See also Katten (on behalf of Int'l Clients) (recommending that,
similar to the SEC's Regulation S, the final rule provide that
involvement of persons located in the United States in the
distribution of a non-U.S. covered fund's securities to potential
purchasers outside of the United States not affect the analysis of
whether a non-U.S. banking entity's investment or sponsorship occurs
outside the United States).
\2421\ See Allen & Overy (on behalf of Foreign Bank Group).
---------------------------------------------------------------------------
Instead of the proposal's transaction-based approach to
implementing the foreign fund exemption, many commenters suggested the
final rule adopt a risk-based approach.\2422\ These commenters argued
that a risk-based approach would prohibit or significantly limit the
amount of financial risk from such activities that could be transferred
to the United States by the foreign activity of foreign banking
entities in line with the purpose of the statute.\2423\ Commenters also
contended that foreign activities of most foreign banking entities are
already subject to activities limitations, capital requirements, and
other prudential requirements of their home-country
supervisor(s).\2424\
---------------------------------------------------------------------------
\2422\ See BaFin/Deutsche Bundesbank; ICSA; IIB/EBF; EBF; Allen
& Overy (on behalf of Canadian Banks); Credit Suisse (Williams);
George Osborne.
\2423\ See IIB/EBF.
\2424\ See IIB/EBF.
---------------------------------------------------------------------------
In response to commenters' concerns and in order to more
effectively implement both the statutory prohibition as well as the
foreign fund exemption, the final rule has been modified to better
reflect the purpose of the statute by ensuring that the principal risks
of covered fund investments and sponsorship by foreign banking entities
permitted under the foreign funds exemption occur and remain solely
outside of the United States. One of the principal purposes of section
13 is to limit the risks that covered fund investments and activities
pose to the safety and soundness of U.S. banking entities and the U.S.
financial system. Another purpose of the foreign fund exemption was to
limit the extraterritorial application of section 13 as it applies to
foreign banking entities subject to section 13.
To accomplish these purposes in light of the structure and purpose
of the statute and in response to commenters, the final rule adopts a
risk-based approach rather than a transaction approach to the foreign
fund exemption. In order to ensure these risks remain solely outside of
the United States, the final rule also includes several conditions on
the availability of the foreign fund exemption. Specifically, the final
rule provides that an activity or investment occurs solely outside the
United States for purposes of the foreign fund exemption only if:
The banking entity acting as sponsor, or engaging as
principal in the acquisition or retention of an ownership interest in
the covered fund, is not itself, and it not controlled directly or
indirectly by, a banking entity that is located in the United States or
established under the laws of the United States or of any State;
The banking entity (including relevant personnel) that
makes the decision to acquire or retain the ownership interest or act
as sponsor to the covered fund is not located in the United States or
organized under the laws of the United States or of any State;
The investment or sponsorship, including any transaction
arising from risk-mitigating hedging related to an ownership interest,
is not accounted for as principal directly or indirectly on a
consolidated basis by any branch or
[[Page 5741]]
affiliate that is located in the United States or organized under the
laws of the United States or of any State; and
No financing for the banking entity's ownership or
sponsorship is provided, directly or indirectly, by any branch or
affiliate that is located in the United States or organized under the
laws of the United States or of any State.\2425\
---------------------------------------------------------------------------
\2425\ See final rule Sec. ----.13(b)(4).
---------------------------------------------------------------------------
These requirements are designed to ensure that any foreign banking
entity engaging in activity under the foreign fund exemption does so in
a manner that ensures the risk and sponsorship of the activity or
investment occurs and resides solely outside of the United States.
The final rule has been modified from the proposal to specifically
recognize that, for purposes of the foreign fund exemption, a U.S.
branch, agency, or subsidiary of a foreign bank, is located in the
United States; however, a foreign bank that operates or controls that
branch, agency, or subsidiary is not considered to be located in the
United States solely by virtue of operation of the U.S. branch, agency,
or subsidiary.\2426\ A subsidiary (wherever located) of a U.S. branch,
agency, or subsidiary of a foreign bank is also considered itself to be
located in the United States. This provision helps give effect to the
statutory language limiting the foreign fund exemption to activities of
foreign banking entities that occur ``solely outside of the United
States'' by clarifying that the U.S. operations of foreign banking
entities may not sponsor or acquire or retain an ownership interest in
a covered fund as principal based on this exemption.
---------------------------------------------------------------------------
\2426\ See final rule Sec. ----.13(b)(5).
---------------------------------------------------------------------------
Because so-called ``back office'' activities do not involve
sponsoring or acquiring or retaining an ownership interest in a covered
fund, the final rule does not impose restrictions on U.S. personnel of
a foreign banking entity engaging in these activities in connection
with one or more covered funds. This allows providing administrative
services or similar functions to the covered fund as an incident to the
activity conducted under the foreign fund exemption (such as clearing
and settlement, maintaining and preserving records of the fund,
furnishing statistical and research data, or providing clerical support
for the fund).
The foreign fund exemption in the final rule also permits the U.S.
personnel and operations of a foreign banking entity to act as
investment adviser to a covered fund in certain circumstances. For
instance, the U.S. personnel of a foreign banking entity may provide
investment advice and recommend investment selections to the manager or
general partner of a covered fund so long as that investment advisory
activity in the United States does not result in the U.S. personnel
participating in the control of the covered fund or offering or selling
an ownership interest to a resident of the United States. As explained
above, the final rule also explicitly provides that acquiring or
retaining an ownership interest does not include acquiring or retaining
an ownership interest in a covered fund by a banking entity acting
solely as agent, broker, or custodian, subject to certain conditions,
or acting on behalf of customers as a trustee, or in a similar
fiduciary capacity for a customer that is not a covered fund, so long
as the activity is conducted for the account of the customer and the
banking entity and its affiliates do not have or retain beneficial
ownership of the ownership interest.\2427\ The final rule would thus
allow a foreign bank to engage in any of these capacities in the U.S.
without the need to rely on the foreign fund exemption.
---------------------------------------------------------------------------
\2427\ See final rule Sec. ----.10(a)(2).
---------------------------------------------------------------------------
3. Offered for Sale or Sold to a Resident of the United States
The proposed rule provided that no ownership interest in the
covered fund be offered for sale or sold to a resident of the United
States, a requirement of the statute.\2428\ Numerous commenters focused
on the definition of ``resident of the United States'' in the proposed
rule and the manner in which the restriction on offers and sales to
such persons would interrelate with Regulation S under the Securities
Act of 1933. Commenters asserted that, since market participants have
long conducted offerings of foreign funds in reliance on Regulation S
\2429\ in order to comply with U.S. securities law obligations, these
same securities law principles should be applied to determine whether a
person is a resident of the United States for purposes of section 13
and the final rule to determine whether an offer or sale is made to
residents of the United States.\2430\
---------------------------------------------------------------------------
\2428\ See proposed rule Sec. ----.13(c)(1)(iii).
\2429\ See 17 CFR 230.901-905.
\2430\ See IIB/EBF; EFAMA; ICI Global.
---------------------------------------------------------------------------
Certain commenters argued that because of the way the restriction
in the statute and proposed rule was written, it was unclear whether
the restriction on offering for sale to a resident of the United States
applied to the foreign banking entity or to any third party that
establishes a fund.\2431\ Commenters argued the prohibition against
offers or sales of ownership interests to residents of the United
States should apply only to offers and sales of covered funds organized
and offered by the foreign banking entity but not to covered funds
established by unaffiliated third parties.\2432\ These commenters
reasoned that a foreign banking entity should be permitted to make a
passive investment in a covered fund sponsored and controlled by an
unaffiliated third party that has U.S. investors as long as the foreign
banking entity does not itself offer or sell ownership interest in the
covered fund to residents of the United States.\2433\ Commenters
contended that this interpretation would be consistent with section
13's purpose to prevent foreign banks from using the foreign fund
exemption to market and sell covered funds to U.S. investors, while
simultaneously limiting the extraterritorial impact of section
13.\2434\ Commenters argued that the proposal's foreign fund exemption
would negatively impact U.S. asset managers unaffiliated with any
banking entity because they would either be forced to exclude foreign
banking entities from investing in their funds or would need to ensure
that no residents of the United States hold ownership interests in
funds offered to these entities.\2435\ Commenters also contended that
foreign banking entities, including sovereign wealth funds that own or
control foreign banking organizations, invest tens of billions of
dollars in U.S. covered funds and that if these types of investments
were not permitted under the foreign fund exemption an important source
of foreign investment in the U.S. could be eliminated.\2436\
---------------------------------------------------------------------------
\2431\ See Cadwalader (on behalf of Thai Banks); Grosvenor;
SIFMA et al. (Covered Funds) (Feb. 2012).
\2432\ See Ass'n. of German Banks; BAROC; Cadwalader (on behalf
of Thai Banks); Comm. on Capital Markets Regulation; Credit Suisse
(Williams); IIB/EBF; Japanese Bankers Ass'n.; Katten (on behalf of
Int'l Clients); PEGCC.
\2433\ See Grosvenor; IIB/EBF; Japanese Bankers Ass'n.; Katten
(on behalf of Int'l Clients); Sens. Merkley & Levin (Feb.2012);
Norinchukin; SIFMA et al. (Covered Funds) (Feb. 2012).
\2434\ See BAROC; Credit Suisse (Williams); Grosvenor; IIB/EBF.
\2435\ See Comm. on Capital Markets Regulation; Credit Suisse
(Williams); PEGCC.
\2436\ See SIFMA et al. (Covered Funds) (Feb. 2012); See also
Grosvenor; PEGCC.
---------------------------------------------------------------------------
Commenters argued that an investment by a foreign banking entity in
a third-party unaffiliated fund does not pose any risk to a U.S.
banking entity or to the U.S. financial system. Moreover, commenters
argued that a foreign banking entity that has invested in a fund
sponsored and advised by a
[[Page 5742]]
third party has no control over whether--and may have no knowledge--
that the third party has determined to offer or sell the fund to U.S.
residents.\2437\
---------------------------------------------------------------------------
\2437\ See AFG; BAROC; Cadwalader (on behalf of Thai Banks);
Japanese Bankers Ass'n.
---------------------------------------------------------------------------
As noted above, one of the purposes of section 13 is to limit the
risk to banking entities and the financial system of the United States.
Another purpose of the statute appears to be to permit foreign banking
entities to engage in foreign activities without being subject to the
restrictions of section 13 while also ensuring that these foreign
entities do not receive a competitive advantage over U.S. banking
entities with respect to offering and selling their covered fund
services in the United States.\2438\ As such, the final rule does not
prohibit a foreign banking entity from making an investment in or
sponsoring a foreign fund. However, a foreign banking entity would not
be permitted under the foreign fund exemption to invest in, or engage
in the sponsorship of, a U.S. or foreign covered fund that offers
ownership interests to residents in the United States unless it does so
pursuant to and subject to the limitations of the permitted activity
exemption for organizing and offering a covered fund, for example,
which has the same effect for U.S. banking entities. The final rule
ensures that the risk of the sponsoring and investing in non-U.S.
covered funds by foreign banking entities remains outside of the United
States and that the foreign fund exemption does not advantage foreign
banking entities relative to U.S. banking entities with respect to
providing their covered fund services in the United States by
prohibiting the offer or sale of ownership interests in related covered
funds to residents of the United States.
---------------------------------------------------------------------------
\2438\ See 156 Cong. Rec. S5897 (daily ed. July 15, 2010)
(statement of Sen. Merkley).
---------------------------------------------------------------------------
Commenters also argued that foreign investors in a foreign covered
fund should not be treated as residents of the United States for
purposes of the final rule if, after purchasing their interest in the
covered fund, they relocate to the U.S.,\2439\ or travel to the U.S. on
a temporary basis.\2440\ Commenters also argued that non-U.S. investors
in a fund offered by a foreign banking entity should not be prohibited
from transferring their interests to residents of the United States in
the secondary market.\2441\ One commenter alleged that, notwithstanding
the reasonable efforts of foreign banking entities to prevent residents
of the United States from investing in their foreign covered funds,
investors may find ways to circumvent and invest in covered funds
without knowledge or assistance from the foreign banking entity.\2442\
---------------------------------------------------------------------------
\2439\ See IIB/EBF; Katten (on behalf of Int'l Clients); Union
Asset.
\2440\ See IFIC; See also Allen & Overy (on behalf of Canadian
Banks).
\2441\ See Ass'n. of German Banks; Credit Suisse (Williams);
IIB/EBF; Katten (on behalf of Int'l Clients).
\2442\ See Credit Suisse (Williams).
---------------------------------------------------------------------------
Certain commenters argued that there was a substantial risk that
foreign funds offered by foreign banking entities would not be able to
rely on the exemption due to the presence of a limited number of
investors who are residents of the United States.\2443\ A few
commenters suggested that the final rule should require that, for both
related and unrelated covered funds, a banking entity need only have a
reasonable belief that an ownership interest in a covered fund is not
offered or sold to residents of the United States in order to qualify
for the foreign fund exemption. Commenters argued that only active
targeting or marketing towards a resident of the United States by the
foreign banking entity should be prohibited by the final rule, and that
the incidental presence of a limited number of investors that are
residents of the United States in a foreign covered fund offered by a
foreign banking entity should not prohibit the foreign banking entity
from relying on the foreign fund exemption.\2444\ One commenter argued
that, for certain complex fund structures (e.g., a structure with a
master fund and multiple feeder funds that investors invest in or a
parallel fund structure both managed by the same fund manager),
eligibility for the foreign fund exemption should not be precluded for
a fund with no ownership interests offered for sale or sold to U.S.
residents even if a related covered fund is offered to residents of the
United States.\2445\
---------------------------------------------------------------------------
\2443\ See BVI; EFAMA; Union Asset.
\2444\ See AFG; Union Asset; See also BVI; Allen & Overy (on
behalf of Canadian Banks); Katten (on behalf of Int'l Clients).
\2445\ See Japanese Bankers Ass'n.
---------------------------------------------------------------------------
After considering comments received on the proposal, the final rule
retains the statutory requirement that no ownership interest in the
covered fund be offered for sale to a resident of the United
States.\2446\ The final rule provides that an ownership interest in a
covered fund is offered for sale or sold to a resident of the United
States for purposes of the foreign fund exemption only if it is sold or
has been sold pursuant to an offering that targets residents of the
United States.\2447\
---------------------------------------------------------------------------
\2446\ See final rule Sec. ----.13(b)(1)(iii).
\2447\ See final rule Sec. ----.13(b)(3).
---------------------------------------------------------------------------
Absent circumstances otherwise indicating a nexus with residents of
the United States, the sponsor of a foreign fund would not be viewed as
targeting U.S. residents for purposes of the foreign fund exemption if
it conducts an offering directed to residents of one or more countries
other than the United States; includes in the offering materials a
prominent disclaimer that the securities are not being offered in the
United States or to residents of the United States; and includes other
reasonable procedures to restrict access to offering and subscription
materials to persons that are not residents of the United States.\2448\
If ownership interests that are issued in a foreign offering are listed
on a foreign exchange, secondary market transactions could be
undertaken by the banking entity outside the United States in
accordance with Regulation S under the foreign fund exemption.\2449\
Foreign banking entities should use precautions not to send offering
materials into the United States or conduct discussions with persons
located in the United States (other than to or with a person known to
be a dealer or other professional fiduciary acting on behalf of a
discretionary account or similar account for a person who is not a
resident of the United States).\2450\ In order to comply with the rule
as adopted, sponsors of covered funds established outside of the United
States must examine the facts and circumstances of their particular
offerings and confirm that the offering does not target residents of
the United States.
---------------------------------------------------------------------------
\2448\ See Statement of the Commission Regarding Use of Internet
Web sites to Offer Securities, Solicit Securities Transactions or
Advertise Investment Services Offshore, Securities Act Release No.
7516 (Mar. 23, 1998). Reliance on these principles only applies with
respect to whether an ownership interest in a covered fund is
offered for sale or sold to a resident of the United States for
purposes of section 13 of the BHC Act. In addition, reliance would
not be appropriate if a foreign fund engages in a private placement
of ownership interests in the United States in reliance on Section
4(a)(2) of the Securities Act of 1933 or Regulation D (17 CFR
230.501-506).
\2449\ An offer or sale is made in an ``offshore transaction''
under Regulation S if, among other conditions, the transaction is
executed in, on or through the facilities of a ``designated offshore
securities market'' as described in Regulation S, which includes a
number of foreign stock exchanges and markets and any others the SEC
designates. See Securities Act rule 902(h).
\2450\ See Securities Act rule 902(k)(2).
---------------------------------------------------------------------------
With respect to the treatment of multi-tiered fund structures under
the foreign fund exemption, the Agencies expect that activities related
to certain complex fund structures should be integrated in
[[Page 5743]]
order to determine whether an ownership interest in a covered fund is
offered for sale to a resident of the United States. For example, a
banking entity may not be able to rely on the foreign fund exemption to
sponsor or invest in an initial covered fund (that is offered for sale
only overseas and not to residents of the United States) that is itself
organized or operated for the purpose of investing in another covered
fund (that is sold pursuant to an offering that targets U.S. residents)
and that is either organized and offered or is advised by that banking
entity.
4. Definition of ``Resident of the United States''
As discussed in greater detail above in Part IV.B.1, section
13(d)(1)(I) of the BHC Act provides that a foreign banking entity may
acquire or retain an ownership interest in or act as sponsor to a
covered fund, but only if that activity is conducted according to the
requirements of the statute, including that no ownership interest in
the covered fund is offered for sale or sold to a ``resident of the
United States.'' As noted above in Part IV.B.1.f describing the
definition of ``resident of the United States,'' the statute does not
define this term.
After carefully considering comments received, the Agencies have
defined the term ``resident of the United States'' in the final rule to
mean a ``U.S. person'' as defined in the SEC's Regulation S.\2451\ The
Agencies note, however, that it would not be permissible under the
foreign fund exemption for a foreign banking entity to facilitate or
participate in the formation of a non-U.S. investment vehicle for a
person or entity that is itself a U.S. person for the specific purpose
of investing in a foreign fund. The Agencies believe that this type of
activity would constitute an evasion of the requirements of section 13
of the BHC Act.
---------------------------------------------------------------------------
\2451\ See final rule Sec. ----.10(d)(8).
---------------------------------------------------------------------------
c. Permitted Covered Fund Interests and Activities by a Regulated
Insurance Company
As discussed above, section 13(d)(1)(F) of the BHC Act permits a
banking entity that is a regulated insurance company acting for its
general account, or an affiliate of an insurance company acting for the
insurance company's general account, to purchase or sell a financial
instrument subject to certain conditions.\2452\ Section 13(d)(1)(D) of
the Act permits a banking entity to purchase or sell a financial
instrument on behalf of customers.\2453\ The proposal implemented these
exemptions with respect to the proprietary trading activities of
insurance companies by permitting a banking entity that is an insurance
company to purchase or sell a financial instrument for the general
account of the insurance company or for a separate account, in each
case subject to certain restrictions.\2454\ The proposal did not apply
these exemptions to covered fund activities or investments.
---------------------------------------------------------------------------
\2452\ See 12 U.S.C. 1851(d)(1)(F).
\2453\ See 12 U.S.C. 1851(d)(1)(D).
\2454\ See proposed rule Sec. Sec. ----.6(b)(2)(iii); --
--.6(c).
---------------------------------------------------------------------------
A number of commenters argued that section 13 was designed to
accommodate the business of insurance by exempting both the proprietary
trading and covered fund activities of insurance companies.\2455\ These
commenters argued that providing an exemption for covered fund
activities and investments through both the general account and
separate accounts of an insurance company was integral to the business
of insurance and that, absent an exemption from the covered fund
provisions, insurance companies would lack an effective means to
diversify their holdings and obtain adequate rates of return in order
to maintain affordable premiums for customers.\2456\
---------------------------------------------------------------------------
\2455\ See, e.g., Sutherland (on behalf of Comm. of Annuity
Insurers); ACLI (Jan. 2012); Country Fin. et al.; Nationwide; NAMIC;
Fin. Services Roundtable (Feb. 3, 2012) (citing FSOC study at 71);
HSBC Life; Chamber (Feb. 2012); Country Fin. et al.; Mutual of
Omaha; See also Rep. McCarthy et al.; Sen. Nelson; Sen. Hagan; Sens.
Brown & Harkin.
\2456\ See, e.g., Fin. Services Roundtable (Feb. 3, 2012); TIAA-
CREF (Feb. 13, 2012); Sutherland (on behalf of Comm. of Annuity
Insurers); USAA (citing FSOC study at 71); HSBC Life; ACLI; NAMIC;
Nationwide.
---------------------------------------------------------------------------
Some commenters argued that section 13 of the BHC Act specifically
provides exemptions from both the covered fund prohibition of section
13(a)(1), and the prohibition on proprietary trading.\2457\ Commenters
contended that the exemptions in section 13(d)(1)(F) (referencing
activity in general accounts of insurance companies) and 13(d)(1)(D)
(referencing activities on behalf of customers) cross-reference the
instruments described in section 13(h)(4) and not activity described in
section 13(h)(4). On this basis, commenters argued the statute exempts
both proprietary trading in these instruments described in section
13(h)(4) and investments in those instruments (including when those
instruments are ownership interests in covered funds).\2458\
---------------------------------------------------------------------------
\2457\ See Sutherland (on behalf of Comm. of Annuity Insurers);
Nationwide; See also Rep. McCarthy et al.; Sens. Brown & Harkin.
\2458\ See, e.g., Fin. Services Roundtable (Feb. 3, 2012); USAA;
HSBC Life; Country Fin. et al.; Sutherland (on behalf of Comm. of
Annuity Insurers); Nationwide (discussing the exemption for the
general account of an insurance company); ACLI; Nationwide
(discussing the exemption for separate accounts).
---------------------------------------------------------------------------
Alternatively, commenters argued that the Agencies should use their
authority in section 13(d)(1)(J) of the BHC Act to provide an exemption
for the covered fund activities and investments of insurance
companies.\2459\ These commenters argued that exempting covered funds
activities and investments of insurance companies would promote and
protect the safety and soundness of the banking entity and financial
stability of the United States and provide certain benefits to the U.S.
financial system by allowing insurance companies to access important
asset classes (for better investment diversity and returns), provide
more diverse product offerings to customers, better manage their
investment risks through diversification and more closely matching the
maturity of their assets and liabilities, contribute liquidity to
capital markets, and support economic growth through the provision of
capital to entrepreneurs and businesses.\2460\ Commenters also argued
that an exemption for insurance companies from the covered fund
prohibitions was necessary to permit insurance companies that are
banking entities to effectively compete with insurance companies not
affiliated with an insured depository institution.\2461\ Commenters
alleged that insurance companies are already subject to extensive
regulation under state insurance laws that specifically include
provisions designed to diversify risk among investment categories,
limit exposure to particular types of asset classes including covered
fund investments, and protect the safety and soundness of the insurance
company.\2462\
---------------------------------------------------------------------------
\2459\ See, e.g., Sutherland (on behalf of Comm. of Annuity
Insurers).
\2460\ See Fin. Services Roundtable (Feb. 3, 2012); TIAA-CREF
(Feb. 13, 2012); USAA; HSBC Life; ACLI (Jan. 2012); NAMIC;
Nationwide.
\2461\ See, e.g., Nationwide.
\2462\ See, e.g., ACLI (Jan. 2012); Fin. Services Roundtable
(Feb. 3, 2012); USAA; Chamber (Feb. 2012); Country Fin. et al.;
Mutual of Omaha; NAMIC; Nationwide; Rep. McCarthy et al. See also
156 Cong. Reg. S. 5896 (daily ed. July 15, 2010) (statement of Sen.
Merkley) (arguing that activities of insurance companies ``are
heavily regulated by State insurance regulators, and in most cases
do not pose the same level of risk as other proprietary trading'').
---------------------------------------------------------------------------
After careful review of the comments in light of the statutory
provisions, the final rule has been modified to permit
[[Page 5744]]
an insurance company or its affiliate \2463\ to acquire or retain an
ownership interest in, or act as sponsor to, a covered fund for either
the general account of the insurance company or one or more separate
accounts established by the insurance company.\2464\
---------------------------------------------------------------------------
\2463\ Some commenters urged the Agencies to provide that an
affiliate or subsidiary of an insurance company could purchase
covered funds for the insurance company's general account or a
separate account. See e.g., Fin. Services Roundtable (Feb. 3, 2012);
TIAA-CREF (Feb. 13, 2012). The Agencies note that the final rule
provides (as does the statute) an exemption that permits an
insurance company or its affiliate to acquire and retain an
ownership interest in a covered fund solely for the insurance's
company general account (or one or more of its separate account);
such an affiliate or subsidiary also may be a wholly-owned
subsidiary, as defined in the final rule.
\2464\ The final rule defines the terms ``general account'' and
``separate account'' largely as proposed, and includes the new
defined term ``insurance company,'' defined as a company that is
organized as an insurance company, primarily and predominantly
engaged in writing insurance or reinsuring risks underwritten by
insurance companies, subject to supervision as such by a state
insurance regulator or a foreign insurance regulator, and not
operated for the purpose of evading the provisions of section 13 of
the BHC Act. Cf. section 2(a)(17) of the Investment Company Act
(defining the term insurance company).
---------------------------------------------------------------------------
These activities are only permitted under the final rule so long
as: (1) the insurance company or its affiliate acquires and retains the
ownership interest solely for the general account of the insurance
company or for one or more separate accounts established by the
insurance company; (2) the acquisition and retention of the ownership
interest is conducted in compliance with, and subject to, the insurance
company investment laws, regulations, and written guidance of the State
or jurisdiction in which the insurance company is domiciled; and (3)
the appropriate Federal banking agencies, after consultation with the
Financial Stability Oversight Council and the relevant insurance
commissioners of the States and relevant foreign jurisdictions, as
appropriate, have not jointly determined, after notice and comment,
that a particular law, regulation, or written guidance described in
Sec. ----.13(c)(2) of the final rule is insufficient to protect the
safety and soundness of the banking entity, or the financial stability
of the United States.\2465\
---------------------------------------------------------------------------
\2465\ See final rule Sec. ----.13(c).
---------------------------------------------------------------------------
The Agencies believe that exempting insurance activities and
investments from the covered fund restrictions is supported by the
language of sections 13(d)(1)(D) and (F) of the BHC Act,\2466\ and more
fully carries out Congressional intent and the statutory purpose of
appropriately accommodating the business of insurance within an
insurance company.\2467\ Section 13(d)(1)(F) of the statute
specifically exempts general accounts of insurance companies, and, as
explained above in Part IV.A.7, separate accounts are managed and
maintained on behalf of customers, an activity exempt under section
13(d)(1)(D) of the statute. By their terms, these are statutory
exemptions from the prohibitions in section 13(a), which includes both
the prohibition on proprietary trading and the prohibition on covered
fund investments and sponsorship. Moreover, the statutory language of
sections 13(d)(1)(D) and 13(d)(1)(F), both cross-reference the
instruments described in section 13(h)(4) and not activity described in
section 13(h)(4). These instruments are ``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 instrument that [the Agencies determine by rule.]'' This
reference covers an ownership interest in a covered fund. The Agencies
believe these exemptions as modified more fully carry out Congressional
intent and the statutory purpose of appropriately accommodating the
business of insurance within an insurance company.\2468\ Insurance
companies are already subject to a robust regulatory regime including
limitations on their investment activities.
---------------------------------------------------------------------------
\2466\ See 12 U.S.C. 1851(d)(1)(D), (F).
\2467\ See 12 U.S.C. 1851(b)(1)(F). See also 156 Cong. Reg. S.
5896 (daily ed. July 15, 2010) (statement of Sen. Merkley) (arguing
that ``section 13 of the BHC Act] was never meant to affect the
ordinary business of insurance'').
\2468\ See 12 U.S.C. 1851(b)(1)(F). See also 156 Cong. Reg. S.
5896 (daily ed. July 15, 2010) (statement of Sen. Merkley) (arguing
that ``section 13 of the BHC Act] was never meant to affect the
ordinary business of insurance'').
---------------------------------------------------------------------------
5. Section ----.14: Limitations on Relationships With a Covered Fund
Section 13(f) of the BHC Act generally prohibits a banking entity
that, directly or indirectly, serves as investment manager, investment
adviser, or sponsor to a covered fund (or that organizes and offers a
covered fund pursuant to section 13(d)(1)(G) of the BHC Act) from
entering into a transaction with a covered fund that would be a covered
transaction as defined in section 23A of the Federal Reserve Act (``FR
Act'').\2469\ The statute also provides an exemption for prime
brokerage transactions between a banking entity and a covered fund in
which a covered fund managed, sponsored, or advised by that banking
entity has taken an ownership interest. Section 13(f) subjects any
transaction permitted under section 13(f) of the BHC Act (including a
permitted prime brokerage transaction) between the banking entity and
covered fund to section 23B of the FR Act.\2470\ In general, section
23B of the FR Act 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.
Section ----.16 of the proposed rule implemented these
provisions.\2471\
---------------------------------------------------------------------------
\2469\ 12 U.S.C. 371c. The Agencies note that this does not
alter the applicability of section 23A of the FR Act and the Board's
Regulation W to covered transactions between insured depository
institutions and their affiliates.
\2470\ 12 U.S.C. 371c-1.
\2471\ See proposed rule Sec. ----.16.
---------------------------------------------------------------------------
a. Scope of Application
Section 13(f) of the BHC Act and the related provisions of the
proposal were among the most commented upon aspects of the covered
funds section. The majority of commenters argued that the broad
definition of ``covered fund'' under the proposal made the proposed
implementation of section 13(f) unworkable and disruptive to existing
market practices because it would prohibit corporate funding
transactions with ordinary corporate entities that do not engage in
hedge fund or private equity activities.\2472\ Commenters also argued
that activities that the proposal appeared to permit as a permitted
activity exemption (e.g., investments in public welfare funds) would be
prohibited by the restrictions in 13(f) \2473\ and that the Agencies
should construe section 13(d)(1)(J) of the BHC Act as allowing them to
permit banking entities to enter into covered transactions with a
covered fund, if those activities would promote and protect the safety
and soundness of banking entities and the financial stability of the
United States.\2474\ However, many of the comments discussed above and
some of the economic burdens noted by these commenters have been
addressed by revisions discussed above in Part IV.B.1 to the definition
of covered fund.\2475\ A number of these and related comments are also
addressed by portions of the
[[Page 5745]]
final rule that provide that the prohibitions of section 13 do not
apply to interests acquired, for example, as agent, broker, custodian,
in satisfaction of a debt previously contracted, through a pension
fund, or as trustee or fiduciary (all within the limits defined in the
final rule).
---------------------------------------------------------------------------
\2472\ See, e.g., Allen & Overy (on behalf of Foreign Bank
Group); BoA; Barclays; Credit Suisse (Williams); Deutsche Bank
(Fund-Linked Products); GE (Feb. 2012); Goldman Sachs (Covered
Funds); ICI Global; ISDA (Feb. 2012); RMA; SIFMA et al. (Covered
Funds) (Feb. 2012).
\2473\ See SunTrust; AHIC; SBIA.
\2474\ See SIFMA et al. (Covered Funds) (Feb. 2012).
\2475\ See final rule Sec. ----.10(b). See supra Part IV.B.1.
---------------------------------------------------------------------------
Several commenters argued that applying the restrictions in section
13(f) to foreign activities of foreign banking entities would be
inconsistent with the presumption against extraterritorial application
of U.S. law and principles of international comity, including deference
to home-country regulation.\2476\ For example, one commenter expressed
concern that rules being developed around custody obligations in the
European Union may require a prime broker or custodian to indirectly
guarantee assets of a fund, which would directly conflict with the
prohibition on guarantees in section 13(f) of the BHC Act.\2477\ As
explained above, the final rule has been modified to more narrowly
focus the scope of the definition of covered fund as it applies to
foreign funds.\2478\ These changes substantially address the issues
raised by commenters regarding the applicability of section 13(f) of
the BHC Act to foreign funds.
---------------------------------------------------------------------------
\2476\ See IIB/EBF; Katten (on behalf of Int'l Clients); EBF;
EFAMA; French Banking Fed'n.; Japanese Bankers Ass'n.
\2477\ See AIMA.
\2478\ See final rule Sec. ----.10(b)(1)(ii) & (c)(1). See
supra Part IV.B.1.
---------------------------------------------------------------------------
Commenters also raised a number of other issues. For instance, some
commenters argued that applying section 13(f) to securitization
entities would in some instances run counter to the rule of
construction contained in section 13(g)(2) regarding the sale and
securitization of loans.\2479\ These commenters recommended that the
final rule, at a minimum, grandfather pre-existing relationships
between banking entities and existing securitization vehicles to reduce
the potential effects of the final rule on agreements and positions
entered into before the enactment of the statute.\2480\
---------------------------------------------------------------------------
\2479\ Section ----.11(b) of the final rule provides that for
purposes of securitizations, organizing and offering includes acting
as the securitizer. As discussed in greater detail above in Part
IV.B.2.b, a banking entity that continues to hold interests in a
securitization in reliance on this exemption must comply with
certain requirements, including the requirements of Sec. ----.14.
Accordingly, Sec. ----.14 of the final rule has also been modified
from the proposal to prohibit a banking entity that continues to
hold an ownership interest in accordance with Sec. ----11(b), and
its affiliates, from entering into a covered transaction with a
covered fund, subject to certain exceptions.
\2480\ See AFME et al.: ASF (Feb. 2012); Ashurst; BoA; Barclays;
Cadwalader (Municipal Securities); Credit Suisse (Williams);
Commercial Real Estate Fin. Council; Deutsche Bank (Fund-Linked
Products); Fidelity; GE (Feb. 2012); Goldman Sachs (Covered Funds);
ICI (Feb. 2012); IIB/EBF; ISDA (Feb. 2012); JPMC; PNC et al.; PNC;
RBC; SIFMA et al. (Covered Funds) (Feb. 2012); SIFMA
(Securitization) (Feb. 2012); Chamber (Feb. 2012). These comments
are addressed above in Part II regarding availability of the
conformance period provisions of section 13 of the BHC Act.
---------------------------------------------------------------------------
One commenter argued that a banking entity that delegates its
responsibility for acting as sponsor, investment manager, or investment
adviser to an unaffiliated entity should no longer be subject to the
restrictions of section 13(f).\2481\ By its terms, section 13(f) of the
BHC Act applies to a banking entity that, directly or indirectly,
serves as investment manager, investment adviser, or sponsor to a
covered fund (or that relies on section 13(d)(1)(G) of the BHC Act in
connection with organizing and offering a covered fund). The Agencies
believe that a banking entity that delegates its responsibility to act
as sponsor, investment manager, or investment adviser to an
unaffiliated party would still be subject to the limitations of section
13(f) if the banking entity retains the ability to select, remove,
direct, or otherwise exert control over the sponsor, investment
manager, or investment adviser designee. In addition, the unaffiliated
party designated as sponsor, investment manager, or investment adviser
would be subject to the restrictions of section 13(f) if the third
party is a banking entity.
---------------------------------------------------------------------------
\2481\ See Katten (on behalf of Int'l Clients).
---------------------------------------------------------------------------
b. Transactions That Would Be a ``Covered Transaction''
Section 13(f) of the BHC Act prohibits covered transactions as
defined in section 23A of the FR Act between a banking entity that
serves as investment manager, investment advisor or sponsor to a
covered fund or that relies on the exemption in section 13(d)(1)(G) and
a covered fund.\2482\ A number of commenters contended that the
definition of ``covered transaction'' in section 13(f) of the BHC Act
should incorporate the exemptions available under section 23A and the
Board's Regulation W.\2483\ These commenters alleged that the statute's
general reference to section 23A suggests that the term ``covered
transaction'' should be construed in light of section 23A as a whole,
including the exemptions in subsection (d) of that Act and as
implemented in the Board's Regulation W.\2484\ These commenters also
argued that the Board's authority to interpret and issue rules pursuant
to section 23A of the FR Act and section 5(b) of the BHC Act, the
general rule-making authority contained in section 13(b) of the BHC
Act, and the exemptive authority in section 13(d)(1)(J) all provide a
basis for providing such exemptions.\2485\
---------------------------------------------------------------------------
\2482\ The term ``covered transaction'' is defined in section
23A of the FR Act to mean, with respect to an affiliate of a member
bank: (i) a loan or extension of credit to the affiliate, including
a purchase of assets subject to an agreement to repurchase; (ii) a
purchase of or an investment in securities issued by the affiliate;
(iii) a purchase of assets from the affiliate, except such purchase
of real and personal property as may be specifically exempted by the
Board by order or regulation; (iv) the acceptance of securities or
other debt obligations issued by the affiliate as collateral
security for a loan or extension of credit to any person or company;
(v) the issuance of a guarantee, acceptance, or letter of credit,
including an endorsement or standby letter of credit, on behalf of
an affiliate; (vi) a transaction with an affiliate that involves the
borrowing or lending of securities, to the extent that the
transaction causes a member bank or subsidiary to have credit
exposure to the affiliate; or (vii) a derivative transaction, as
defined in paragraph (3) of section 5200(b) of the Revised Statutes
of the United States (12 U.S.C. 84(b)), with an affiliate, to the
extent that the transaction causes a member bank or a subsidiary to
have credit exposure to the affiliate. See 12 U.S.C. 371c(b)(7), as
amended by section 608 of the Dodd-Frank Act.
\2483\ See 12 U.S.C. 371c(d); 12 CFR 223.42; ABA (Keating);
Ass'n. of Institutional Investors (Feb. 2012); BoA; BNY Mellon et
al.; Credit Suisse (Williams); SIFMA et al. (Covered Funds) (Feb.
2012); See also Allen & Overy (on behalf of Foreign Bank Group).
\2484\ See ABA (Keating); Ass'n. of Institutional Investors
(Feb. 2012); BoA; BNY Mellon et al.; SIFMA et al. (Covered Funds)
(Feb. 2012).
\2485\ See BNY Mellon et al.; SIFMA et al. (Covered Funds) (Feb.
2012); See also Credit Suisse (Williams).
---------------------------------------------------------------------------
In particular, commenters argued that intraday extensions of
credit;\2486\ transactions fully secured by cash or U.S. government
securities;\2487\ purchases of liquid assets and marketable securities
from covered funds;\2488\ and riskless principal transactions with
covered funds all should be exempt from the restrictions in section
13(f) of the BHC Act.\2489\ These commenters argued that providing an
exemption for intraday extensions of credit in particular was necessary
to allow a banking entity to continue to provide affiliated covered
funds with standard custody, clearing, and settlement services that
include intra-day or overnight overdrafts necessary to facilitate
securities settlement, contractual settlement, pre-determined income,
or similar custody-related transactions. Some commenters argued that
transactions fully secured by
[[Page 5746]]
cash or U.S. government securities do not expose banking entities to
inappropriate risks, are permitted in unlimited amounts under section
23A, and should not be entirely prohibited under the rule.\2490\ A few
commenters argued that the proposal would prohibit securities lending
transactions and argued that borrower default indemnifications by a
banking entity in agency securities lending arrangements should not be
prohibited under section 13(f).\2491\ Some commenters argued that a
banking entity should be allowed to accept the shares of a sponsored
covered fund as collateral for a loan to any person or entity, in
particular where the loan is not for the purpose of purchasing
interests in the covered fund.\2492\
---------------------------------------------------------------------------
\2486\ See ABA (Keating); AFG; Ass'n. of Institutional Investors
(Feb. 2012); BoA; BNY Mellon et al.; Credit Suisse (Williams);
EFAMA; French Treasury et al.; JPMC; IMA; RMA; SIFMA et al. (Covered
Funds) (Feb. 2012); State Street (Feb. 2012); SSgA (Feb. 2012);
Vanguard.
\2487\ See BoA; Credit Suisse (Williams); SIFMA et al. (Covered
Funds) (Feb. 2012).
\2488\ See Credit Suisse (Williams).
\2489\ See, e.g., Credit Suisse (Williams).
\2490\ See BoA; Credit Suisse (Williams); SIFMA et al. (Covered
Funds) (Feb. 2012).
\2491\ See State Street (Feb. 2012); RMA.
\2492\ See BoA; SIFMA et al. (Covered Funds) (Feb. 2012); See
also Katten (on behalf of Int'l Clients).
---------------------------------------------------------------------------
One commenter argued that no exceptions should be granted to the
definition of covered transaction, and financing of covered funds would
relate to greater fund risk.\2493\ In addition, that commenter
contended that the Agencies should prohibit a sale of securities by a
banking entity to a covered fund even though these transactions are not
within the definition of covered transaction for purposes of section
23A of the FR Act.\2494\
---------------------------------------------------------------------------
\2493\ See Occupy.
\2494\ See 12 U.S.C. 371c(b)(7); See also 12 U.S.C. 371c-
1(a)(2)(B) (including the sale of securities or other assets to an
affiliate as a transaction subject to section 23B).
---------------------------------------------------------------------------
The final rule continues to apply the same definition of covered
transaction as the proposal. Section 13(f) refers to a covered
transaction, as defined in section 23A of the FR Act. Section 13(f) of
the BHC Act does not incorporate or reference the exemptions contained
in section 23A of the FR Act or the Board's Regulation W. Indeed, the
exemptions for these transactions are not included in the definition of
covered transactions in section 23A; the exemptions are instead in a
different subsection of section 23A and provide an exemption from only
some (but not all) of the provisions of section 23A governing covered
transactions.\2495\ Therefore, the final rule does not incorporate the
exemptions in section 23A.
---------------------------------------------------------------------------
\2495\ See 12 U.S.C. 371c(d).
---------------------------------------------------------------------------
Similarly, the final rule incorporates the statutory restriction as
written, which provides that a banking entity that serves in certain
specified roles may not enter into a transaction with a covered fund
that would be a covered transaction as defined in section 23A of the FR
Act as if the banking entity were a member bank and the covered fund
were an affiliate thereof. There are certain occasions when the
restrictions of section 23A apply to transactions that involve a third
party other than an affiliate of a member bank. For example, section
23A would apply to an extension of credit by a member bank to a
customer where the extension of credit is secured by shares of an
affiliate. The Agencies believe that these transactions between a
banking entity and a third party that is not a covered fund are not
covered by the terms of section 13(f), which (as discussed above) make
specific reference to transactions by the banking entity with the
covered fund. A contrary reading would prohibit securities margin
lending, which Congress has specifically addressed (and permitted) in
other statutes. There is no indication in the legislative history that
Congress intended section 13(f) to prohibit margin lending that occurs
in accordance with other specific statutes. Thus, section 13(f) does
not prohibit a banking entity from extending credit to a customer
secured by shares of a covered fund (as well as, perhaps, other
securities) held in a margin account. However, the Agencies expect
banking entities not to structure transactions with third parties in an
attempt to evade the restrictions on transactions with covered funds,
and the Agencies will use their supervisory authority to monitor and
restrict transactions that appear to be evasions of section 13(f).
c. Certain Transactions and Relationships Permitted
While section 13(f)(1) of the BHC Act generally prohibits a banking
entity from entering into a transaction with a related covered fund
that would be a covered transaction as defined under section 23A of the
FR Act, other specific portions of the statute permit a banking entity
to engage in certain transactions or relationships with such funds.
1. Permitted Investments and Ownerships Interests
The proposed rule permitted a banking entity to acquire or retain
an ownership interest in a covered fund in accordance with the
requirements of section 13.\2496\ This was consistent with the text of
section 13(f), which by its terms is triggered by the presence of
certain ownership interests. This view also resolved an apparent
conflict between the text of section 13(f) and the reference in section
13(f) prohibiting covered transactions under section 23A of the FR Act,
which includes acquiring or retaining an interest in securities issued
by an affiliate.
---------------------------------------------------------------------------
\2496\ See proposed rule Sec. ----.16(a)(2)(i).
---------------------------------------------------------------------------
Several commenters supported this aspect of the proposal.\2497\
There is no evidence that Congress intended section 13(f)(1) of the BHC
Act to override the other provisions of section 13 with regard to the
acquisition or retention of ownership interests specifically permitted
by the section. Moreover, a contrary reading would make these more
specific sections that permit covered transactions between a banking
entity and a covered fund mere surplusage. Therefore, the final rule
adopts this provision as proposed.\2498\
---------------------------------------------------------------------------
\2497\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012).
\2498\ The final rule modifies the proposal to clarify that a
banking entity may acquire and retain an ownership interest in a
covered fund by express reference to the permitted activities
described in Sec. Sec. ----.11, ----.12 and ----.13.
---------------------------------------------------------------------------
2. Prime Brokerage Transactions
Section 13(f) provides an exception from the prohibition on covered
transactions with a covered fund for any prime brokerage transaction
with a covered fund in which a covered fund managed, sponsored, or
advised by a banking entity has taken an ownership interest (a
``second-tier fund''). However, the statute does not define prime
brokerage transaction. The proposed rule defined prime brokerage
transaction to include providing one or more products or services, such
as custody, clearance, securities borrowing or lending services, trade
execution, or financing, data, operational, and portfolio management
support.\2499\
---------------------------------------------------------------------------
\2499\ See proposed rule Sec. ----.10(b)(4).
---------------------------------------------------------------------------
A few commenters argued that the proposed definition of prime
brokerage transaction was overly broad and should not permit securities
lending or borrowing services. These commenters argued that securities
lending and borrowing (and certain other services) could increase
leverage by covered funds and the risk that a banking entity would
bailout these funds.\2500\
---------------------------------------------------------------------------
\2500\ See, e.g., Occupy; Public Citizen.
---------------------------------------------------------------------------
Other commenters argued that the proposed definition of prime
brokerage transaction was confusing because it included transactions
(such as data or portfolio management support) that were not ``covered
transactions'' under section 23A of the FR Act and thus not prohibited
as an initial matter by section 13(f). These commenters argued that
including otherwise permissible transactions within the definition of
prime brokerage transaction created uncertainty about the
permissibility of other transactions or services that are not expressly
covered transactions
[[Page 5747]]
under section 23A of the FR Act and thus not prohibited under section
13(f). One commenter proposed defining prime brokerage transaction as
any ``covered transaction'' entered into by a banking entity with a
covered fund ``for purposes of custody, clearance, securities borrowing
or lending services, trade execution and settlement, financing and
related hedging, intermediation, or a similar purpose.'' \2501\
---------------------------------------------------------------------------
\2501\ See SIFMA et al. (Mar. 2012).
---------------------------------------------------------------------------
A few commenters supported expanding the definition of prime
brokerage transaction to include any service or transaction ``related
to'' a specific list of permissible transactions. For instance, one
commenter argued that acting as agent in providing contractual income
and settlement services and intraday and overnight overdraft protection
should expressly be included within the definition of prime brokerage
transaction.\2502\ This commenter also urged that borrower default
indemnification should be included as a prime brokerage transaction to
the extent it would be a covered transaction that is prohibited by
section 13(f).\2503\ Another commenter recommended that the definition
of prime brokerage transaction expressly include transactions in
commodities, futures and foreign exchange, as well as securities, and
transactions effected through OTC derivatives, including, without
limitation, contracts for differences, various swaps and security-based
swaps, foreign exchange swaps and forwards and ``FX prime brokerage.''
\2504\
---------------------------------------------------------------------------
\2502\ See RMA.
\2503\ See RMA.
\2504\ See Katten (on behalf of Int'l Clients).
---------------------------------------------------------------------------
Based on review of the comments, the definition of prime brokerage
transaction has been modified in several ways. For purposes of the
final rule, prime brokerage transaction is defined to mean any
transaction that would be a covered transaction, as defined in section
23A(b)(7) of the FR Act (12 U.S.C. 371c(b)(7)), that is provided in
connection with custody, clearance and settlement, securities borrowing
or lending services, trade execution, financing, or data, operational,
and administrative support. The definition of prime brokerage
transaction under the final rule generally recognizes the same
relationships that were considered when defining prime brokerage
transaction under the proposal,\2505\ without certain of the
modifications suggested by some commenters that are discussed above.
The Agencies carefully considered comments received on the definition
of prime brokerage transaction. As noted above, certain commenters
requested that various types of transactions be included in or omitted
from the definition. The Agencies believe it appropriate to include
within the definition of prime brokerage transaction those transactions
that the Agencies believe generally constitute the typical type of
prime brokerage transactions provided in the market. Including this
list of relationships provides clarity and certainty for transactions
that are commonly considered to be prime brokerage transactions.
---------------------------------------------------------------------------
\2505\ See final rule Sec. ----.10(d)(5).
---------------------------------------------------------------------------
The final rule incorporates within the definition of prime
brokerage transaction a reference to covered transactions under section
23A(b)(7) of the FR Act. This change aligns the final rules with
section 13(f) of the BHC Act and is designed to eliminate confusion and
provide certainty regarding both the breath of the prohibition on
covered transactions in section 13(f) and the scope of the exception
for prime brokerage transactions. Thus, a transaction or relationship
that is not a covered transaction under section 13(f) of the BHC Act is
not prohibited in the first instance (unless prohibited elsewhere in
section 13). Within the category of transactions prohibited by section
13(f), transactions within the definition of prime brokerage
transaction are permitted.
Some commenters argued that the Agencies should provide an
exemption for prime brokerage transactions with a broader array of
funds than the proposal permitted. For instance, some commenters argued
that the Agencies should permit a banking entity to enter into a prime
brokerage transaction with any covered fund or fund structure that the
banking entity organizes and offers or for which it directly serves as
investment manager, investment adviser, or sponsor, and should not
limit the exception for prime brokerage transactions to only a second-
tier covered fund.\2506\ Conversely, a few commenters argued that the
prime brokerage exemption should only permit a banking entity to
provide these services to a third-party fund in order to ensure that
the provision of prime brokerage services does not give rise to the
same risks that section 13 was designed more generally to limit.\2507\
---------------------------------------------------------------------------
\2506\ See RMA; Katten (on behalf of Int'l Clients); EFAMA; See
also Hong Kong Inv. Funds Ass'n.; IMA; Union Asset.
\2507\ See Sens. Merkley & Levin (Feb. 2012); Occupy.
---------------------------------------------------------------------------
The Agencies note that the statute by its terms does not restrict
prime brokerage transactions generally. As noted above, section
13(f)(3)(A) of the BHC Act provides that a banking entity may enter
into any prime brokerage transaction with a second-tier fund. The
statute by its terms permits a banking entity with a relationship to a
covered fund described in section 13(f) to engage in prime brokerage
transactions (that are covered transactions) only with second-tier
funds and does not extend to covered funds more generally. Neither the
statute nor the final rule limit covered transactions between a banking
entity and a covered fund for which the banking entity does not serve
as investment manager, investment adviser, or sponsor (as defined in
section 13 of the BHC Act) or have an interest in reliance on section
13(d)(1)(G) of the BHC Act. Under the statute, the exemption for prime
brokerage transactions is available only so long as certain enumerated
conditions are satisfied.\2508\ The conditions are that (i) the chief
executive officer (or equivalent officer) of the banking entity
certifies in writing annually that the banking entity does not,
directly or indirectly, guarantee, assume, or otherwise insure the
obligations or performance of the covered fund or of any covered fund
in which such covered fund invests, and (ii) the Board has not
determined that such transaction is inconsistent with the safe and
sound operation and condition of the banking entity. The proposed rule
incorporated each of these provisions. The final rule provides that
this certification be made to the appropriate Federal supervisor for
the banking entity.
---------------------------------------------------------------------------
\2508\ See 12 U.S.C. 1851(f)(3).
---------------------------------------------------------------------------
A few commenters argued that the proposal did not adequately
address how the CEO attestation requirement in section 13(f) would
apply to foreign banking organizations. They argued that a senior
officer with authority for the U.S. operations of the foreign bank
should be permitted to make the required attestation.\2509\
---------------------------------------------------------------------------
\2509\ See proposed rule Sec. ----.16(a)(2)(ii); IIB/EBF;
Credit Suisse (Williams).
---------------------------------------------------------------------------
The statute allows the attestation for purposes of the prime
brokerage exception in section 13(f) of the BHC Act to be from the
chief executive officer or ``equivalent officer.'' \2510\ In the case
of the U.S. operations of foreign banking entities, the senior officer
of the foreign banking entity's U.S. operations or the chief executive
officer of the U.S.
[[Page 5748]]
banking entity may provide the required attestation.
---------------------------------------------------------------------------
\2510\ See 12 U.S.C. 1851(f)(3)(A)(ii).
---------------------------------------------------------------------------
d. Restrictions on Transactions With Any Permitted Covered Fund
Sections 13(f)(2) and 13(f)(3)(B) of the BHC Act apply section 23B
of the FR Act \2511\ to certain transactions and investments between a
banking entity and a covered fund as if such banking entity were a
member bank and such covered fund were an affiliate thereof.\2512\
Section 23B provides that transactions between a member bank and an
affiliate must be on terms and under circumstances, including credit
standards, that are substantially the same or at least as favorable to
the banking entity as those prevailing at the time for comparable
transactions with or involving unaffiliated companies or, in the
absence of comparable transactions, on terms and under circumstances,
including credit standards, that in good faith would be offered to, or
would apply to, non-affiliated companies.\2513\
---------------------------------------------------------------------------
\2511\ 12 U.S.C. 371c-1.
\2512\ See proposed rule Sec. ----.16(b).
\2513\ 12 U.S.C. 371c-1(a); 12 CFR 223.51.
---------------------------------------------------------------------------
Mirroring the statute, the proposal applied this requirement to
transactions between a banking entity that serves as investment
manager, investment adviser, or sponsor to a covered fund and that fund
and any other fund controlled by that fund. It also applied this
condition to a permissible prime brokerage transaction in which a
banking entity may engage under the proposal.
Commenters generally did not raise any issues regarding the
proposal's implementation of section 13(f)(2) and 13(f)(3)(B). The
final rule generally implements these requirements in the same manner
as the proposal.\2514\
---------------------------------------------------------------------------
\2514\ See final rule Sec. ----.14(b). As discussed above,
Sec. ----.11(b) of the final rule provides that for purposes of
securitizations, organizing and offering includes acting as the
securitizer. A banking entity that continues to own interests in a
securitization in reliance on this exemption must comply, among
other things, with the requirements of Sec. ----.14. Accordingly,
Sec. ----.14(b) of the final rule has been modified to require that
a banking entity that continues to hold an ownership interest in
accordance with Sec. ----.11(b) is subject to section 23B of the
Federal Reserve Act, as if such banking entity were a member bank
and the covered fund were an affiliate.
---------------------------------------------------------------------------
6. Section ----.15: Other Limitations on Permitted Covered Fund
Activities
Like Sec. ----.8, Sec. ----.17 of the proposed rule implemented
section 13(d)(2) of the BHC Act, which places certain limitations on
the permitted covered fund activities and investments in which a
banking entity may engage. Consistent with the statute and Sec. ----.8
of the proposed rule, Sec. ----.17 provided that no transaction, class
of transactions, or activity was permissible under Sec. Sec. ----.11
through ----.14 and Sec. ----.16 of the proposed rule if the
transaction, class of transactions, or activity would: (i) involve or
result in a material conflict of interest between the banking entity
and its clients, customers, or counterparties; (ii) result, directly or
indirectly, in a material exposure by the banking entity to a high-risk
asset or a high-risk trading strategy; or (iii) pose a threat to the
safety and soundness of the banking entity or the financial stability
of the United States.
Section ----.17 of the proposed rule defined ``material conflict of
interest,'' ``high-risk assets,'' and ``high-risk trading strategies''
for these purposes in a fashion identical to the definitions of the
same terms for purposes of Sec. ----.8 of the proposed rule related to
proprietary trading. In the final rule, other than the permitted
activities to which Sec. Sec. ----.7 and ----.15 apply, Sec. Sec. --
--.7 and ----.15 are also identical. Comments received on the
definitions in these sections, as well as the treatment of these
concepts under the final rule, are described in detail in Part IV.A.9
above.
The Agencies also note that some concerns identified by commenters
regarding the rule's extraterritorial application are addressed by
modifications in the final rule to the definition of a covered fund
under Sec. ----.10. As noted above, commenters requested that the
Agencies clarify that the limitations in Sec. Sec. ----.8 or ----.17
of the proposed rule apply only to a foreign banking entity's U.S.
activities and affiliates.\2515\ As discussed in greater detail above
in Part IV.B.1, the final rule has been modified to more narrowly focus
the scope of the definition of covered fund as it applies to foreign
funds. Pursuant to the definition of a covered fund in Sec. --
--.10(b)(1), a foreign fund may be a covered fund with respect to the
U.S. banking entity that sponsors the fund, but not be a covered fund
with respect to a foreign bank that invests in the fund solely outside
the United States. Foreign public funds, as defined in Sec. --
--.10(c)(1) of the final rule, are also excluded from the definition of
a covered fund. By excluding foreign public funds from the definition
of covered fund and by narrowing the scope of the definition of a
covered fund with respect to foreign funds, the Agencies have addressed
some commenters' concerns regarding the burdens imposed by proposed
rule Sec. ----.17.
---------------------------------------------------------------------------
\2515\ See EBF; Ass'n. of German Banks.
---------------------------------------------------------------------------
C. Subpart D and Appendices A and B--Compliance Program, Reporting, and
Violations
Subpart D of the proposed rule implemented section 13(e)(1) of the
BHC Act and required certain banking entities to develop and provide
for the continued administration of a program reasonably designed to
ensure and monitor compliance with the prohibitions and restrictions on
activities and investments set forth in section 13 and the proposed
rule.
As explained in detail below, in response to comments on the
compliance program requirements and Appendix C (Minimum Standards for
Programmatic Compliance) and to conform to modifications to other
sections of the proposed rule, the Agencies are adopting a variety of
modifications to Subpart D of the proposed rule, which requires certain
banking entities to develop and provide for the continued
administration of a program reasonably designed to ensure and monitor
compliance with the prohibitions and restrictions on proprietary
trading activities and covered fund activities and investments set
forth in section 13 of the BHC Act and the final rule. As described
above, this compliance program requirement forms a key part of the
multi-faceted approach to implementing section 13 of the BHC Act, and
is intended to ensure that banking entities establish, maintain and
enforce compliance procedures and controls to prevent violation or
evasion of the prohibitions and restrictions on proprietary trading
activities and covered fund activities and investments.
The proposal adopted a tiered approach to implementing the
compliance program mandate, requiring a banking entity engaged in
proprietary trading activities or covered fund activities and
investments to establish a compliance program that contained specific
elements and, if the banking entity's activities were significant, meet
a number of more detailed minimum standards. If a banking entity did
not engage in proprietary trading activities and covered fund
activities and investments, it was required to ensure that its existing
compliance policies and procedures included measures that were designed
to prevent the banking entity from becoming engaged in such activities
and making such investments and to develop and provide for the required
program under Sec. ----.20(a) of the proposed rule prior to engaging
in such activities or making such investments, but was not otherwise
required to meet
[[Page 5749]]
the requirements of subpart D of the proposed rule.
1. Section ----.20: Compliance Program Mandate
a. Program Requirement
A number of commenters argued that the compliance program
requirements of the proposal were overly specific, too prescriptive and
complex to be workable, and not justified by the costs and benefits of
having a compliance program.\2516\ For instance, one commenter
expressed concern that the complexity of the proposed compliance regime
would undermine compliance efforts because the requirements were
overlapping, imprecise, and did not provide sufficient clarity to
traders or banking entities as to what types or levels of activities
would be viewed as permissible trading.\2517\ Some commenters argued
that the compliance program would be challenging to enforce or
administer with any consistency across different banking entities and
jurisdictions.\2518\ A few commenters objected to any attempt to
identify every possible instance of prohibited proprietary trading in
otherwise permitted activity.\2519\ By contrast, some commenters
supported the proposed compliance program as effective and consistent
with the statute but also suggested a number of ways that the
proposal's compliance program could be improved.\2520\
---------------------------------------------------------------------------
\2516\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);
Citigroup (Feb. 2012); Wells Fargo (Prop. Trading); See also
Barclays; BlackRock; Chamber (Dec. 2011); Comm. on Capital Markets
Regulation; Credit Suisse (Williams); FIA; Goldman (Covered Funds);
Investure; NYSE Euronext; RBC; STANY; Wedbush; See also Northern
Trust; Chamber (Feb. 2012).
\2517\ See Citigroup (Feb. 2012).
\2518\ See ABA (Abernathy); IIB/EBF; ICFR. While the Agencies
recognize these issues, the Agencies believe the final rule's
modifications to the proposal--for example, providing for simplified
programs for smaller, less active banking entities and increasing
the asset threshold that triggers enhanced compliance requirements--
helps balance enforceability and consistency concerns with
implementing a program that helps to ensure compliance consistent
with section 13(e)(1) of the BHC Act. See 12 U.S.C. 1851(e)(1).
\2519\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); RBC;
STANY; See also Barclays.
\2520\ See AFR (Nov. 2012); Occupy; Sens. Merkley & Levin (Feb.
2012)
---------------------------------------------------------------------------
A few commenters argued that the proposed compliance program should
be replaced with a more principles-based framework that provides
banking entities the discretion and flexibility to customize compliance
programs tailored to the structure and activities of their
organizations.\2521\ A few commenters argued that building on
compliance regimes that already exist at banking entities, including
risk limits, risk management systems, board-level governance protocols,
and the level at which compliance is monitored, would reduce the costs
and complexity of the proposal while also enabling a robust compliance
mechanism for section 13.\2522\
---------------------------------------------------------------------------
\2521\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Wells Fargo
(Prop. Trading); See also M&T Bank; Credit Suisse (Seidel); State
Street (Feb. 2012); See also NYSE Euronext; Stephen Roach.
\2522\ See Citigroup (Feb. 2012); SIFMA et al. (Prop. Trading)
(Feb. 2012); See also ABA (Abernathy); Paul Volcker.
---------------------------------------------------------------------------
Another commenter suggested that the focus of the compliance
program be on the key goal of reducing risk at banking entities by
requiring each banking entity to establish a risk architecture that
prescribes a customer-focused business model for market making-related
activities including a comprehensive set of risk limits that focuses on
servicing customers and ensuring safety and soundness.\2523\ This
commenter suggested the proposal's compliance requirements be replaced
by a simpler compliance framework that could be harmonized with the
broader systemic capital and risk management framework under the Basel
accord. This commenter argued such a framework would increase
transparency as well as reduce overall complexity and costs of
regulation, and that information relevant to the compliance
infrastructure, including customer orientation policies and procedures,
target customer and product lists, trade histories, and risk limit
calibration methodology and analyses, should all be made available to
examiners.\2524\ Another commenter urged that the compliance program
could be generally improved by having a greater focus on the
compensation incentives within the compliance program of banking
entities.\2525\
---------------------------------------------------------------------------
\2523\ See Citigroup (Feb. 2012); See also SIFMA et al. (Prop.
Trading) (Feb. 2012).
\2524\ See Citigroup (Feb. 2012).
\2525\ See Occupy.
---------------------------------------------------------------------------
A number of other commenters requested certain types of banking
entities be specifically excluded from having to implement the
requirements of the compliance program. For example, some commenters
urged that the details required in proposed Appendix C apply only to
those banking entities and business lines within a banking group that
have ``significant'' covered funds or trading activities and not apply
to an affiliate of a banking entity that does not engage in the types
of activities section 13 is designed to address (e.g., an industrial
affiliate that manufactures machinery).\2526\ One commenter argued that
the final rule should not impose a compliance program requirement on a
banking entity that owns 50 percent or less of another banking entity
in order to ensure the compliance program did not discourage joint
ventures or other arrangements where a banking entity does not have
actual control over an affiliate.\2527\ As discussed in Part IV.B.4.c.
above,\2528\ other commenters argued that the reporting and
recordkeeping and compliance requirements of the rule should not apply
to permitted insurance company investment activities because insurance
companies are already subject to comprehensive regulation of the kinds
and amounts of investments they can make under State or foreign
insurance laws and regulations.\2529\ However, another commenter
suggested that insurance company affiliates of banking entities
expressly be made subject to data collection and reporting requirements
to prevent possible evasion of the restrictions of section 13 and the
final rule using their insurance affiliates.\2530\
---------------------------------------------------------------------------
\2526\ See, e.g., Credit Suisse (Williams); GE (Feb. 2012); See
also NAIB et al.; Chamber (Feb. 2012).
\2527\ See GE (Feb. 2012). Under the BHC Act, an entity would
generally be considered an affiliate of a banking entity, and
therefore a banking entity itself, if it controls, is controlled by,
or is under common control with an insured depository institution.
Pursuant to the BHC Act, a company controls another company if, for
instance, the company directly or indirectly or acting through one
or more other persons owns, controls, or has power to vote 25 per
cent or more of any class of voting securities of the company. See
12 U.S.C. 1841(a)(2). The compliance program requirement applies to
all banking entities in order to ensure their compliance with the
final rule.
\2528\ See Part IV.B.4.c.
\2529\ See, e.g., ACLI (Jan. 2012); Country Fin. et al.; NAMIC.
\2530\ See Sens. Merkley & Levin (Feb. 2012). As noted above,
the compliance program requirement applies to all banking entities,
including insurance companies that are considered banking entities,
in order to ensure their compliance with the final rule.
---------------------------------------------------------------------------
A few commenters argued that requiring securitization vehicles to
establish even the minimal requirements set forth in Sec. ----.20(d)
would impose unnecessary costs and burdens on these entities.\2531\ By
contrast, another commenter argued that, because of the perceived risks
of these entities, securitization vehicles related to a banking entity
should be required to comply fully with the proposed rule regardless of
how such compliance procedures are funded by the banking entity.\2532\
---------------------------------------------------------------------------
\2531\ See ASF (Feb. 2012); AFME et al.; SIFMA (Securitization)
(Feb. 2012); Commercial Real Estate Fin. Council.
\2532\ See Occupy.
---------------------------------------------------------------------------
Several commenters urged that foreign activities of foreign banking
entities, which are already subject to
[[Page 5750]]
their own prudential regulation under applicable home country
regulation, be excluded from the compliance program and argued that to
do otherwise would be an extraterritorial expansion of U.S. law.\2533\
These commenters contended that the compliance program requirements for
foreign banking entities should, in any event, be narrowly
circumscribed.\2534\ One commenter proposed that the foreign activity
of foreign banking entities be excluded from compliance, reporting and
other obligations where the risk of the activity is outside of the
United States because those risks do not pose a threat to U.S.
taxpayers.\2535\ Another commenter argued that only U.S. affiliates of
foreign banking entities engaged in proprietary trading and covered
fund activities as principal in the United States should be required to
institute the compliance and reporting systems required in the
proposal, and that all foreign affiliates only be required to have
policies and procedures designed to prevent the banking entity from
engaging in relevant trading and covered fund activities in the United
States.\2536\ This commenter also expressed concern that the reporting
and recordkeeping requirements could be interpreted to apply to an
entire trading unit, even trading activities with no U.S. nexus, if any
portion of a trading unit's activities, even a single trade, would be
required to rely on the market-making, hedging, underwriting or U.S.
government security exemptions.\2537\
---------------------------------------------------------------------------
\2533\ See, e.g., Soci[eacute]t[eacute] G[eacute]n[eacute]rale;
IIB/EBF; Australian Bankers Ass'n. (Feb. 2012); Banco de
M[eacute]xico; Norinchukin; Cadwalader (on behalf of Thai Banks);
Cadwalader (on behalf of Singapore Banks); Allen & Overy (on behalf
of Canadian Banks); BAROC; Comm. on Capital Markets Regulation;
Credit Suisse (Williams); EFAMA; Hong Kong Inv. Funds Ass'n.; HSBC;
IIAC; IMA; Katten (on behalf of Int'l Clients); Ass'n. of Banks in
Malaysia; RBC; Sumitomo Trust; See also AFME et al.; British
Bankers' Ass'n.; EBF; Commissioner Barnier; French Banking Fed'n.;
UBS; Union Asset.
\2534\ See, e.g., AFME et al.; IIB/EBF; BaFin/Deutsche
Bundesbank; Credit Suisse (Williams); HSBC.
\2535\ See Australian Bankers Ass'n. (Feb. 2012); See also RBC.
\2536\ See IIB/EBF.
\2537\ See IIB/EBF.
---------------------------------------------------------------------------
Commenters also offered thoughts on the timeframe within which
banking entities must establish a compliance program. One commenter
urged that reporting begin immediately,\2538\ while another commenter
contended that the effective date provided banking entities with
sufficient time to implement the proposal's compliance program.\2539\
Other commenters, however, argued that banking entities should have
additional time to establish compliance programs.\2540\ Some commenters
argued banking entities should have one-year from the date of
publication of the final rule to implement their compliance
programs,\2541\ while others urged that banking entities have a two-
year period to build compliance systems.\2542\ One commenter suggested
the Board amend its conformance rule to provide U.S. banking entities
with an additional year for implementing the compliance requirements
with respect to their foreign operations.\2543\
---------------------------------------------------------------------------
\2538\ See Occupy.
\2539\ See Alfred Brock.
\2540\ See Wells Fargo (Prop. Trading); PNC et al.; Australian
Bankers Ass'n. (Feb. 2012); SIFMA et al. (Prop.Trading) (Feb. 2012);
ABA (Keating); AFME et al.; BoA; Barclays; SIFMA et al. (Covered
Funds) (Feb. 2012); SIFMA et al. (Mar. 2012); Comm. on Capital
Markets Regulation; Credit Suisse (Williams); T. Rowe Price; See
also Citigroup (Feb. 2012); Soci[eacute]t[eacute]
G[eacute]n[eacute]rale; IIB/EBF; Am. Express; Arnold & Porter; BDA
(Mar. 2012).
\2541\ See Wells Fargo (Prop. Trading); PNC et al.; Australian
Bankers Ass'n. (Feb. 2012); BoA; Barclays; SIFMA et al. (Covered
Funds) (Feb. 2012); SIFMA et al. (Mar. 2012); Credit Suisse
(Seidel); See also BDA (Mar. 2012).
\2542\ See SIFMA et al. (Prop.Trading) (Feb. 2012); ABA
(Keating); AFME et al.; GE; Credit Suisse (Williams); Goldman (Prop.
Trading); Morgan Stanley; RBC; SVB.
\2543\ See Morgan Stanley.
---------------------------------------------------------------------------
After considering comments on the proposal, the final rule retains
the compliance program requirement with a variety of modifications. In
particular, the modifications are designed to make the compliance
program requirements clearer and more tailored to the size, complexity
and type of activity conducted by each banking entity.\2544\ The
Agencies also believe that the revisions build on the limits,
procedures and elements of risk management programs that many banking
entities have already developed to monitor and control the risk of
existing trading and investment activities.\2545\
---------------------------------------------------------------------------
\2544\ The Agencies believe these modifications, such as
increasing the threshold that triggers enhanced compliance standards
and allowing smaller banking entities to customize their compliance
programs, help address concerns that the proposed requirement was
too complex and unworkable. See, e.g., SIFMA et al. (Prop.Trading)
(Feb. 2012); Citigroup (Feb. 2012); Wells Fargo (Prop. Trading).
\2545\ Some commenters argued that the requirement should build
on banking entities' existing compliance regimes. See Citigroup
(Feb. 2012); SIFMA et al. (Prop.Trading) (Feb. 2012); See also ABA
(Abernathy); Paul Volcker.
---------------------------------------------------------------------------
The final rule builds on the proposed rule's tiered approach by
adjusting asset thresholds and by adding a new provision allowing a
banking entity with modest covered activities to customize its
compliance program. Specifically, the final rule allows banking
entities with total assets below $10 billion to fold compliance
measures into their existing compliance program in a manner that
addresses the types and amounts of activities the entity
conducts.\2546\ The proposal did not contain such a provision. Similar
to the proposal, the final rule requires that a banking entity that
conducts no activity subject to section 13 of the BHC Act is not
required to develop any compliance program until it begins conducting
activities subject to section 13.\2547\ The final rule further modifies
the proposal by requiring that a banking entity with total assets
greater than $10 billion but less than $50 billion is generally
required to establish a compliance program suited to its activities
which includes the six elements described in the final rule.\2548\
Additionally, the final rule requires that the largest and most active
banking entities, with total assets above $50 billion, or that are
subject to the quantitative measurements requirement due to the size of
their trading assets and liabilities, adopt an enhanced compliance
program that addresses the six elements described in the rule plus a
number of more detailed requirements described in Appendix B.\2549\
---------------------------------------------------------------------------
\2546\ See final rule Sec. ----.20(f)(2).
\2547\ See final rule Sec. ----.20(f)(1). In response to a few
commenters, the final rule, unlike Sec. ----.20(d) of the proposed
rule, no longer requires a banking entity include measures that are
designed to prevent such entity from becoming engaged in covered
trading activities or covered fund investments and activities.
\2548\ Under the proposal, each banking entity was required to
have a compliance program that addressed the elements described in
the rule, unless the banking entity did not engage in prohibited
activities or investments, in which case it need only have existing
policies and procedures requiring the banking entity to develop a
compliance program before engaging in such activities. Further, a
banking entity that has trading assets and liabilities equal to or
greater than $1 billion, or equal to 10% or more of total assets,
would have been subject to additional standards under the proposed
rule. See proposed rule Sec. Sec. ----.20(a), (c), (d).
\2549\ Because the Agencies have determined not to retain
proposed Appendix B in the final rule, proposed Appendix C is now
Appendix B under the final rule.
---------------------------------------------------------------------------
In response to commenters' concerns regarding compliance program
burdens in connection with covered fund activities and investments, the
final rule is further modified with respect to thresholds for covered
fund activities and investments. As noted above, this and the other
modifications are designed to make the compliance program requirement
clearer and more tailored to the size, complexity and type of activity
conducted by each banking entity. The final rule, unlike the proposal,
does not require a banking entity to adopt the enhanced compliance
program if the banking entity, together with its affiliates and
subsidiaries, invests in the aggregate
[[Page 5751]]
more than $1 billion in covered funds or if they sponsor or advise
covered funds, the average total assets of which are equal to or
greater than $1 billion. Banking entities would look to the total asset
thresholds discussed above, instead of the amount of covered fund
investments and activities, in determining whether they would be
subject to the enhanced compliance program requirements. The Agencies
have also modified the compliance program reporting obligations of
foreign banking entities with respect to their covered trading and
covered fund activities that are conducted pursuant to the exemptions
contained in Sec. Sec. ----.6(e) and ----.13(b).\2550\
---------------------------------------------------------------------------
\2550\ See, e.g., Soci[eacute]t[eacute] G[eacute]n[eacute]rale;
IIB/EBF; Australian Bankers Ass'n. (Feb. 2012); Banco de
M[eacute]xico; Norinchukin; Cadwalader (on behalf of Thai Banks);
Cadwalader (on behalf of Singapore Banks); Allen & Overy (on behalf
of Canadian Banks); BAROC; Comm. on Capital Markets Regulation;
Credit Suisse (Williams); EFAMA; Hong Kong Inv. Funds Ass'n.; HSBC;
IIAC; IMA; Katten (on behalf of Int'l Clients); Ass'n. of Banks in
Malaysia; RBC; Sumitomo Trust; See also AFME et al.; British
Bankers' Ass'n.; EBF; Commissioner Barnier; French Banking Fed'n.;
UBS; Union Asset.
---------------------------------------------------------------------------
The final rule also responds to commenters' concerns regarding the
timeframe within which a banking entity must establish and implement
the compliance program required for that entity under Sec. ----.20.
Under the final rule, each banking entity must establish the compliance
program required for that entity under Sec. ----.20 as soon as
practicable and in no case later than the end of the conformance
period.\2551\ The Agencies expect that during this period a banking
entity will develop and implement the compliance program requirements
of the final rule as part of its good-faith efforts to fully conform
its activities and investments to the requirements of section 13 and
the final rule. As explained below in the discussion of the enhanced
minimum standards for compliance programs under Appendix B, the final
rule also requires larger and more active banking entities to report
certain data regarding their trading activities. These requirements
have been phased-in to provide banking entities an opportunity to
develop the necessary systems to capture and report the relevant
data.\2552\ In addition, as explained below, the Agencies will
consider, after a period to gain experience with the data, revisiting
these data collections to determine their usefulness in monitoring the
risk and types of activities conducted by banking entities.
---------------------------------------------------------------------------
\2551\ As discussed in Part II., the Board is extending the
conformance period by one year. Extension of the conformance period
will, among other things, provide banking entities with additional
time to establish the required compliance program. The Agencies
believe the extension of the conformance period, as well as the
phased-in approach to implementing the enhanced compliance program
in Appendix B, address certain commenters' requests for additional
time to establish a compliance program. See Wells Fargo (Prop.
Trading); PNC et al.; Australian Bankers Ass'n. (Feb. 2012); SIFMA
et al. (Prop.Trading) (Feb. 2012); ABA (Keating); AFME et al.; BoA;
Barclays; SIFMA et al. (Covered Funds) (Feb. 2012); SIFMA et al.
(Mar. 2012); Comm. on Capital Markets Regulation; Credit Suisse
(Williams); T. Rowe Price; See also Citigroup (Feb. 2012);
Soci[eacute]t[eacute] G[eacute]n[eacute]rale; IIB/EBF; Am. Express;
Arnold & Porter; BDA (Mar. 2012); Morgan Stanley.
\2552\ Commenters provided a wide range of feedback regarding
the timeframe for establishing a compliance program, from requesting
that reporting begin immediately to requesting two years from the
date of publication of the final rule. See, e.g., Occupy; Alfred
Brock; Wells Fargo (Prop. Trading); PNC et al.; SIFMA et al.
(Prop.Trading) (Feb. 2012). The Agencies believe that the final
rule's approach appropriately balances the desire for effective
regulation with requests for additional time to establish a
compliance program.
---------------------------------------------------------------------------
b. Compliance Program Elements
Section ----.20 of the final rule specifies six elements that each
compliance program required under that section must at a minimum
contain. With some minor modifications, these are the same six elements
that were included in the proposed rule. The changes reflect
modifications made in requirements and limits in the other provisions
of the rule and, in particular, acknowledge the importance of trading
and hedging limits, appropriate setting, monitoring and management
review of trading and hedging limits, strategies, and activities and
investments, incentive compensation and other matters.
The six elements specified in Sec. ----.20(b) are:
Written policies and procedures reasonably designed to
document, describe, monitor and limit trading activities and covered
fund activities and investments conducted by the banking entity to
ensure that all activities and investments that are subject to
section 13 of the BHC Act and the rule comply with section 13 of the
BHC Act and the rule; \2553\
---------------------------------------------------------------------------
\2553\ This requirement is substantially the same as the
proposed written policies and procedures requirement. See proposed
rule Sec. ----20(b)(1).
---------------------------------------------------------------------------
A system of internal controls reasonably designed to
monitor compliance with section 13 of the BHC Act and the rule and
to prevent the occurrence of activities or investments that are
prohibited by section 13 of the BHC Act and the rule; \2554\
---------------------------------------------------------------------------
\2554\ This requirement is substantially the same as the
proposed internal controls requirement. See proposed rule Sec. --
--.20(b)(2).
---------------------------------------------------------------------------
A management framework that clearly delineates
responsibility and accountability for compliance with section 13 of
the BHC Act and the rule and includes appropriate management review
of trading limits, strategies, hedging activities, investments,
incentive compensation and other matters identified in the rule or
by management as requiring attention; \2555\
---------------------------------------------------------------------------
\2555\ The final rule modifies the proposed management framework
requirement by adding that the management framework element must
include appropriate management review of trading limits, strategies,
hedging activities, incentive compensation, and other matters. See
final rule Sec. ----.20(b)(3). See also proposed rule Sec. ----
20(b)(3). One commenter suggested that the compliance program
requirement have a greater focus on compensation incentives. See
Citigroup (Feb. 2012).
---------------------------------------------------------------------------
Independent testing and audit of the effectiveness of
the compliance program conducted periodically by qualified personnel
of the banking entity or by a qualified outside party; \2556\
---------------------------------------------------------------------------
\2556\ The final rule modifies the proposed independent testing
requirement by specifying that such testing must be done
``periodically.'' See final rule Sec. ----.20(b)(4). See also
proposed rule Sec. ----.20(b)(4). The meaning of ``independent
testing'' is discussed in more detail below in Part IV.C.2.e. The
reference to ``audit'' does not mean that the independent testing
must be performed by a designated auditor, whether internal or
external.
---------------------------------------------------------------------------
Training for trading personnel and managers, as well as
other appropriate personnel, to effectively implement and enforce
the compliance program; \2557\ and
---------------------------------------------------------------------------
\2557\ The final rule retains the proposed training requirement.
See final rule Sec. ----.20(b)(5). See also proposed rule Sec. --
--.20(b)(5).
---------------------------------------------------------------------------
Making and keeping records sufficient to demonstrate
compliance with section 13 of the BHC Act and the rule, which a
banking entity must promptly provide to the relevant supervisory
Agency upon request and retain for a period of no less than 5 years.
Under the final rule, these six elements must be part of the compliance
program of each banking entity with total consolidated assets greater
than $10 billion that engages in activities covered by section 13 of
the BHC Act.
As discussed above, the Agencies have moved particular elements
with respect to the required compliance program for the exemptions
contained in Sec. ----.4(a), Sec. ----.4(b), and Sec. ----.5 into
the specific requirements of these exemptions. The Agencies believe
this structure more effectively conveys that satisfying the
requirements of these exemptions involves specific compliance measures
or, with respect to underwriting and market making, a customer-focused
business model, as requested by some commenters.\2558\
---------------------------------------------------------------------------
\2558\ One of these commenters suggested the Agencies adopt a
simpler compliance framework that could be harmonized with the Basel
accord. See Citigroup (Feb. 2012). The Agencies believe the final
framework described above helps address concerns about streamlining
the compliance program requirement while meeting the statutory
requirement to issue regulations ``in order to insure compliance''
with section 13. 12 U.S.C. 1851(e)(1).
---------------------------------------------------------------------------
In addition to the generally required compliance program elements
specified in Sec. ----.20(b), a banking entity relying on any of these
exemptions should employ the specific compliance tools specified within
the relevant section of
[[Page 5752]]
this rule to facilitate compliance with the applicable exemption and
should appropriately tailor the required compliance program elements to
the individual trading activities and strategies of each trading desk
on an ongoing basis. By specifying particular compliance program-
related requirements in the exemptions, the Agencies have sought to
provide additional guidance and clarity as to how a compliance program
should be structured,\2559\ while at the same time providing the
banking entity with sufficient discretion to consider the type, size,
scope and complexity of its activities and business structure in
designing a compliance program to meet the requirements set forth in
Sec. ----.20(b).\2560\
---------------------------------------------------------------------------
\2559\ One commenter stated that the proposed rule did not
provide sufficient clarity as to what types or levels of activities
would be permissible. See Citigroup (Feb. 2012).
\2560\ Some commenters requested a more principles-based
framework that allows banking entities to customize compliance
programs to the structure and activities of their organizations. See
SIFMA et al. (Prop.Trading) (Feb. 2012); Wells Fargo (Prop.
Trading); See also M&T Bank; Credit Suisse (Seidel); State Street
(Feb. 2012); NYSE Euronext; Stephen Roach.
---------------------------------------------------------------------------
For a banking entity with more than $10 billion in total
consolidated assets, the compliance program requires additional
documentation with respect to funds. For example, the banking entity is
required to maintain records that include documentation of exclusions
or exemptions other than sections 3(c)(1) and 3(c)(7) of the Investment
Company Act of 1940 relied on by each fund sponsored by the banking
entity (including all subsidiaries and affiliate) in determining that
such fund is not a covered fund.\2561\ The banking entity is also
required to maintain, with respect to each fund sponsored by the
banking entity (including all subsidiaries and affiliates) for which
the banking entity relies on one or more of the exclusions provided by
Sec. Sec. ----.10(c)(1), ----.10(c)(5), ----.10(c)(8), ----.10(c)(9),
or ----.10(c)(10) of subpart C, documentation supporting the banking
entity's determination that the fund is not a covered fund pursuant to
one or more of those exclusions.\2562\ If the banking entity operates a
seeding vehicle described in Sec. Sec. ----.10(c)(12)(i) or --
--.10(c)(12)(iii) of subpart C that will become a registered investment
company or SEC-regulated business development company, the compliance
program must also include a written plan documenting the banking
entity's determination that the seeding vehicle will become a
registered investment company or SEC-regulated business development
company; the period of time during which the vehicle will operate as a
seeding vehicle; and the banking entity's plan to market the vehicle to
third-party investors and convert it into a registered investment
company or SEC-regulated business development company within the time
period specified in Sec. ----.12(a)(2)(i)(B) of subpart C.\2563\
Furthermore, for any banking entity that is, or is controlled directly
or indirectly by a banking entity that is, located in or organized
under the laws of the United States or of any State, if the aggregate
amount of ownership interest in foreign public funds as described in
Sec. ----.10(c)(1) of subpart C owned by such banking entity
(including ownership interests owned by any affiliate that is
controlled directly or indirectly by a banking entity that is located
in or organized under the laws of the United States or of any State)
exceeds $50 million at the end of two or more consecutive calendar
quarters, beginning with the next succeeding calendar quarter, such
banking entity must include in its compliance program documentation the
value of the ownership interests owned by the banking entity (and such
affiliates) in each foreign public fund and each jurisdiction in which
any such foreign public fund is organized. Such calculation must be
done at the end of each calendar quarter and must continue until the
banking entity's aggregate amount of ownership interests in foreign
public funds is below $50 million for two consecutive calendar
quarters.\2564\
---------------------------------------------------------------------------
\2561\ See final rule Sec. ----.20(e)(1). As discussed under
Sec. ----.10 regarding entities excluded from the definition of
covered fund, the Agencies recognize that the final rule's
definition of covered fund does not include certain pooled
investment vehicles. The Agencies expect that the types of pooled
investment vehicles sponsored by the financial services industry
will continue to evolve, including in response to the final rule,
and the Agencies will be monitoring this evolution to determine
whether excluding these and other types of entities remains
appropriate. The Agencies will also monitor use of the exclusions
for attempts to evade the requirements of section 13 and intend to
use their authority where appropriate to prevent evasions of the
rule. The Agencies are adopting this additional documentation
requirement to facilitate such monitoring activities.
\2562\ See final rule Sec. ----.20(e)(2). The Agencies are
adopting this additional documentation requirement for the same
reasons discussed above with respect to Sec. ----.20(e)(1).
\2563\ See final rule Sec. ----.20(e)(3). The rationale for
this additional documentation requirement is provided under the
discussion regarding registered investment companies and business
development companies in Sec. ----.10.
\2564\ See final rule Sec. ----.20(e)(4). The rationale for
this additional documentation requirement is provided under the
discussion regarding foreign public funds in Sec. ----.10. For
purposes of this requirement, a U.S. branch, agency, or subsidiary
of a foreign banking entity is located in the United States;
however, the foreign bank that operates or controls that branch,
agency, or subsidiary is not considered to be located in the United
States solely by virtue of operating or controlling the U.S. branch,
agency, or subsidiary. See final rule Sec. ----.20(e)(5).
---------------------------------------------------------------------------
c. Simplified Programs for Less Active Banking Entities
The proposed rule provided that the six elements of the compliance
program required by Sec. ----.20 would apply to all banking entities
engaged in covered trading activities or covered fund activities and
investments and that the minimum detailed standards of Appendix C would
apply to only those banking entities above specified thresholds. The
application of detailed minimum standards was intended to reflect the
heightened compliance risks of significant covered trading and
significant covered fund activities and investments.
The proposed rule provided that a banking entity with no covered
activities or investments could satisfy the requirements of Sec. --
--.20 if its existing compliance policies and procedures were amended
to include measures that were designed to prevent the banking entity
from becoming engaged in such activities or making such investments and
required the banking entity to develop and provide for the required
compliance program prior to engaging in covered activities or making
covered investments.
Several commenters expressed concern over the requirement in Sec.
----.20(d) of the proposed rule that a banking entity that did not
engage in any covered trading activities or covered fund activities or
investments must ensure that its existing compliance policies and
procedures include measures designed to prevent the banking entity from
becoming engaged in such activities and making such investments.\2565\
In particular, some commenters expressed concern that the proposal
would have a burdensome impact on community banks and force community
banks to hire specialists to amend their policies and procedures to
ensure compliance with section 13 and the final regulations. These
commenters argued that a banking entity should not be required to amend
its compliance policies and procedures and set up a monitoring program
if the banking entity does not engage in prohibited activities.\2566\
---------------------------------------------------------------------------
\2565\ See, e.g., ICBA; ABA (Keating); Conf. of State Bank
Supervisors; NAIB; Ryan Kamphuis; Wisconsin Bankers Ass'n.
\2566\ See, e.g., ICBA; ABA (Keating).
---------------------------------------------------------------------------
A few commenters argued that the Agencies should more carefully
[[Page 5753]]
consider the burden of the compliance program on smaller institutions
that engage in a modest level of permissible trading or covered fund
activity.\2567\ One commenter recommended that smaller banks be given
the benefit of the doubt regarding compliance.\2568\ For instance, one
commenter recommended that banking entities with consolidated assets of
$10 billion or less be permitted to engage in a limited amount of
interest rate swaps and certain other traditional banking activities
without being required to establish a compliance program.\2569\
---------------------------------------------------------------------------
\2567\ See Sens. Merkley & Levin (Feb. 2012); Conf. of State
Bank Supervisors; Ryan Kamphuis; SVB.
\2568\ See Sens. Merkley & Levin (Feb. 2012).
\2569\ See ICBA.
---------------------------------------------------------------------------
The Agencies have considered carefully the comments received and,
as noted above, have modified the rule in order to limit the
implementation, operational or other burdens or expenses associated
with the compliance requirements for a banking entity that engages in
no covered activities or investments. The final rule permits banking
entities that have no covered activities or investments (other than
covered transactions in obligations of or guaranteed by the United
States or an agency of the United States and municipal securities) to
satisfy the compliance program requirements by establishing the
required compliance program prior to becoming engaged in such
activities or making such investments. This eliminates the burden on
banking entities that do not engage in covered activities or
investments.
Similarly, Sec. ----.20(f)(2) of the final rule provides that a
banking entity with total consolidated assets of $10 billion or less as
measured on December 31 of the previous two years that does engage in
covered activities and investments may satisfy the requirements of
Sec. ----.20 by including in its existing compliance policies and
procedures references to the requirements of section 13 and subpart D
as appropriate given the activities, size, scope and complexity of the
banking entity. \2570\ This could include appropriate references to the
limits on trading activities permitted in reliance upon any of the
exemptions contained in Sec. ------.4(a), Sec. ------.4(b) or Sec.
------.5.
---------------------------------------------------------------------------
\2570\ Some commenters asked the Agencies to consider the burden
of the compliance program requirement on smaller institutions and
recommended that small banks be given the benefit of the doubt
regarding compliance. See Sens. Merkley & Levin (Feb. 2012); Conf.
of State Bank Supervisors; Ryan Kamphuis; SVB. The Agencies decline
to follow the approach suggested by another commenter to allow
banking entities with assets of $10 billion or less be permitted to
engage in certain limited activities without having to establish a
compliance program. See ICBA. The Agencies believe that requiring a
banking entity engaged in covered trading or covered fund activity
to establish a compliance program is a fundamental part of the
multi-faceted approach to implementing section 13 of the BHC Act,
which requires the Agencies to implement rules ``to insure
compliance with this section.'' 12 U.S.C. 1851(e)(1). Further, the
Agencies believe that the final rule's modification of the proposal
to allow banking entities with total assets under $10 billion to
customize their compliance programs helps ease the burden of this
requirement on smaller institutions.
---------------------------------------------------------------------------
d. Threshold for Application of Enhanced Minimum Standards
Under the proposed rule, banking entities with significant covered
trading activities or covered fund activities and investments were
required to establish an enhanced compliance program in accordance with
Appendix C, which contained detailed compliance program requirements.
The proposed rule required a banking entity to implement the enhanced
compliance program under Appendix C if the banking entity engaged in
covered activities and investments and either: (i) Has, on a
consolidated basis, trading assets and liabilities the average gross
sum of which (on a worldwide consolidated basis), as measured as of the
last day of each of the four prior calendar quarters, is equal to or
greater than $1 billion or equals 10 percent or more of its total
assets; or (ii) has, on a consolidated basis, aggregate investments in
covered funds the average value of which (on a worldwide consolidated
basis), as measured as of the last day of each of the four prior
calendar quarters, is equal to or greater than $1 billion, or sponsors
and advises one or more covered funds the total assets of which are, as
measured as of the last day of each of the four prior calendar
quarters, equal to or greater than $1 billion.
In general, commenters argued that the activities and investments
subject to section 13 are conducted by only a small number of the
nation's largest financial firms and that the compliance program
requirements should be tailored to target these firms.\2571\ Some
commenters urged the Agencies to raise substantially the proposed $1
billion threshold for trading assets and liabilities in Sec. --
--.20(c)(2) of the proposal to $10 billion or higher due to the high
costs of implementing the enhanced compliance program. A few commenters
argued that even if the threshold were raised to $10 billion, an
overwhelming percentage of trading assets and liabilities in the
banking industry (approximately 98 percent) would still remain subject
to heightened compliance requirements included in Appendix C.\2572\
Some of these commenters recommended the threshold for trading assets
for compliance should be increased to no less than $10 billion to
mitigate the costs and impact on regional banking organizations that do
not engage proprietary trading subject to the prohibition of section
13. These commenters argued that the compliance requirements of Sec.
----.20(a)-(b) are sufficient to ensure that regional banking
organizations have appropriate compliance programs.\2573\ One commenter
suggested the threshold for the enhanced compliance requirement be
increased to $50 billion in combined trading assets and
liabilities.\2574\ One commenter also argued that banking entities
required to establish enhanced compliance programs should no longer be
required to do so if they fall below the threshold.\2575\
---------------------------------------------------------------------------
\2571\ See, e.g., Sens. Merkley & Levin (Feb. 2012); PNC et al.
\2572\ See ABA (Keating); M&T Bank; PNC et al.
\2573\ See PNC et al.; M&T Bank; See also ABA (Abernathy).
\2574\ See State Street (Feb. 2012).
\2575\ See ABA (Keating).
---------------------------------------------------------------------------
Commenters also offered a number of suggestions for modifying the
activity that would be considered in meeting the thresholds for
determining which compliance program requirements apply to a banking
entity. Several commenters argued that certain types of trading assets
or fund investments should not be included for purposes of determining
whether the relevant dollar threshold triggering the enhanced
compliance was met, particularly those that are not prohibited
activities or investments. For instance, some commenters urged that
trading in U.S. government obligations should not count toward the
calculation of whether a banking organization meets the trading
threshold triggering Appendix C.\2576\ These commenters also argued
that other positions or transactions that do not involve financial
instruments and that may constitute trading assets and liabilities,
such as loans, should be excluded from the thresholds because exempt
activities should not determine the type of compliance program a
banking entity must implement.\2577\ One commenter urged that foreign
exchange swaps and forwards be excluded from the definition of a
``derivative'' and not be subject to compliance requirements as a
result.\2578\ Conversely, one commenter urged that all assets and
liabilities defined as trading assets for purposes of the Market Risk
Capital Rule should be
[[Page 5754]]
included in the $1 billion standard for becoming subject to any
reporting and recordkeeping requirements under the final rule.\2579\
---------------------------------------------------------------------------
\2576\ See PNC et al.
\2577\ See PNC et al.
\2578\ See Northern Trust.
\2579\ See Occupy.
---------------------------------------------------------------------------
A few commenters argued that the $1 billion threshold for
establishing an enhanced compliance program should not include the
amount of investments in, or assets of, funds that are SBICs or similar
funds that contain, SBICs or other investments specified under section
13(d)(1)(E) of the BHC Act, such as investments in and funds that
qualify for low-income housing tax credits, or New Markets Tax Credits
or that qualify for Federal historic tax credits or similar state
programs.\2580\ These commenters argued that each of these types of
funds is expressly permitted by the statute and that including these
investments and funds in the dollar thresholds that trigger the
programmatic compliance requirements of Appendix C would provide a
disincentive to banking entities investing in or sponsoring these
funds, a result inconsistent with permitting these types of
investments. Similarly, one commenter urged that investments by a
banking entity in, and assets held by, loan securitizations not be
included in these thresholds because these activities and investments
are expressly excluded from coverage under the rule of construction
contained in section 13(g)(2) of the BHC Act regarding the
securitization of loans.\2581\ Another commenter urged that this
threshold not include investments in, or assets of, any securitization
vehicle that would be considered a covered fund because many smaller
and regional banking entities that were not intended to be subject to
Appendix C likely would exceed the $1 billion threshold if these assets
are included.\2582\ A few commenters also argued that, during the
conformance period, investments in, and relationships with, a covered
fund that a banking entity is required to terminate or otherwise divest
in order to comply with section 13 should not be included for purposes
of calculating the compliance thresholds.\2583\
---------------------------------------------------------------------------
\2580\ See ABA (Keating); PNC et al.
\2581\ See PNC et al.
\2582\ See ASF (Feb. 2012).
\2583\ See PNC et al.; SIFMA et al. (Covered Funds) (Feb. 2012).
---------------------------------------------------------------------------
After considering comments received on the proposal and in order to
implement a compliance program requirement that is consistent with the
purpose and language of the statute and rule while at the same time
appropriately calibrating the associated resource burden on banking
entities, the final rule applies the enhanced minimum standards
contained in Appendix B to only those banking entities with the most
significant covered trading activities or those that meet a specified
threshold of total consolidated assets. The final rule, unlike the
proposal, does not require a banking entity to adopt the enhanced
compliance program if the banking entity, together with its affiliates
and subsidiaries, invest in the aggregate more than $1 billion in
covered funds or if they sponsor or advise covered funds, the average
total assets of which are equal to or greater than $1 billion. Banking
entities would look to the total consolidated asset thresholds, instead
of the amount of covered fund investments and activities, in
determining whether they would be subject to the enhanced compliance
program requirements. The Agencies believe that commenters' concerns
about whether certain types of covered fund investments or activities
(e.g., amounts or relationships held during the conformance period) are
included for purposes of calculating the enhanced compliance thresholds
are addressed because under the final rule, the enhanced compliance
thresholds are based on total consolidated assets and not the amount of
covered fund investments and activities. Similar to the proposed rule,
which provided that a banking entity could be subject to the enhanced
compliance program if the Agency deemed it appropriate, the final
rule's enhanced compliance program also could apply if the Agency
notifies the banking entity in writing that it must satisfy the
requirements.\2584\
---------------------------------------------------------------------------
\2584\ See proposed rule Sec. ----.20(c)(2)(iii); final rule
Sec. ----.20(c)(3).
---------------------------------------------------------------------------
Section ----.20 provides that three categories of banking entities
will be subject to the enhanced minimum standards contained in Appendix
B. The first category is any banking entity that engages in proprietary
trading and is required to report metrics regarding its trading
activities to its primary Federal supervisory agency under the final
rule.\2585\ This category includes a banking entity that has, together
with its affiliates and subsidiaries, trading assets and liabilities
that equal or exceed $50 billion based on the average gross sum of
trading assets and liabilities (on a worldwide consolidated basis and
after excluding trading assets and liabilities involving obligations of
or guaranteed by the United States or any agency of the United States)
over the previous consecutive four quarters, as measured as of the last
day of each of the four prior calendar quarters. A foreign banking
entity with U.S. operations is required to adopt an enhanced compliance
program if its total trading assets and liabilities across all its U.S.
operations equal or exceed $50 billion (after excluding trading assets
and liabilities involving obligations of or guaranteed by the U.S. or
any agency of the U.S.). While these banking entities will be required
to begin to report and record quantitative measurements by June 30,
2014, they will not be required to implement an enhanced compliance
program by this date. Instead, as discussed above, a banking entity
must establish a compliance program as soon as practicable and in no
event later than the end of the conformance period. As explained more
fully in Part IV.C.3., this category expands over time to include any
banking entity with trading assets and liabilities that equal or exceed
$10 billion (as measured in the manner described above). For banking
entities below the $50 billion threshold that become subject to the
quantitative measurements requirement through the phased-in approach,
they will not become subject to the enhanced compliance program until
the date they are required to comply with the quantitative measurements
requirement. However, these banking entities will be required to have a
compliance program that meets the requirements of Sec. ----.20(b) by
the end of the conformance period. Thus, banking entities with between
$25 billion and $50 billion trading assets and liabilities (as
described in Sec. ----.20(d)) will be required to implement an
enhanced compliance program under Appendix B by April 30, 2016.
Similarly, banking entities with between $10 billion and $25 billion
trading assets and liabilities will be subject to the requirements of
Appendix B by December 31, 2016.
---------------------------------------------------------------------------
\2585\ Issues related to the threshold for reporting
quantitative measurements are discussed in detail in Part IV.C.3.,
below.
---------------------------------------------------------------------------
After considering comments, the Agencies have increased the trading
asset and liability thresholds triggering the enhanced compliance
program requirements. The Agencies believe that banking entities with a
significant amount of trading assets should have the most detailed
programs for ensuring compliance with the trading and other
requirements of section 13 of the BHC Act and the final rule.
Specifically, consistent with the thresholds for reporting and
recording quantitative measurements, the threshold will initially be
$50 billion trading assets and liabilities and, over time, will be
reduced to $10 billion.\2586\ As noted by
[[Page 5755]]
commenters, these thresholds will continue to capture a significant
percentage of the total trading assets and liabilities in the banking
system, but will reduce the burdens to smaller, less complex banking
entities.\2587\ With respect to this first category, the Agencies
determined, in response to comments,\2588\ that the threshold for
proprietary trading should not include trading assets and liabilities
involving obligations of or guaranteed by the United States or any
agency of the United States. This approach reduces the burdens
associated with the enhanced minimum compliance program on banking
entities whose trading operations consist primarily of trading U.S.
government or agency obligations, which are generally exempt from the
proprietary trading prohibition under Sec. ----.6(a)(1)(i). While some
commenters argued that additional assets or liabilities, such as
securitizations or investments in SBICs, should be excluded from the
calculation,\2589\ the Agencies believe that trading in other assets
involves more complex trading activity and warrants being included in
the threshold calculation for applying the enhanced compliance program
requirement.
---------------------------------------------------------------------------
\2586\ Some commenters requested raising this dollar threshold
to at least $10 billion. See PNC et al.; PNC; ABA (Keating). One
commenter suggested the threshold be increased to $50 billion. See
State Street (Feb. 2012).
\2587\ See PNC et al.; M&T Bank; See also ABA (Abernathy); ABA
(Keating). The Agencies recognize that, at the $10 billion
threshold, a significant percentage of the trading assets and
liabilities in the banking industry will remain subject to the
enhanced compliance program requirement. See PNC.
\2588\ See PNC et al.
\2589\ See, e.g., ABA (Keating) (suggesting the threshold should
not include the amount of investments in or assets of SBICs, or
those that qualify for low-income housing tax credits (LIHTC) New
Markets Tax Credits (NMTC), or Federal historic tax credits (HTC));
PNC et al. (loans); Northern Trust.
---------------------------------------------------------------------------
To balance the increased trading asset and liability threshold with
the goal of requiring appropriate specificity and rigor for large and
complex banking organizations' compliance programs, the Agencies have
determined to also require an enhanced compliance program for any
banking entity that has reported total consolidated assets, as of the
previous calendar year-end, of $50 billion or more. Banking entities
with total assets of $50 billion or more are among the most complex
banking entities and have been found by Congress to pose sufficient
risk to the financial stability of the United States to warrant being
generally subject to enhanced prudential standards under section 165 of
the Dodd-Frank Act. With respect to foreign banking entities, this
threshold is calculated by reference solely to the aggregate assets of
the foreign banking entity's U.S. operations, including its U.S.
branches and agencies. This approach is consistent with the statute's
focus on the risks posed by covered trading activities and investments
within the United States and also responds to commenters' concerns
regarding the level of burden placed on foreign banking entities with
respect to their foreign operations.\2590\
---------------------------------------------------------------------------
\2590\ Several commenters requested that foreign activities of
foreign banking entities be excluded from the compliance program
requirement. See, e.g., Soci[eacute]t[eacute]
G[eacute]n[eacute]rale; IIB/EBF; Australian Bankers Ass'n. (Feb.
2012); Banco de Mexico; Norinchukin. One commenter stated the only
U.S. affiliates of foreign banking entities should be required to
institute the proposed reporting and compliance requirements. See
IIB/EBF.
---------------------------------------------------------------------------
The third category includes any banking entity that is notified by
its primary Federal supervisory Agency in writing that it must satisfy
the requirements and other standards contained in Appendix B. By
retaining the flexibility to impose enhanced compliance requirements on
a given banking entity upon specific notice to the firm, the Agencies
have the ability to apply additional standards to any banking entity
with a mix, level, complexity or risk of activities that, in the
judgment of the relevant supervisory Agency, indicates that the firm
should appropriately have in place an enhanced compliance program.
Some commenters argued that the final rule should not require a
banking entity to establish the type of detailed compliance regime
dictated by Appendix C for both trading and covered fund activities and
investments simply because the banking entity engages in one but not
the other activity.\2591\
---------------------------------------------------------------------------
\2591\ See, e.g., SIFMA et al. (Prop.Trading) (Feb. 2012).
---------------------------------------------------------------------------
To comply with the applicable compliance program requirements under
Sec. ----.20 and Appendix B of the final rule, banking entities should
appropriately take into account the type, size, scope and complexity of
their activities and business structure in determining the terms, scope
and detail of the compliance program to be instituted.\2592\ For
example, if all of a banking entity's activities subject to the rule
involve covered fund activities or investments, it would be expected
that the banking entity would have an appropriate compliance program
governing those activities (including an enhanced compliance program if
applicable) and it would not be expected that the banking entity would
construct the same detailed compliance program under the proprietary
trading provision of the rule. Similarly, if a banking entity engages
only in activities that are subject to the proprietary trading
provisions of the rule and does not engage in any covered fund
activities or investments, it would not be expected that the banking
entity would implement the same detailed compliance program under the
covered funds section as would be required for its proprietary trading
activities. In each of these situations, the banking entity would be
expected to put in place sufficient controls to ensure that an
appropriate compliance program is established before the banking entity
commences a new covered activity. The Agencies believe that this
treatment is consistent with the statutory language regarding internal
controls and recordkeeping to ensure compliance with section 13 and
also reduces unnecessary costs and burdens associated with requiring
banking entities to implement compliance requirements that are not
appropriate to the size, scope and risk of their relevant activities.
---------------------------------------------------------------------------
\2592\ This is generally consistent with the proposed rule's
compliance program requirement. See proposed rule Sec. ----.20(a)
(requiring that the banking entity's compliance program be
appropriate for the size, scope and complexity of activities and
business structure of the banking entity).
---------------------------------------------------------------------------
2. Appendix B: Enhanced Minimum Standards for Compliance Programs
The proposed rule contained an appendix (Appendix C) which
specified a variety of minimum standards applicable to the compliance
program of a banking entity with significant covered trading activities
or covered fund activities and investments. The Agencies proposed to
include these minimum standards as part of the regulation itself,
rather than as accompanying guidance, reflecting the compliance
program's importance within the general implementation framework for
the rule.
As explained above, the Agencies continue to believe that the
inclusion of specified minimum standards for the compliance program
within the regulation itself rather than as accompanying guidance
serves to reinforce the importance of the compliance program in the
implementation framework for section 13 of the BHC Act. As explained
above, the Agencies believe that large banking entities and banking
entities engaged in significant trading activities should establish,
maintain and enforce an enhanced compliance program. The requirements
for an enhanced compliance program have been consolidated in Appendix B
of the final rule.
[[Page 5756]]
Similar to the proposed rule, section I of Appendix B provides that
the enhanced compliance program must:
Be reasonably designed to identify, document, monitor
and report the covered trading and covered fund activities and
investments of the banking entity; identify, monitor and promptly
address the risks of these covered activities and investments and
potential areas of noncompliance; and prevent activities or
investments prohibited by, or that do not comply with, section 13 of
the BHC Act and the rule;
Establish and enforce appropriate limits on the covered
activities and investments of the banking entity, including limits
on the size, scope, complexity, and risks of the individual
activities or investments consistent with the requirements of
section 13 of the BHC Act and the rule;
Subject the effectiveness of the compliance program to
periodic independent review and testing, and ensure that the
entity's internal audit, corporate compliance and internal control
functions involved in review and testing are effective and
independent;
Make senior management, and others as appropriate,
accountable for the effective implementation of the compliance
program, and ensure that the board of directors and CEO (or
equivalent) of the banking entity review the effectiveness of the
compliance program; and
Facilitate supervision and examination by the Agencies
of the banking entity's covered trading and covered fund activities
and investments.
The proposed rule included several definitions within the appendix.
In the final rule, all definitions have been moved to other sections of
the rule or into Appendix A (governing metrics). Any banking entity
subject to the enhanced minimum standards contained in Appendix B may
incorporate existing policies, procedures and internal controls into
the compliance program required by Appendix B to the extent that such
existing policies, procedures and internal controls assist in
satisfying the requirements of Appendix B.
Section II of Appendix B contains two parts: one that sets forth
the enhanced minimum compliance program standards applicable to covered
trading activities of a banking entity and one that sets forth the
corresponding enhanced minimum compliance program standards with
respect to covered fund activities and investments. As noted above, if
all of a banking entity's activities subject to the final rule involve
only covered trading activities (or only covered fund activities and
investments), it would be expected that the banking entity would have
an appropriate compliance program governing those activities (including
an enhanced compliance program if applicable) and it would not be
expected that the banking entity would construct the same detailed
compliance program under the covered funds (or proprietary trading)
provisions of the rule. As discussed below, the Agencies have
determined not to include the provisions regarding enterprise-wide
compliance programs.
a. Proprietary Trading Activities
Like the proposed compliance appendix, section II.A of Appendix B
requires a banking entity subject to the enhanced minimum standards
contained in Appendix B to establish, maintain and enforce a compliance
program that includes written policies and procedures that are
appropriate for the types, size, and complexity of, and risks
associated with, its permitted trading activities.\2593\ This portion
of Appendix B requires a banking entity to devote adequate resources
and use knowledgeable personnel in conducting, supervising and managing
its covered trading activities, and to promote consistency,
independence and rigor in implementing its risk controls and compliance
efforts. The compliance program must be updated with a frequency
sufficient to account for changes in the activities of the banking
entity, results of independent testing of the program, identification
of weaknesses in the program and changes in legal, regulatory or other
requirements.
---------------------------------------------------------------------------
\2593\ See Joint Proposal, 76 FR 68,963.
---------------------------------------------------------------------------
Similar to the proposed rule, section II.A of Appendix B requires a
banking entity subject to the Appendix to: (i) Have written policies
and procedures governing each trading desk that include a description
of certain information specific to each trading desk that will
delineate its processes, mission and strategy, risks, limits, types of
clients, customers and counterparties and its compensation
arrangements; (ii) include a comprehensive description of the risk
management program for the trading activity of the banking entity, as
well as a description of the governance, approval, reporting,
escalation, review and other processes that the banking entity will use
to reasonably ensure that trading activity is conducted in compliance
with section 13 of the BHC Act and subpart B; (iii) implement and
enforce limits and internal controls for each trading desk that are
reasonably designed to ensure that trading activity is conducted in
conformance with section 13 of the BHC Act and subpart B and with the
banking entity's policies and procedures, and establish and enforce
risk limits appropriate for the activity of each trading desk; and (iv)
for any hedging activities that are conducted in reliance on the
exemption contained in Sec. ----.5, establish, maintain and enforce
policies and procedures regarding the use of risk-mitigating hedging
instruments and strategies that describe the positions, techniques and
strategies that each trading desk may use, the manner in which the
banking entity will determine that the risks generated by each trading
desk have been properly and effectively hedged, the level of the
organization at which hedging activity and management will occur, the
management in which such hedging strategies will be monitored and the
personnel responsible for such monitoring, the risk management
processes used to control unhedged or residual risks, and a description
of the process for developing, documenting, testing, approving and
reviewing all hedging positions, techniques and strategies permitted
for each trading desk and for the banking entity in reliance on Sec.
----.5.
To the extent that any of the standards contained in Appendix B may
be appropriately met by policies and procedures, internal controls and
other requirements that are common to more than one trading desk, a
banking entity may satisfy the requirements for the enhanced minimum
standards of the compliance program by implementing such common
requirements with respect to any such desks as to which they are
appropriately applicable.\2594\ To the extent the required elements of
the compliance program apply differently to different trading desks
that conduct trading in the same financial instruments, a banking
entity must document the differences and adopt policies and procedures
and implement internal controls specific to each of the different
trading desks. Overall, the policies and procedures should provide the
Agencies with a clear, comprehensive picture of a banking entity's
covered trading activities that can be effectively reviewed.
---------------------------------------------------------------------------
\2594\ This is consistent with proposed Appendix C, except that
the term ``trading unit'' from the proposal has been replaced with
the term ``trading desk.'' See Joint Proposal, 76 FR 68,965.
---------------------------------------------------------------------------
Appendix B also requires that the banking entity perform robust
analysis and quantitative measurement of its covered trading activities
that is reasonably designed to ensure that the trading activity of each
trading desk is consistent with the banking entity's compliance
program; monitor and assist in the identification of potential and
actual prohibited proprietary trading
[[Page 5757]]
activity; and prevent the occurrence of prohibited proprietary trading.
In particular, the banking entity must incorporate into its compliance
program any quantitative measure reported by the banking entity
pursuant to Appendix A where applicable, and include at a minimum: (i)
Internal controls and written policies and procedures reasonably
designed to ensure the accuracy and integrity of the quantitative
measures employed; (ii) ongoing timely monitoring and review of
calculated quantitative measurements; (iii) the establishment of
thresholds and trading measures for each trading desk and heightened
review of any trading activity that is inconsistent with those
thresholds; and (iv) review, investigation and escalation with respect
to matters that suggest a reasonable likelihood that a trading desk has
violated any part of section 13 of the BHC Act or the rule.\2595\
---------------------------------------------------------------------------
\2595\ See Joint Proposal, 76 FR 68,965.
---------------------------------------------------------------------------
Where a banking entity is subject to the reporting requirements of
Appendix A, any additional quantitative measurements developed and
implemented by the banking entity under the compliance program
requirement are not required to be routinely submitted to the relevant
Agency as provided in Appendix A, but are subject to the recordkeeping
requirements set forth in subpart D, including the requirement to
promptly produce such records to the relevant Agency upon request.
Where a banking entity is not subject to the requirements of Appendix
A, that banking entity would likewise not be required by this rule to
routinely submit these additional quantitative measurements to the
relevant Agency, but would be subject to the recordkeeping requirements
set forth in subpart D, including the requirement to promptly produce
such records to the relevant Agency upon request.
In addition to the other requirements that are specific to
proprietary trading, the banking entity's compliance program must
identify the activities of each trading desk that will be conducted in
reliance on the exemptions contained in Sec. Sec. ----.4 through --
--.6, including an explanation of (i) how and where in the organization
such activity occurs, and (ii) which exemption is being relied on and
how the activity meets the specific requirements of such exemption. For
trading activities that rely on an exemption contained in Sec. Sec. --
--.4 through Sec. ----.6, the banking entity's compliance program
should include an explanation of how, and its policies, procedures and
internal controls that demonstrate that, such trading activities
satisfy such exemption and any other requirements of section 13 of the
BHC Act and the final rule that are applicable to such activities. A
foreign banking entity that engages in proprietary trading in reliance
on the exemption contained in Sec. ----.6(e) will be expected to
provide information regarding the compliance program implemented to
ensure compliance with the requirements of that section, including
compliance by the U.S. operations of the foreign banking firm, but will
only be expected to provide trading information regarding activity
conducted within the United States (absent an indication of activity
conducted or designed to evade the requirements of section 13 of the
BHC Act of the final rule).\2596\
---------------------------------------------------------------------------
\2596\ See AFME et al.; IIB/EBF; BaFin/Deutsche Bundesbank;
Credit Suisse (Seidel); HSBC.
---------------------------------------------------------------------------
In addition, the compliance program must describe the process for
ensuring that liquidity management activities are conducted in
conformance with the limits and policies contained in Sec. --
--.3(d)(3). This includes processes for ensuring that liquidity
management activities are not conducted for the purpose of prohibited
proprietary trading.
The banking entity's compliance program must be reasonably designed
and established to effectively monitor and identify for further
analysis any proprietary trading activity that may indicate potential
violations of section 13 of the BHC Act and subpart B and to prevent
violations of section 13 of the BHC Act and subpart B. The standards
set forth in subpart D direct the banking entity to include
requirements in its compliance program for documenting remediation
efforts, assessing the extent to which modification of the compliance
program is warranted and providing prompt notification to appropriate
management and the board of directors of material weakness or
significant deficiencies in the implementation of the compliance
program.
b. Covered Fund Activities or Investments
Section II.B of Appendix B requires a banking entity subject to the
enhanced minimum standards contained in Appendix B to establish,
maintain and enforce a compliance program that includes written
policies and procedures that are appropriate for the types, size,
complexity and risks of the covered fund and related activities
conducted and investments made, by the banking entity.
The enhanced compliance program requirements for covered funds and
investments focus on: (i) Ensuring that the compliance program provides
a process for identifying all covered funds that the banking entity
sponsors, organizes or offers, and covered funds in which the banking
entity invests; (ii) ensuring that the compliance program provides a
method for identifying all funds and pools that the banking entity
sponsors or has an interest in and the type of exemption from the
Investment Company Act or Commodity Exchange Act (whether or not the
fund relies on section 3(c)(1) or 3(c)(7) of the Investment Company Act
or section 4.7 of the regulations under the Commodity Exchange Act),
and the amount of ownership interest the banking entity has in those
funds or pools; (iii) identifying, documenting, and mapping where any
covered fund activities are permitted to be conducted within the
banking entity; and (iv) including an explanation of compliance; (v)
describing sponsorship activities related to covered funds; and (vi)
establishing, maintaining and enforcing internal controls that are
reasonably designed to ensure that its covered fund activities or
investments comply with the requirements of section 13 of the BHC Act
and subpart C, and (vii) monitoring of the banking entity's investments
in and transactions with any covered funds.
In addition, the banking entity's compliance program must document
the banking entity's plan for seeking unaffiliated investors to ensure
that any investment by the banking entity in a covered fund conforms to
the limits contained in the final rule or that the covered fund is
registered in compliance with the securities laws within the
conformance period provided in the final rule. Similarly, the
compliance program must ensure that the banking entity complies with
any limits on transactions or relationships with the covered fund
contained in the final rule, including in situations in which the
banking entity is designated as a sponsor, investment manager,
investment adviser or commodity trading adviser by another banking
entity.
The banking entity's compliance program must be reasonably designed
and established to effectively monitor and identify for further
analysis any covered fund activity that may indicate potential
violations of section 13 of the BHC Act and subpart C. The standards
set forth in subpart D require the banking entity to include
requirements in its compliance program for documenting remediation
efforts,
[[Page 5758]]
assessing the extent to which modification of the compliance program is
warranted and providing prompt notification to appropriate management
and the board of directors of material weakness or significant
deficiencies in the design or implementation of the compliance program.
c. Enterprise-Wide Programs
Appendix C in the proposed rule contained a provision that
permitted a banking entity to establish a compliance program on an
enterprise-wide basis. Some commenters argued that a less specific and
more flexible compliance regime would be essential to make the
enterprise-wide compliance structures contemplated in Appendix C
effective because requiring individualized policies and procedures for
each business line would diminish the benefits of enterprise-wide
compliance and prevent consistency of these policies and procedures
within the banking entity.\2597\ One of these commenters recommended
the Agencies provide greater options for developing a compliance
program and not limit a banking entity to a choice between a single
enterprise-wide program or a separate program for each subsidiary
engaged in activities covered by the proposed rule.\2598\
---------------------------------------------------------------------------
\2597\ See SIFMA et al. (Prop.Trading) (Feb. 2012); Wells Fargo
(Prop. Trading).
\2598\ See Wells Fargo (Prop. Trading).
---------------------------------------------------------------------------
In contrast, one commenter argued that any enterprise-wide
compliance program would only be effective if combined with additional
programs at the trading unit or subsidiary level to train all employees
at a banking entity.\2599\ This commenter argued that each trading unit
is different and suggested that it would be more efficient to mandate
enterprise-wide default internal controls, but provide each individual
trading unit the flexibility to tailor these requirements to its own
specific business.\2600\ This commenter also urged that Appendix C's
elements III (internal controls), IV (responsibility and
accountability) and VII (recordkeeping) should not be imposed solely at
the enterprise-wide level.\2601\
---------------------------------------------------------------------------
\2599\ See Occupy.
\2600\ See Occupy.
\2601\ See Occupy.
---------------------------------------------------------------------------
After considering carefully the comments on the proposal, the
Agencies have removed the reference to an enterprise-wide compliance
program from the final rule; however, the Agencies acknowledge that a
banking entity may establish a compliance program on an enterprise-wide
basis, as long as the program satisfies the requirements of Sec. --
--.20 and, where applicable, Appendix B. A banking entity may employ
common policies and procedures that are established at the enterprise-
wide level or at a business-unit level to the extent that such policies
and procedures are appropriately applicable to more than one trading
desk or activity, as long as the required elements of Appendix B and
all of the other applicable compliance-related provisions of the rule
are incorporated in the compliance program and effectively administered
across trading desks and banking entities within the consolidated
enterprise or designated business. If a banking entity establishes an
enterprise-wide program, like a non-enterprise wide program, that
program will be subject to supervisory review and examination by any
Agency vested with rule writing authority under section 13 of the BHC
Act with respect to the compliance program and the activities or
investments of each banking entity for which the Agency has such
authority.\2602\ The banking organization would be expected to provide
each appropriate Agency with access to all records related to the
enterprise-wide compliance program pertaining to any banking entity
that is supervised by the Agency vested with such rule writing
authority.
---------------------------------------------------------------------------
\2602\ See 12 U.S.C. 1851(b)(2)(B)(i).
---------------------------------------------------------------------------
For similar reasons, the Agencies have determined not to adopt some
commenters' requests that a single agency be responsible for
determining compliance with section 13.\2603\ At this time the Agencies
do not believe such an approach would be consistent with the statute,
which requires each Agency to adopt a rule for the types of banking
entities under its jurisdiction,\2604\ or effective given the different
authorities and expertise of each Agency. 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.\2605\
---------------------------------------------------------------------------
\2603\ See Barclays; Goldman (Prop. Trading); BoA; SIFMA Funds
et al. (Prop. Trading) (Feb. 2012); Comm. on Capital Markets
Regulation.
\2604\ See 12 U.S.C. 1851(b)(2)(B).
\2605\ Accordingly, the SEC's and CFTC's final rules, unlike the
applicable proposals, do not incorporate by reference the rules and
interpretations of the Federal banking agencies with respect to
covered fund activities or investments. See SEC proposed rule
255.10(a)(2), Joint Proposal, 76 FR 68,942-68,943, and CFTC proposed
rule, 77 FR 8421-8423.
---------------------------------------------------------------------------
d. Responsibility and Accountability
Section III of Appendix B includes the enhanced minimum standards
for responsibility and accountability. Section III contains many of the
provisions contained in the proposed rule relating to responsibility
and accountability, with certain modifications.\2606\ Section III
requires a banking entity to establish, maintain and enforce both a
governance and management framework to manage its business and
employees with a view to preventing violations of section 13 of the BHC
Act and the rule. The standards in Section III focus on four key
constituencies--the board of directors, the CEO, senior management, and
business line managers. Certain of the standards contained in the
proposed rule relating to business management are separately covered by
specific requirements contained in sections II.A and II.B of Appendix
B. Section III makes it clear that the board of directors, or similar
corporate body, and the CEO and senior management are responsible for
creating an appropriate ``tone at the top'' by setting an appropriate
culture of compliance and establishing clear policies regarding the
management of the firm's trading activities and its fund activities and
investments. Senior management must be made responsible for
communicating and reinforcing the culture of compliance established by
it and the board of directors, for the actual implementation and
enforcement of the approved compliance program, and for taking
corrective action where appropriate.
---------------------------------------------------------------------------
\2606\ See Joint Proposal, 76 FR 68,966.
---------------------------------------------------------------------------
In response to a question in the preamble to the proposed rule
regarding whether the chief executive officer or similar officer of a
banking entity should be required to provide a certification regarding
the compliance program requirements, a few commenters urged that the
final rule should not require that the board of directors or CEO of a
banking entity review or certify the effectiveness of the compliance
program.\2607\ These commenters argued that existing processes
developed by large, complex banking entities for board of director
reporting and governance processes ensure that compliance programs work
appropriately, and argued that these protocols would establish
appropriate management and board of directors' oversight of the section
13 compliance
[[Page 5759]]
program.\2608\ By contrast, several commenters advocated requiring CEO
attestation regarding compliance with section 13.\2609\ One commenter
suggested that the rule require an annual assessment by management of
the effectiveness of internal controls and policies and require a
public accounting firm to attest to the accuracy of those annual
assessments.\2610\
---------------------------------------------------------------------------
\2607\ See SIFMA et al. (Prop.Trading) (Feb. 2012); Wells Fargo
(Prop. Trading).
\2608\ See SIFMA et al. (Prop.Trading); See also Wells Fargo
(Prop. Trading).
\2609\ See Occupy; AFR et al. (Feb. 2012); Sens. Merkley & Levin
(Feb. 2012); Public Citizen; Ralph Saul (Oct. 2011); John Reed; See
also BEC et al. (Oct. 2011); Matthew Richardson.
\2610\ See Merkley & Levin (Feb. 2012).
---------------------------------------------------------------------------
After considering comments received on the proposal, the Agencies
have determined to include a requirement in the final rule that a
banking entity's CEO annually attest in writing to the appropriate
Agency for the banking entity that the banking entity has in place
processes to establish, maintain, enforce, review, test and modify the
compliance program established pursuant to Appendix B and Sec. ----.20
of the rule in a manner reasonably designed to achieve compliance with
section 13 of the BHC Act and this rule. Although some commenters
stated that existing protocols of certain banking entities would
establish appropriate oversight of the rule's compliance program,\2611\
the Agencies believe this requirement will better help to ensure that a
strong governance framework is implemented with respect to compliance
with section 13 of the BHC Act, and that it more directly underscores
the importance of CEO engagement in the governance and management
framework supporting compliance with the rule. In the case of the U.S.
operations of a foreign banking entity, including a U.S. branch or
agency of a foreign banking entity, the attestation may be provided for
the entire U.S. operations of the foreign banking entity by the senior
management officer of the U.S. operations of the foreign banking entity
who is located in the United States.
---------------------------------------------------------------------------
\2611\ See SIFMA et al. (Prop.Trading) (Feb. 2012); See also
Wells Fargo (Prop. Trading).
---------------------------------------------------------------------------
e. Independent Testing
Section IV of the Appendix B includes the enhanced minimum
standards for independent testing, which are substantially similar to
the proposed independent testing standards.\2612\ A banking entity
subject to Appendix B must ensure that independent testing regarding
the effectiveness of the banking entity's compliance program is
conducted by a qualified independent party, such as the banking
entity's internal audit department, compliance personnel or risk
managers independent of the trading desk or other organizational unit
being tested, outside auditors, consultants, or other qualified
independent parties. If a banking entity uses internal personnel to
conduct the independent testing, the Agencies would expect that the
banking entity ensure that the personnel responsible for the testing
are separate from the unit and functions being tested (e.g., the
personnel do not report to a person who is directly responsible for the
unit or involved in the functions being tested) and have knowledge of
the requirements of section 13 and its implementing rules. Although an
external audit is not required to meet the independent testing
requirement, the Agencies would expect that, when external auditors are
engaged to review compliance by a banking entity with laws and
regulations, the banking entity would give appropriate consideration to
the need to review the compliance program required under this rule.
---------------------------------------------------------------------------
\2612\ See Joint Proposal, 76 FR 68,967.
---------------------------------------------------------------------------
While one commenter suggested the final rule prescribe the precise
manner in which a banking entity must conduct its compliance
testing,\2613\ the Agencies believe such a requirement is unnecessary
because the standards in the final rule will ensure that independent
testing of the effectiveness of a banking entity's compliance program
is objective and robust. The independent testing must examine both the
banking entity's compliance program and its actual compliance with the
rule. This testing must include not only testing of the overall
adequacy and effectiveness of the compliance program and compliance
efforts, but also the effectiveness of each element of the compliance
program and the banking entity's compliance with each provision of the
rule. This requirement is intended to ensure that a banking entity
continually reviews and assesses, in an objective manner, the strength
of its compliance efforts and promptly identifies and remedies any
weaknesses or matters requiring attention within the compliance
framework.
---------------------------------------------------------------------------
\2613\ One commenter suggested that any compliance testing under
the final rule be monitored by the Agencies and initially tested by
internal audit personnel of the banking entity who are subject to a
specific licensing and registration process for section 13 of the
BHC Act and supplemented by an annual independent external review.
See Occupy; See also proposed rule Sec. ----.20(b)(4). The Agencies
believe it would be unnecessarily burdensome to require particular
licensing and registration processes for internal auditors that are
specific to section 13 of the BHC Act.
---------------------------------------------------------------------------
f. Training
Like the proposed compliance appendix, Section V of Appendix B
includes the enhanced minimum standards for training.\2614\ It requires
that a banking entity provide adequate training to its trading
personnel and managers, as well as other appropriate personnel, in
order to effectively implement and enforce the compliance program. In
particular, personnel engaged in covered trading activities and
investments should be educated with respect to applicable prohibitions
and restrictions, exemptions, and compliance program elements to an
extent sufficient to permit them to make informed, day-to-day decisions
that support the banking entity's compliance with section 13 of the BHC
Act and the rule. In particular, any personnel with discretionary
authority to trade, in any amount, should be appropriately trained
regarding the differentiation of prohibited proprietary trading and
permitted trading activities and given detailed guidance regarding what
types of trading activities are prohibited. Similarly, personnel
providing investment management or advisory services, or acting as
general partner, managing member, or trustee of a covered fund, should
be appropriately trained regarding what covered fund activities and
investments are permitted and prohibited.
---------------------------------------------------------------------------
\2614\ See Joint Proposal, 76 FR 68,967.
---------------------------------------------------------------------------
g. Recordkeeping
Section VI of Appendix B contains the enhanced minimum standards
for recordkeeping which are consistent with the proposed recordkeeping
standards.\2615\ Generally, a banking entity must create records
sufficient to demonstrate compliance and support the operation and
effectiveness of its compliance program (i.e., records demonstrating
the banking entity's compliance with the requirements of section 13 of
the BHC Act and the rule, any scrutiny or investigation by compliance
personnel or risk managers, and any remedies taken in the event of a
violation or non-compliance), and retain these records for no less than
five years in a form that allows the banking entity to promptly produce
these records to any relevant Agency upon request. Records created and
retained under the compliance program must include trading records of
the trading units, including trades and positions of each such unit.
Records created and
[[Page 5760]]
retained under the enhanced compliance program must also include
documentation of any exemption in the final rule relied on by the
banking entity to invest in or sponsor a covered fund.
---------------------------------------------------------------------------
\2615\ See Joint Proposal, 76 FR 68,967.
---------------------------------------------------------------------------
While one commenter requested that the period for retaining records
be extended from 5 years to 6 years, the final rule does not make this
change.\2616\ The Agencies believe that 5 years is an appropriate
minimum period for requiring retention of records to demonstrate
compliance with the final rule. The final rule allows the Agencies to
require a banking entity to retain records for a longer period if
appropriate.
---------------------------------------------------------------------------
\2616\ One commenter specifically urged that records for any
type of compliance program be required to be kept on all hedges,
rather than only those placed at a different level or trading unit
as under the proposal, and that the retention period for all
compliance records be changed from 5 years to 6 years in line with
the statute of limitations on civil suits for fraud, contracts and
collection of debt in accounts in New York State. See Occupy.
---------------------------------------------------------------------------
3. Section ----.20(d) and Appendix A: Reporting and Recordkeeping
Requirements Applicable to Trading Activities
Section ----.7 of the proposed rule, which the Agencies proposed to
implement in part section 13(e)(1) of the BHC Act,\2617\ required
certain banking entities to comply with the reporting and recordkeeping
requirements specified in Appendix A of the proposed rule. In addition,
Sec. ----.7 required banking entities to comply with the recordkeeping
requirements in Sec. ----.20 of the proposed rule, related to the
banking entity's compliance program,\2618\ as well as any other
reporting or recordkeeping requirements that the relevant Agency may
impose to evaluate the banking entity's compliance with the proposed
rule.\2619\
---------------------------------------------------------------------------
\2617\ Section 13(e)(1) of the BHC Act requires the Agencies to
issue regulations regarding internal controls and recordkeeping to
ensure compliance with section 13. See 12 U.S.C. 1851(e)(1). Section
----.20 and Appendix C of the proposed rule also implemented section
13(e)(1) of the BHC Act.
\2618\ See Part III.D. of this SUPPLEMENTARY INFORMATION.
\2619\ See proposed rule Sec. ----.7.
---------------------------------------------------------------------------
Proposed Appendix A required a banking entity with significant
trading activities to furnish periodic reports to the relevant Agency
regarding various quantitative measurements of its trading activities
and create and retain records documenting the preparation and content
of these reports. The measurements varied depending on the scope, type,
and size of trading activities. In addition, proposed Appendix B
contained a detailed commentary regarding the characteristics of
permitted market making-related activities and how such activities may
be distinguished from trading activities that, even if conducted in the
context of a banking entity's market-making operations, would
constitute prohibited proprietary trading.\2620\ Under the proposal, a
banking entity was required to comply with proposed Appendix A's
reporting and recordkeeping requirements only if it had, together with
its affiliates and subsidiaries, trading assets and liabilities the
average gross sum of which (on a worldwide consolidated basis) was, as
measured as of the last day of each of the four prior calendar
quarters, equal to or greater than $1 billion.\2621\ The Agencies did
not propose to extend the reporting and recordkeeping requirements to
banking entities with smaller amounts of trading activity, as it
appeared that the more limited benefits of applying these requirements
to such banking entities, whose trading activities are typically small,
less complex, and easier to supervise, would not justify the burden
associated with complying with the reporting and recordkeeping
requirements.
---------------------------------------------------------------------------
\2620\ See supra Part IV.A.3.c.8 (explaining why Appendix B was
removed from the final rule).
\2621\ See proposed rule Sec. ----.7(a).
---------------------------------------------------------------------------
a. Approach to Reporting and Recordkeeping Requirements Under the
Proposal
The proposal explained that the reporting and recordkeeping
requirements of Sec. ----.7 and Appendix A of the proposed rule were
an important part of the proposed rule's multi-faceted approach to
implementing the prohibition on proprietary trading. These requirements
were intended, in particular, to address some of the difficulties
associated with (i) identifying permitted market making-related
activities and distinguishing such activities from prohibited
proprietary trading, and (ii) identifying certain trading activities
resulting in material exposure to high-risk assets or high-risk trading
strategies. To do so, the proposed rule required certain banking
entities to calculate and report detailed quantitative measurements of
their trading activity, by trading unit. These measurements were meant
to help banking entities and the Agencies in assessing whether such
trading activity is consistent with permitted trading activities in
scope, type and profile. The quantitative measurements required to be
reported under the proposed rule were generally designed to reflect,
and to provide meaningful information regarding, certain
characteristics of trading activities that appear to be particularly
useful in differentiating permitted market making-related activities
from prohibited proprietary trading. For example, the proposed
quantitative measurements measured the size and type of revenues
generated, and the types of risks taken, by a trading unit. Each of
these measurements appeared to be useful in assessing whether a trading
unit was (i) engaged in permitted market making-related activity or
(ii) materially exposed to high-risk assets or high-risk trading
strategies. Similarly, the proposed quantitative measurements also
measured how much revenue was generated per such unit of risk, the
volatility of a trading unit's profitability, and the extent to which a
trading unit trades with customers. Each of those characteristics
appeared to be useful in assessing whether a trading unit is engaged in
permitted market making-related activity.
However, as noted in the proposal, the Agencies recognize that no
single quantitative measurement or combination of measurements can
accurately identify prohibited proprietary trading without further
analysis of the context, facts, and circumstances of the trading
activity. In addition, certain quantitative measurements may be useful
for assessing one type of trading activity, but not helpful in
assessing another type of trading activity. As a result, the Agencies
proposed to use a variety of quantitative measurements to help identify
transactions or activities that warrant more in-depth analysis or
review.
To be effective, this approach requires identification of useful
quantitative measurements as well as judgment regarding the type of
measurement results that suggest a further review of the trading unit's
activity is warranted. The Agencies proposed to take a heuristic
approach to implementation in this area that recognized that
quantitative measurements can only be usefully identified and employed
after a process of substantial public comment, practical experience,
and revision. In particular, the Agencies noted that, although a
variety of quantitative measurements have traditionally been used by
market participants and others to manage the risks associated with
trading activities, these quantitative tools have not been developed,
nor have they previously been utilized, for the explicit purpose of
identifying trading activity that warrants additional scrutiny in
differentiating prohibited
[[Page 5761]]
proprietary trading from permitted market making-related
activities.\2622\
---------------------------------------------------------------------------
\2622\ Joint Proposal, 76 FR 68,883.
---------------------------------------------------------------------------
Consistent with this heuristic approach, the proposed rule included
a large number of potential quantitative measurements on which public
comment was sought, many of which overlap to some degree in terms of
their informational value. The proposal explained that not all of these
quantitative measurements may ultimately be adopted in the final rule,
depending on their relative strengths, weaknesses, costs, and benefits.
The Agencies noted that some of the proposed quantitative measurements
may not be relevant to all types of trading activities or may provide
only limited benefits, relative to cost, when applied to certain types
of trading activities. In addition, certain quantitative measurements
may be difficult or impracticable to calculate for a specific covered
trading activity due to differences between asset classes, market
structure, or other factors. The Agencies therefore requested comment
on a large number of issues related to the relevance, practicability,
costs, and benefits of the quantitative measurements proposed. The
Agencies also sought comment on whether the quantitative measurements
described in the proposal were appropriate to use to help assess
compliance with section 13 of the BHC Act.
In addition to the proposed quantitative measurements, the proposal
explained that a banking entity may itself develop and implement other
quantitative measurements in order to effectively monitor its covered
trading activities for compliance with section 13 of the BHC Act and
the proposed rule and to establish, maintain, and enforce an effective
compliance program, as required by Sec. ----.20 of the proposed rule
and Appendix C. The Agencies noted that the proposed quantitative
measurements in Appendix A were intended to assist banking entities and
Agencies in monitoring compliance with the proprietary trading
restrictions and would not necessarily provide all the data necessary
for the banking entity to establish an effective compliance program.
The Agencies also recognized that appropriate and effective
quantitative measurements may differ based on the profile of the
banking entity's businesses in general and, more specifically, of the
particular trading unit, including types of instruments traded, trading
activities and strategies, and history and experience (e.g., whether
the trading desk is an established, successful market maker or a new
entrant to a competitive market). In all cases, banking entities needed
to ensure that they have robust measures in place to identify and
monitor the risks taken in their trading activities, to ensure the
activities are within risk tolerances established by the banking
entity, and to monitor for compliance with the proprietary trading
restrictions in the proposed rule.
To the extent that data regarding measurements, as set forth in the
proposed rule, are collected, the Agencies proposed to utilize the
conformance period provided in section 13 of the BHC Act to carefully
review that data, further study the design and utility of these
measurements, and if necessary, propose changes to the reporting
requirements as the Agencies believe are needed to ensure that these
measurements are as effective as possible.\2623\ This heuristic,
gradual approach to implementing reporting requirements for
quantitative measurements was intended to ensure that the requirements
are formulated in a manner that maximizes their utility for identifying
trading activity that warrants additional scrutiny in assessing
compliance with the prohibition on proprietary trading, while limiting
the risk that the use of quantitative measurements could inadvertently
curtail permissible market making-related activities that provide an
important service to market participants and the capital markets at
large.
---------------------------------------------------------------------------
\2623\ See 12 U.S.C. 1851(c)(2); Joint Proposal, 76 FR 68,883.
---------------------------------------------------------------------------
In addition, the Agencies requested comment on the use of numerical
thresholds for certain quantitative measurements that, if reported by a
banking entity, would require the banking entity to review its trading
activities for compliance and summarize that review to the relevant
Agency. The Agencies did not propose specific numerical thresholds in
the proposal because substantial public comment and analysis would be
beneficial prior to formulating and proposing specific numerical
thresholds. Instead, the Agencies intended to carefully consider public
comments provided on this issue and to separately determine whether it
would be appropriate to propose, subsequent to finalizing the current
proposal, such numerical thresholds.
Part III of proposed Appendix A defined the scope of the reporting
requirements. The proposed rule adopted a tiered approach that required
banking entities with the most extensive trading activities to report
the largest number of quantitative measurements, while banking entities
with smaller trading activities had fewer or no reporting requirements.
This tiered approach was intended to reflect the heightened compliance
risks of banking entities with extensive trading activities and limit
the regulatory burden imposed on banking entities with relatively small
or no trading activities, which appear to pose significantly less
compliance risk.
Under the proposal, any banking entity that had, together with its
affiliates and subsidiaries, trading assets and liabilities the average
gross sum of which (on a worldwide consolidated basis), as measured as
of the last day of each of the four prior calendar quarters, equals or
exceeds $5 billion would be required the banking entity to furnish
quantitative measurements for all trading units of the banking entity
engaged in trading activity subject to Sec. Sec. ----.4, ----.5, or --
--.6(a) of the proposed rule (i.e., permitted underwriting and market
making-related activity, risk-mitigated hedging, and trading in certain
government obligations). The scope of data to be furnished depended on
the activity in which the trading unit was engaged. First, for the
trading units of such a banking entity that are engaged in market
making-related activity pursuant to Sec. ----.4(b) of the proposed
rule, proposed Appendix A required that a banking entity furnish
seventeen quantitative measurements.\2624\ Second, all trading units of
such a banking entity engaged in trading activity subject to Sec. Sec.
----.4(a), ----.5, or ----.6(a) of the proposed rule were required to
report five quantitative measurements designed to measure the general
risk and profitability of the trading unit.\2625\ The Agencies expected
that each of these general types of measurements would be useful in
assessing the extent to which any permitted trading activity involves
exposure to high-risk assets or high-risk trading strategies. These
requirements would apply to all type of trading units engaged in
underwriting and market making-related activity, risk-mitigated
hedging, and trading in certain government obligations. These
additional measurements applicable only to trading units engaged in
market making-related activities were designed to help evaluate the
extent to which the quantitative profile of a trading unit's
[[Page 5762]]
activities is consistent with permissible market making-related
activities.
---------------------------------------------------------------------------
\2624\ See proposed rule Appendix A.III.A. These seventeen
quantitative measurements are discussed further below.
\2625\ See proposed rule Appendix A.III.A. These five
quantitative measurements are: (i) Comprehensive Profit and Loss;
(ii) Comprehensive Profit and Loss Attribution; (iii) VaR and Stress
VaR; (iv) Risk Factor Sensitivities; and (v) Risk and Position
Limits. Each of these and other quantitative measurements discussed
in proposed Appendix A are discussed in detail below.
---------------------------------------------------------------------------
Under the proposal, any banking entity that had, together with its
affiliates and subsidiaries, trading assets and liabilities the average
gross sum of which (on a worldwide consolidated basis), as measured as
of the last day of each of the four prior calendar quarters, equals or
exceeds $1 billion but is less than $5 billion would be required to
provide quantitative measurements to be furnished for trading units
that engaged in market making-related activity subject to Sec. --
--.4(b) of the proposed rule. Trading units of such banking entities
that engaged in market making-related activities needed to report eight
quantitative measurements designed to help evaluate the extent to which
the quantitative profile of a trading unit's activities is consistent
with permissible market making-related activities.\2626\ The proposal
applied a smaller number of measurements to a smaller universe of
trading units for this class of banking entities because they are
likely to pose lesser compliance risk and fewer supervisory and
examination challenges. The Agencies noted in the proposal that a less
burdensome reporting regime, coupled with other elements of the
proposal (e.g., the compliance program requirement), was likely to be
equally as effective in ensuring compliance with section 13 of the BHC
Act and the proposed rule for banking entities with smaller trading
operations.
---------------------------------------------------------------------------
\2626\ See proposed rule Appendix A.III.A. These eight
quantitative measurements are: (i) Comprehensive Profit and Loss;
(ii) Comprehensive Profit and Loss Attribution; (iii) Portfolio
Profit and Loss; (iv) Fee Income and Expense; (v) Spread Profit and
Loss; (vi) VaR; (vii) Volatility of Comprehensive Profit and Loss
and Volatility of Portfolio Profit and Loss; and (viii)
Comprehensive Profit and Loss to Volatility Ratio and Portfolio
Profit and Loss to Volatility Ratio.
---------------------------------------------------------------------------
Section III.B of proposed Appendix A specified the frequency of
required calculation and reporting of quantitative measurements. Under
the proposed rule, each required quantitative measurement needed to be
calculated for each trading day. Required quantitative measurements
were required to be reported to the relevant Agency on a monthly basis,
within 30 days of the end of the relevant calendar month, or on such
other reporting schedule as the relevant Agency may require. Section
III.C of proposed Appendix A required a banking entity to create and
retain records documenting the preparation and content of any
quantitative measurement furnished by the banking entity, as well as
such information as is necessary to permit the relevant Agency to
verify the accuracy of such measurements, for a period of 5 years. This
included records for each trade and position.
b. General Comments on the Proposed Metrics
A number of commenters were supportive of metrics. A few commenters
argued that the metrics could reveal prohibited proprietary trading
activity and be an appropriate and valuable tool in analyzing
positions.\2627\ One commenter argued that metrics are the single most
valuable tool available to the Agencies for distinguishing between
prohibited and permitted activities and recommended the compliance
program be structured around metrics.\2628\ Another commenter stated
that the identification of metrics is one of the strengths of the
proposed rule and offered great promise for successful implementation
of the rule.\2629\ One commenter expressed support for the metrics and
argued that there would be substantial evasion of the rule without
reporting of these measurements.\2630\ Some commenters proposed a
presumption of compliance so long as trading activity is conducted in a
manner consistent with tailored quantitative metrics and related
specific thresholds as coordinated and agreed with the relevant
Agency.\2631\ A few of commenters suggested that metrics not be used as
a bright-line trigger and recommended flexibility in the application of
metrics for assessing market-making activities.\2632\ Two commenters
supported metrics as part of a bright lines approach.\2633\
---------------------------------------------------------------------------
\2627\ See, e.g., Paul Volcker; SIFMA et al. (Prop.Trading)
(Feb. 2012); Invesco; Comm. on Capital Markets Regulation.
\2628\ See Goldman (Prop. Trading).
\2629\ See Sens. Merkley & Levin (Feb. 2012).
\2630\ See Occupy.
\2631\ See Barclays; See also BoA; Invesco; ISDA (Feb. 2012);
JPMC; Morgan Stanley; SIFMA et al. (Prop.Trading) (Feb. 2012).
\2632\ See SIFMA et al. (Prop.Trading) (Feb. 2012); Wells Fargo
(Prop. Trading); NYSE Euronext; Oliver Wyman (Feb. 2012); UBS;
Western Asset Mgmt.; Goldman (Prop. Trading); Northern Trust.
\2633\ See John Reed; Public Citizen.
---------------------------------------------------------------------------
A number of commenters felt that some metrics might be more
relevant than others, depending upon the particular asset class,
activity, particular market, and unique characteristics of each banking
entity.\2634\ These commenters advocated an approach where banking
entities and examiners would determine over time the usefulness and
relevance of particular metrics.\2635\ One commenter expressed support
for the 5 metrics required for trading in U.S. government
obligations.\2636\ A number of commenters recommended that metrics be
tailored to different asset classes and markets, to avoid the drawbacks
of a one-size-fits-all approach.\2637\ One commenter argued that
application of metrics to market-making activities at different firms
may produce very different results, all of which might reflect
legitimate market-making.\2638\ Commenters also indicated that not all
metrics are meaningful and calculable for all trading units and some
would be unnecessarily burdensome.\2639\
---------------------------------------------------------------------------
\2634\ See Morgan Stanley; SIFMA et al. (Prop.Trading) (Feb.
2012); Stephen Roach.
\2635\ See Wells Fargo (Prop. Trading); Morgan Stanley; SIFMA et
al. (Prop.Trading) (Feb. 2012); Stephen Roach.
\2636\ See UBS.
\2637\ See Goldman (Prop. Trading); Northern Trust; See also
UBS.
\2638\ See Comm. on Capital Markets Regulation.
\2639\ See Morgan Stanley; See also ISDA (Feb. 2012).
---------------------------------------------------------------------------
Other commenters did not support the use of metrics. These
commenters argued that metrics reporting was one aspect of the
complexity of the proposal that increased the cost and difficulty of
distinguishing market-making from prohibited proprietary trading.\2640\
One commenter argued that banking entities may avoid legitimate market
making activities that would produce ``worse'' metrics results.\2641\
---------------------------------------------------------------------------
\2640\ See ABA (Keating); Barclays; Citigroup (Feb. 2012); ISDA
(Feb. 2012); UBS; Oliver Wyman (Feb. 2012); Prof. Duffie;
Wellington.
\2641\ See Oliver Wyman (Feb. 2012).
---------------------------------------------------------------------------
Several commenters expressed concern that the costs exceeded the
benefits of the required quantitative metrics in the proposal. In
particular, commenters argued that the 17 metrics in the proposal
calculated at each trading unit was excessive, would generate an
unmanageable amount of data, would yield numerous false positives, and
would require the construction and programming of highly sophisticated
systems that are not currently employed.\2642\ A few commenters
suggested that a more limited set of metrics would reduce compliance
complexity.\2643\ Some commenters noted that many of these metrics have
not been historically reported by banking entities and some of the
metrics would require substantial resources and investment
infrastructure to produce some of the metrics without a clear
functional purpose.\2644\ According to other commenters, however,
banking entities currently use
[[Page 5763]]
all or nearly all of the proposed metrics.\2645\ One commenter urged
that it would be good to make metrics consistent with the banking
entities' internal reporting and control systems.\2646\ Some commenters
argued it was critical for the Agencies to get the metrics right,\2647\
while others indicated it was unclear how the Agencies could analyze
such information to draw useful conclusions.\2648\
---------------------------------------------------------------------------
\2642\ See BoA (expressing concern about the need for new
systems to distinguish bid-ask spreads from price appreciation);
UBS; Wellington.
\2643\ See BoA; Barclays; Citigroup (Feb. 2012).
\2644\ See Credit Suisse (Seidel); Morgan Stanley; UBS; Wells
Fargo (Prop. Trading); Soci[eacute]t[eacute] G[eacute]n[eacute]rale
(arguing that many calculation questions need to be resolved before
banking entities can create necessary systems to measure metrics).
\2645\ See Occupy; AFR et al. (Feb. 2012); Western Asset Mgmt.;
Public Citizen. For example, one commenter cited a study finding
that 14 out of 17 of the proposed metrics are either in wide use
today or are possible to implement fairly easily using data already
collected for internal risk management and profit and loss purposes.
See AFR et al. (Feb. 2012) (citing John Lester and Dylan Walsh,
``The Volcker Rule Ban On Prop Trading: A Step Closer to Reality,
Point of View,'' Oliver Wyman Company (Oct. 2011)).
\2646\ See Paul Volcker.
\2647\ See, e.g., UBS.
\2648\ See BoA; UBS; Wellington.
---------------------------------------------------------------------------
Some commenters expressed concern that metrics were vulnerable to
manipulation and arbitrage.\2649\ These commenters generally felt that
the quantitative measurements were only appropriate for certain liquid
and transparent trading activities but not meaningful for illiquid
markets, including opaque securities and derivatives.\2650\ These
commenters also argued that the vast majority of proprietary trading
would not be differentiable through analysis of the data.\2651\ Other
commenters expressed concern that the use of metrics not replace
regulatory review of actual specific trading positions held by banking
entities.\2652\ One commenter argued that in relying on metrics to be
elaborated upon and discussed in the examination process, the proposed
rule did not meet the fundamental fair notice goal of regulation.\2653\
---------------------------------------------------------------------------
\2649\ See AFR (Nov. 2012); See also Occupy; Public Citizen.
\2650\ See Occupy; AFR (Nov. 2012); Wells Fargo (Prop. Trading).
\2651\ See Occupy.
\2652\ See Sens. Merkley & Levin (Feb. 2012).
\2653\ See ISDA (Feb. 2012) (citing Mason v. Florida Bar, 208
F.3d 952, 958-59 (11th Cir. 2000)).
---------------------------------------------------------------------------
A few commenters also recommended creation of a central data
repository or data sharing protocol that would promote consistency and
accountability in oversight and regulation and suggested the Office of
Financial Research (``OFR'') be given access to this data so that it
can provide centralized analysis and monitoring to identify any trends
that give rise to systemic risk.\2654\ These commenters generally
supported compliance benefits that would result from increased public
disclosure of banking entities' trading and funds activities, including
all of their trading positions, their valuation models, and their
compliance metrics.\2655\
---------------------------------------------------------------------------
\2654\ See Sens. Merkley & Levin (Feb. 2012); See also Occupy;
Public Citizen.
\2655\ See Sens. Merkley & Levin (Feb. 2012); See also Public
Citizen; John Reed.
---------------------------------------------------------------------------
Some commenters expressed support for the reporting thresholds
contained in Appendix A.\2656\ One commenter suggested that all banking
entities that engage in any trading (regardless of threshold) report
certain metrics.\2657\ Other commenters supported metrics reporting,
but recommended the threshold for trading assets and liabilities be
increased from $1 billion to $10 billion to mitigate any cost and
burden impact on smaller banking entities.\2658\ These commenters
pointed out that even if the minimum dollar threshold were raised to
$10 billion, an overwhelming percentage of trading assets and
liabilities in the banking industry (approximately 98 percent) would
still remain subject to heightened compliance requirements including
Appendix A.\2659\ One commenter suggested the threshold be raised to
$50 billion in combined trading assets and liabilities.\2660\
---------------------------------------------------------------------------
\2656\ See ICBA; Occupy.
\2657\ See Occupy (suggesting all banking entities that engage
in trading be required to provide VaR Exceedance, Risk Factor
Sensitivities and Risk and Position Limits).
\2658\ See PNC et al.; M&T Bank; See also ABA (Abernathy).
\2659\ See ABA (Keating); M&T Bank; PNC et al.
\2660\ See State Street (Feb. 2012).
---------------------------------------------------------------------------
Commenters also offered a number of suggestions for modifying the
activity that would be considered in meeting the thresholds for
determining which reporting requirements apply to a banking entity.
Several commenters argued that certain types of trading assets or fund
investments should not be included for purposes of determining whether
the relevant dollar threshold for compliance was met, particularly
those that are not prohibited activities or investments. For instance,
some commenters urged that trading in U.S. government obligations
should not count toward the calculation of whether a banking
organization meets the trading threshold triggering metrics
reporting.\2661\ These commenters also argued that other positions or
transactions that do not involve financial instruments and that may
constitute trading assets and liabilities, such as loans, should be
excluded from the thresholds because exempt activities should not
determine the type of compliance program a banking entity must
implement.\2662\ One commenter urged that foreign exchange swaps and
forwards be excluded from the definition of a ``derivative'' and not be
subject to compliance requirements as a result.\2663\ Conversely, one
commenter urged that all assets and liabilities defined as trading
assets for purposes of the Market Risk Capital Rule should be included
in the $1 billion standard for becoming subject to any reporting and
record-keeping requirements under the final rule.\2664\
---------------------------------------------------------------------------
\2661\ See PNC et al.
\2662\ See PNC et al.
\2663\ See Northern Trust.
\2664\ See Occupy at 60.
---------------------------------------------------------------------------
A number of commenters argued that monthly reporting was too
frequent because of the complexity of the process that surrounds
generation of regulatory reports and suggested that the frequency of
reporting should be quarterly.\2665\ One commenter supported the
reporting frequency as extremely effective and said it should not be
reduced in any way.\2666\
---------------------------------------------------------------------------
\2665\ See JPMC; See also Stephen Roach.
\2666\ See Occupy.
---------------------------------------------------------------------------
A number of comments were received on the implementation timeframe
for metrics reporting. Several commenters urged allowing banking
entities the use of the full conformance period for creating the
systems and processes to capture and report the quantitative
metrics.\2667\ Some commenters suggested that metrics should not be
required to be reported until one year after adoption of final
regulations.\2668\ A different commenter suggested that the Agencies
provide a one-year period during which they determine which metrics
will be employed for different asset classes and an additional one-year
period during which such metrics could be reviewed so metrics would be
a required component of a banking entity's compliance program no sooner
than 2 years after issuance of the final rule.\2669\ Another commenter
suggested that banking entities and regulators use the first year of
the conformance period to consult with one another and determine the
usefulness and relevance of individual metrics for different
activities, asset classes, and markets and the second year of the
conformance period to test the metrics systems to validate the accuracy
and relevance of metrics that are agreed upon the first year.\2670\ One
commenter suggested a subset of metrics be rolled out gradually
[[Page 5764]]
across trading units before implementing the full suite of metrics that
are ultimately adopted or metrics could be rolled out one trading unit
at a time.\2671\ Another commenter said the Agencies should identify
key metrics that are clearly workable across all ranges of trading
activity and most likely to provide useful data and require those
metrics be implemented first and require other metrics to be phased in
over time in consultation with the banking entity's primary federal
regulator.\2672\ One commenter supported the heuristic approach of the
proposal and suggested the Agencies should draw on resources and
comment from the public and the industry in continuing the process of
developing and building out metrics.\2673\
---------------------------------------------------------------------------
\2667\ See BoA; Barclays; Citigroup (Feb. 2012); Goldman (Prop.
Trading); JPMC; Morgan Stanley; SIFMA et al. (Prop.Trading) (Feb.
2012); UBS; Stephen Roach.
\2668\ See Credit Suisse (Seidel); JPMC; Wells Fargo (Prop.
Trading).
\2669\ See BoA.
\2670\ See Morgan Stanley; See also SIFMA et al. (Prop.Trading)
(Feb. 2012).
\2671\ See Goldman (Prop. Trading).
\2672\ See Wells Fargo (Prop. Trading).
\2673\ See AFR et al. (Feb. 2012).
---------------------------------------------------------------------------
Another commenter requested that the final rule specify how trading
assets and liabilities should be reported for savings and loan holding
companies.\2674\ This commenter requested clarification that positions
held for hedging or liquidity management purposes should not count as
trading assets or liabilities for the $5 billion threshold in Appendix
A. Another commenter expressed concern that derivatives valuation may
value derivatives substantially lower than their notional exposure and
thereby make high reporting thresholds not meaningful or reflective of
inherent risk.\2675\
---------------------------------------------------------------------------
\2674\ See GE (Feb. 2012).
\2675\ See Occupy.
---------------------------------------------------------------------------
Many commenters expressed concern that the smallest trading unit
level was too low a level for collecting metrics data and suggested the
final rule provide a higher reporting level.\2676\ These commenters
stated that calculating at too low of a level would be more likely to
generate false positives \2677\ and would be burdensome, particularly
for firms with large trading operations.\2678\ In addition, some
commenters indicated that it would be problematic if the definition of
``trading unit'' is applied at a legal entity level and cannot be
applied across multiple legal entities within the same affiliate
group.\2679\ By contrast, two commenters supported the collection of
metrics at the trading desk level and appropriate levels above the
trading desk.\2680\ One of these commenters expressed concern that the
rule allowed for an inappropriately large trading desk unit that could
combine significantly unrelated trading desks, which would impede
detection of proprietary trading and supported measurements at multiple
levels of organization to combat evasion concerns.
---------------------------------------------------------------------------
\2676\ See, e.g., BoA; Goldman (Prop.Trading); JPMC; SIFMA et
al. (Prop.Trading) (Feb. 2012); Morgan Stanley; RBC.
\2677\ See JPMC; Goldman (Prop.Trading); SIFMA et al.
(Prop.Trading) (Feb. 2012); BoA. See also Sen. Gillibrand.
\2678\ See Goldman (Prop.Trading); SIFMA et al. (Prop.Trading)
(Feb. 2012); BoA.
\2679\ See Goldman (Prop.Trading); SIFMA et al. (Prop.Trading)
(Feb. 2012).
\2680\ See Sens. Merkley & Levin (Feb. 2012); Occupy.
---------------------------------------------------------------------------
In response to questions in the proposal about whether the Agencies
should establish numerical thresholds for some or all of the proposed
quantitative measurements, a number of commenters expressed opposition
to establishing numerical thresholds for purposes of the rule,\2681\
while others stated that thresholds should be established over
time.\2682\ In opposition of thresholds, one commenter expressed
concern that numerical thresholds could be easily abused and evaded and
may need to be constantly revised and updated as financial markets
evolve.\2683\ In addition, another commenter stated that numerical
thresholds should not be imposed because metric levels will differ by
asset class and type of activity.\2684\ A few commenters suggested that
numerical thresholds, based on the specific asset class or market,
would be useful to provide clarity or consistency about the types of
activity that are permitted under the rule.\2685\ Two commenters
expressed support for banking entities establishing numerical
thresholds, in consultation with the relevant regulator, for different
trading units based on differences between markets and asset
classes.\2686\
---------------------------------------------------------------------------
\2681\ See SIFMA et al. (Prop.Trading) (Feb. 2012); Occupy;
Alfred Brock.
\2682\ See Wellington; Barclays; Goldman (Prop. Trading);
CalPERS; John Reed.
\2683\ See Occupy.
\2684\ See SIFMA et al. (Prop.Trading) (Feb. 2012).
\2685\ See Wellington; CalPERS; John Reed.
\2686\ See Goldman (Prop. Trading); Barclays.
---------------------------------------------------------------------------
c. Approach of the Final Rule
As explained below, the Agencies have reduced the number of metrics
that banking entities must report under Appendix A from the 17 metrics
in the proposal to 7 metrics in the final rule. The final rule also
increases the level of activity that is required to trigger mandatory
reporting of metrics data and phases in the reporting requirement over
time.
Under the final rule, a banking entity engaged in significant
trading activity as defined by Sec. ----.20 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.
In response to comments, 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.\2687\ Banking entities that meet the
relevant thresholds must collect and report metrics for all trading
desks engaged in covered trading activity beginning on the dates
established in Sec. ----.20 of the final rule. 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 less than
$50 billion and greater than or equal to $25 billion in trading assets
and liabilities and banking entities with less than $25 billion and
greater than or equal to $10
[[Page 5765]]
billion in trading assets and liabilities would also be required to
report these metrics beginning on April 30, 2016, and December 31,
2016, respectively. The Agencies believe that these delayed dates for
reporting metrics should allow firms adequate time to develop systems
to calculate and report the quantitative metrics. The Agencies will
review the data collected and revise this collection requirement as
appropriate based on a review of the data collected prior to September
30, 2015.
---------------------------------------------------------------------------
\2687\ As noted above, a number of commenters suggested setting
a higher threshold than the proposed $1 billion and $5 billion
trading asset and liability thresholds because even thresholds of
$10 billion to $50 billion would capture a significant percentage of
the total trading assets and liabilities in the banking system. See
ABA (Keating); M&T Bank; PNC et al.; State Street (Feb. 2012). The
Agencies believe that the phase-in approach to the metrics
requirement established in the final rule should generally address
commenters' concerns about the implementation timeframe by providing
time for analysis, development of systems (if needed), and
implementation of the quantitative measurements requirement. See,
e.g., BoA; Barclays; Citigroup (Feb. 2012); Goldman (Prop. Trading);
JPMC; Morgan Stanley; SIFMA et al. (Prop.Trading) (Feb. 2012); UBS;
Stephen Roach; Credit Suisse (Seidel); Wells Fargo (Prop. Trading).
The Agencies are establishing a phase-in approach, rather than
requiring all banking entities above the $10 billion threshold to
report metrics within the same timeframe, to strike a balance
between the benefits of receiving data to help monitor compliance
with the rule against the need for time to assess the effectiveness
and usefulness of the quantitative measurements in practice and for
some firms to develop additional systems for purposes of this
requirement.
---------------------------------------------------------------------------
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 Sec. ----.20 unless otherwise
requested by the primary supervisory Agency for the entity. The largest
banking entities with $50 billion or greater in 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.\2688\ All quantitative measurements for any calendar month must
be reported no later than 10 days after the end of the calendar month
required by Sec. ----.20, unless another time is requested by the
primary supervisory Agency for the entity except for a preliminary
period when 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.\2689\
---------------------------------------------------------------------------
\2688\ Consistent with certain commenters' requests, the final
rule generally requires less frequent reporting than was proposed.
However, the Agencies continue to believe that monthly reporting is
appropriate for the largest banking entities above the $50 billion
threshold. More frequent reporting for these firms is appropriate to
allow for more effective supervision of their large-scale trading
operations. See JPMC; Stephen Roach.
\2689\ See final rule Sec. ----.20(d)(3). The final rule
includes a shorter period of time for reporting quantitative
measurements after the end of the relevant period 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.
---------------------------------------------------------------------------
The Agencies believe that together the reduced number of metrics,
the higher thresholds for reporting metrics, delayed reporting dates,
and modified reporting frequency reduce the costs and burden from the
proposal while allowing collection of data to permit better monitoring
of compliance with section 13 of the BHC Act. The Agencies also believe
that the delayed dates for reporting quantitative metrics will provide
banking entities with the time to develop systems to calculate and
report these metrics. The Agencies are not applying these reporting and
recordkeeping requirements to banking entities with smaller amounts of
trading activity, as it appears that the more limited benefits of
applying these requirements to banking entities with lower levels of
trading activities, which represent entities that are typically small,
less complex, and easier to supervise, would not justify the burden
associated with complying with the reporting and recordkeeping
requirements of Appendix A.
The final rule defines ``trading desk'' to replace the concept of
``trading unit'' in the proposal.\2690\ Under the final rule, trading
desk means 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 believe
that applying quantitative measurements to a level that aggregates a
variety of distinct trading activities may obscure or ``smooth''
differences between distinct lines of business, asset categories and
risk management processes in a way that renders the measurement
relatively uninformative because it does not adequately reflect the
specific characteristics of the trading activities being conducted.
---------------------------------------------------------------------------
\2690\ See final rule Sec. ----.3(e)(13); See also supra Parts
IV.A.2.c.1.c.ii. and IV.A.3.c.1.c.i.
---------------------------------------------------------------------------
While the Agencies recognize that applying quantitative
measurements at the trading desk level may result in some ``noise'' in
the data and false positives, the Agencies believe it is necessary to
apply the quantitative measurements at the trading desk level to
enhance consistency with other provisions of the final rule. For
example, because the requirements of the market-making exemption apply
at the trading desk level of organization, the Agencies believe
quantitative measurements used to monitor a banking entity's market
making-related activities should also calculated, reported, and
recorded at the trading desk level. In response to commenters' concerns
that trading desk level measurements are more likely to generate false
positives, the Agencies emphasize that quantitative measurements will
not be used as a dispositive tool for determining compliance and,
rather, will be used to monitor patterns and identify activity that may
warrant further review.
Like the proposal, the final rule does not include specific
numerical thresholds. Commenters did not suggest specific thresholds
for particular metrics or provide data and analysis that would support
particular thresholds.\2691\ Given the range of financial instruments
and trading activity covered by the final rule, as well as potential
differences among banking entities' organizational structures, trading
strategies, and level of presence in a particular market, the Agencies
are concerned that numerical thresholds for specific metrics would not
account for these differences and could inappropriately constrain
legitimate activity.\2692\ Further, mandated thresholds for the metrics
would not recognize the impact changing market conditions may have on a
given trading desk's quantitative measurements. Consistent with two
commenters' suggested approach, banking entities will be required to
establish their own numerical thresholds for quantitative measurements
under the enhanced compliance program requirement in Appendix B.\2693\
---------------------------------------------------------------------------
\2691\ See Wellington; CalPERS; John Reed.
\2692\ See SIFMA et al. (Prop.Trading) (Feb. 2012).
\2693\ See Goldman (Prop. Trading); Barclays. See also final
rule Appendix B.
---------------------------------------------------------------------------
d. Proposed Quantitative Measurements and Comments on Specific Metrics
Section IV of proposed Appendix A described, in detail, the
individual quantitative measurements that must be furnished. These
measurements were grouped into the following five broad categories,
each of which is described in more detail below:
Risk-management measurements--VaR, Stress VaR, VaR
Exceedance, Risk Factor Sensitivities, and Risk and Position Limits;
Source-of-revenue measurements--Comprehensive Profit
and Loss, Portfolio Profit and Loss, Fee Income and Expense, Spread
Profit and Loss, and Comprehensive Profit and Loss Attribution;
Revenues-relative-to-risk measurements--Volatility of
Comprehensive Profit and Loss, Volatility of Portfolio Profit and
Loss, Comprehensive Profit and Loss to Volatility Ratio, Portfolio
Profit and Loss to Volatility Ratio, Unprofitable Trading Days based
on Comprehensive Profit and Loss, Unprofitable Trading Days based on
Portfolio Profit and Loss, Skewness of Portfolio Profit and Loss,
and Kurtosis of Portfolio Profit and Loss;
Customer-facing activity measurements--Inventory
Turnover, Inventory Aging, and Customer-facing Trade Ratio; and
Payment of fees, commissions, and spreads
measurements--Pay-to-Receive Spread Ratio.
[[Page 5766]]
The Agencies proposed these quantitative measurements because,
taken together, these measurements appeared useful for understanding
the context in which trading activities occur and identifying
activities that may warrant additional scrutiny to determine whether
these activities involve prohibited proprietary trading because the
trading activity either is inconsistent with permitted market making-
related activities or presents a material exposure to high-risk assets
or high-risk trading strategies. As described below, different
quantitative measurements were proposed to identify different aspects
and characteristics of trading activity for the purpose of helping to
identify prohibited proprietary trading, and the Agencies stated in the
proposal that they expected that the quantitative measurements would be
most useful for this purpose when implemented and reviewed
collectively, rather than in isolation. The Agencies stated in the
proposal that they believed that, in the aggregate, many banking
entities already collect and review many of these measurements as part
of their risk management activities, and stated that they expected that
many of the quantitative measurements proposed would be readily
computed and monitored at the multiple levels of organization included
in proposed Appendix A's definition of ``trading unit,'' to which they
would apply.
Under the proposal, the first set of quantitative measurements
related to risk management, and included VaR, Stress VaR, VaR
Exceedance, Risk Factor Sensitivities, and Risk and Position Limits.
Commenters generally supported the use of risk-management metrics as
the most important measure of compliance, indicating that these metrics
could potentially provide useful supervisory information.\2694\
---------------------------------------------------------------------------
\2694\ See, e.g., AFR et al. (Feb. 2012); Barclays; Citigroup
(Feb. 2012); Prof. Duffie; Goldman (Prop. Trading); Invesco; JPMC;
Occupy; Public Citizen; See also BNY Mellon et al. (suggesting the
use of VaR measures for foreign exchange trading activity).
---------------------------------------------------------------------------
In general, commenters supported the use of the VaR metric.\2695\
One of these commenters argued that VaR was not particularly indicative
of proprietary trading, but could be helpful to reveal a trading unit's
overall size and risk profile.\2696\ Another commenter indicated that
significant, abrupt or inconsistent changes to VaR may need to be
absorbed by market makers who absorb large demand and supply shocks
into their inventories.\2697\ This commenter contended that the six
largest bank holding companies had proprietary trading losses that
frequently exceeded their VaR estimates and the design and supervision
of such risk measures should be revisited.
---------------------------------------------------------------------------
\2695\ See, e.g., Citigroup (Feb. 2012); Prof. Duffie; Goldman
(Prop. Trading); Invesco; Public Citizen.
\2696\ See Goldman (Prop. Trading).
\2697\ See Prof. Duffie.
---------------------------------------------------------------------------
One commenter argued that the definition of VaR was not made clear
in the proposal and was missing some important information regarding
methodology as VaR methodologies tend to vary among banking
entities.\2698\ This commenter recommended the development of a
standard methodology by the OFR including a central repository for
historical calculation data for each asset for the purpose of ensuring
standard calculation across the industry. This commenter also expressed
concern that VaR calculations are heavily reliant on the quality of
input data and stated that many markets are unable to provide
sufficient information such that VaR calculations are meaningful,
including markets for illiquid products for which accurate historical
price and market information is sparse and could severely under
represent true potential losses under VaR calculations.\2699\
---------------------------------------------------------------------------
\2698\ See Occupy.
\2699\ See Occupy.
---------------------------------------------------------------------------
A few commenters expressed concern about the applicability of VaR
when applied to ALM activities.\2700\ These commenters argued that risk
management metrics such as VaR would not help to distinguish ALM and
valid risk mitigating hedging activities from prohibited proprietary
trading. For instance, one of these commenters stated that the proposed
reliance on VaR and Stress VaR to demonstrate bona fide hedging is
misleading for ALM activities due to the typical accounting asymmetry
in ALM where, for example, managed liabilities such as deposits are not
marked to market but the corresponding hedge may be.
---------------------------------------------------------------------------
\2700\ See JPMC; State Street (Feb. 2012); See also BoA; CH/
ABASA. For instance, one of these commenters stated that the
proposed reliance on VaR and Stress VaR to demonstrate bona fide
hedging is misleading for ALM activities due to the typical
accounting asymmetry in ALM where, for example, managed liabilities
such as deposits are not mark-to-market but the corresponding hedge
may be. See State Street (Feb. 2012).
---------------------------------------------------------------------------
One commenter argued that the use of stress VaR would be important
to guard against excessive risk taking.\2701\ A few commenters
suggested that additional guidance be provided for Stress VaR including
linking it to the broader stress testing regime and based on extreme
conditions that are not based on historic precedent.\2702\ These
commenters also argued that a one-day holding period assumption is
inadequate, especially for less liquid asset classes, and recommended
that stress be measured over a longer period. One commenter argued that
Stress VaR should be removed from the list of required metrics as it is
not in regular use for day-to-day risk management and provides little
relevant information about the intent or proportionality between risk
assumed and client demands.\2703\
---------------------------------------------------------------------------
\2701\ See Public Citizen.
\2702\ See AFR et al. (Feb. 2012); Public Citizen.
\2703\ See JPMC.
---------------------------------------------------------------------------
A number of commenters requested that VaR Exceedance be removed
from the list of metrics. These commenters argued that the primary
function of VaR Exceedance is to analyze the quality of a VaR model and
that VaR backtesting is already reported to regulators as part of the
supervisory process. These commenters argued that VaR Exceedance does
not reveal trading intent or actual risk taken.\2704\ One commenter
argued that VaR Exceedance may be useful to the Agencies as an
indicator of the quality of the VaR measure relative to the profit and
loss of the trading unit but that a more rigorous back-testing process
would serve as a better analytical tool than VaR Exceedance to evaluate
the quality of the VaR model result and should be included as an
additional metric.\2705\ One commenter suggested that risk-based
metrics should measure risk as a function of capital.\2706\ Another
commenter warned that risk metrics could be significantly higher during
times of market stress and volatility than during normal times.\2707\
---------------------------------------------------------------------------
\2704\ See ABA (Keating); Barclays; Goldman (Prop. Trading);
SIFMA et al. (Prop.Trading) (Feb. 2012); Wells Fargo (Prop.
Trading); UBS.
\2705\ See Occupy.
\2706\ See Citigroup (Feb. 2012).
\2707\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------
A few commenters expressed support for risk factor sensitivities as
useful, supervisory information.\2708\ One of these commenters
suggested that risk factor sensitivities could orient regulators to a
trading unit's overall size and risk profile,\2709\ while another
commenter stated that risk factor sensitivities would be the most
useful tool for identifying the accumulation of market risk in
different areas of a banking entity.\2710\ One commenter suggested that
several risk factor sensitivity snapshots be taken throughout the day
with an average
[[Page 5767]]
value reported at the end of day.\2711\ This commenter also recommended
that trading strategies that rely heavily on models to calculate risk
exposures (e.g., correlation trading portfolios), should trigger
additional disclosures in risk factor sensitivity reporting.\2712\
---------------------------------------------------------------------------
\2708\ See Citigroup (Feb. 2012); Prof. Duffie; Occupy.
\2709\ See Goldman (Prop. Trading).
\2710\ See Occupy.
\2711\ See Occupy.
\2712\ See Occupy.
---------------------------------------------------------------------------
Commenters also supported risk and position limits as providing
useful, supervisory information. Several commenters indicated that
these limits could be helpful to orient regulators to a trading unit's
overall size and risk profile.\2713\ Another commenter expressed the
view risk and position limits are the most comprehensive measures of
risk taking and incorporate VaR, Stress VaR, and Risk Factor
Sensitivities.\2714\ A different commenter argued it was unclear how
position limits are in fact a quantitative metric and not a description
of a banking entity's internal risk policies.\2715\
---------------------------------------------------------------------------
\2713\ See, e.g., Barclays; Citigroup (Feb. 2012); Prof. Duffie;
Goldman (Prop. Trading).
\2714\ See Barclays.
\2715\ See Occupy.
---------------------------------------------------------------------------
After carefully considering the comments received, the final rule
retains the risk-management metrics other than VaR Exceedance. The
collection of information regarding Risk and Position Limits, VaR,
Stress VaR, and Risk Factor Sensitivities is consistent with the aim of
providing a means of characterizing the overall risk profile of the
trading activities of each trading desk and evaluating the extent to
which the quantitative profile of a trading desk's activities is
consistent with permissible activities. Moreover, a number of
commenters indicated that the risk management measures would be
effective at achieving these goals.\2716\ The risk management measure
that was not retained in the final rule, VaR Exceedance, was
considered, in light of the comments, as not offering significant
additional information on the overall risk profile and activities of
the trading desk relative to the burden associated with computing,
auditing and reporting it on an ongoing basis.\2717\
---------------------------------------------------------------------------
\2716\ See, e.g., AFR et al. (Feb. 2012); Barclays; Citigroup
(Feb. 2012); Prof. Duffie; Goldman (Prop. Trading); Invesco; JPMC;
Occupy; Public Citizen; See also Northern Trust; State Street (Feb.
2012).
\2717\ See ABA (Keating); Barclays; Goldman (Prop. Trading);
SIFMA et al. (Prop.Trading) (Feb. 2012); Wells Fargo (Prop.
Trading); UBS.
---------------------------------------------------------------------------
The risk-management measurements included in the final rule are
widely used by banking entities to measure and manage trading risks and
activities.\2718\ VaR, Stress VaR, and Risk Factor Sensitivities
provide internal, model-based assessments of overall risk, stated in
terms of large but plausible losses that may occur or changes in
revenue that would be expected to result from movements in underlying
risk factors. The provided description and calculation guidance for
each of these measures is consistent with both current market practice
and regulatory capital requirements for banks. The final rule does not
provide a prescriptive definition of each of these measurements as
these measures must be flexible enough to be tailored to the specific
trading activities of each trading desk. Supervisory guidance and
comparisons of these measures across similarly situated trading desks
at a given entity as well as across entities will be used to ensure
that the provided measurements conform to the description and
calculation guidance provided in Appendix A. Risk and Position Limits
and Usage provide an explicit assessment of management's expectation of
how much risk is required to perform permitted market-making,
underwriting and hedging activities. The final rule requires that the
usage of each risk and position limit be reported so that the risk
taking by each trading desk can be monitored and assessed on an ongoing
basis.\2719\
---------------------------------------------------------------------------
\2718\ See Joint Proposal, 76 FR 68,887.
\2719\ The Agencies believe this clarification responds to one
commenter's question regarding how risk and position limits will be
used and assessed for purposes of the rule. See Occupy.
---------------------------------------------------------------------------
With the exception of Stress VaR, each of these measurements are
routinely used to manage and control risk taking activities, and are
also used by some banking entities for purposes of calculating
regulatory capital and allocating capital internally.\2720\ In the
context of permitted market making-related activities, these risk
management measures are useful in assessing whether the actual risk
taken is consistent with the level of principal risk that a banking
entity must retain in order to service the near-term demands of
customers. Significant, abrupt or inconsistent changes to key risk
management measures, such as VaR, that are inconsistent with prior
experience, the experience of similarly situated trading desks and
management's stated expectations for such measures may indicate
impermissible proprietary trading, and may warrant further review. In
addition, indicators of unanticipated or unusual levels of risk taken,
such as breaches of internal Risk and Position Limits, may suggest
behavior that is inconsistent with appropriate levels of risk and may
warrant further scrutiny. The limits required under Sec. --
--.4(b)(2)(iii) and Sec. ----.5(b)(1)(i) must meet the applicable
requirements under Sec. ----.4(b)(2)(iii) and Sec. ----.5(b)(1)(i)
and also must include appropriate metrics for the trading desk limits
including, at a minimum, the ``Risk Factor Sensitivities'' and ``Value-
at-Risk and Stress Value-at-Risk'' metrics 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.
---------------------------------------------------------------------------
\2720\ See Joint Proposal, 76 FR 68,887.
---------------------------------------------------------------------------
Under the proposal, the second set of quantitative measurements
related to the source of revenues, and included Comprehensive Profit
and Loss, Portfolio Profit and Loss, Fee Income, Spread Profit and
Loss, and Comprehensive Profit and Loss Attribution. A few commenters
expressed support for Comprehensive Profit and Loss as a reasonable
contextual metric and contended that the metric could inform the
analysis of whether market-making revenues are from customer
transactions.\2721\
---------------------------------------------------------------------------
\2721\ See Goldman (Prop.Trading); Japanese Bankers Ass'n;
Occupy; See also Barclays.
---------------------------------------------------------------------------
As described above, a number of commenters expressed concern about
a focus on revenues as part of evaluating market-making.\2722\ For
instance, one commenter argued that the rule should not require, even
in guidance, that market making-related permitted activities be
``designed to generate revenues from fees, commissions, bid-asks
spreads or other income,'' arguing that this prejudges appropriate
results for revenue metrics and implies that a bona fide market maker
is not permitted to benefit from revenues from market movements.\2723\
One commenter expressed concern that the source-of-revenue metrics are
subject to manipulation as these metrics depend on correctly
classifying revenue into market bid-ask spreads as opposed to other
sources of revenue.\2724\ One commenter stated that this metric should
serve as a secondary indication of risk levels because it could be
subject to manipulation.\2725\ Another commenter recommended use of the
sub-metric in Comprehensive P&L Attribution.\2726\ A different
commenter recommended the adoption of clearer metrics to distinguish
customer revenues from revenues from price
[[Page 5768]]
movements.\2727\ One commenter indicated that after-the-fact
application of quantitative measurements such as Comprehensive Profit
and Loss may cause firms to reconsider their commitment to market
making and recommended that, to the extent this metric is used, it
should be applied flexibly in light of market conditions prevailing
during the relevant time period, and as one of many factors relevant to
an overall assessment of bona fide market making.\2728\
---------------------------------------------------------------------------
\2722\ See supra Part IV.A.3.c.7.b.
\2723\ See SIFMA (May 2012).
\2724\ See AFR (Nov. 2012).
\2725\ See Occupy.
\2726\ See Barclays.
\2727\ See Public Citizen.
\2728\ See NYSE Euronext.
---------------------------------------------------------------------------
A few commenters supported Portfolio Profit and Loss as a
reasonable contextual metric to inform whether revenues from market-
making transactions are from customer transactions.\2729\ However, one
of these commenters argued that this metric would not necessarily be
indicative of prohibited proprietary trading and profits may reflect
bona fide market making-related, underwriting, and hedging
activities.\2730\ Another commenter argued that this metric should
serve as a secondary indication of risk levels and may be subject to
manipulation.\2731\
---------------------------------------------------------------------------
\2729\ See Goldman (Prop. Trading); Japanese Bankers Ass'n;
Occupy.
\2730\ See Goldman (Prop. Trading).
\2731\ See Occupy.
---------------------------------------------------------------------------
Some commenters felt that Fee Income and Expense was a useful
metric.\2732\ One of these commenters argued this metric has the
potential to help distinguish permitted activities from prohibited
proprietary trading.\2733\ Another commenter felt this metric would be
useful in liquid markets that trade with the convention of fees and
commissions but less useful, but still indicative, in other markets
that use inter-dealer brokers to conduct client-related
activities.\2734\ One commenter argued that it would be impracticable
to produce Fee Income and Expense data for foreign exchange trading,
which is predominantly based on bid/offer spread.\2735\
---------------------------------------------------------------------------
\2732\ See Goldman (Prop. Trading); Japanese Bankers Ass'n;
Occupy.
\2733\ See Goldman (Prop. Trading). This commenter urged that
fee income and expense should be considered together with Spread P&L
arguing that these two both measures of customer revenues and, in
practice, may function as substitutes for each other.
\2734\ See Occupy.
\2735\ See Northern Trust.
---------------------------------------------------------------------------
A few commenters thought that Spread P&L could be useful.\2736\ One
of these commenters argued that Spread P&L has the potential to help
distinguish permitted activities from prohibited proprietary
trading.\2737\ This commenter suggested that the final rule remove the
proposal's revenue requirement as part of market-making and instead
rely on revenue metrics such as Spread P&L.\2738\ This commenter
argued, however, that it will not always be clear how to best calculate
Spread P&L and it would be critical for the Agencies to be flexible and
work with banking entities to determine the appropriate proxies for
spreads on an asset-class-by-asset class and trading desk-by-trading-
desk basis. One commenter contended that the proposed implementation in
the proposal was more difficult than necessary and suggested End of Day
Spread Proxy is sufficient. Another commenter suggested expanding the
flexibility offered in choosing a bid-offer source to calculate Spread
P&L.\2739\
---------------------------------------------------------------------------
\2736\ See, e.g., Goldman (Prop. Trading); JPMC; UBS.
\2737\ See Goldman (Prop. Trading).
\2738\ See Goldman (Prop. Trading); See also Paul Volcker
(supporting a metric considering the extent to which earnings are
generated by pricing spreads rather than changes in price).
\2739\ See JPMC; UBS; See also SIFMA et al. (Prop. Trading)
(Feb. 2012).
---------------------------------------------------------------------------
However, the majority of commenters recommended removal of Spread
P&L as a metric.\2740\ These commenters argued that a meaningful
measure for Spread P&L cannot be calculated in the absence of a
continuous bid-ask spread, making this metric misleading especially for
illiquid positions and shallow markets.
---------------------------------------------------------------------------
\2740\ See ABA et al.; BoA; Barclays; Credit Suisse (Seidel);
Japanese Bankers Ass'n; Northern Trust; SIFMA et al. (Prop. Trading)
(Feb. 2012); Wells Fargo (Prop.Trading); See also AFR et al. (Feb.
2012); Occupy.
---------------------------------------------------------------------------
A few commenters generally expressed support for the inclusion of
Comprehensive Profit and Loss Attribution.\2741\ One of these
commenters stated that this metric was the most comprehensive metric
for measuring sources of revenue and included other metrics as sub-
metrics, such as Comprehensive Profit and Loss, Portfolio Profit and
Loss, and Fee Income and Expense. Another commenter contended the
mention of ``customer spreads'' and ``bid-ask spreads'' was unclear and
that both of these terms should be removed from the calculation
guidance. Other commenters argued that the benefits of this metric do
not justify the costs of generating a report of Comprehensive P&L
Attribution on a daily basis.\2742\ One commenter urged the Agencies to
ensure that each institution be permitted to calculate this metric in a
way that reflects the institution's unique characteristics.\2743\
---------------------------------------------------------------------------
\2741\ See Barclays; Occupy.
\2742\ See BOK; Goldman (Prop. Trading); SIFMA et al. (Prop
Trading) (Feb. 2012); Wells Fargo (Prop. Trading).
\2743\ See SIFMA et al. (Prop Trading) (Feb. 2012).
---------------------------------------------------------------------------
After carefully considering the comments received, the final rule
maintains only a modified version of Comprehensive P&L Attribution
metric and does not retain the proposed Comprehensive Profit and Loss,
Portfolio Profit and Loss, Fee Income, or Spread Profit and Loss
metrics. The final rule also requires volatility of comprehensive
profit and loss to be reported. As pointed out by a number of
commenters, Comprehensive Profit and Loss Attribution provides a
holistic attribution of each trading desk's profit and loss and
contains much of the information content that is provided by many of
the other metrics, such as Fee Income and Expense.\2744\ Accordingly,
the use of Comprehensive Profit and Loss Attribution in the final rule
greatly simplifies the metric reporting requirement and reduces burden
while retaining much of the information and analysis that was provided
in the full set of five metrics that were contained in the proposal. In
addition, in response to commenters' concerns about the burdens of
separately identifying specific revenue sources (e.g., revenues from
bid-ask spreads, revenues from price appreciation), the Agencies have
modified the focus of the proposed source of revenue metrics to focus
on when revenues are generated, rather than the specific sources of
revenue.\2745\ This approach should also help address one commenter's
concern about the need for new, sophisticated systems to differentiate
bid-ask spreads from price appreciation.\2746\ The utility of this
modified approach is discussed in more detail in the discussion of the
market-making exemption.\2747\ Finally, the Comprehensive Profit and
Loss Attribution metric will ensure that all components of a trading
desk's profit and loss are measured in a consistent and comprehensive
fashion so that each individual component can be reliably compared
against other components of a trading desk's profit and loss without
being considered in isolation or taken out of context.
---------------------------------------------------------------------------
\2744\ See Barclays.
\2745\ See JPMC; UBS; SIFMA et al. (Prop Trading) (Feb. 2012);
ABA (Keating); BoA; Barclays; Credit Suisse (Seidel).
\2746\ See BoA.
\2747\ See supra Part IV.A.3.c.7.c.
---------------------------------------------------------------------------
This measurement is intended to capture the extent, scope, and type
of profits and losses generated by trading activities and provide
important context for understanding how revenue is generated by trading
activities. Because permitted market making-related
[[Page 5769]]
activities seek to generate profits by providing customers with
intermediation and related services while, managing, and to the extent
practicable minimizing, the risks associated with any asset or risk
inventory required to meet customer demands, these revenue measurements
would appear to provide helpful information to banking entities and the
Agencies regarding whether actual revenues are consistent with these
expectations.
Under the proposal, the third set of measurements related to
realized risks and revenue relative to realized risks, and includes
Volatility of Profit and Loss, Comprehensive Profit and Loss to
Volatility Ratio and Portfolio Profit and Loss to Volatility Ratio,
Unprofitable Trading Days based on Comprehensive Profit and Loss and
Unprofitable Trading Days based on Portfolio Profit and Loss, and
Skewness of Portfolio Profit and Loss and Kurtosis of Portfolio Profit
and Loss.
A few commenters indicated support for these metrics as
appropriate, contextual metrics.\2748\ These commenters indicated that
these metrics may serve to highlight areas requiring further
investigation, since high P&L volatility may indicate a deviation from
traditional client related activities and that a well-structured
trading operation should be able to obtain relatively high ratios of
revenue-to-risk (as measured by various metrics), low volatility, and
relatively high turnover.\2749\ One commenter recommended that New
Trades P&L be substituted for Portfolio P&L for purposes of computing
Volatility of P&L because New Trades P&L captures customer revenues
more completely and is therefore more useful for distinguishing market
making from proprietary trading.\2750\ Another commenter indicated that
Skewness of Portfolio Profit and Loss and Kurtosis of Portfolio Profit
and Loss incorporates (and therefore obviates the need for a separate
calculation of) the metric Volatility of Portfolio Profit and
Loss.\2751\
---------------------------------------------------------------------------
\2748\ See, e.g., Goldman (Prop. Trading); Volcker; John S.
Reed; See also AFR et al. (Feb. 2012); Sen. Merkley; Occupy; Public
Citizen.
\2749\ See Occupy; Public Citizen; Sen. Merkley.
\2750\ See Goldman (Prop. Trading) (also suggesting that New
Trades P&L be substituted for Portfolio P&L in Comprehensive Profit
and Loss to Volatility Ratio and Portfolio Profit and Loss to
Volatility Ratio and Unprofitable Trading Days based on
Comprehensive Profit and Loss and Unprofitable Trading Days based on
Portfolio Profit and Loss).
\2751\ See Barclays.
---------------------------------------------------------------------------
One commenter urged that after-the-fact application of
Comprehensive Profit and Loss to Volatility Ratio may cause firms to
reconsider their commitment to market making and argued that this
metric should be applied flexibly in light of market conditions
prevailing during the relevant time period and as one of many factors
relevant to an assessment of overall bona fide market making.\2752\ One
commenter supported monitoring Portfolio Profit and Loss to Volatility
Ratio and argued that the Agencies should establish a clear pattern of
profit and loss results of individual trading units through iterative
application of the metrics.\2753\
---------------------------------------------------------------------------
\2752\ See NYSE Euronext.
\2753\ See AFR et al. (Feb. 2012).
---------------------------------------------------------------------------
One commenter expressed support for Unprofitable Trading Days based
on Comprehensive Profit and Loss and Unprofitable Trading Days based on
Portfolio Profit and Loss indicating that these metrics may serve to
highlight areas requiring further investigation, since a significant
number of unprofitable trading days may indicate a deviation from
traditional client-related activities.\2754\ Another commenter
suggested that these metrics be removed as they would result in market
makers being less likely to take client-facing positions due to
reluctance to incur unprofitable trading days that could indicate the
presence of impermissible activity despite the utility of such trades
in providing liquidity to customers.\2755\
---------------------------------------------------------------------------
\2754\ See Occupy.
\2755\ See Barclays.
---------------------------------------------------------------------------
One commenter requested including Skewness of Portfolio Profit and
Loss and Kurtosis of Portfolio Profit and Loss in the metrics set as
the most comprehensive metric in the revenue-relative-to-risk category
making other metrics unnecessary in this area.\2756\ Another commenter
argued that this metric would produce inconsistent results within and
across trading units and would generally not support any meaningful
conclusions regarding the permissibility or risk of trading
activities.\2757\
---------------------------------------------------------------------------
\2756\ See Barclays.
\2757\ See Goldman (Prop. Trading).
---------------------------------------------------------------------------
After carefully considering the comments received, the final rule
does not include any of the proposed revenue-relative-to-risk
measurements. Each of these measures provides information that may
generally be useful for characterizing the overall risk profile of the
trading activities of each trading unit and evaluating the extent to
which the quantitative profile of a trading unit's activities is
consistent with permissible trading activities. The broad information
content of these measures, however, can largely be reproduced from
transformations of information that will be provided in the
Comprehensive Profit and Loss Attribution and, as noted above,
volatility of comprehensive profit and loss must be reported. Analogs
to the other metrics such as Skewness of Portfolio Profit and Loss and
Kurtosis of Portfolio Profit and Loss can be computed similarly from
information that will be provided in the Comprehensive Profit and Loss
Attribution. Accordingly, the information contained in these metrics is
retained in the final rule while the burden associated with computing,
auditing and reporting these additional metrics on an ongoing basis has
been eliminated.
Under the proposal, the fourth set of quantitative measurements
related to customer-facing activity measurements. These metrics include
Inventory Risk Turnover, Inventory Aging, and Customer-facing Trade
Ratio.
A few commenters supported the proposal's Inventory Risk Turnover
metric though some of these commenters suggested modifications to the
metric.\2758\ One commenter argued that this metric could indicate
whether a given trading unit holds risk and inventory consistently with
the asset class in which such trading unit deals, the types of trading
activity in which the trading unit engages, and the scale and scope of
the client activity that such trading unit serves.\2759\ Another
commenter argued that the final rule should explicitly state that a
trading unit's inventory management practices will be evaluated using
this metric.\2760\ Some commenters expressed the view that this metric
might be useful in the case of liquid positions but not in the case of
illiquid or difficult-to-hedge products, which naturally have lower
risk turnover. Others noted support for this metric tailored on an
asset-by-asset basis.\2761\
---------------------------------------------------------------------------
\2758\ See Goldman (Prop. Trading); Barclays; John Reed; JPMC;
SIFMA et al. (Prop. Trading) (Feb. 2012); Wells Fargo (Prop.
Trading).
\2759\ See Barclays.
\2760\ See Goldman (Prop. Trading).
\2761\ See, e.g., Barclays; Goldman (Prop. Trading); JPMC; John
Reed.
---------------------------------------------------------------------------
A few commenters requested that the final rule clarify that this
metric will not be required to be calculated for every possible Risk
Factor Sensitivity measurement for the applicable portfolio and that a
banking entity and its regulator should determine one or two core risk
factors per asset classes with respect to which this metric that will
be calculated to strike a reasonable balance between costs of
calculations
[[Page 5770]]
and benefits of this metric.\2762\ Other commenters argued the
Inventory Risk Turnover Metric was difficult to measure, burdensome,
and would create uncertainty for derivatives counterparties.\2763\
---------------------------------------------------------------------------
\2762\ See Goldman (Prop. Trading); JPMC; SIFMA et al. (Prop.
Trading) (Feb. 2012); See also Morgan Stanley.
\2763\ See Japanese Bankers Ass'n; SIFMA (Asset Mgmt.) (Feb.
2012); Morgan Stanley.
---------------------------------------------------------------------------
A few commenters supported the Inventory Aging metric. One
commenter argued it should be included in the metrics set to indicate
whether a given trading desk holds risk and inventory consistently
within the asset class in which such trading desk deals, the type of
trading activity in which the trading unit engages, and the scale and
scope of the client activity that such trading desk serves.\2764\ This
commenter suggested tailoring the metric based on the market for a
particular asset class and market conditions because aging levels may
be higher in less liquid markets. A number of commenters argued that
application of the Inventory Aging metric is only appropriate for cash
products and should not be used for trading units engaged in
transactions in financial instruments such as derivatives.\2765\
Another commenter argued that the Inventory Aging metric is generally
not useful for derivatives, and for non-derivatives it provides
essentially similar information to Inventory Risk Turnover.\2766\ One
commenter requested additional guidance on how to calculate this
metric.\2767\
---------------------------------------------------------------------------
\2764\ See Barclays; See also Invesco.
\2765\ See Barclays; Goldman (Prop. Trading); Japanese Bankers
Ass'n; Morgan Stanley; SIFMA (Prop. Trading) (Feb. 2012).
\2766\ See Goldman (Prop. Trading).
\2767\ See Soci[eacute]t[eacute] G[eacute]n[eacute]rale.
---------------------------------------------------------------------------
A few commenters indicated that the Customer-Facing Trade Ratio
could be helpful in distinguishing prohibited proprietary trading from
market making and would be more effective than the proposal's negative
presumption against interdealer trading to evaluate the amount of
interdealer trading that is consistent with market making-related or
hedging activity in a particular business.\2768\ Some commenters
suggested that the metric could be improved and argued that the number
of transactions executed over a calculation period does not provide an
adequate measure for the level of customer-facing trading because it
does not reflect the size of transactions or the amount of risk. These
commenters suggested replacing the metric with a more risk-sensitive
metric or defining the ratio so that it measures notional principal
risk associated with customer transactions and is appropriately
tailored to the relevant asset class or market.\2769\
---------------------------------------------------------------------------
\2768\ See Goldman (Prop. Trading); See also Invesco.
\2769\ See Barclays; Goldman (Prop. Trading); JPMC; SIFMA (Prop.
Trading) (Feb. 2012); UBS.
---------------------------------------------------------------------------
A number of commenters raised concerns about the definition of
customer for purposes of this metric. One commenter argued that a
failure to define ``customer'' to differentiate between customers and
non-customers would render this metric meaningless.\2770\ Another
commenter contended that the metric would be appropriate as long as
banking entities have the flexibility to determine who is a
customer.\2771\ One commenter argued that using a definition of
``customer'' that is different between the market making-related
activity and the reported metric could make legitimate market making-
related activity with customers appear to be prohibited proprietary
trading.\2772\ This commenter argued that other dealers and other
registered market participants should be recognized as customers of the
banking entity. A few commenters contended that this metric would be
burdensome if it required a banking entity to tag individual trades as
customer or non-customer.\2773\ A few commenters argued that
interdealer trading should be allowed as part of market making and
argued this metric would not provide a useful measure of customer-
facing activity.\2774\ Some commenters also expressed concern about the
implications of such a metric for hedging activity, which may involve
relatively less customer-facing activity.\2775\
---------------------------------------------------------------------------
\2770\ See Occupy.
\2771\ See Wells Fargo (Prop. Trading).
\2772\ See SIFMA (Prop. Trading) (Feb. 2012).
\2773\ See SIFMA (Prop. Trading) (Feb. 2012); See also Goldman
(Prop Trading).
\2774\ See Barclays; Japanese Bankers Ass'n; Oliver Wyman (Dec.
2011); SIFMA (Prop. Trading) (Feb. 2012).
\2775\ See Barclays; Wells Fargo (Prop. Trading).
---------------------------------------------------------------------------
After carefully considering the comments received, the final rule
retains all three of the customer-facing activity measurements from the
proposal, though each measure has been modified. A number of commenters
raised issues regarding the complexities associated with computing the
Inventory Risk Turnover metric. In particular, as noted above, some
commenters argued that computing the metric for every reported risk
factor sensitivity would be burdensome and would not be
informative.\2776\ The inventory metric required in the final rule,
Inventory Turnover, is applied at the transaction level and not at the
risk factor sensitivity level. Accordingly, for a given trading desk
and calculation period, e.g., 30 days, there is only one value of the
Inventory Turnover metric rather than one value for each risk factor
sensitivity that is managed and reported by the trading desk. In this
sense, the turnover metric required in the final rule is similar to
more traditional and common measures of inventory turnover. Moreover,
the required turnover metric is simpler and less costly to track and
record while still providing banking entities and Agencies with
meaningful information regarding the extent to which the size and
volume of trading activities are directed at servicing the demands of
customers. In addition, the description of Inventory Turnover in the
final rule provides explicit guidance on how to apply the metric to
derivative positions.\2777\
---------------------------------------------------------------------------
\2776\ See Goldman (Prop. Trading); JPMC; SIFMA (Prop. Trading)
(Feb. 2012).
\2777\ The Agencies believe that this should address commenters'
uncertainty with respect to how the Inventory Risk Turnover metric
would work for derivatives. See Japanese Bankers Ass'n; SIFMA (Asset
Mgmt.) (Feb. 2012); Morgan Stanley.
---------------------------------------------------------------------------
Inventory Aging provides banking entities and Agencies with
meaningful information regarding the extent to which the size and
volume of trading activities are directed at servicing the demands of
customers. In the case of Inventory Aging, the proposal required that
the aging schedule be organized according to a specific set of age
ranges (i.e., 0-30 days, 30-60 days, 60-90 days, 90-180 days, 180-360
days, and more than 360 days). This requirement has not been adopted in
the final rule in order to provide greater flexibility and to recognize
that specific age ranges that may be relevant for one asset class may
be less relevant for another asset class. Also, to address commenters'
uncertainty about how this metric would apply to derivatives, the final
rule's description of the Inventory Aging metric provides guidance on
how to apply the metric to derivative positions.\2778\
---------------------------------------------------------------------------
\2778\ See Barclays; Goldman (Prop.Trading); Japanese Bankers
Ass'n; Morgan Stanley; SIFMA (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------
The Customer Facing Trade Ratio provides directionally useful
information regarding the extent to which trading transactions are
conducted with customers. In the case of the Customer Facing Trade
Ratio, the proposal required that customer trades be measured on a
trade count basis. The final rule requires that the Customer Facing
Trade Ratio be computed in two ways. As in the proposal, the metric
must be computed by measuring trades on a trade count basis.
Additionally, as suggested by some commenters, the
[[Page 5771]]
final rule requires that the metric be computed by measuring trades on
a notional value basis. The value based approach is required to reflect
the fact noted by some commenters, that a trade count based measure may
not accurately represent the amount of customer facing activity if
customer trade sizes systematically differ from the sizes of non-
customer trades. In addition, the term ``customer'' for purposes of the
Customer-Facing Trade Ratio is defined in the same manner as the terms
client, customer, and counterparty used for purposes of the market-
making exemption. This will ensure that the information provided by
this metric is useful for purposes of monitoring compliance with the
market-making exemption.\2779\
---------------------------------------------------------------------------
\2779\ See SIFMA (Prop. Trading) (Feb. 2012).
---------------------------------------------------------------------------
The fifth set of quantitative measurements relates to the payment
of fees, commissions, and spreads, and includes the Pay-to-Receive
Spread Ratio. This measurement was intended to measure the extent to
which trading activities generate revenues for providing intermediation
services, rather than generate expenses paid to other intermediaries
for such services. Because market making-related activities ultimately
focus on servicing customer demands, they typically generate
substantially more fees, spreads and other sources of customer revenue
than must be paid to other intermediaries to support customer
transactions. Proprietary trading activities, however, that generate
almost no customer facing revenue will typically pay a significant
amount of fees, spreads and commissions in the execution of trading
strategies that are expected to benefit from short-term price
movements. Accordingly, the Agencies expected that the proposed Pay-to-
Receive Spread Ratio measurement would be useful in assessing whether
permitted market making-related activities are primarily generating,
rather than paying, fees, spreads and other transactional revenues or
expenses. A level of fees, commissions, and spreads paid that is
inconsistent with prior experience, the experience of similarly
situated trading desks and management's stated expectations for such
measures could indicate impermissible proprietary trading.
One commenter expressed concern that after-the-fact application of
the Pay-to-Receive Spread Ratio could cause firms to reconsider their
commitment to market making. This commenter suggested that if this
measure is used, it be applied flexibly, in light of market conditions
prevailing during the relevant time period, and as one of many factors
relevant to an overall assessment of bona fide market making.\2780\
Another commenter suggested expanding the flexibility offered in
choosing a bid-offer source to the entire process of calculating Pay-
to-Receive Spread Ratio.\2781\ A number of commenters argued for
removing this metric because its calculation incorporates the Spread
P&L metric.\2782\ Some of these commenters argued that the metric
requires a trade-by-trade analysis which would be expensive to compute
and would not provide any additional information that is not available
from other metrics. One commenter alleged that this metric was not
calculable by any methodology.\2783\
---------------------------------------------------------------------------
\2780\ See NYSE Euronext.
\2781\ See UBS.
\2782\ See CH/ABASA; Goldman (Prop.Trading); Japanese Bankers
Ass'n; Occupy; SIFMA (Prop.Trading) (Feb. 2012); Wells Fargo
(Prop.Trading).
\2783\ See Morgan Stanley.
---------------------------------------------------------------------------
The Pay-to-Receive Spread Ratio has not been retained in the final
rule. As noted by some commenters, the broad information content of
this metric will largely be captured in the Comprehensive Profit and
Loss Attribution measurement. In addition, the Comprehensive Profit and
Loss Attribution will place such factors that are related to the
proposed Pay-to-Receive Spread Ratio in context with other factors that
determine total profitability. Accordingly, factors relating to the
payment of fees, commissions and spreads will not be considered in
isolation but will be viewed in a context that is appropriate to the
entirety of the trading desk's activities. Finally, using the
information contained in the Comprehensive Profit and Loss Attribution
to holistically assess the range of factors that determine overall
profitability, rather than requiring a large number of separate and
distinct measurements, will reduce the resulting compliance burden
while ensuring an integrated and holistic approach to assessing the
activities of each trading desk.
Commenters also suggested a number of additional metrics be added
to the final rule that were not contained in the proposal. One
commenter, who advocated for an alternative framework for market making
supported by structural and transactional metrics, suggested that
structural metrics could include the ratio of salespeople to traders
and the level of resources devoted to client research and trading
content.\2784\ Two commenters supported the use of a counterparty risk
exposure measure, not only to the risk of counterparty default but also
to potential gains and losses to major counterparties for each of a
list of systemically important scenarios.\2785\ One of these commenters
suggested that entity-wide inflation risk assessments be produced on a
daily basis.\2786\ This commenter also argued that an important metric
that is missing is a Liquidity Gap Risk metric that estimates the price
change that occurs following a sudden disruption in liquidity for a
product, arguing that there needs to be an industry-wide effort to more
accurately measure and account for the significant effect that
liquidity and changes in its prevailing level have on the valuation of
each asset.
---------------------------------------------------------------------------
\2784\ See Morgan Stanley.
\2785\ See Prof. Duffie; Occupy.
\2786\ See Occupy.
---------------------------------------------------------------------------
One commenter argued that the metrics regime was well-designed for
market-making but lacking in other areas like hedging. This commenter
recommended the addition of additional metrics more applicable to other
non-market making activities like a net profit metric for
hedging.\2787\ Two commenters argued that quantitative measurement for
underwriting was not included in the proposal and stated that in a bona
fide underwriting, unsold balances should be relatively small so a
marker for potential non-bona fide underwriting should be recognized if
VaR (unhedged and uncovered) of the unsold balance that is allocated to
a banking entity is large relative to the expected revenue measured by
the pro rata underwriting spread.\2788\
---------------------------------------------------------------------------
\2787\ See AFR et al. (Feb. 2012).
\2788\ See AFR et al. (Feb. 2012); See also Public Citizen.
---------------------------------------------------------------------------
After carefully considering the comments received, these and other
proposed metrics have not been included as part of the final rule. One
major concern raised by a range of commenters was the degree of
complexity and burden that would be required by the metrics reporting
regime. In light of these comments, the final rule includes a number of
quantitative measurements that are expected to provide a means of
characterizing the overall risk profile of the trading activities of
each trading desk and evaluating the extent to which the quantitative
profile of a trading desk's activities is consistent with permissible
trading activities in a cost effective and efficient manner while being
appropriate for a range of different trading activities. Moreover,
while many commenters suggested a number of different alternative
metrics, many of
[[Page 5772]]
these alternatives are consistent with the broad themes, risk
management, sources of revenues, customer facing activity, that inform
the quantitative measurements that are retained in the final rule.
Finally, banking entities will be expected to develop their own
metrics, as appropriate, to further inform and improve their own
monitoring and understanding of their trading activities. Many of the
alternative metrics that were suggested by commenters, especially those
that relate to a specific market or type of instrument, may be used by
banking entities as they develop their own quantitative measurements.
For each individual quantitative measurement in the final rule,
Appendix A describes the measurement, provides general guidance
regarding how the measurement should be calculated and specifies the
period over which each calculation should be made. The proposed
quantitative measurements attempt to incorporate, wherever possible,
measurements already used by banking entities to manage risks
associated with their trading activities. Of the measurements proposed,
the Agencies expect that a large majority of measurements proposed are
either (i) already routinely calculated by banking entities or (ii)
based solely on underlying data that are already routinely calculated
by banking entities. However, calculating these measurements according
to the specifications described in Appendix A and at the trading desk
level mandated by the final rule may require banking entities to
implement new processes to calculate and furnish the required
data.\2789\
---------------------------------------------------------------------------
\2789\ See Credit Suisse (Seidel) ; Morgan Stanley; UBS; Wells
Fargo (Prop. Trading); Soci[eacute]t[eacute] G[eacute]n[eacute]rale;
Occupy; Paul Volcker; AFR et al. (Feb. 2012); Western Asset Mgmt.;
Public Citizen.
---------------------------------------------------------------------------
The extent of the burden associated with calculating and reporting
quantitative measurements will likely vary depending on the particular
measurements and differences in the sophistication of management
information systems at different banking entities. As noted, the
proposal tailored these data collections to the size and type of
activity conducted by each banking entity in an effort to minimize the
burden in particular on firms that engage in few or no trading
activities subject to the proposed rule.
The Agencies have also attempted to provide, to the extent
possible, a standardized description and general method of calculating
each quantitative measurement that, while taking into account the
potential variation among trading practices and asset classes, would
facilitate reporting of sufficiently uniform information across
different banking entities so as to permit horizontal reviews and
comparisons of the quantitative profile of trading desks across firms.
The Agencies expect to evaluate the data collected during the
compliance period both for its usefulness as a barometer of
impermissible trading activity and excessive risk-taking and for its
costs. This evaluation will consider, among other things, whether all
of the quantitative measurements are useful for all asset classes and
markets, as well as for all the trading activities subject to the
metrics requirement, or if further tailoring is warranted.\2790\ The
Agencies propose to revisit the metrics and determine, based on a
review of the data collected by September 30, 2015, whether to modify,
retain or replace the metrics. To allow firms to develop systems to
calculate and report these metrics, the Agencies have delayed all
reporting of the metrics until July 2014, phased in the reporting
requirements over a multi-year period, and reduced the category of
banking entities that must report the metrics to a smaller number of
firms that engage in significant trading activity. These steps,
combined with the reduction in the number of metrics required to be
reported, are designed to reduce the cost and burden associated with
compiling and reporting the metrics while retaining the usefulness of
this data collection in helping to ensure that trading activities are
conducted in compliance with section 13 of the BHC Act and the final
rule and in a manner that monitors, assesses and controls the risks
associated with these activities.
---------------------------------------------------------------------------
\2790\ The Agencies believe this review, along with the fact
that quantitative measurements will not be used as a dispositive
tool for determining compliance and the removal of many of the
proposed metrics, should help address commenters' concerns that some
of the proposed quantitative measurements will not be as relevant
for certain asset classes, markets, and activities. See Morgan
Stanley; SIFMA et al. (Prop. Trading); Stephen Roach.
---------------------------------------------------------------------------
4. Section ----.21: Termination of Activities or Investments;
Authorities for Violations
Section ----.21 implements section 13(e)(2) of the BHC Act, which
authorizes an Agency to order a banking entity subject to its
jurisdiction to terminate activities or investments that violate or
function as an evasion of section 13 of the Act.\2791\ Section 13(e)(2)
further provides that this paragraph shall not be construed to limit
the inherent authority of any Federal agency or State regulatory
authority to further restrict any investments or activities under
otherwise applicable provisions of law.\2792\
---------------------------------------------------------------------------
\2791\ See 12 U.S.C. 1851(e)(2).
\2792\ Id.
---------------------------------------------------------------------------
The proposed rule implemented section 13(e)(2) in two parts. First,
Sec. ----.21(a) of the proposal required any banking entity that
engages in an activity or makes an investment in violation of section
13 of the BHC Act or the proposed rule, or in a manner that functions
as an evasion of the requirements of section 13 of the BHC Act or the
proposed rule, including through an abuse of any activity or investment
permitted under subparts B or C, or otherwise violates the restrictions
and requirements of section 13 of the BHC Act or the proposed rule, to
terminate the activity and, as relevant, dispose of the
investment.\2793\ Second, Sec. ----.21(b) of the proposal provided
that if, after due notice and an opportunity for hearing, the
respective Agency finds reasonable cause to believe that any banking
entity has engaged in an activity or made an investment described in
paragraph (a), the Agency may, by order, direct the entity to restrict,
limit, or terminate the activity and, as relevant, dispose of the
investment.\2794\
---------------------------------------------------------------------------
\2793\ See proposed rule Sec. ----.21(a). The proposal noted
that the Agencies included Sec. ----.21(a), in addition to the
provisions of Sec. ----.21(b) of the proposed rule, to clarify that
the requirement to terminate an activity or, as relevant, dispose of
an investment would be triggered when a banking entity discovers the
violation or evasion, regardless of whether an Agency order has been
issued.
\2794\ See proposed rule Sec. ----.21(b).
---------------------------------------------------------------------------
Several commenters urged the Agencies to strengthen the authorities
provided for under Sec. ----.21,\2795\ with some commenters expressing
concern that the proposed rule does not establish sufficient
enforcement mechanisms and penalties for violations of the rule's
requirements.\2796\ Some commenters suggested the Agencies add language
in Sec. ----.21 authorizing the imposition of automatic and
significant financial penalties--as significant as the potential gains
from illegal proprietary trading--on traders, supervisors, executives,
and firms for violating section 13 of the BHC Act and the final
rule.\2797\ These
[[Page 5773]]
commenters suggested the Agencies incorporate reference to the Board's
authority under section 8 of the BHC Act into the rule,\2798\ and
others encouraged the Agencies to rely on their inherent authority to
impose automatic penalties and fines.\2799\ A few commenters stated
that traders, management, and banking entities should be held
responsible for violations under certain circumstances.\2800\ Finally,
another commenter recommended that officers and directors of a banking
entity be removed from office, be prohibited from being affiliated with
a banking entity, and be subject to salary clawbacks for violations of
section 13 of the BHC Act and the final rule.\2801\
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\2795\ See Sen. Merkley; Better Markets (Feb. 2012); Occupy; AFR
et al. (Feb. 2012); Public Citizen.
\2796\ See, e.g., BEC et al. (Jan. 2012); John Reed; Better
Markets (Feb. 2012); AFR et al. (Feb. 2012); Occupy; Sen. Merkley;
Public Citizen.
\2797\ See, e.g., Form Letter Type A; Form Letter Type B; Sarah
McKee; David R. Wilkes; Ben Leet; Karen Michaelis; Barry Rein; Allan
Richardson; Ronald Gedrim; Susan Pashkoff; Joan Budd; Frances
Vreman; Lisa Kazmier; Michael Wenger; Dyanne DiRosario; Alexander
Clayton; James Ofsink; Richard Leining (arguing that violators
should face penalties such as seizure and discharge of the board and
executives); Lee Smith; See also Occupy; Public Citizen.
\2798\ See Better Markets (Feb. 2012) (contending that penalties
should include specific administrative penalties, including monetary
penalties, bars, cease and desist orders, strengthened penalties for
recurring violations, and sanctioning of employees involved in the
violation and public reporting of such sanctions); AFR et al.
(arguing that section 8 of the BHC Act provides civil penalties for
violations by a company or individual and criminal penalties for
willful violations of the BHC Act). See also Occupy (requesting the
Agencies provide penalties that are specific to this rule in
addition to the general framework for criminal and civil penalties
in section 8 of the BHC Act).
\2799\ See Better Markets (Feb. 2012); Occupy; AFR et al. (Feb.
2012).
\2800\ See John Reed; Better Markets (Feb. 2012). See also BEC
et al. (Jan. 2012) (arguing that CEOs and CFOs should be held fully
responsible for any violations of the rule by any employees above
the clerical level); Occupy (recommending that traders relying on an
exemption in the proposed rule be held personally liable for any
losses on trading positions).
\2801\ See Occupy.
---------------------------------------------------------------------------
The Agencies note that the authorities provided for in Sec. --
--.21 are not exclusive. The Agencies have a number of enforcement
tools at their disposal to carry out their obligations to ensure
compliance with section 13 of the BHC Act and the final rule, and need
not reference them expressly in Sec. ----.21 in order to exercise
them. Specifically, the Agencies may rely on their inherent authorities
under otherwise applicable provisions of banking, securities, and
commodities laws to bring enforcement actions against banking entities,
their officers and directors, and other institution-affiliated parties
for violations of law.\2802\ For example, a banking entity that
violates section 13 of the BHC Act and the final rule may be subject to
criminal and civil penalties under section 8 of the BHC Act. Banking
entities may also be subject to formal enforcement actions under
section 8 of the Federal Deposit Insurance Act (FDIA), such as cease
and desist orders or civil money penalty actions,\2803\ or safety and
soundness orders under section 39 of the FDIA which may be enforceable
through assessment of civil money penalties and through the federal
court system. In addition, officers, directors, and other institution-
affiliated parties\2804\ may be subject to civil money penalties,
prohibition or removal actions, and personal cease and desist orders
under section 8 of the FDIA. Submission of late, false, or misleading
reports, including false statements on compliance with section 13 of
the BHC Act or the final rule, may also result in actions under
applicable securities, commodities, banking, and criminal laws,
including imposition of civil money and criminal penalties.\2805\
Therefore, the final rule is consistent with the proposal and does not
mention other enforcement actions available to address violations of
section 13 of the BHC Act and this final rule.
---------------------------------------------------------------------------
\2802\ See 12 U.S.C. 1851(g)(3).
\2803\ See, e.g., 12 U.S.C. 1818(i) (authorizing imposition of
civil money penalties up to the maximum daily amount of $1,000,000
for, among other things, knowing violations of law or regulation).
\2804\ See 12 U.S.C. 1813(u) (defining ``institution-affiliated
party'').
\2805\ See, e.g., 12 U.S.C. 164 (authorizing imposition of civil
money penalties for, among other things, submitting false or
misleading reports or information to the OCC); 18 U.S.C. 1005
(authorizing imposition of fines of not more than $1,000,000 or
imprisonment not more than 30 years, or both, for, among other
things, making a false entry in the books, reports or statements of
a bank with intent to injure, defraud or deceive).
---------------------------------------------------------------------------
Section 13 of the BHC Act and the final rule do not limit the reach
or applicability of the antifraud and other provisions of the federal
laws to banking entities, including, for example, section 17(a) of the
Securities Act of 1933 or section 10(b) and 15(c) of the Exchange Act
and the rules promulgated thereunder.
One commenter also suggested that the Agencies use their authority
under section 13(d)(3) of the BHC Act to impose additional capital
requirements and quantitative limitations on banking entities for
repeat violations of the prohibition on proprietary trading.\2806\ The
Agencies believe they can rely on other inherent enforcement
authorities to address repeat violations. The Agencies note that
several other commenters also requested the Agencies to exercise their
authority under section 13(d)(3).\2807\ The Agencies do not believe
that it is appropriate to exercise their authority under this section
at this time, primarily because the capital treatment of banking
entities' trading activities is currently being addressed through the
Agencies' risk-based capital rulemakings.\2808\ Additionally, the
Agencies believe Congress intended section 13(d)(3) to serve the
prudential purposes of bolstering the safety and soundness of
individual banking entities and the wider U.S. financial system. To the
extent commenters suggested section 13(d)(3) be employed for a punitive
purpose, the Agencies do not believe the provision was designed to
serve such a purpose nor do the Agencies believe that would be an
appropriate use of the provision. Thus, the Agencies believe section
13(d)(3) is more appropriately employed for the prudential purposes of
bolstering the safety and soundness of individual banking entities and
the wider financial stability of the U.S. financial system.
---------------------------------------------------------------------------
\2806\ See Better Markets (Feb. 2012).
\2807\ See Sen. Merkley; Public Citizen; Better Markets (Feb.
2012); Profs. Admati & Pfleiderer.
\2808\ See Regulatory Capital Rules: Regulatory Capital,
Implementation of Basel III, Capital Adequacy, Transition
Provisions, Prompt Corrective Action, Standardized Approach for
Risk-weighted Assets, Market Discipline and Disclosure Requirements,
Advanced Approaches Risk-Based Capital Rule, and Market Risk Capital
Rule; Final Rule, 78 FR 62,017 (Friday, October 11, 2013).
---------------------------------------------------------------------------
Commenters also urged the Agencies to clearly delineate in the
final rule the jurisdictional authority of each of the Agencies to
enforce compliance with section 13 of the BHC Act and the implementing
final rule. A number of commenters recommended approaches to
coordinating examinations and enforcement among the Agencies, as well
as to providing interpretive guidance.\2809\ For example, some
commenters observed that more than one Agency would have jurisdiction
over a given banking entity, and recommended that supervision and
enforcement of the final rule for all entities within a banking
enterprise remain completely with one Agency. \2810\ Further, some
commenters recommended that a single Agency be appointed to provide
interpretations, supervision, and enforcement of section 13 and the
rules thereunder for all banking entities.\2811\ Similarly, one
commenter suggested that the Board be given initial authority to
supervise the implementation of the rule because it is the primary
enforcer of the BHC Act and the single regulator that can currently
look across a banking group's entire global businesses, regardless of
legal entity. This commenter stated that the Board could then determine
whether an activity should be delegated to one of
[[Page 5774]]
the other Agencies for further examination or enforcement.\2812\ In
addition, with respect to interpretive authority, some commenters
indicated that the Board should be given sole interpretive authority of
the statute and the rules thereunder.\2813\ Other commenters urged the
Agencies to supervise and enforce the rule on a coordinated basis so as
to minimize duplicative enforcement efforts, reduce costs, and promote
certainty.\2814\
---------------------------------------------------------------------------
\2809\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC;
Barclays; Goldman (Prop. Trading); BoA; ABA (Keating); Comm. on
Capital Market Regulation; BEC et al.; ISDA (Apr. 2012).
\2810\ See Barclays (arguing that ideally the umbrella federal
regulator of the enterprise should take this role); Goldman (Prop.
Trading).
\2811\ See BoA; BEC et al.
\2812\ See Comm. on Capital Market Regulation.
\2813\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA
(recommending that the Board be responsible for resolving
potentially conflicting supervisory recommendations or matters
requiring attention arising from examinations as well); ISDA (Apr.
2012). See also ABA (Keating) (arguing that the Agencies should
defer to the Board's sole authority to interpret provisions of
Volcker that intersect with other statutory provisions subject to
the Board's jurisdictional authority, such as Super 23A); JPMC
(contending that the Agencies should adopt and Seek comment on a
protocol for supervision and enforcement that will ensure a given
banking entity will face one set of rules and different banking
entities will face the same set of rules). The Agencies decline to
adopt the commenter's suggested approach of deferring to the Board's
sole interpretive authority with respect to the provisions of the
final rule. The Agencies believe at this time that such an approach
would be neither appropriate nor effective given the different
authorities and expertise of each Agency. See Part IV.C (discussing
the Agencies' decision not to adopt some commenters' requests that a
single agency be responsible for determining compliance with section
13).
\2814\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA
(stating that the Agencies should issue one set of exam findings
under these circumstances); ISDA (Apr. 2012).
---------------------------------------------------------------------------
Section 13(e)(2) mandates that each Agency enforce compliance of
section 13 with respect to a banking entity ``under the respective
[A]gency's jurisdiction.'' \2815\ This section provides the Agencies
with the authority to order a banking entity to terminate activities or
investments that violate or function as an evasion of section 13 of the
BHC Act.\2816\ Decisions about whether to issue such orders could be
made after examinations or otherwise. Nothing in the final rule limits
an Agency's inherent authority to conduct examinations or otherwise
inspect banking entities to ensure compliance with the final rule.
Section ----.1 of each Agency's proposed rule described the specific
types of banking entities to which that Agency's rule applies. The
Agencies acknowledge commenters' concerns about overlapping
jurisdictional authority. The Agencies recognize that, on occasion, a
banking entity may be subject to jurisdiction by more than one Agency.
As is customary, the Agencies plan to coordinate their examination and
enforcement proceedings under section 13, to the extent possible and
practicable, so as to limit duplicative actions and undue costs and
burdens for banking entities.\2817\
---------------------------------------------------------------------------
\2815\ See 12 U.S.C. 1851(c)(2).
\2816\ See 12 U.S.C. 1851(e)(2) (requiring ``due notice and
opportunity for hearing'').
\2817\ See 12 U.S.C. 1844 (establishing jurisdictional
boundaries for regulation of bank holding companies); See also 12
U.S.C. 1828a (antievasion statute empowering OCC, FDIC, and the
Board to impose restrictions on relationships or transactions
between banks and their subsidiaries and affiliates).
---------------------------------------------------------------------------
The Agencies are adopting Sec. ----.21 substantially as proposed.
Accordingly, Sec. ----.21(a) of the final rule provides that any
banking entity that engages in an activity or makes an investment in
violation of section 13 of the BHC Act or the final rule or acts in a
manner that functions as an evasion of the requirements of section 13
of the BHC Act or the final rule, including through an abuse of any
activity or investment permitted or expressly excluded by the terms of
the final rule, or otherwise violates the restrictions and requirements
of section 13 of the BHC Act or the final rule, shall, upon discovery,
promptly terminate the activity and, as relevant, dispose of the
investment. This provision allows the Agencies to enforce the rule's
prohibitions against proprietary trading and sponsoring or owning
interests in covered funds regardless of how banking entities classify
their actions, while also providing banking entities the freedom to
legitimately engage in those banking activities which are outside the
scope of the statute.
V. Administrative Law Matters
A. Use of Plain Language
Section 722 of the Gramm-Leach Bliley Act (Pub. L. 106-102, 113
Stat. 1338, 1471, 12 U.S.C. 4809) requires the Federal banking agencies
to use plain language in all proposed and final rules published after
January 1, 2000. The OCC, Board and FDIC invited comment on whether the
proposed rule was written plainly and clearly, or whether there were
ways the Federal banking agencies could make the rule easier to
understand. The Federal banking agencies received no comments on these
matters and believe that the final rule is written plainly and clearly.
B. Paperwork Reduction Act Analysis
Certain provisions of the final rule contain ``collection of
information'' requirements within the meaning of the Paperwork
Reduction Act (PRA) of 1995 (44 U.S.C. 3501-3521). In accordance with
the requirements of the PRA, the Agencies may not conduct or sponsor,
and a respondent is not required to respond to, an information
collection unless it displays a currently valid Office of Management
and Budget (OMB) control number. The OCC, FDIC, and Board will obtain
OMB control numbers. The information collection requirements contained
in this joint final rule, to the extent they apply to insured financial
institutions that are not under a holding company, have been submitted
to OMB for review and approval by the OCC and FDIC under section
3507(d) of the PRA and Sec. 1320.11 of OMB's implementing regulations
(5 CFR part 1320). The Board reviewed the final rule under the
authority delegated to the Board by OMB.
PRA Submission to OMB
The Board will submit information collection burden estimates to
OMB and the submission will include burden for Federal Reserve-
supervised institutions, as well as burden for OCC-, FDIC-, SEC-, and
CFTC-supervised institutions under a holding company. The OCC and the
FDIC will take burden for banking entities that are not under a holding
company.
The FDIC and OCC submitted these information collection estimates
to OMB at the proposed rule stage as well. OMB filed comments
instructing the OCC and FDIC to examine public comment in response to
the notice of proposed rulemaking and include in the supporting
statement of the next Information Collection Request (ICR), to be
submitted to OMB at the final rule stage, a description of how the OCC
and FDIC have responded to any public comments in response to the ICR.
Provisions Requiring PRA Clearance
The final rule contains requirements subject to the PRA. The
reporting requirements are found in Sec. Sec. ----.12(e) and --
--.20(d); the recordkeeping requirements are found in Sec. Sec. --
--.3(d)(3), ----.4(b)(3)(i)(A), ----.5(c), ----.11(a)(2), and --
--.20(b)-(f); and the disclosure requirements are found in Sec. --
--.11(a)(8)(i). The recordkeeping burden for Sec. Sec. --
--.4(a)(2)(iii), ----.4(b)(2)(iii), ----.5(b)(1), ----.5(b)(2)(i), --
--.5(b)(2)(iv), ----.13(a)(2)(i), and ----.13(a)(2)(ii)(A) is accounted
for in Sec. ----.20(b); the recordkeeping burden for Appendix B is
accounted for in Sec. ----.20(c); the reporting and recordkeeping
burden for Appendix A is accounted for in Sec. ----.20(d); and the
recordkeeping burden for Sec. Sec. ----.10(c)(12)(i) and --
--.10(c)(12)(iii) is accounted for in Sec. ----.20(e). These
information collection requirements would implement section 619 of the
Dodd-Frank Act, as mentioned in the Abstract below. The respondent/
[[Page 5775]]
recordkeepers are for-profit financial institutions, including small
businesses. A covered entity must retain these records for a period
that is no less than 5 years in a form that allows it to promptly
produce such records to [the Agency] on request.
Comments Received on PRA
Of the comments received in response to the proposed rule, three
specifically referenced the PRA.\2818\ They were received from five
industry trade groups and focused on the analysis of the regulatory
burden imposed by regulation. They referenced the PRA burden as an
example of the significance of the burden imposed by the regulation but
did not address burden in the context of the PRA. A number of other
comments addressed reporting and recordkeeping requirements and the
utility of the information to be collected outside the context of the
PRA. As a result of these and other comments, the Agencies made changes
to the rule. These comments are discussed throughout the release.
---------------------------------------------------------------------------
\2818\ See BoA (acknowledging that the Agencies performed an
analysis of the information costs as required by the Paperwork
Reduction Act); SIFMA et al. (Covered Funds) (Feb. 2012) (noting
that the Agencies conducted a limited cost/benefit analysis of the
information requirements of the proposed rules under the PRA);
Chamber (Nov. 2013) (noting that the burden estimates for the
proposed rule stand at almost 6,600,000 hours per year).
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Proposed Information Collection
Title of Information Collection: Reporting, Recordkeeping, and
Disclosure Requirements Associated with Proprietary Trading and Certain
Interests in and Relationships with Covered Funds.
Frequency of Response: Annual, monthly, quarterly, and on occasion.
Affected Public: Businesses or other for-profit.
Respondents:
Board: State member banks, bank holding companies, savings and loan
holding companies, mutual holding companies, foreign banking
organizations, U.S. branches or agencies of foreign banks, and other
holding companies that control an insured depository institution. The
Board will take burden for all institutions under a holding company
including:
OCC-supervised institutions,
FDIC-supervised institutions,
Banking entities for which the CFTC is the primary
financial regulatory agency, as defined in section 2(12)(C) of the
Dodd-Frank Act, and
Banking entities for which the SEC is the primary
financial regulatory agency, as defined in section 2(12)(B) of the
Dodd-Frank Act.
OCC: National banks, federal savings associations, federal savings
banks not under a holding company, and their respective subsidiaries,
and their affiliates not under a holding company, and U.S. branches or
agencies of foreign banks. The OCC will take the burden with respect to
registered investment advisers and commodity trading advisers and
commodity pool operators that are subsidiaries of national banks,
federal savings associations, and federal savings banks not under a
bank holding company.
FDIC: Insured state nonmember banks not under a holding company;
state savings associations and state savings banks not under a holding
company; subsidiaries of state nonmember banks, state savings
associations, and state savings banks not under a holding company; and
foreign banks having an insured branch and their branches and agencies.
Abstract:
Section 619 of the Dodd-Frank Act added a new section 13 to the BHC
Act (to be codified at 12 U.S.C. 1851) that generally prohibits any
banking entity from engaging in proprietary trading or from investing
in, sponsoring, or having certain relationships with a hedge fund or
private equity fund, subject to certain exemptions. As noted above, the
final rule contains requirements subject to the PRA. The Agencies
believe that the reporting, recordkeeping, and disclosure requirements
associated with the rule will permit banking entities and the Agencies
to enforce compliance with section 13 of the BHC Act and the final rule
and to identify, monitor and limit risks of activities permitted under
section 13, particularly involving banking entities posing the greatest
risk to financial stability. Compliance with the information
collections would be mandatory. As noted above, a number of commenters
addressed reporting and recordkeeping requirements and the utility of
the information to be collected outside the context of the PRA. As a
result of these comments, the Agencies made changes to the rule, which
are discussed throughout the release. The final burden estimates take
these changes into account and reflect the anticipated burden under the
final rules. As discussed in the release, in brief, the purpose for the
recordkeeping, disclosure, and reporting requirements contained within
the rule is to facilitate compliance with section 13 of the BHC and
implementing rules.
Section-by-Section Analysis
PRA Reporting Requirements
Section ----.12(e) states that, upon application by a banking
entity, the Board may extend the period of time to meet the
requirements on ownership limitations in this section for up to 2
additional years, if the Board finds that an extension would be
consistent with safety and soundness and not detrimental to the public
interest. An application for extension must (1) be submitted to the
Board at least 90 days prior to expiration, (2) provide the reasons for
application including information that addresses the factors in
paragraph (e)(2) of Sec. ----.12, and (3) explain the banking entity's
plan for reducing the permitted investment in a covered fund through
redemption, sale, dilution or other methods.
Section ----.20(d) provides that a banking entity engaged in
proprietary trading activity must comply with the reporting
requirements described in Appendix A, if (1) the banking entity has,
together with its affiliates and subsidiaries, trading assets and
liabilities the average gross sum of which over the previous
consecutive four quarters, as measured as of the last day of each of
the four prior calendar quarters, equals or exceeds the established
threshold; (2) in the case of a foreign banking entity, the average
gross sum of the trading assets and liabilities of the combined U.S.
operations of the foreign banking entity (including all subsidiaries,
affiliates, branches and agencies of the foreign banking entity
operating, located or organized in the United States and excluding
trading assets and liabilities involving obligations of or guaranteed
by the United States or any agency of the United States) over the
previous consecutive four quarters, as measured as of the last day of
each of the four prior calendar quarters, equals or exceeds the
established threshold; or (3) the appropriate agency notifies the
banking entity in writing that it must satisfy the reporting
requirements contained in Appendix A of this part. The threshold for
reporting is $50 billion beginning on June 30, 2014; $25 billion
beginning on April 30, 2016; and $10 billion beginning on December 31,
2016. Unless the appropriate agency notifies the banking entity in
writing that it must report on a different basis, a banking entity with
$50 billion or more in trading assets and liabilities shall report the
information required by Appendix A for each calendar month within 30
days of the end of the relevant calendar month; beginning with
information for the month of January
[[Page 5776]]
2015, such information shall be reported within 10 days of the end of
that calendar month. Any other banking entity subject to Appendix A
shall report the information required by Appendix A for each calendar
quarter within 30 days of the end of that calendar quarter unless the
appropriate agency notifies the banking entity in writing that it must
report on a different basis. Appendix A requires banking entities to
furnish the following quantitative measurements for each trading desk
of the banking entity: (1) risk and position limits and usage; (2) risk
factor sensitivities; (3) Value-at-Risk and stress VaR; (4)
comprehensive profit and loss attribution; (5) inventory turnover; (6)
inventory aging; and (7) customer facing trade ratio.
Recordkeeping Requirements
Section ----.3(d)(3) specifies that proprietary trading does not
include any purchase or sale of a security by a banking entity for the
purpose of liquidity management in accordance with a documented
liquidity management plan of the banking entity that (1) specifically
contemplates and authorizes the particular securities to be used for
liquidity management purposes, the amount, types, and risks of these
securities that are consistent with liquidity management, and the
liquidity circumstances in which the particular securities may or must
be used; (2) requires that any purchase or sale of securities
contemplated and authorized by the plan 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; (3) requires
that any securities purchased or sold for liquidity management purposes
be highly liquid and limited to securities 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; (4) limits any securities purchased or sold for liquidity
management purposes, together with any other instruments purchased or
sold for such 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; (5)
includes written policies and procedures, internal controls, analysis
and independent testing to ensure that the purchase and sale of
securities that are not permitted under Sec. ----.6(a) or (b) of this
part are for the purpose of liquidity management and in accordance with
the liquidity management plan described in this paragraph; and (6) is
consistent with the appropriate agency's supervisory requirements,
guidance and expectations regarding liquidity management.
Section ----.4(b)(3)(i)(A) provides that a trading desk or other
organizational unit of another entity with more than $50 billion in
trading assets and liabilities is not a client, customer, or
counterparty unless the trading desk documents how and why a particular
trading desk or other organizational unit of the entity should be
treated as a client, customer, or counterparty of the trading desk for
purposes of Sec. ----.4(b). This modification responds to comments
received on the proposal regarding the definition of client, customer,
or counterparty for purposes of the market making exemption.
Section ----.5(c) requires documentation for any purchase or sale
of a financial instrument for risk-mitigating hedging purposes that is:
(1) not established by the specific trading desk establishing the
underlying positions, contracts, or other holdings the risks of which
the hedging activity is designed to reduce; (2) established by the
specific trading desk establishing or responsible for the underlying
positions, contracts, or other holdings but that is not specifically
identified in the trading desk's written policies and procedures; or
(3) established to hedge aggregated positions across two or more
trading desks. In connection with any purchase or sale that meets these
specified circumstances, a banking entity must, at a minimum and
contemporaneously with the purchase or sale, document (1) the specific,
identifiable risk(s) of the identified positions, contracts, or other
holdings of the banking entity 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 desks or other
business unit that is establishing and responsible for the hedge. The
banking entity must also create and retain records sufficient to
demonstrate compliance with this section for at least 5 years in a form
that allows the banking entity to promptly produce such records to the
appropriate agency on request, or such longer period as required under
other law or this part.
Section ----.11(a)(2) requires that covered funds generally must be
organized and offered only in connection with the provision of bona
fide trust, fiduciary, investment advisory, or commodity trading
advisory services and only to persons that are customers of such
services of the banking entity, pursuant to a written plan or similar
documentation outlining how the banking entity intends to provide
advisory or other similar services to its customers through organizing
and offering the covered fund.
Section ----.20(b) specifies the contents of the compliance program
for a banking entity with total consolidated assets of $10 billion or
more. It includes: (1) written policies and procedures reasonably
designed to document, describe, monitor and limit trading activities,
including setting and monitoring required limits set out in Sec. --
--.4 and Sec. ----.5 and activities and investments with respect to a
covered fund (including those permitted under Sec. Sec. ----.3 through
----.6 or Sec. Sec. ----.11 through ----.14) to ensure that all
activities and investments conducted by the banking entity that are
subject to section 13 of the BHC Act and this part comply with section
13 of the BHC Act and applicable regulations; (2) a system of internal
controls reasonably designed to monitor compliance with section 13 of
the BHC Act and this part and to prevent the occurrence of activities
or investments that are prohibited by section 13 of the BHC Act and
applicable regulations; (3) a management framework that clearly
delineates responsibility and accountability for compliance with
section 13 of the BHC Act and this part and includes appropriate
management review of trading limits, strategies, hedging activities,
investments, incentive compensation and other matters identified in
this part or by management as requiring attention; (4) independent
testing and audit of the effectiveness of the compliance program
conducted periodically by qualified personnel of the banking entity or
by a qualified outside party; (5) training for trading personnel and
managers, as well as other appropriate personnel, to effectively
implement and enforce the compliance program; and (6) records
sufficient to demonstrate compliance with section 13 of the BHC Act and
applicable regulations, which a banking entity must promptly provide to
the [Agency] upon request and retain for a period of no less than 5
years or such longer period as required by [Agency].
Section ----.20(c) specifies that the compliance program of a
banking entity must satisfy the requirements and other standards
contained in Appendix B, if (1) the banking entity engages in
proprietary trading permitted under
[[Page 5777]]
subpart B and is required to comply with the reporting requirements of
Sec. ----.20(d); (2) the banking entity has reported total
consolidated assets as of the previous calendar year end of $50 billion
or more or, in the case of a foreign banking entity, has total U.S.
assets as of the previous calendar year end of $50 billion or more
(including all subsidiaries, affiliates, branches and agencies of the
foreign banking entity operating, located or organized in the United
States); or (3) the [Agency] notifies the banking entity in writing
that it must satisfy the requirements and other standards contained in
Appendix B. Appendix B provides enhanced minimum standards for
compliance programs for banking entities that meet the thresholds in
Sec. ----.20(c) as described above. These include the establishment,
maintenance, and enforcement of the enhanced compliance program and
meeting the minimum written policies and procedures, internal controls,
management framework, independent testing, training, and recordkeeping.
The program must: (1) be reasonably designed to identify, document,
monitor and report the permitted trading and covered fund activities
and investments; identify, monitor and promptly address the risk of
these covered activities and investments and potential areas of
noncompliance; and prevent activities or investments prohibited by, or
that do not comply with, section 13 of the BHC Act and this part; (2)
establish and enforce appropriate limits on covered activities and
investments, including limits on size, scope, complexity, and risks of
individual activities or investments consistent with the requirements
of section 13 of the BHC Act and this part; (3) subject the
effectiveness of the compliance program to periodic independent review
and testing, and ensure that internal audit, corporate compliance and
internal control functions involved in review and testing are effective
and independent; (4) make senior management and others accountable for
effective implementation of compliance program and ensure that board of
directors and chief executive officer (or equivalent) of the banking
entity review effectiveness of the compliance program; and (5)
facilitate supervision and examination by Agencies of permitted trading
and covered fund activities and investments.
Section ----.20(d) provides that certain banking entities engaged
in certain proprietary trading activities must comply with the
reporting requirements described in Appendix A. A banking entity must
also, for any quantitative measurement furnished to the appropriate
agency pursuant to Sec. ----.20(d) and Appendix A, create and maintain
records documenting the preparation and content of these reports, as
well as such information as is necessary to permit the appropriate
agency to verify the accuracy of such reports, for a period of 5 years
from the end of the calendar year for which the measurement was taken.
Section ----.20(e) specifies additional documentation required for
covered funds. Any banking entity that has more than $10 billion in
total consolidated assets as reported on December 31 of the previous
two calendar years shall maintain records that include: (1)
documentation of the exclusions or exemptions other than sections
3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 relied on by
each fund sponsored by the banking entity (including all subsidiaries
and affiliates) in determining that such fund is not a covered fund;
(2) for each fund sponsored by the banking entity (including all
subsidiaries and affiliates) for which the banking entity relies on one
or more of the exclusions from the definition of covered fund provided
by Sec. Sec. ----.10(c)(1),----.10(c)(5), ----.10(c)(8), --
--.10(c)(9), or ----.10(c)(10) of subpart C, documentation supporting
the banking entity's determination that the fund is not a covered fund
pursuant to one or more of those exclusions; (3) for each seeding
vehicle described in Sec. Sec. ----.10(c)(12)(i) or --
--.10(c)(12)(iii) of subpart C that will become a registered investment
company or SEC-regulated business development company, a written plan
documenting the banking entity's determination that the seeding vehicle
will become a registered investment company or SEC-regulated business
development company; the period of time during which the vehicle will
operate as a seeding vehicle; and the banking entity's plan to market
the vehicle to third-party investors and convert it into a registered
investment company or SEC-regulated business development company within
the time period specified in Sec. ----.12(a)(2)(i)(B) of subpart C;
and (4) for any banking entity that is, or is controlled directly or
indirectly by a banking entity that is, located in or organized under
the laws of the United States or of any State, if the aggregate amount
of ownership interests in foreign public funds that are described in
Sec. ----.10(c)(1) of subpart C owned by such banking entity
(including ownership interests owned by any affiliate that is
controlled directly or indirectly by a banking entity that is located
in or organized under the laws of the United States or of any State)
exceeds $50 million at the end of two or more consecutive calendar
quarters, beginning with the next succeeding calendar quarter,
documentation of the value of the ownership interests owned by the
banking entity (and such affiliates) in each foreign public fund and
each jurisdiction in which any such foreign public fund is organized,
calculated as of the end of each calendar quarter, which documentation
must continue until the banking entity's aggregate amount of ownership
interests in foreign public funds is below $50 million for two
consecutive calendar quarters.
Section ----.20(f)(1) applies to banking entities with no covered
activities. A banking entity that does not engage in activities or
investments pursuant to subpart B or subpart C (other than trading
activities permitted pursuant to Sec. ----.6(a) of subpart B) may
satisfy the requirements of this section by establishing the required
compliance program prior to becoming engaged in such activities or
making such investments (other than trading activities permitted
pursuant to Sec. ----.6(a) of subpart B).
Section ----.20(f)(2) applies to banking entities with modest
activities. A banking entity with total consolidated assets of $10
billion or less as reported on December 31 of the previous two calendar
years that engages in activities or investments pursuant to subpart B
or subpart C of this part (other than trading activities permitted
under section ----.6(a)) may satisfy the requirements of this section
by including in its existing compliance policies and procedures
appropriate references to the requirements of section 13 and this part
and adjustments as appropriate given the activities, size, scope and
complexity of the banking entity.
Disclosure Requirements
Section ----.11(a)(8)(i) requires that a banking entity must
clearly and conspicuously disclose, in writing, to any prospective and
actual investor in the covered fund (such as through disclosure in the
covered fund's offering documents) (1) that ``any losses in [such
covered fund] will be borne solely by investors in [the covered fund]
and not by [the banking entity]; therefore, [the banking entity's]
losses in [such covered fund] will be limited to losses attributable to
the ownership interests in the covered fund held by [the banking
entity] in its capacity as investor in the [covered fund] or as
[[Page 5778]]
beneficiary of a restricted profit interest held by [the banking
entity]''; (2) that such investor should read the fund offering
documents before investing in the covered fund; (3) that the
``ownership interests in the covered fund are not insured by the FDIC,
and are not deposits, obligations of, or endorsed or guaranteed in any
way, by any banking entity'' (unless that happens to be the case); and
(4) the role of the banking entity and its affiliates and employees in
sponsoring or providing any services to the covered fund.
PRA Burden Estimates
In determining the method for estimating the paperwork burden, the
Agencies made the assumption that affiliated entities under a holding
company would act in concert with one another to take advantage of
efficiencies that may exist.
Estimated PRA Burden per Response:
Reporting Burden
Sec. ----.12(e)--20 hours (Initial set up 50 hours).
Sec. ----.20(d)--2 hours (Initial setup 6 hours).
PRA Recordkeeping Burden
Sec. ----.3(d)(3)--1 hour (Initial setup 3 hours).
Sec. ----.4(b)(3)(i)(A)--2 hours.
Sec. ----.5(c)--100 hours (Initial setup 50 hours).
Sec. ----.11(a)(2)--10 hours.
Sec. ----.20(b)--265 hours (Initial setup 795 hours).
Sec. ----.20(c)--1,200 hours (Initial setup 3,600 hours).
Sec. ----.20(d)--440 hours for entities with $50 billion or more
in trading assets/liabilities; 350 hours for entities with $10 to $50
billion in trading assets/liabilities.
Sec. ----.20(e)--200 hours.
Sec. ----.20(f)(1)--8 hours.
Sec. ----.20(f)(2)--40 (Initial setup 100 hours).
PRA Disclosure Burden
Sec. ----.11(a)(8)(i)--0.1 hours.
Board
Number of respondents: 5,027.
Total estimated annual burden: 2,336,190 hours (968,488 hours for
initial setup and 1,367,702 hours for ongoing compliance).
FDIC
Number of respondents: 797.
Total estimated annual burden: 28,234 hours (14,165 hours for
initial setup and 14,069 hours for ongoing compliance).
OCC
Number of respondents: 381.
Total estimated annual burden: 28,016 hours (14,386 hours for
initial setup and 13,630 hours for ongoing compliance).
C. Regulatory Flexibility Act Analysis
In general, section 4 of the Regulatory Flexibility Act (5 U.S.C.
604) (RFA) requires an agency to prepare a final regulatory flexibility
analysis (FRFA) for a final rule unless the agency certifies that the
rule will not, if promulgated, have a significant economic impact on a
substantial number of small entities (defined as of July 22, 2013, to
include banking entities with total assets of $500 million or less
(``small banking entities'').\2819\ Pursuant to section 605(b) of the
RFA, a FRFA is not required if an agency certifies that the final rule
will not have a significant economic impact on a substantial number of
small entities. The Agencies have considered the potential economic
impact of the final rule on small banking entities in accordance with
the RFA. The Agencies believe that the final rule will not have a
significant economic impact on a substantial number of small banking
entities for the reasons described below.
---------------------------------------------------------------------------
\2819\ See 13 CFR 121.201; See also 13 CFR 121.103(a)(6) (noting
factors that the Small Business Administration considers in
determining whether an entity qualifies as a small business,
including receipts, employees, and other measures of its domestic
and foreign affiliates).
---------------------------------------------------------------------------
The Agencies previously considered the impact of the proposed rule
for purposes of the RFA and concluded that the proposed rule would not
appear to have a significant economic impact on a substantial number of
small banking entities. In support of this conclusion, the proposed
rule, among other things, noted that the thresholds for the metrics
reporting requirements under Sec. --.7 and Appendix A and for the
enhanced and core compliance program requirements under Sec. --.20 and
Appendix C of the proposed rule would not capture small banking
entities.\2820\
---------------------------------------------------------------------------
\2820\ See Joint Proposal, 76 FR 68,938-68,939.
---------------------------------------------------------------------------
The Agencies received several comments on the impact of the
proposed rule on small entities. Commenters argued that the Agencies
incorrectly concluded that the proposed rule would not have a
significant economic impact on a substantial number of small
entities.\2821\ Commenters asserted that the proposed rule would have a
significant economic impact on numerous small non-banking entities by
restricting their access to a variety of products and services,
including covered fund-linked products for investment and hedging
purposes and underwriting and market-making related services.\2822\
---------------------------------------------------------------------------
\2821\ See BoA; SIFMA et al. (Covered Funds) (Feb. 2012);
Chamber (Feb. 2012); ABA (Keating).
\2822\ See SIFMA et al. (Covered Funds) (Feb. 2012); Chamber
(Feb. 2012).
---------------------------------------------------------------------------
The Agencies have carefully considered these comments in developing
a final rule. To minimize burden on small banking entities, section --
--.20(f)(1) of 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. In addition, to minimize the burden on small 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 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. Only those banking entities with
total assets of greater than $10 billion will need to adopt more
detailed or enhanced compliance requirements under the final rule. (For
purposes of the enhanced compliance program in Appendix B of the final
rule, the threshold for banking entities is total consolidated assets
of $50 billion or more.) Accordingly, the compliance requirements under
the final rule do not have a significant economic impact on a
substantial number of small banking entities.
Likewise, the final rule raises the threshold for metrics reporting
from the proposed rule to capture only firms that engage in significant
trading activities. Specifically, the metrics reporting requirements
under Sec. --.20 and Appendix A of the final rule apply only to
banking entities with average trading assets and liabilities on a
consolidated, worldwide basis for the preceding year equal to or
greater than $10 billion. Accordingly, the metrics reporting
requirements under the final rule do not impact small banking entities.
Moreover, the Agencies have revised the definition of covered fund
in the final rule to address many of the concerns raised by commenters
regarding the unintended consequences
[[Page 5779]]
of the proposed definition.\2823\ The definition of covered fund under
the final rule 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, acquisition vehicles, insurance company
separate accounts, registered investments companies, and public welfare
investment funds. The Agencies believe that these changes will further
minimize the burden for small banking entities such as those that may
use wholly owned subsidiaries for organizational convenience or make
public welfare investments to achieve their financial and Community
Reinvestment Act goals.
---------------------------------------------------------------------------
\2823\ See Part IV.B.1. of this SUPPLEMENTARY INFORMATION.
---------------------------------------------------------------------------
Finally, in response to commenters' assertion that the proposed
rule would have had a significant economic impact on numerous small
non-banking entities by restricting their access to a variety of
products and services,\2824\ the Agencies note that the RFA does not
require the Agencies to consider the impact of the final rule,
including its indirect economic effects, on small entities that are not
subject to the requirements of the final rule.\2825\
---------------------------------------------------------------------------
\2824\ See SIFMA et al. (Covered Funds) (Feb. 2012); Chamber
(Feb. 2012).
\2825\ See e.g., In Mid-Tex Electric Cooperative v. FERC, 773
F.2d 327 (D.C. Cir. 1985); United Distribution Cos. v. FERC, 88 F.3d
1105, 1170 (D.C. Cir. 1996); Cement Kiln Recycling Coalition v. EPA,
255 F.3d 855 (D.C. Cir. 2001). Commenters relied on Aeronautical
Repair Station Association v. Federal Aviation Administration, 494
F.3d 161 (D.C. Cir 2007) to argue that the Agencies must consider
the indirect economic effects of the final rule on small non-banking
entities. This case is inapposite, however, because there the
agency's own rulemaking release expressly stated that the rule
imposed responsibilities directly on certain small business
contractors. The court reaffirmed its prior holdings that the RFA
limits its application to small entities ``which will be subject to
the proposed regulation--that is, those small entities to which the
proposed rule will apply.'' Id. at 176 (emphasis and internal
quotations omitted).
---------------------------------------------------------------------------
For the reasons stated above, the OCC, FDIC, SEC, and CFTC certify,
for the banking entities subject to each such Agency's jurisdiction,
that the final rule will not result in a significant economic impact on
a substantial number of small entities. In light of the foregoing, the
Board does not believe, for the banking entities subject to the Board's
jurisdiction, that the final rule would have a significant economic
impact on a substantial number of small entities.
D. OCC Unfunded Mandates Reform Act of 1995 Determination
The Unfunded Mandates Reform Act of 1995, Public Law 104-4 (2
U.S.C. 1532) (UMRA) requires a Federal agency to prepare a budgetary
impact statement before promulgating any rule likely to result in a
Federal mandate that may result in the expenditure by State, local, and
tribal governments, in the aggregate, or by the private sector of $100
million or more (adjusted annually for inflation) in any one year. If a
budgetary impact statement is required, Section 205 of the UMRA also
requires an agency to identify and consider a reasonable number of
regulatory alternatives before promulgating a rule.
The OCC previously determined that the proposed rule would not
impose any Federal mandates resulting in expenditures by State, local,
and tribal governments, in the aggregate, or by the private sector of
$100 million or more (adjusted annually for inflation) in any one year.
Several commenters argued that the OCC failed to consider all relevant
expenditures and that that the proposed rule should have qualified as a
significant regulatory action under UMRA.\2826\
---------------------------------------------------------------------------
\2826\ See BoA; SIFMA et al. (Covered Funds); Chamber.
---------------------------------------------------------------------------
The OCC has carefully considered these comments in completing its
UMRA analysis of the final rule. The OCC has determined that the final
rule qualifies as a significant regulatory action under the UMRA
because its Federal mandates may result in expenditures by the private
sector in excess of $100 million or more (adjusted annually for
inflation) in any one year.
Text of Common Rule
PART [----] PROPRIETARY TRADING AND CERTAIN INTERESTS IN AND
RELATIONSHIPS WITH COVERED FUNDS
Subpart A Authority and Definitions
Sec.
----.1 Authority, purpose, scope, and relationship to other
authorities [Reserved].
----.2 Definitions.
Subpart B Proprietary Trading
----.3 Prohibition on proprietary trading.
----.4 Permitted underwriting and market making-related activities.
----.5 Permitted risk-mitigating hedging activities.
----.6 Other permitted proprietary trading activities.
----.7 Limitations on permitted proprietary trading activities.
----.8 [Reserved]
----.9 [Reserved]
Subpart C Covered Fund Activities and Investments
----.10 Prohibition on acquiring or retaining an ownership interest
in and having certain relationships with a covered fund.
----.11 Permitted organizing and offering, underwriting, and market
making with respect to a covered fund.
----.12 Permitted investment in a covered fund.
----.13 Other permitted covered fund activities and investments.
----.14 Limitations on relationships with a covered fund.
----.15 Other limitations on permitted covered fund activities and
investments.
----.16 [Reserved]
----.17 [Reserved]
----.18 [Reserved]
----.19 [Reserved]
Subpart D Compliance Program Requirement; Violations
----.20 Program for compliance; reporting.
----.21 Termination of activities or investments; penalties for
violations.
Appendix A Reporting and Recordkeeping Requirements for Covered
Trading Activities
Appendix B Enhanced Minimum Standards for Compliance Programs
Subpart A--Authority and Definitions
Sec. ----.1 Authority, purpose, scope, and relationship to other
authorities [Reserved]
Sec. ----.2 Definitions.
Unless otherwise specified, for purposes of this part:
(a) Affiliate has the same meaning as in section 2(k) of the Bank
Holding Company Act of 1956 (12 U.S.C. 1841(k)).
(b) Bank holding company has the same meaning as in section 2 of
the Bank Holding Company Act of 1956 (12 U.S.C. 1841).
(c) Banking entity. (1) Except as provided in paragraph (c)(2) of
this section, banking entity means:
(i) Any insured depository institution;
(ii) Any company that controls an insured depository institution;
(iii) Any company that is treated as a bank holding company for
purposes of section 8 of the International Banking Act of 1978 (12
U.S.C. 3106); and
(iv) Any affiliate or subsidiary of any entity described in
paragraphs (c)(1)(i), (ii), or (iii) of this section.
(2) Banking entity does not include:
(i) A covered fund that is not itself a banking entity under
paragraphs (c)(1)(i), (ii), or (iii) of this section;
(ii) A portfolio company held under the authority contained in
section 4(k)(4)(H) or (I) of the BHC Act (12 U.S.C. 1843(k)(4)(H),
(I)), or any portfolio concern, as defined under 13 CFR 107.50, that is
controlled by a small business investment company, as
[[Page 5780]]
defined in section 103(3) of the Small Business Investment Act of 1958
(15 U.S.C. 662), so long as the portfolio company or portfolio concern
is not itself a banking entity under paragraphs (c)(1)(i), (ii), or
(iii) of this section; or
(iii) The FDIC acting in its corporate capacity or as conservator
or receiver under the Federal Deposit Insurance Act or Title II of the
Dodd-Frank Wall Street Reform and Consumer Protection Act.
(d) Board means the Board of Governors of the Federal Reserve
System.
(e) CFTC means the Commodity Futures Trading Commission.
(f) Dealer has the same meaning as in section 3(a)(5) of the
Exchange Act (15 U.S.C. 78c(a)(5)).
(g) Depository institution has the same meaning as in section 3(c)
of the Federal Deposit Insurance Act (12 U.S.C. 1813(c)).
(h) Derivative. (1) Except as provided in paragraph (h)(2) of this
section, derivative means:
(i) Any swap, as that term is defined in section 1a(47) of the
Commodity Exchange Act (7 U.S.C. 1a(47)), or security-based swap, as
that term is defined in section 3(a)(68) of the Exchange Act (15 U.S.C.
78c(a)(68));
(ii) Any purchase or sale of a commodity, that is not an excluded
commodity, for deferred shipment or delivery that is intended to be
physically settled;
(iii) Any foreign exchange forward (as that term is defined in
section 1a(24) of the Commodity Exchange Act (7 U.S.C. 1a(24)) or
foreign exchange swap (as that term is defined in section 1a(25) of the
Commodity Exchange Act (7 U.S.C. 1a(25));
(iv) Any agreement, contract, or transaction in foreign currency
described in section 2(c)(2)(C)(i) of the Commodity Exchange Act (7
U.S.C. 2(c)(2)(C)(i));
(v) Any agreement, contract, or transaction in a commodity other
than foreign currency described in section 2(c)(2)(D)(i) of the
Commodity Exchange Act (7 U.S.C. 2(c)(2)(D)(i)); and
(vi) Any transaction authorized under section 19 of the Commodity
Exchange Act (7 U.S.C. 23(a) or (b));
(2) A derivative does not include:
(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, as that term is defined in section 1a(47) of the
Commodity Exchange Act (7 U.S.C. 1a(47)), or security-based swap, as
that term is defined in section 3(a)(68) of the Exchange Act (15 U.S.C.
78c(a)(68)); or
(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)).
(i) Employee includes a member of the immediate family of the
employee.
(j) Exchange Act means the Securities Exchange Act of 1934 (15
U.S.C. 78a et seq.).
(k) Excluded commodity has the same meaning as in section 1a(19) of
the Commodity Exchange Act (7 U.S.C. 1a(19)).
(l) FDIC means the Federal Deposit Insurance Corporation.
(m) Federal banking agencies means the Board, the Office of the
Comptroller of the Currency, and the FDIC.
(n) Foreign banking organization has the same meaning as in section
211.21(o) of the Board's Regulation K (12 CFR 211.21(o)), but does not
include a foreign bank, as defined in section 1(b)(7) of the
International Banking Act of 1978 (12 U.S.C. 3101(7)), that is
organized under the laws of the Commonwealth of Puerto Rico, Guam,
American Samoa, the United States Virgin Islands, or the Commonwealth
of the Northern Mariana Islands.
(o) Foreign insurance regulator means the insurance commissioner,
or a similar official or agency, of any country other than the United
States that is engaged in the supervision of insurance companies under
foreign insurance law.
(p) General account means all of the assets of an insurance company
except those allocated to one or more separate accounts.
(q) Insurance company means a company that is organized as an
insurance company, primarily and predominantly engaged in writing
insurance or reinsuring risks underwritten by insurance companies,
subject to supervision as such by a state insurance regulator or a
foreign insurance regulator, and not operated for the purpose of
evading the provisions of section 13 of the BHC Act (12 U.S.C. 1851).
(r) Insured depository institution has the same meaning as in
section 3(c) of the Federal Deposit Insurance Act (12 U.S.C. 1813(c)),
but does not include an insured depository institution that is
described in section 2(c)(2)(D) of the BHC Act (12 U.S.C.
1841(c)(2)(D)).
(s) Loan means any loan, lease, extension of credit, or secured or
unsecured receivable that is not a security or derivative.
(t) Primary financial regulatory agency has the same meaning as in
section 2(12) of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (12 U.S.C. 5301(12)).
(u) Purchase includes any contract to buy, purchase, or otherwise
acquire. For security futures products, purchase includes any contract,
agreement, or transaction for future delivery. With respect to a
commodity future, purchase includes any contract, agreement, or
transaction for future delivery. With respect to a derivative, purchase
includes the execution, termination (prior to its scheduled maturity
date), assignment, exchange, or similar transfer or conveyance of, or
extinguishing of rights or obligations under, a derivative, as the
context may require.
(v) Qualifying foreign banking organization means a foreign banking
organization that qualifies as such under section 211.23(a), (c) or (e)
of the Board's Regulation K (12 CFR 211.23(a), (c), or (e)).
(w) SEC means the Securities and Exchange Commission.
(x) Sale and sell each include any contract to sell or otherwise
dispose of. For security futures products, such terms include any
contract, agreement, or transaction for future delivery. With respect
to a commodity future, such terms include any contract, agreement, or
transaction for future delivery. With respect to a derivative, such
terms include the execution, termination (prior to its scheduled
maturity date), assignment, exchange, or similar transfer or conveyance
of, or extinguishing of rights or obligations under, a derivative, as
the context may require.
(y) Security has the meaning specified in section 3(a)(10) of the
Exchange Act (15 U.S.C. 78c(a)(10)).
(z) Security-based swap dealer has the same meaning as in section
3(a)(71) of the Exchange Act (15 U.S.C. 78c(a)(71)).
(aa) Security future has the meaning specified in section 3(a)(55)
of the Exchange Act (15 U.S.C. 78c(a)(55)).
(bb) Separate account means an account established and maintained
by an insurance company in connection with one or more insurance
contracts to hold assets that are legally segregated from the insurance
company's other assets, under which income, gains, and losses, whether
or not realized, from assets allocated to such account, are, in
accordance with the applicable contract, credited to or charged against
such account without regard to other income, gains, or losses of the
insurance company.
(cc) State means any State, the District of Columbia, the
Commonwealth of Puerto Rico, Guam, American Samoa, the United States
Virgin Islands, and the Commonwealth of the Northern Mariana Islands.
[[Page 5781]]
(dd) Subsidiary has the same meaning as in section 2(d) of the Bank
Holding Company Act of 1956 (12 U.S.C. 1841(d)).
(ee) State insurance regulator means the insurance commissioner, or
a similar official or agency, of a State that is engaged in the
supervision of insurance companies under State insurance law.
(ff) Swap dealer has the same meaning as in section 1(a)(49) of the
Commodity Exchange Act (7 U.S.C. 1a(49)).
Subpart B--Proprietary Trading
Sec. ------.3 Prohibition on proprietary trading.
(a) Prohibition. Except as otherwise provided in this subpart, a
banking entity may not engage in proprietary trading. Proprietary
trading means engaging as principal for the trading account of the
banking entity in any purchase or sale of one or more financial
instruments.
(b) Definition of trading account. (1) Trading account means any
account that is used by a banking entity to:
(i) Purchase or sell one or more financial instruments principally
for the purpose of:
(A) Short-term resale;
(B) Benefitting from actual or expected short-term price movements;
(C) Realizing short-term arbitrage profits; or
(D) Hedging one or more positions resulting from the purchases or
sales of financial instruments described in paragraphs (b)(1)(i)(A),
(B), or (C) of this section;
(ii) Purchase or sell one or more financial instruments that are
both market risk capital rule covered positions and trading positions
(or hedges of other market risk capital rule covered positions), if the
banking entity, or any affiliate of the banking entity, is an insured
depository institution, bank holding company, or savings and loan
holding company, and calculates risk-based capital ratios under the
market risk capital rule; or
(iii) Purchase or sell one or more financial instruments for any
purpose, if the banking entity:
(A) Is licensed or registered, or is 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
(B) Is 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.
(2) Rebuttable presumption for certain purchases and sales. The
purchase (or sale) of a financial instrument by a banking entity shall
be presumed to be for the trading account of the banking entity under
paragraph (b)(1)(i) of this section if the banking entity holds the
financial instrument for fewer than sixty days or substantially
transfers the risk of the financial instrument within sixty days of the
purchase (or sale), unless the banking entity can demonstrate, based on
all relevant facts and circumstances, that the banking entity did not
purchase (or sell) the financial instrument principally for any of the
purposes described in paragraph (b)(1)(i) of this section.
(c) Financial instrument. (1) Financial instrument means:
(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
option on a contract of sale of a commodity for future delivery.
(2) A financial instrument does not include:
(i) A loan;
(ii) A commodity that is not:
(A) An excluded commodity (other than foreign exchange or
currency);
(B) A derivative;
(C) A contract of sale of a commodity for future delivery; or
(D) An option on a contract of sale of a commodity for future
delivery; or
(iii) Foreign exchange or currency.
(d) Proprietary trading. Proprietary trading does not include:
(1) Any purchase or sale of one or more financial instruments by a
banking entity that arises under a repurchase or reverse repurchase
agreement pursuant to which the banking entity has simultaneously
agreed, in writing, to both purchase and sell a stated asset, at stated
prices, and on stated dates or on demand with the same counterparty;
(2) Any purchase or sale of one or more financial instruments by a
banking entity that arises under 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 by the parties;
(3) Any purchase or sale of a security by a banking entity for the
purpose of liquidity management in accordance with a documented
liquidity management plan of the banking entity that:
(i) Specifically contemplates and authorizes the particular
securities to be used for liquidity management purposes, the amount,
types, and risks of these securities that are consistent with liquidity
management, and the liquidity circumstances in which the particular
securities may or must be used;
(ii) Requires that any purchase or sale of securities contemplated
and authorized by the plan 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;
(iii) Requires that any securities purchased or sold for liquidity
management purposes be highly liquid and limited to securities 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;
(iv) Limits any securities purchased or sold for liquidity
management purposes, together with any other instruments purchased or
sold for such 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;
(v) Includes written policies and procedures, internal controls,
analysis, and independent testing to ensure that the purchase and sale
of securities that are not permitted under Sec. Sec. ----.6(a) or (b)
of this subpart are for the purpose of liquidity management and in
accordance with the liquidity management plan described in paragraph
(d)(3) of this section; and
(vi) Is consistent with [Agency]'s supervisory requirements,
guidance, and expectations regarding liquidity management;
(4) Any purchase or sale of one or more financial instruments by a
banking entity that is a derivatives clearing organization or a
clearing agency in connection with clearing financial instruments;
(5) Any 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;
(6) Any purchase or sale of one or more financial instruments by a
banking entity, so long as:
[[Page 5782]]
(i) The purchase (or sale) 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; or
(ii) The purchase (or sale) satisfies an obligation of the banking
entity in connection with a judicial, administrative, self-regulatory
organization, or arbitration proceeding;
(7) Any purchase or sale of one or more financial instruments by a
banking entity that is acting solely as agent, broker, or custodian;
(8) Any purchase or sale of one or more financial instruments by a
banking entity through a deferred compensation, stock-bonus, profit-
sharing, or pension plan of the banking entity that is established and
administered in accordance with the law 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 persons
who are or were employees of the banking entity; or
(9) Any purchase or sale of one or more financial instruments by a
banking entity 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, and in no event may the
banking entity retain such instrument for longer than such period
permitted by the [Agency].
(e) Definition of other terms related to proprietary trading. For
purposes of this subpart:
(1) Anonymous means that each party to a purchase or sale is
unaware of the identity of the other party(ies) to the purchase or
sale.
(2) Clearing agency has the same meaning as in section 3(a)(23) of
the Exchange Act (15 U.S.C. 78c(a)(23)).
(3) Commodity has the same meaning as in section 1a(9) of the
Commodity Exchange Act (7 U.S.C. 1a(9)), except that a commodity does
not include any security;
(4) Contract of sale of a commodity for future delivery means a
contract of sale (as that term is defined in section 1a(13) of the
Commodity Exchange Act (7 U.S.C. 1a(13)) for future delivery (as that
term is defined in section 1a(27) of the Commodity Exchange Act (7
U.S.C. 1a(27))).
(5) Derivatives clearing organization means:
(i) A derivatives clearing organization registered under section 5b
of the Commodity Exchange Act (7 U.S.C. 7a-1);
(ii) A derivatives clearing organization that, pursuant to CFTC
regulation, is exempt from the registration requirements under section
5b of the Commodity Exchange Act (7 U.S.C. 7a-1); 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.
(6) Exchange, unless the context otherwise requires, means any
designated contract market, swap execution facility, or foreign board
of trade registered with the CFTC, or, for purposes of securities or
security-based swaps, an exchange, as defined under section 3(a)(1) of
the Exchange Act (15 U.S.C. 78c(a)(1)), or security-based swap
execution facility, as defined under section 3(a)(77) of the Exchange
Act (15 U.S.C. 78c(a)(77)).
(7) Excluded clearing activities means:
(i) With respect to customer transactions cleared on a derivatives
clearing organization, a clearing agency, or a designated financial
market utility, any purchase or sale necessary to correct trading
errors made by or on behalf of a customer provided that such purchase
or sale is conducted in accordance with, for transactions cleared on a
derivatives clearing organization, the Commodity Exchange Act, CFTC
regulations, and the rules or procedures of the derivatives clearing
organization, or, for transactions cleared on a clearing agency, the
rules or procedures of the clearing agency, or, for transactions
cleared on a designated financial market utility that is neither a
derivatives clearing organization nor a clearing agency, the rules or
procedures of the designated financial market utility;
(ii) Any purchase or sale in connection with and related to the
management of a default or threatened imminent default of a customer
provided that such purchase or sale is conducted in accordance with,
for transactions cleared on a derivatives clearing organization, the
Commodity Exchange Act, CFTC regulations, and the rules or procedures
of the derivatives clearing organization, or, for transactions cleared
on a clearing agency, the rules or procedures of the clearing agency,
or, for transactions cleared on a designated financial market utility
that is neither a derivatives clearing organization nor a clearing
agency, the rules or procedures of the designated financial market
utility;
(iii) Any purchase or sale in connection with and related to the
management of a default or threatened imminent default of a member of a
clearing agency, a member of a derivatives clearing organization, or a
member of a designated financial market utility;
(iv) Any purchase or sale in connection with and related to the
management of the default or threatened default of a clearing agency, a
derivatives clearing organization, or a designated financial market
utility; and
(v) Any purchase or sale that is required by the rules or
procedures of a clearing agency, a derivatives clearing organization,
or a designated financial market utility to mitigate the risk to the
clearing agency, derivatives clearing organization, or designated
financial market utility that would result from the clearing by a
member of security-based swaps that reference the member or an
affiliate of the member.
(8) Designated financial market utility has the same meaning as in
section 803(4) of the Dodd-Frank Act (12 U.S.C. 5462(4)).
(9) Issuer has the same meaning as in section 2(a)(4) of the
Securities Act of 1933 (15 U.S.C. 77b(a)(4)).
(10) Market risk capital rule covered position and trading position
means a financial instrument that is both a covered position and a
trading position, as those terms are respectively defined:
(i) In the case of a banking entity that is a bank holding company,
savings and loan holding company, or insured depository institution,
under the market risk capital rule that is applicable to the banking
entity; and
(ii) In the case of a banking entity that is affiliated with a bank
holding company or savings and loan holding company, other than a
banking entity to which a market risk capital rule is applicable, under
the market risk capital rule that is applicable to the affiliated bank
holding company or savings and loan holding company.
(11) Market risk capital rule means the market risk capital rule
that is contained in subpart F of 12 CFR part 3, 12 CFR parts 208 and
225, or 12 CFR part 324, as applicable.
(12) Municipal security means a security that 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.
(13) Trading desk means 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.
[[Page 5783]]
Sec. ------.4 Permitted underwriting and market making-related
activities.
(a) Underwriting activities--(1) Permitted underwriting activities.
The prohibition contained in Sec. ----.3(a) does not apply to a
banking entity's underwriting activities conducted in accordance with
this paragraph (a).
(2) Requirements. The underwriting activities of a banking entity
are permitted under paragraph (a)(1) of this section only if:
(i) The banking entity is acting as an underwriter for a
distribution of securities and the trading desk's underwriting position
is related to such distribution;
(ii) The amount and type of the securities in the trading desk's
underwriting position are designed not to exceed the reasonably
expected near term demands of clients, customers, or counterparties,
and reasonable efforts are 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;
(iii) The banking entity has established and implements, maintains,
and enforces an internal compliance program required by subpart D of
this part that is reasonably designed to ensure the banking entity's
compliance with the requirements of paragraph (a) of this section,
including reasonably designed written policies and procedures, internal
controls, analysis and independent testing identifying and addressing:
(A) The products, instruments or exposures each trading desk may
purchase, sell, or manage as part of its underwriting activities;
(B) 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:
(1) Amount, types, and risk of its underwriting position;
(2) Level of exposures to relevant risk factors arising from its
underwriting position; and
(3) Period of time a security may be held;
(C) Internal controls and ongoing monitoring and analysis of each
trading desk's compliance with its limits; and
(D) 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 increase to a trading desk's limit(s), and independent
review of such demonstrable analysis and approval;
(iv) The compensation arrangements of persons performing the
activities described in this paragraph (a) are designed not to reward
or incentivize prohibited proprietary trading; and
(v) The banking entity is licensed or registered to engage in the
activity described in this paragraph (a) in accordance with applicable
law.
(3) Definition of distribution. For purposes of this paragraph (a),
a distribution of securities means:
(i) An offering of securities, whether or not subject to
registration under the Securities Act of 1933, 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 of 1933.
(4) Definition of underwriter. For purposes of this paragraph (a),
underwriter means:
(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.
(5) Definition of selling security holder. For purposes of this
paragraph (a), selling security holder means any person, other than an
issuer, on whose behalf a distribution is made.
(6) Definition of underwriting position. For purposes of this
paragraph (a), underwriting position means 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
affiliate is acting as an underwriter.
(7) Definition of client, customer, and counterparty. For purposes
of this paragraph (a), the terms client, customer, and counterparty, on
a collective or individual basis, refer to market participants that may
transact with the banking entity in connection with a particular
distribution for which the banking entity is acting as underwriter.
(b) Market making-related activities--(1) Permitted market making-
related activities. The prohibition contained in Sec. ----.3(a) does
not apply to a banking entity's market making-related activities
conducted in accordance with this paragraph (b).
(2) Requirements. The market making-related activities of a banking
entity are permitted under paragraph (b)(1) of this section only if:
(i) The trading desk that establishes and manages the 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, purchase 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;
(ii) 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, based on:
(A) The liquidity, maturity, and depth of the market for the
relevant types of financial instrument(s); and
(B) 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;
(iii) The banking entity has established and implements, maintains,
and enforces an internal compliance program required by subpart D of
this part that is reasonably designed to ensure the banking entity's
compliance with the requirements of paragraph (b) of this section,
including reasonably designed written policies and procedures, internal
controls, analysis and independent testing identifying and addressing:
(A) The financial instruments each trading desk stands ready to
purchase and sell in accordance with paragraph (b)(2)(i) of this
section;
(B) The actions the trading desk will take to demonstrably reduce
or otherwise significantly mitigate promptly the risks of its financial
exposure consistent with the limits required under paragraph
(b)(2)(iii)(C) of this section; 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
[[Page 5784]]
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;
(C) 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 paragraph (b)(2)(ii) of this section, on:
(1) The amount, types, and risks of its market-maker inventory;
(2) The amount, types, and risks of the products, instruments, and
exposures the trading desk may use for risk management purposes;
(3) The level of exposures to relevant risk factors arising from
its financial exposure; and
(4) The period of time a financial instrument may be held;
(D) Internal controls and ongoing monitoring and analysis of each
trading desk's compliance with its limits; and
(E) 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 this paragraph (b), and independent review of such
demonstrable analysis and approval;
(iv) To the extent that any limit identified pursuant to paragraph
(b)(2)(iii)(C) of this section 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;
(v) The compensation arrangements of persons performing the
activities described in this paragraph (b) are designed not to reward
or incentivize prohibited proprietary trading; and
(vi) The banking entity is licensed or registered to engage in
activity described in this paragraph (b) in accordance with applicable
law.
(3) Definition of client, customer, and counterparty. For purposes
of paragraph (b) of this section, the terms client, customer, and
counterparty, on a collective or individual basis refer to 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, provided that:
(i) A trading desk or other organizational unit of another banking
entity is not a client, customer, or counterparty of the trading desk
if that other entity has trading assets and liabilities of $50 billion
or more as measured in accordance with Sec. ----.20(d)(1) of subpart
D, unless:
(A) The trading desk documents how and why a particular trading
desk or other organizational unit of the entity should be treated as a
client, customer, or counterparty of the trading desk for purposes of
paragraph (b)(2) of this section; or
(B) The purchase or sale by the trading desk is conducted
anonymously on an exchange or similar trading facility that permits
trading on behalf of a broad range of market participants.
(4) Definition of financial exposure. For purposes of this
paragraph (b), financial exposure means 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.
(5) Definition of market-maker inventory. For the purposes of this
paragraph (b), market-maker inventory means 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.
Sec. ----.5 Permitted risk-mitigating hedging activities.
(a) Permitted risk-mitigating hedging activities. The prohibition
contained in Sec. ----.3(a) does not apply to the risk-mitigating
hedging activities of a banking entity in connection with and related
to individual or aggregated positions, contracts, or other holdings of
the banking entity and designed to reduce the specific risks to the
banking entity in connection with and related to such positions,
contracts, or other holdings.
(b) Requirements. The risk-mitigating hedging activities of a
banking entity are permitted under paragraph (a) of this section only
if:
(1) The banking entity has established and implements, maintains
and enforces an internal compliance program required by subpart D of
this part that is reasonably designed to ensure the banking entity's
compliance with the requirements of this section, including:
(i) 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 particular trading desk may use in its risk-mitigating
hedging activities, as well as position and aging limits with respect
to such positions, contracts or other holdings;
(ii) Internal controls and ongoing monitoring, management, and
authorization procedures, including relevant escalation procedures; and
(iii) The conduct of analysis, including correlation 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 risk(s) being hedged, and such correlation
analysis demonstrates that the hedging activity demonstrably reduces or
otherwise significantly mitigates the specific, identifiable risk(s)
being hedged;
(2) The risk-mitigating hedging activity:
(i) Is conducted in accordance with the written policies,
procedures, and internal controls required under this section;
(ii) At the inception of the hedging activity, including, without
limitation, any adjustments to the hedging activity, is 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 positions, contracts, or other holdings of the
banking entity, based upon the facts and circumstances of the
identified underlying and hedging positions, contracts or other
holdings and the risks and liquidity thereof;
(iii) Does not give rise, at the inception of the hedge, to any
significant new or additional risk that is not itself hedged
contemporaneously in accordance with this section;
(iv) Is subject to continuing review, monitoring and management by
the banking entity that:
(A) Is consistent with the written hedging policies and procedures
required under paragraph (b)(1) of this section;
(B) Is designed to reduce or otherwise significantly mitigate and
demonstrably reduces or otherwise significantly mitigates the specific,
identifiable risks that develop over time from the risk-mitigating
hedging activities undertaken under this section and the underlying
positions, contracts, and other holdings of the banking entity, based
upon the facts and circumstances of the
[[Page 5785]]
underlying and hedging positions, contracts and other holdings of the
banking entity and the risks and liquidity thereof; and
(C) Requires ongoing recalibration of the hedging activity by the
banking entity to ensure that the hedging activity satisfies the
requirements set out in paragraph (b)(2) of this section and is not
prohibited proprietary trading; and
(3) The compensation arrangements of persons performing risk-
mitigating hedging activities are designed not to reward or incentivize
prohibited proprietary trading.
(c) Documentation requirement--(1) A banking entity must comply
with the requirements of paragraphs (c)(2) and (3) of this section with
respect to any purchase or sale of financial instruments made in
reliance on this section for risk-mitigating hedging purposes that is:
(i) Not established 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;
(ii) Established by the specific trading desk establishing or
responsible for the underlying positions, contracts, or other holdings
the risks of which the purchases or sales are designed to reduce, but
that is effected through a financial instrument, exposure, technique,
or strategy that is not specifically identified in the trading desk's
written policies and procedures established under paragraph (b)(1) of
this section or under Sec. ----.4(b)(2)(iii)(B) of this subpart as a
product, instrument, exposure, technique, or strategy such trading desk
may use for hedging; or
(iii) Established to hedge aggregated positions across two or more
trading desks.
(2) In connection with any purchase or sale identified in paragraph
(c)(1) of this section, a banking entity must, at a minimum, and
contemporaneously with the purchase or sale, document:
(i) The specific, identifiable risk(s) of the identified positions,
contracts, or other holdings of the banking entity that the purchase or
sale is designed to reduce;
(ii) The specific risk-mitigating strategy that the purchase or
sale is designed to fulfill; and
(iii) The trading desk or other business unit that is establishing
and responsible for the hedge.
(3) A banking entity must create and retain records sufficient to
demonstrate compliance with the requirements of this paragraph (c) for
a period that is no less than five years in a form that allows the
banking entity to promptly produce such records to [Agency] on request,
or such longer period as required under other law or this part.
Sec. ----.6 Other permitted proprietary trading activities.
(a) Permitted trading in domestic government obligations. The
prohibition contained in Sec. ----.3(a) does not apply to the purchase
or sale by a banking entity of a financial instrument that is:
(1) An obligation of, or issued or guaranteed by, the United
States;
(2) An obligation, participation, or other instrument of, or issued
or guaranteed by, an agency of the United States, 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.);
(3) An obligation of any State or any political subdivision
thereof, including any municipal security; or
(4) An obligation of the FDIC, or any entity formed by or on behalf
of the FDIC for 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 or Title II of the
Dodd-Frank Wall Street Reform and Consumer Protection Act.
(b) Permitted trading in foreign government obligations--(1)
Affiliates of foreign banking entities in the United States. The
prohibition contained in Sec. ----.3(a) does not apply to the purchase
or sale of a financial instrument that is an obligation of, or issued
or guaranteed by, a foreign sovereign (including any multinational
central bank of which the foreign sovereign is a member), or any agency
or political subdivision of such foreign sovereign, by a banking
entity, so long as:
(i) The banking entity is organized under or is directly or
indirectly controlled by a banking entity that is organized under the
laws of a foreign sovereign and is not directly or indirectly
controlled by a top-tier banking entity that is organized under the
laws of the United States;
(ii) The financial instrument is an obligation of, or issued or
guaranteed by, the foreign sovereign under the laws of which the
foreign banking entity referred to in paragraph (b)(1)(i) of this
section is organized (including any multinational central bank of which
the foreign sovereign is a member), or any agency or political
subdivision of that foreign sovereign; and
(iii) The purchase or sale as principal is not made by an insured
depository institution.
(2) Foreign affiliates of a U.S. banking entity. The prohibition
contained in Sec. ----.3(a) does not apply to the purchase or sale of
a financial instrument that is an obligation of, or issued or
guaranteed by, a foreign sovereign (including any multinational central
bank of which the foreign sovereign is a member), or any agency or
political subdivision of that foreign sovereign, by a foreign entity
that is owned or controlled by a banking entity organized or
established under the laws of the United States or any State, so long
as:
(i) The foreign entity is a foreign bank, as defined in section
211.2(j) of the Board's Regulation K (12 CFR 211.2(j)), or is regulated
by the foreign sovereign as a securities dealer;
(ii) The financial instrument is an obligation of, or issued or
guaranteed by, the foreign sovereign under the laws of which the
foreign entity is organized (including any multinational central bank
of which the foreign sovereign is a member), or any agency or political
subdivision of that foreign sovereign; and
(iii) The financial instrument is owned by the foreign entity and
is not financed by an affiliate that is located in the United States or
organized under the laws of the United States or of any State.
(c) Permitted trading on behalf of customers--(1) Fiduciary
transactions. The prohibition contained in Sec. ----.3(a) does not
apply to the purchase or sale of financial instruments by a banking
entity acting as trustee or in a similar fiduciary capacity, so long
as:
(i) The transaction is conducted for the account of, or on behalf
of, a customer; and
(ii) The banking entity does not have or retain beneficial
ownership of the financial instruments.
(2) Riskless principal transactions. The prohibition contained in
Sec. ----.3(a) does not apply to the purchase or sale of financial
instruments by a banking entity acting 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 own account to offset a
contemporaneous sale to (or purchase from) the customer.
(d) Permitted trading by a regulated insurance company. The
prohibition contained in Sec. ----.3(a) does not apply to the purchase
or sale of financial instruments by a banking entity that is
[[Page 5786]]
an insurance company or an affiliate of an insurance company if:
(1) The insurance company or its affiliate purchases or sells the
financial instruments solely for:
(i) The general account of the insurance company; or
(ii) A separate account established by the insurance company;
(2) The purchase or sale is conducted in compliance with, and
subject to, the insurance company investment laws, regulations, and
written guidance of the State or jurisdiction in which such insurance
company is domiciled; and
(3) The appropriate Federal banking agencies, after consultation
with the Financial Stability Oversight Council and the relevant
insurance commissioners of the States and foreign jurisdictions, as
appropriate, have not jointly determined, after notice and comment,
that a particular law, regulation, or written guidance described in
paragraph (d)(2) of this section is insufficient to protect the safety
and soundness of the covered banking entity, or the financial stability
of the United States.
(e) Permitted trading activities of foreign banking entities. (1)
The prohibition contained in Sec. ----.3(a) does not apply to the
purchase or sale of financial instruments by a banking entity if:
(i) The banking entity is not organized or directly or indirectly
controlled by a banking entity that is organized under the laws of the
United States or of any State;
(ii) The purchase or sale by the banking entity is made pursuant to
paragraph (9) or (13) of section 4(c) of the BHC Act; and
(iii) The purchase or sale meets the requirements of paragraph
(e)(3) of this section.
(2) A purchase or sale of financial instruments by a banking entity
is made pursuant to paragraph (9) or (13) of section 4(c) of the BHC
Act for purposes of paragraph (e)(1)(ii) of this section only if:
(i) The purchase or sale is conducted in accordance with the
requirements of paragraph (e) of this section; and
(ii)(A) With respect to a banking entity that is a foreign banking
organization, the banking entity meets the qualifying foreign banking
organization requirements of section 211.23(a), (c) or (e) of the
Board's Regulation K (12 CFR 211.23(a), (c) or (e)), as applicable; or
(B) With respect to a banking entity that is not a foreign banking
organization, the banking entity is not organized under the laws of the
United States or of any State and the banking entity, on a fully-
consolidated basis, meets at least two of the following requirements:
(1) Total assets of the banking entity held outside of the United
States exceed total assets of the banking entity held in the United
States;
(2) Total revenues derived from the business of the banking entity
outside of the United States exceed total revenues derived from the
business of the banking entity in the United States; or
(3) Total net income derived from the business of the banking
entity outside of the United States exceeds total net income derived
from the business of the banking entity in the United States.
(3) A purchase or sale by a banking entity is permitted for
purposes of this paragraph (e) if:
(i) The banking entity engaging as principal in the purchase or
sale (including any personnel of the banking entity or its affiliate
that arrange, negotiate or execute such purchase or sale) is not
located in the United States or organized under the laws of the United
States or of any State;
(ii) The banking entity (including relevant personnel) that makes
the decision to purchase or sell as principal is not located in the
United States or organized under the laws of the United States or of
any State;
(iii) The purchase or sale, including any transaction arising from
risk-mitigating hedging related to the instruments purchased or sold,
is not accounted for as principal directly or on a consolidated basis
by any branch or affiliate that is located in the United States or
organized under the laws of the United States or of any State;
(iv) No financing for the banking entity's purchases or sales is
provided, directly or indirectly, by any branch or affiliate that is
located in the United States or organized under the laws of the United
States or of any State; and
(v) The purchase or sale is not conducted with or through any U.S.
entity, other than:
(A) A purchase or sale with the foreign operations of a U.S. entity
if no personnel of such U.S. entity that are located in the United
States are involved in the arrangement, negotiation, or execution of
such purchase or sale;
(B) A purchase or sale with an unaffiliated market intermediary
acting as principal, provided the purchase or sale is promptly cleared
and settled through a clearing agency or derivatives clearing
organization acting as a central counterparty; or
(C) A purchase or sale through an unaffiliated market intermediary
acting as agent, provided the purchase or sale is conducted anonymously
on an exchange or similar trading facility and is promptly cleared and
settled through a clearing agency or derivatives clearing organization
acting as a central counterparty.
(4) For purposes of this paragraph (e), a U.S. entity is any entity
that is, or is controlled by, or is acting on behalf of, or at the
direction of, any other entity that is, located in the United States or
organized under the laws of the United States or of any State.
(5) For purposes of this paragraph (e), a U.S. branch, agency, or
subsidiary of a foreign banking entity is considered to be located in
the United States; however, the foreign bank that operates or controls
that branch, agency, or subsidiary is not considered to be located in
the United States solely by virtue of operating or controlling the U.S.
branch, agency, or subsidiary.
(6) For purposes of this paragraph (e), unaffiliated market
intermediary means an unaffiliated entity, acting as an intermediary,
that is:
(i) A broker or dealer registered with the SEC under section 15 of
the Exchange Act or exempt from registration or excluded from
regulation as such;
(ii) A swap dealer registered with the CFTC under section 4s of the
Commodity Exchange Act or exempt from registration or excluded from
regulation as such;
(iii) A security-based swap dealer registered with the SEC under
section 15F of the Exchange Act or exempt from registration or excluded
from regulation as such; or
(iv) A futures commission merchant registered with the CFTC under
section 4f of the Commodity Exchange Act or exempt from registration or
excluded from regulation as such.
Sec. ----.7 Limitations on permitted proprietary trading activities.
(a) No transaction, class of transactions, or activity may be
deemed permissible under Sec. Sec. ----.4 through ----.6 if the
transaction, class of transactions, or activity would:
(1) Involve or result in a material conflict of interest between
the banking entity and its clients, customers, or counterparties;
(2) Result, directly or indirectly, in a material exposure by the
banking entity to a high-risk asset or a high-risk trading strategy; or
(3) Pose a threat to the safety and soundness of the banking entity
or to the financial stability of the United States.
(b) Definition of material conflict of interest. (1) For purposes
of this section,
[[Page 5787]]
a material conflict of interest between a banking entity and its
clients, customers, or counterparties exists if the banking entity
engages in any transaction, class of transactions, or activity that
would involve or result in the banking entity's interests being
materially adverse to the interests of its client, customer, or
counterparty with respect to such transaction, class of transactions,
or activity, and the banking entity has not taken at least one of the
actions in paragraph (b)(2) of this section.
(2) Prior to effecting the specific transaction or class or type of
transactions, or engaging in the specific activity, the banking entity:
(i) Timely and effective disclosure. (A) Has made clear, timely,
and effective disclosure of the conflict of interest, together with
other necessary information, in reasonable detail and in a manner
sufficient to permit a reasonable client, customer, or counterparty to
meaningfully understand the conflict of interest; and
(B) Such disclosure is made in a manner that provides the client,
customer, or counterparty the opportunity to negate, or substantially
mitigate, any materially adverse effect on the client, customer, or
counterparty created by the conflict of interest; or
(ii) Information barriers. Has established, maintained, and
enforced information barriers that are memorialized in written policies
and procedures, such as physical separation of personnel, or functions,
or limitations on types of activity, that are reasonably designed,
taking into consideration the nature of the banking entity's business,
to prevent the conflict of interest from involving or resulting in a
materially adverse effect on a client, customer, or counterparty. A
banking entity may not rely on such information barriers if, in the
case of any specific transaction, class or type of transactions or
activity, the banking entity knows or should reasonably know that,
notwithstanding the banking entity's establishment of information
barriers, the conflict of interest may involve or result in a
materially adverse effect on a client, customer, or counterparty.
(c) Definition of high-risk asset and high-risk trading strategy.
For purposes of this section:
(1) High-risk asset means an asset or group of related assets that
would, if held by a banking entity, significantly increase the
likelihood that the banking entity would incur a substantial financial
loss or would pose a threat to the financial stability of the United
States.
(2) High-risk trading strategy means a trading strategy that would,
if engaged in by a banking entity, significantly increase the
likelihood that the banking entity would incur a substantial financial
loss or would pose a threat to the financial stability of the United
States.
Sec. ----.8 [Reserved]
Sec. ----.9 [Reserved]
Subpart C--Covered Funds Activities and Investments
Sec. ----.10 Prohibition on acquiring or retaining an ownership
interest in and having certain relationships with a covered fund.
(a) Prohibition. (1) Except as otherwise provided in this subpart,
a banking entity may not, as principal, directly or indirectly, acquire
or retain any ownership interest in or sponsor a covered fund.
(2) Paragraph (a)(1) of this section does not include acquiring or
retaining an ownership interest in a covered fund by a banking entity:
(i) Acting solely as agent, broker, or custodian, so long as;
(A) The activity is conducted for the account of, or on behalf of,
a customer; and
(B) The banking entity and its affiliates do not have or retain
beneficial ownership of such ownership interest;
(ii) Through a deferred compensation, stock-bonus, profit-sharing,
or pension plan of the banking entity (or an affiliate thereof) that is
established and administered in accordance with the law of the United
States or a foreign sovereign, if the ownership interest is held or
controlled directly or indirectly by the banking entity as trustee for
the benefit of persons who are or were employees of the banking entity
(or an affiliate thereof);
(iii) In the ordinary course of collecting a debt previously
contracted in good faith, provided that the banking entity divests the
ownership interest as soon as practicable, and in no event may the
banking entity retain such ownership interest for longer than such
period permitted by the [Agency]; or
(iv) On behalf of customers as trustee or in a similar fiduciary
capacity for a customer that is not a covered fund, so long as:
(A) The activity is conducted for the account of, or on behalf of,
the customer; and
(B) The banking entity and its affiliates do not have or retain
beneficial ownership of such ownership interest.
(b) Definition of covered fund. (1) Except as provided in paragraph
(c) of this section, covered fund means:
(i) An issuer that would be an investment company, as defined in
the Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.), but for
section 3(c)(1) or 3(c)(7) of that Act (15 U.S.C. 80a-3(c)(1) or (7));
(ii) Any commodity pool under section 1a(10) of the Commodity
Exchange Act (7 U.S.C. 1a(10)) for which:
(A) The commodity pool operator has claimed an exemption under 17
CFR 4.7; or
(B)(1) A commodity pool operator is registered with the CFTC as a
commodity pool operator in connection with the operation of the
commodity pool;
(2) Substantially all participation units of the commodity pool are
owned by qualified eligible persons under 17 CFR 4.7(a)(2) and (3); and
(3) Participation units of the commodity pool have not been
publicly offered to persons who are not qualified eligible persons
under 17 CFR 4.7(a)(2) and (3); or
(iii) For any banking entity that is, or is controlled directly or
indirectly by a banking entity that is, located in or organized under
the laws of the United States or of any State, an entity that:
(A) Is organized or established outside the United States and the
ownership interests of which are offered and sold solely outside the
United States;
(B) Is, or holds itself out as being, an entity or arrangement that
raises money from investors primarily for the purpose of investing in
securities for resale or other disposition or otherwise trading in
securities; and
(C)(1) Has as its sponsor that banking entity (or an affiliate
thereof); or
(2) Has issued an ownership interest that is owned directly or
indirectly by that banking entity (or an affiliate thereof).
(2) An issuer shall not be deemed to be a covered fund under
paragraph (b)(1)(iii) of this section if, were the issuer subject to
U.S. securities laws, the issuer could rely on an exclusion or
exemption from the definition of ``investment company'' under the
Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.) other than the
exclusions contained in section 3(c)(1) and 3(c)(7) of that Act.
(3) For purposes of paragraph (b)(1)(iii) of this section, a U.S.
branch, agency, or subsidiary of a foreign banking entity is located in
the United States; however, the foreign bank that operates or controls
that branch, agency, or subsidiary is not considered to be located in
the United States solely by virtue of operating or controlling the U.S.
branch, agency, or subsidiary.
[[Page 5788]]
(c) Notwithstanding paragraph (b) of this section, unless the
appropriate Federal banking agencies, the SEC, and the CFTC jointly
determine otherwise, a covered fund does not include:
(1) Foreign public funds. (i) Subject to paragraphs (ii) and (iii)
below, an issuer that:
(A) Is organized or established outside of the United States;
(B) Is authorized to offer and sell ownership interests to retail
investors in the issuer's home jurisdiction; and
(C) Sells ownership interests predominantly through one or more
public offerings outside of the United States.
(ii) With respect to a banking entity that is, or is controlled
directly or indirectly by a banking entity that is, located in or
organized under the laws of the United States or of any State and any
issuer for which such banking entity acts as sponsor, the sponsoring
banking entity may not rely on the exemption in paragraph (c)(1)(i) of
this section for such issuer unless ownership interests in the issuer
are sold predominantly to persons other than:
(A) Such sponsoring banking entity;
(B) Such issuer;
(C) Affiliates of such sponsoring banking entity or such issuer;
and
(D) Directors and employees of such entities.
(iii) For purposes of paragraph (c)(1)(i)(C) of this section, the
term ``public offering'' means a distribution (as defined in Sec. --
--.4(a)(3) of subpart B) of securities in any jurisdiction outside the
United States to investors, including retail investors, provided that:
(A) The distribution complies with all applicable requirements in
the jurisdiction in which such distribution is being made;
(B) The distribution does not restrict availability to investors
having a minimum level of net worth or net investment assets; and
(C) The issuer has filed or submitted, with the appropriate
regulatory authority in such jurisdiction, offering disclosure
documents that are publicly available.
(2) Wholly-owned subsidiaries. An entity, all of the outstanding
ownership interests of which are owned directly or indirectly by the
banking entity (or an affiliate thereof), except that:
(i) Up to five percent of the entity's outstanding ownership
interests, less any amounts outstanding under paragraph (c)(2)(ii) of
this section, may be held by employees or directors of the banking
entity or such affiliate (including former employees or directors if
their ownership interest was acquired while employed by or in the
service of the banking entity); and
(ii) Up to 0.5 percent of the entity's outstanding ownership
interests may be held by a third party if the ownership interest is
acquired or retained by the third party for the purpose of establishing
corporate separateness or addressing bankruptcy, insolvency, or similar
concerns.
(3) Joint ventures. A joint venture between a banking entity or any
of its affiliates and one or more unaffiliated persons, provided that
the joint venture:
(i) Is comprised of no more than 10 unaffiliated co-venturers;
(ii) Is in the business of engaging in activities that are
permissible for the banking entity or affiliate, other than investing
in securities for resale or other disposition; and
(iii) Is not, and does not hold itself out as being, an entity or
arrangement that raises money from investors primarily for the purpose
of investing in securities for resale or other disposition or otherwise
trading in securities.
(4) Acquisition vehicles. An issuer:
(i) Formed solely for the purpose of engaging in a bona fide merger
or acquisition transaction; and
(ii) That exists only for such period as necessary to effectuate
the transaction.
(5) Foreign pension or retirement funds. A plan, fund, or program
providing pension, retirement, or similar benefits that is:
(i) Organized and administered outside the United States;
(ii) A broad-based plan for employees or citizens that is subject
to regulation as a pension, retirement, or similar plan under the laws
of the jurisdiction in which the plan, fund, or program is organized
and administered; and
(iii) Established for the benefit of citizens or residents of one
or more foreign sovereigns or any political subdivision thereof.
(6) Insurance company separate accounts. A separate account,
provided that no banking entity other than the insurance company
participates in the account's profits and losses.
(7) Bank owned life insurance. A separate account that is used
solely for the purpose of allowing one or more banking entities to
purchase a life insurance policy for which the banking entity or
entities is beneficiary, provided that no banking entity that purchases
the policy:
(i) Controls the investment decisions regarding the underlying
assets or holdings of the separate account; or
(ii) Participates in the profits and losses of the separate account
other than in compliance with applicable supervisory guidance regarding
bank owned life insurance.
(8) Loan securitizations. (i) Scope. An issuing entity for asset-
backed securities that satisfies all the conditions of this paragraph
(c)(8) and the assets or holdings of which are comprised solely of:
(A) Loans as defined in Sec. ----.2(s) of subpart A;
(B) Rights or other assets designed to assure the servicing or
timely distribution of proceeds to holders of such securities and
rights or other assets that are related or incidental to purchasing or
otherwise acquiring and holding the loans, provided that each asset
meets the requirements of paragraph (c)(8)(iii) of this section;
(C) Interest rate or foreign exchange derivatives that meet the
requirements of paragraph (c)(8)(iv) of this section; and
(D) Special units of beneficial interest and collateral
certificates that meet the requirements of paragraph (c)(8)(v) of this
section.
(ii) Impermissible assets. For purposes of this paragraph (c)(8),
the assets or holdings of the issuing entity shall not include any of
the following:
(A) A security, including an asset-backed security, or an interest
in an equity or debt security other than as permitted in paragraph
(c)(8)(iii) of this section;
(B) A derivative, other than a derivative that meets the
requirements of paragraph (c)(8)(iv) of this section; or
(C) A commodity forward contract.
(iii) Permitted securities. Notwithstanding paragraph (c)(8)(ii)(A)
of this section, the issuing entity may hold securities if those
securities are:
(A) Cash equivalents for purposes of the rights and assets in
paragraph (c)(8)(i)(B) of this section; or
(B) Securities received in lieu of debts previously contracted with
respect to the loans supporting the asset-backed securities.
(iv) Derivatives. The holdings of derivatives by the issuing entity
shall be limited to interest rate or foreign exchange derivatives that
satisfy all of the following conditions:
(A) The written terms of the derivative directly relate to the
loans, the asset-backed securities, or the contractual rights of other
assets described in paragraph (c)(8)(i)(B) of this section; and
(B) The derivatives reduce the interest rate and/or foreign
exchange risks related to the loans, the asset-backed securities, or
the contractual rights or other assets described in paragraph
(c)(8)(i)(B) of this section.
(v) Special units of beneficial interest and collateral
certificates. The assets or holdings of the issuing entity may
[[Page 5789]]
include collateral certificates and special units of beneficial
interest issued by a special purpose vehicle, provided that:
(A) The special purpose vehicle that issues the special unit of
beneficial interest or collateral certificate meets the requirements in
this paragraph (c)(8);
(B) The special unit of beneficial interest or collateral
certificate is used for the sole purpose of transferring to the issuing
entity for the loan securitization the economic risks and benefits of
the assets that are permissible for loan securitizations under this
paragraph (c)(8) and does not directly or indirectly transfer any
interest in any other economic or financial exposure;
(C) The special unit of beneficial interest or collateral
certificate is created solely to satisfy legal requirements or
otherwise facilitate the structuring of the loan securitization; and
(D) The special purpose vehicle that issues the special unit of
beneficial interest or collateral certificate and the issuing entity
are established under the direction of the same entity that initiated
the loan securitization.
(9) Qualifying asset-backed commercial paper conduits. (i) An
issuing entity for asset-backed commercial paper that satisfies all of
the following requirements:
(A) The asset-backed commercial paper conduit holds only:
(1) Loans and other assets permissible for a loan securitization
under paragraph (c)(8)(i) of this section; and
(2) Asset-backed securities supported solely by assets that are
permissible for loan securitizations under paragraph (c)(8)(i) of this
section and acquired by the asset-backed commercial paper conduit as
part of an initial issuance either directly from the issuing entity of
the asset-backed securities or directly from an underwriter in the
distribution of the asset-backed securities;
(B) The asset-backed commercial paper conduit issues only asset-
backed securities, comprised of a residual interest and securities with
a legal maturity of 397 days or less; and
(C) A regulated liquidity provider has entered into a legally
binding commitment to provide full and unconditional liquidity coverage
with respect to all of the outstanding asset-backed securities issued
by the asset-backed commercial paper conduit (other than any residual
interest) in the event that funds are required to redeem maturing
asset-backed securities.
(ii) For purposes of this paragraph (c)(9), a regulated liquidity
provider means:
(A) A depository institution, as defined in section 3(c) of the
Federal Deposit Insurance Act (12 U.S.C. 1813(c));
(B) A bank holding company, as defined in section 2(a) of the Bank
Holding Company Act of 1956 (12 U.S.C. 1841(a)), or a subsidiary
thereof;
(C) A savings and loan holding company, as defined in section 10a
of the Home Owners' Loan Act (12 U.S.C. 1467a), provided all or
substantially all of the holding company's activities are permissible
for a financial holding company under section 4(k) of the Bank Holding
Company Act of 1956 (12 U.S.C. 1843(k)), or a subsidiary thereof;
(D) A foreign bank whose home country supervisor, as defined in
Sec. 211.21(q) of the Board's Regulation K (12 CFR 211.21(q)), has
adopted capital standards consistent with the Capital Accord for the
Basel Committee on banking Supervision, as amended, and that is subject
to such standards, or a subsidiary thereof; or
(E) The United States or a foreign sovereign.
(10) Qualifying covered bonds--(i) Scope. An entity owning or
holding a dynamic or fixed pool of loans or other assets as provided in
paragraph (c)(8) of this section for the benefit of the holders of
covered bonds, provided that the assets in the pool are comprised
solely of assets that meet the conditions in paragraph (c)(8)(i) of
this section.
(ii) Covered bond. For purposes of this paragraph (c)(10), a
covered bond means:
(A) A debt obligation issued by an entity that meets the definition
of foreign banking organization, the payment obligations of which are
fully and unconditionally guaranteed by an entity that meets the
conditions set forth in paragraph (c)(10)(i) of this section; or
(B) A debt obligation of an entity that meets the conditions set
forth in paragraph (c)(10)(i) of this section, provided that the
payment obligations are fully and unconditionally guaranteed by an
entity that meets the definition of foreign banking organization and
the entity is a wholly-owned subsidiary, as defined in paragraph (c)(2)
of this section, of such foreign banking organization.
(11) SBICs and public welfare investment funds. An issuer:
(i) That is a small business investment company, as defined in
section 103(3) of the Small Business Investment Act of 1958 (15 U.S.C.
662), or that has received from the Small Business Administration
notice to proceed to qualify for a license as a small business
investment company, which notice or license has not been revoked; or
(ii) The business of which is to make investments that are:
(A) Designed primarily to promote the public welfare, of the type
permitted under paragraph (11) of section 5136 of the Revised Statutes
of the United States (12 U.S.C. 24), including the welfare of low- and
moderate-income communities or families (such as providing housing,
services, or jobs); or
(B) Qualified rehabilitation expenditures with respect to a
qualified rehabilitated building or certified historic structure, as
such terms are defined in section 47 of the Internal Revenue Code of
1986 or a similar State historic tax credit program.
(12) Registered investment companies and excluded entities. An
issuer:
(i) That is registered as an investment company under section 8 of
the Investment Company Act of 1940 (15 U.S.C. 80a-8), or that is formed
and operated pursuant to a written plan to become a registered
investment company as described in Sec. ----.20(e)(3) of subpart D and
that complies with the requirements of section 18 of the Investment
Company Act of 1940 (15 U.S.C. 80a-18);
(ii) That may rely on an exclusion or exemption from the definition
of ``investment company'' under the Investment Company Act of 1940 (15
U.S.C. 80a-1 et seq.) other than the exclusions contained in section
3(c)(1) and 3(c)(7) of that Act; or
(iii) That has elected to be regulated as a business development
company pursuant to section 54(a) of that Act (15 U.S.C. 80a-53) and
has not withdrawn its election, or that is formed and operated pursuant
to a written plan to become a business development company as described
in Sec. ----.20(e)(3) of subpart D and that complies with the
requirements of section 61 of the Investment Company Act of 1940 (15
U.S.C. 80a-60).
(13) Issuers in conjunction with the FDIC's receivership or
conservatorship operations. An issuer that is an entity formed by or on
behalf of the FDIC for the purpose of facilitating the disposal of
assets acquired in the FDIC's capacity as conservator or receiver under
the Federal Deposit Insurance Act or Title II of the Dodd-Frank Wall
Street Reform and Consumer Protection Act.
(14) Other excluded issuers. (i) Any issuer that the appropriate
Federal banking agencies, the SEC, and the CFTC jointly determine the
exclusion of which is consistent with the purposes of section 13 of the
BHC Act.
[[Page 5790]]
(ii) A determination made under paragraph (c)(14)(i) of this
section will be promptly made public.
(d) Definition of other terms related to covered funds. For
purposes of this subpart:
(1) Applicable accounting standards means U.S. generally accepted
accounting principles, or such other accounting standards applicable to
a banking entity that the [Agency] determines are appropriate and that
the banking entity uses in the ordinary course of its business in
preparing its consolidated financial statements.
(2) Asset-backed security has the meaning specified in Section
3(a)(79) of the Exchange Act (15 U.S.C. 78c(a)(79).
(3) Director has the same meaning as provided in section
215.2(d)(1) of the Board's Regulation O (12 CFR 215.2(d)(1)).
(4) Issuer has the same meaning as in section 2(a)(22) of the
Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(22)).
(5) Issuing entity means with respect to asset-backed securities
the special purpose vehicle that owns or holds the pool assets
underlying asset-backed securities and in whose name the asset-backed
securities supported or serviced by the pool assets are issued.
(6) Ownership interest--(i) Ownership interest means any equity,
partnership, or other similar interest. An ``other similar interest''
means an interest that:
(A) Has the right to participate in the selection or removal of a
general partner, managing member, member of the board of directors or
trustees, investment manager, investment adviser, or commodity trading
advisor of the covered fund (excluding the rights of a creditor to
exercise remedies upon the occurrence of an event of default or an
acceleration event);
(B) Has the right under the terms of the interest to receive a
share of the income, gains or profits of the covered fund;
(C) Has the right to receive the underlying assets of the covered
fund after all other interests have been redeemed and/or paid in full
(excluding the rights of a creditor to exercise remedies upon the
occurrence of an event of default or an acceleration event);
(D) Has the right to receive all or a portion of excess spread (the
positive difference, if any, between the aggregate interest payments
received from the underlying assets of the covered fund and the
aggregate interest paid to the holders of other outstanding interests);
(E) Provides under the terms of the interest that the amounts
payable by the covered fund with respect to the interest could be
reduced based on losses arising from the underlying assets of the
covered fund, such as allocation of losses, write-downs or charge-offs
of the outstanding principal balance, or reductions in the amount of
interest due and payable on the interest;
(F) Receives income on a pass-through basis from the covered fund,
or has a rate of return that is determined by reference to the
performance of the underlying assets of the covered fund; or
(G) Any synthetic right to have, receive, or be allocated any of
the rights in paragraphs (d)(6)(i)(A) through (F) of this section.
(ii) Ownership interest does not include: Restricted profit
interest. An interest held by an entity (or an employee or former
employee thereof) in a covered fund for which the entity (or employee
thereof) serves as investment manager, investment adviser, commodity
trading advisor, or other service provider so long as:
(A) The sole purpose and effect of the interest is to allow the
entity (or employee or former employee thereof) to share in the profits
of the covered fund as performance compensation for the investment
management, investment advisory, commodity trading advisory, or other
services provided to the covered fund by the entity (or employee or
former employee thereof), provided that the entity (or employee or
former employee thereof) may be obligated under the terms of such
interest to return profits previously received;
(B) All such profit, once allocated, is distributed to the entity
(or employee or former employee thereof) promptly after being earned
or, if not so distributed, is retained by the covered fund for the sole
purpose of establishing a reserve amount to satisfy contractual
obligations with respect to subsequent losses of the covered fund and
such undistributed profit of the entity (or employee or former employee
thereof) does not share in the subsequent investment gains of the
covered fund;
(C) Any amounts invested in the covered fund, including any amounts
paid by the entity (or employee or former employee thereof) in
connection with obtaining the restricted profit interest, are within
the limits of Sec. ----.12 of this subpart; and
(D) The interest is not transferable by the entity (or employee or
former employee thereof) except to an affiliate thereof (or an employee
of the banking entity or affiliate), to immediate family members, or
through the intestacy, of the employee or former employee, or in
connection with a sale of the business that gave rise to the restricted
profit interest by the entity (or employee or former employee thereof)
to an unaffiliated party that provides investment management,
investment advisory, commodity trading advisory, or other services to
the fund.
(7) Prime brokerage transaction means any transaction that would be
a covered transaction, as defined in section 23A(b)(7) of the Federal
Reserve Act (12 U.S.C. 371c(b)(7)), that is provided in connection with
custody, clearance and settlement, securities borrowing or lending
services, trade execution, financing, or data, operational, and
administrative support.
(8) Resident of the United States means a person that is a ``U.S.
person'' as defined in rule 902(k) of the SEC's Regulation S (17 CFR
230.902(k)).
(9) Sponsor means, with respect to a covered fund:
(i) To serve as a general partner, managing member, or trustee of a
covered fund, or to serve as a commodity pool operator with respect to
a covered fund as defined in (b)(1)(ii) of this section;
(ii) In any manner to select or to control (or to have employees,
officers, or directors, or agents who constitute) a majority of the
directors, trustees, or management of a covered fund; or
(iii) To share with a covered fund, for corporate, marketing,
promotional, or other purposes, the same name or a variation of the
same name.
(10) Trustee. (i) For purposes of paragraph (d)(9) of this section
and Sec. ----.11 of subpart C, a trustee does not include:
(A) A trustee that does not exercise investment discretion with
respect to a covered fund, including a trustee that is subject to the
direction of an unaffiliated named fiduciary who is not a trustee
pursuant to section 403(a)(1) of the Employee's Retirement Income
Security Act (29 U.S.C. 1103(a)(1)); or
(B) A trustee that is subject to fiduciary standards imposed under
foreign law that are substantially equivalent to those described in
paragraph (d)(10)(i)(A) of this section;
(ii) Any entity that directs a person described in paragraph
(d)(10)(i) of this section, or that possesses authority and discretion
to manage and control the investment decisions of a covered fund for
which such person serves as trustee, shall be considered to be a
trustee of such covered fund.
Sec. ----.11 Permitted organizing and offering, underwriting, and
market making with respect to a covered fund.
(a) Organizing and offering a covered fund in general.
Notwithstanding Sec. ----.10(a) of this subpart, a banking entity
[[Page 5791]]
is not prohibited from acquiring or retaining an ownership interest in,
or acting as sponsor to, a covered fund in connection with, directly or
indirectly, organizing and offering a covered fund, including serving
as a general partner, managing member, trustee, or commodity pool
operator of the covered fund and in any manner selecting or controlling
(or having employees, officers, directors, or agents who constitute) a
majority of the directors, trustees, or management of the covered fund,
including any necessary expenses for the foregoing, only if:
(1) The banking entity (or an affiliate thereof) provides bona fide
trust, fiduciary, investment advisory, or commodity trading advisory
services;
(2) The covered fund is organized and offered only in connection
with the provision of bona fide trust, fiduciary, investment advisory,
or commodity trading advisory services and only to persons that are
customers of such services of the banking entity (or an affiliate
thereof), pursuant to a written plan or similar documentation outlining
how the banking entity or such affiliate intends to provide advisory or
similar services to its customers through organizing and offering such
fund;
(3) The banking entity and its affiliates do not acquire or retain
an ownership interest in the covered fund except as permitted under
Sec. ----.12 of this subpart;
(4) The banking entity and its affiliates comply with the
requirements of Sec. ----.14 of this subpart;
(5) The banking entity and its affiliates do not, directly or
indirectly, guarantee, assume, or otherwise insure the obligations or
performance of the covered fund or of any covered fund in which such
covered fund invests;
(6) The covered fund, for corporate, marketing, promotional, or
other purposes:
(i) Does not share the same name or a variation of the same name
with the banking entity (or an affiliate thereof); and
(ii) Does not use the word ``bank'' in its name;
(7) No director or employee of the banking entity (or an affiliate
thereof) takes or retains an ownership interest in the covered fund,
except for any director or employee of the banking entity or such
affiliate who is directly engaged in providing investment advisory,
commodity trading advisory, or other services to the covered fund at
the time the director or employee takes the ownership interest; and
(8) The banking entity:
(i) Clearly and conspicuously discloses, in writing, to any
prospective and actual investor in the covered fund (such as through
disclosure in the covered fund's offering documents):
(A) That ``any losses in [such covered fund] will be borne solely
by investors in [the covered fund] and not by [the banking entity] or
its affiliates; therefore, [the banking entity's] losses in [such
covered fund] will be limited to losses attributable to the ownership
interests in the covered fund held by [the banking entity] and any
affiliate in its capacity as investor in the [covered fund] or as
beneficiary of a restricted profit interest held by [the banking
entity] or any affiliate'';
(B) That such investor should read the fund offering documents
before investing in the covered fund;
(C) That the ``ownership interests in the covered fund are not
insured by the FDIC, and are not deposits, obligations of, or endorsed
or guaranteed in any way, by any banking entity'' (unless that happens
to be the case); and
(D) The role of the banking entity and its affiliates and employees
in sponsoring or providing any services to the covered fund; and
(ii) Complies with any additional rules of the appropriate Federal
banking agencies, the SEC, or the CFTC, as provided in section 13(b)(2)
of the BHC Act, designed to ensure that losses in such covered fund are
borne solely by investors in the covered fund and not by the covered
banking entity and its affiliates.
(b) Organizing and offering an issuing entity of asset-backed
securities. (1) Notwithstanding Sec. ----.10(a) of this subpart, a
banking entity is not prohibited from acquiring or retaining an
ownership interest in, or acting as sponsor to, a covered fund that is
an issuing entity of asset-backed securities in connection with,
directly or indirectly, organizing and offering that issuing entity, so
long as the banking entity and its affiliates comply with all of the
requirements of paragraph (a)(3) through (8) of this section.
(2) For purposes of this paragraph (b), organizing and offering a
covered fund that is an issuing entity of asset-backed securities means
acting as the securitizer, as that term is used in section 15G(a)(3) of
the Exchange Act (15 U.S.C. 78o-11(a)(3)) of the issuing entity, or
acquiring or retaining an ownership interest in the issuing entity as
required by section 15G of that Act (15 U.S.C.78o-11) and the
implementing regulations issued thereunder.
(c) Underwriting and market making in ownership interests of a
covered fund. The prohibition contained in Sec. ----.10(a) of this
subpart does not apply to a banking entity's underwriting activities or
market making-related activities involving a covered fund so long as:
(1) Those activities are conducted in accordance with the
requirements of Sec. ----.4(a) or Sec. ----.4(b) of subpart B,
respectively;
(2) With respect to any banking entity (or any affiliate thereof)
that: Acts as a sponsor, investment adviser or commodity trading
advisor to a particular covered fund or otherwise acquires and retains
an ownership interest in such covered fund in reliance on paragraph (a)
of this section; acquires and retains an ownership interest in such
covered fund and is either a securitizer, as that term is used in
section 15G(a)(3) of the Exchange Act (15 U.S.C. 78o-11(a)(3)), or is
acquiring and retaining an ownership interest in such covered fund in
compliance with section 15G of that Act (15 U.S.C.78o-11) and the
implementing regulations issued thereunder each as permitted by
paragraph (b) of this section; or, directly or indirectly, guarantees,
assumes, or otherwise insures the obligations or performance of the
covered fund or of any covered fund in which such fund invests, then in
each such case any ownership interests acquired or retained by the
banking entity and its affiliates in connection with underwriting and
market making related activities for that particular covered fund are
included in the calculation of ownership interests permitted to be held
by the banking entity and its affiliates under the limitations of Sec.
----.12(a)(2)(ii) and Sec. ----.12(d) of this subpart; and
(3) With respect to any banking entity, the aggregate value of all
ownership interests of the banking entity and its affiliates in all
covered funds acquired and retained under Sec. ----.11 of this
subpart, including all covered funds in which the banking entity holds
an ownership interest in connection with underwriting and market making
related activities permitted under this paragraph (c), are included in
the calculation of all ownership interests under Sec. --
--.12(a)(2)(iii) and Sec. ----.12(d) of this subpart.
Sec. ----.12 Permitted investment in a covered fund.
(a) Authority and limitations on permitted investments in covered
funds. (1) Notwithstanding the prohibition contained in Sec. --
--.10(a) of this subpart, a banking entity may acquire and retain an
ownership interest in a covered fund that the banking entity or an
affiliate thereof organizes and offers pursuant to Sec. ----.11, for
the purposes of:
[[Page 5792]]
(i) Establishment. Establishing the fund and providing the fund
with sufficient initial equity for investment to permit the fund to
attract unaffiliated investors, subject to the limits contained in
paragraphs (a)(2)(i) and (iii) of this section; or
(ii) De minimis investment. Making and retaining an investment in
the covered fund subject to the limits contained in paragraphs
(a)(2)(ii) and (iii) of this section.
(2) Investment limits--(i) Seeding period. With respect to an
investment in any covered fund made or held pursuant to paragraph
(a)(1)(i) of this section, the banking entity and its affiliates:
(A) Must actively seek unaffiliated investors to reduce, through
redemption, sale, dilution, or other methods, the aggregate amount of
all ownership interests of the banking entity in the covered fund to
the amount permitted in paragraph (a)(2)(i)(B) of this section; and
(B) Must, no later than 1 year after the date of establishment of
the fund (or such longer period as may be provided by the Board
pursuant to paragraph (e) of this section), conform its ownership
interest in the covered fund to the limits in paragraph (a)(2)(ii) of
this section;
(ii) Per-fund limits. (A) Except as provided in paragraph
(a)(2)(ii)(B) of this section, an investment by a banking entity and
its affiliates in any covered fund made or held pursuant to paragraph
(a)(1)(ii) of this section may not exceed 3 percent of the total number
or value of the outstanding ownership interests of the fund.
(B) An investment by a banking entity and its affiliates in a
covered fund that is an issuing entity of asset-backed securities may
not exceed 3 percent of the total fair market value of the ownership
interests of the fund measured in accordance with paragraph (b)(3) of
this section, unless a greater percentage is retained by the banking
entity and its affiliates in compliance with the requirements of
section 15G of the Exchange Act (15 U.S.C. 78o-11) and the implementing
regulations issued thereunder, in which case the investment by the
banking entity and its affiliates in the covered fund may not exceed
the amount, number, or value of ownership interests of the fund
required under section 15G of the Exchange Act and the implementing
regulations issued thereunder.
(iii) Aggregate limit. The aggregate value of all ownership
interests of the banking entity and its affiliates in all covered funds
acquired or retained under this section may not exceed 3 percent of the
tier 1 capital of the banking entity, as provided under paragraph (c)
of this section, and shall be calculated as of the last day of each
calendar quarter.
(iv) Date of establishment. For purposes of this section, the date
of establishment of a covered fund shall be:
(A) In general. The date on which the investment adviser or similar
entity to the covered fund begins making investments pursuant to the
written investment strategy for the fund;
(B) Issuing entities of asset-backed securities. In the case of an
issuing entity of asset-backed securities, the date on which the assets
are initially transferred into the issuing entity of asset-backed
securities.
(b) Rules of construction--(1) Attribution of ownership interests
to a covered banking entity. (i) For purposes of paragraph (a)(2) of
this section, the amount and value of a banking entity's permitted
investment in any single covered fund shall include any ownership
interest held under Sec. ------.12 directly by the banking entity,
including any affiliate of the banking entity.
(ii) Treatment of registered investment companies, SEC-regulated
business development companies and foreign public funds. For purposes
of paragraph (b)(1)(i) of this section, a registered investment
company, SEC-regulated business development companies or foreign public
fund as described in Sec. ------.10(c)(1) of this subpart will not be
considered to be an affiliate of the banking entity so long as the
banking entity:
(A) Does not own, control, or hold with the power to vote 25
percent or more of the voting shares of the company or fund; and
(B) Provides investment advisory, commodity trading advisory,
administrative, and other services to the company or fund in compliance
with the limitations under applicable regulation, order, or other
authority.
(iii) Covered funds. For purposes of paragraph (b)(1)(i) of this
section, a covered fund will not be considered to be an affiliate of a
banking entity so long as the covered fund is held in compliance with
the requirements of this subpart.
(iv) Treatment of employee and director investments financed by the
banking entity. For purposes of paragraph (b)(1)(i) of this section, an
investment by a director or employee of a banking entity who acquires
an ownership interest in his or her personal capacity in a covered fund
sponsored by the banking entity will be attributed to the banking
entity if the banking entity, directly or indirectly, extends financing
for the purpose of enabling the director or employee to acquire the
ownership interest in the fund and the financing is used to acquire
such ownership interest in the covered fund.
(2) Calculation of permitted ownership interests in a single
covered fund. Except as provided in paragraph (b)(3) or (4), for
purposes of determining whether an investment in a single covered fund
complies with the restrictions on ownership interests under paragraphs
(a)(2)(i)(B) and (a)(2)(ii)(A) of this section:
(i) The aggregate number of the outstanding ownership interests
held by the banking entity shall be the total number of ownership
interests held under this section by the banking entity in a covered
fund divided by the total number of ownership interests held by all
entities in that covered fund, as of the last day of each calendar
quarter (both measured without regard to committed funds not yet called
for investment);
(ii) The aggregate value of the outstanding ownership interests
held by the banking entity shall be the aggregate fair market value of
all investments in and capital contributions made to the covered fund
by the banking entity, divided by the value of all investments in and
capital contributions made to that covered fund by all entities, as of
the last day of each calendar quarter (all measured without regard to
committed funds not yet called for investment). If fair market value
cannot be determined, then the value shall be the historical cost basis
of all investments in and contributions made by the banking entity to
the covered fund;
(iii) For purposes of the calculation under paragraph (b)(2)(ii) of
this section, once a valuation methodology is chosen, the banking
entity must calculate the value of its investment and the investments
of all others in the covered fund in the same manner and according to
the same standards.
(3) Issuing entities of asset-backed securities. In the case of an
ownership interest in an issuing entity of asset-backed securities, for
purposes of determining whether an investment in a single covered fund
complies with the restrictions on ownership interests under paragraphs
(a)(2)(i)(B) and (a)(2)(ii)(B) of this section:
(i) For securitizations subject to the requirements of section 15G
of the Exchange Act (15 U.S.C. 78o-11), the calculations shall be made
as of the date and according to the valuation methodology applicable
pursuant to the requirements of section 15G of the Exchange Act (15
U.S.C. 78o-11) and
[[Page 5793]]
the implementing regulations issued thereunder; or
(ii) For securitization transactions completed prior to the
compliance date of such implementing regulations (or as to which such
implementing regulations do not apply), the calculations shall be made
as of the date of establishment as defined in paragraph (a)(2)(iv)(B)
of this section or such earlier date on which the transferred assets
have been valued for purposes of transfer to the covered fund, and
thereafter only upon the date on which additional securities of the
issuing entity of asset-backed securities are priced for purposes of
the sales of ownership interests to unaffiliated investors.
(iii) For securitization transactions completed prior to the
compliance date of such implementing regulations (or as to which such
implementing regulations do not apply), the aggregate value of the
outstanding ownership interests in the covered fund shall be the fair
market value of the assets transferred to the issuing entity of the
securitization and any other assets otherwise held by the issuing
entity at such time, determined in a manner that is consistent with its
determination of the fair market value of those assets for financial
statement purposes.
(iv) For purposes of the calculation under paragraph (b)(3)(iii) of
this section, the valuation methodology used to calculate the fair
market value of the ownership interests must be the same for both the
ownership interests held by a banking entity and the ownership
interests held by all others in the covered fund in the same manner and
according to the same standards.
(4) Multi-tier fund investments--(i) Master-feeder fund
investments. If the principal investment strategy of a covered fund
(the ``feeder fund'') is to invest substantially all of its assets in
another single covered fund (the ``master fund''), then for purposes of
the investment limitations in paragraphs (a)(2)(i)(B) and (a)(2)(ii) of
this section, the banking entity's permitted investment in such funds
shall be measured only by reference to the value of the master fund.
The banking entity's permitted investment in the master fund shall
include any investment by the banking entity in the master fund, as
well as the banking entity's pro-rata share of any ownership interest
of the master fund that is held through the feeder fund; and
(ii) Fund-of-funds investments. If a banking entity organizes and
offers a covered fund pursuant to Sec. ----.11 of this subpart for the
purpose of investing in other covered funds (a ``fund of funds'') and
that fund of funds itself invests in another covered fund that the
banking entity is permitted to own, then the banking entity's permitted
investment in that other fund shall include any investment by the
banking entity in that other fund, as well as the banking entity's pro-
rata share of any ownership interest of the fund that is held through
the fund of funds. The investment of the banking entity may not
represent more than 3 percent of the amount or value of any single
covered fund.
(c) Aggregate permitted investments in all covered funds. (1) For
purposes of paragraph (a)(2)(iii) of this section, the aggregate value
of all ownership interests held by a banking entity shall be the sum of
all amounts paid or contributed by the banking entity in connection
with acquiring or retaining an ownership interest in covered funds
(together with any amounts paid by the entity (or employee thereof) in
connection with obtaining a restricted profit interest under Sec. ----
--.10(d)(6)(ii) of this subpart), on a historical cost basis.
(2) Calculation of tier 1 capital. For purposes of paragraph
(a)(2)(iii) of this section:
(i) Entities that are required to hold and report tier 1 capital.
If a banking entity is required to calculate and report tier 1 capital,
the banking entity's tier 1 capital shall be equal to the amount of
tier 1 capital of the banking entity as of the last day of the most
recent calendar quarter, as reported to its primary financial
regulatory agency; and
(ii) If a banking entity is not required to calculate and report
tier 1 capital, the banking entity's tier 1 capital shall be determined
to be equal to:
(A) In the case of a banking entity that is controlled, directly or
indirectly, by a depository institution that calculates and reports
tier 1 capital, be equal to the amount of tier 1 capital reported by
such controlling depository institution in the manner described in
paragraph (c)(2)(i) of this section;
(B) In the case of a banking entity that is not controlled,
directly or indirectly, by a depository institution that calculates and
reports tier 1 capital:
(1) Bank holding company subsidiaries. If the banking entity is a
subsidiary of a bank holding company or company that is treated as a
bank holding company, be equal to the amount of tier 1 capital reported
by the top-tier affiliate of such covered banking entity that
calculates and reports tier 1 capital in the manner described in
paragraph (c)(2)(i) of this section; and
(2) Other holding companies and any subsidiary or affiliate
thereof. If the banking entity is not a subsidiary of a bank holding
company or a company that is treated as a bank holding company, be
equal to the total amount of shareholders' equity of the top-tier
affiliate within such organization as of the last day of the most
recent calendar quarter that has ended, as determined under applicable
accounting standards.
(iii) Treatment of foreign banking entities--(A) Foreign banking
entities. Except as provided in paragraph (c)(2)(iii)(B) of this
section, with respect to a banking entity that is not itself, and is
not controlled directly or indirectly by, a banking entity that is
located or organized under the laws of the United States or of any
State, the tier 1 capital of the banking entity shall be the
consolidated tier 1 capital of the entity as calculated under
applicable home country standards.
(B) U.S. affiliates of foreign banking entities. With respect to a
banking entity that is located or organized under the laws of the
United States or of any State and is controlled by a foreign banking
entity identified under paragraph (c)(2)(iii)(A) of this section, the
banking entity's tier 1 capital shall be as calculated under paragraphs
(c)(2)(i) or (ii) of this section.
(d) Capital treatment for a permitted investment in a covered fund.
For purposes of calculating compliance with the applicable regulatory
capital requirements, a banking entity shall deduct from the banking
entity's tier 1 capital (as determined under paragraph (c)(2) of this
section) the greater of:
(1) The sum of all amounts paid or contributed by the banking
entity in connection with acquiring or retaining an ownership interest
(together with any amounts paid by the entity (or employee thereof) in
connection with obtaining a restricted profit interest under Sec. ----
--.10(d)(6)(ii) of subpart C), on a historical cost basis, plus any
earnings received; and
(2) The fair market value of the banking entity's ownership
interests in the covered fund as determined under paragraph (b)(2)(ii)
or (b)(3) of this section (together with any amounts paid by the entity
(or employee thereof) in connection with obtaining a restricted profit
interest under Sec. ------.10(d)(6)(ii) of subpart C), if the banking
entity accounts for the profits (or losses) of the fund investment in
its financial statements.
(e) Extension of time to divest an ownership interest. (1) Upon
application by a banking entity, the Board may extend the period under
paragraph (a)(2)(i) of this section for up to 2 additional years if the
Board finds that an extension would be consistent with safety and
soundness and not detrimental to the public interest. An application
for extension must:
[[Page 5794]]
(i) Be submitted to the Board at least 90 days prior to the
expiration of the applicable time period;
(ii) Provide the reasons for application, including information
that addresses the factors in paragraph (e)(2) of this section; and
(iii) Explain the banking entity's plan for reducing the permitted
investment in a covered fund through redemption, sale, dilution or
other methods as required in paragraph (a)(2) of this section.
(2) Factors governing Board determinations. In reviewing any
application under paragraph (e)(1) of this section, the Board may
consider all the facts and circumstances related to the permitted
investment in a covered fund, including:
(i) Whether the investment would result, directly or indirectly, in
a material exposure by the banking entity to high-risk assets or high-
risk trading strategies;
(ii) The contractual terms governing the banking entity's interest
in the covered fund;
(iii) The date on which the covered fund is expected to have
attracted sufficient investments from investors unaffiliated with the
banking entity to enable the banking entity to comply with the
limitations in paragraph (a)(2)(i) of this section;
(iv) The total exposure of the covered banking entity to the
investment and the risks that disposing of, or maintaining, the
investment in the covered fund may pose to the banking entity and the
financial stability of the United States;
(v) The cost to the banking entity of divesting or disposing of the
investment within the applicable period;
(vi) Whether the investment or the divestiture or conformance of
the investment would involve or result in a material conflict of
interest between the banking entity and unaffiliated parties, including
clients, customers or counterparties to which it owes a duty;
(vi) The banking entity's prior efforts to reduce through
redemption, sale, dilution, or other methods its ownership interests in
the covered fund, including activities related to the marketing of
interests in such covered fund;
(viii) Market conditions; and
(ix) Any other factor that the Board believes appropriate.
(3) Authority to impose restrictions on activities or investment
during any extension period. The Board may impose such conditions on
any extension approved under paragraph (e)(1) of this section as the
Board determines are necessary or appropriate to protect the safety and
soundness of the banking entity or the financial stability of the
United States, address material conflicts of interest or other unsound
banking practices, or otherwise further the purposes of section 13 of
the BHC Act and this part.
(4) Consultation. In the case of a banking entity that is primarily
regulated by another Federal banking agency, the SEC, or the CFTC, the
Board will consult with such agency prior to acting on an application
by the banking entity for an extension under paragraph (e)(1) of this
section.
Sec. ----.13 Other permitted covered fund activities and investments.
(a) Permitted risk-mitigating hedging activities. (1) The
prohibition contained in Sec. ------.10(a) of this subpart does not
apply with respect to an ownership interest in a covered fund acquired
or retained by a banking entity that is designed to demonstrably reduce
or otherwise significantly mitigate the specific, identifiable risks to
the banking entity in connection with a compensation arrangement with
an employee of the banking entity or an affiliate thereof that directly
provides investment advisory, commodity trading advisory or other
services to the covered fund.
(2) Requirements. The risk-mitigating hedging activities of a
banking entity are permitted under this paragraph (a) only if:
(i) The banking entity has established and implements, maintains
and enforces an internal compliance program required by subpart D of
this part that is reasonably designed to ensure the banking entity's
compliance with the requirements of this section, including:
(A) Reasonably designed written policies and procedures; and
(B) Internal controls and ongoing monitoring, management, and
authorization procedures, including relevant escalation procedures; and
(ii) The acquisition or retention of the ownership interest:
(A) Is made in accordance with the written policies, procedures and
internal controls required under this section;
(B) At the inception of the hedge, is designed to reduce or
otherwise significantly mitigate and demonstrably reduces or otherwise
significantly mitigates one or more specific, identifiable risks
arising in connection with the compensation arrangement with the
employee that directly provides investment advisory, commodity trading
advisory, or other services to the covered fund;
(C) Does not give rise, at the inception of the hedge, to any
significant new or additional risk that is not itself hedged
contemporaneously in accordance with this section; and
(D) Is subject to continuing review, monitoring and management by
the banking entity.
(iii) The compensation arrangement relates solely to the covered
fund in which the banking entity or any affiliate has acquired an
ownership interest pursuant to this paragraph and such compensation
arrangement provides that any losses incurred by the banking entity on
such ownership interest will be offset by corresponding decreases in
amounts payable under such compensation arrangement.
(b) Certain permitted covered fund activities and investments
outside of the United States. (1) The prohibition contained in Sec. --
--.10(a) of this subpart does not apply to the acquisition or retention
of any ownership interest in, or the sponsorship of, a covered fund by
a banking entity only if:
(i) The banking entity is not organized or directly or indirectly
controlled by a banking entity that is organized under the laws of the
United States or of one or more States;
(ii) The activity or investment by the banking entity is pursuant
to paragraph (9) or (13) of section 4(c) of the BHC Act;
(iii) No ownership interest in the covered fund is offered for sale
or sold to a resident of the United States; and
(iv) The activity or investment occurs solely outside of the United
States.
(2) An activity or investment by the banking entity is pursuant to
paragraph (9) or (13) of section 4(c) of the BHC Act for purposes of
paragraph (b)(1)(ii) of this section only if:
(i) The activity or investment is conducted in accordance with the
requirements of this section; and
(ii)(A) With respect to a banking entity that is a foreign banking
organization, the banking entity meets the qualifying foreign banking
organization requirements of section 211.23(a), (c) or (e) of the
Board's Regulation K (12 CFR 211.23(a), (c) or (e)), as applicable; or
(B) With respect to a banking entity that is not a foreign banking
organization, the banking entity is not organized under the laws of the
United States or of one or more States and the banking entity, on a
fully-consolidated basis, meets at least two of the following
requirements:
(1) Total assets of the banking entity held outside of the United
States exceed total assets of the banking entity held in the United
States;
(2) Total revenues derived from the business of the banking entity
outside of the United States exceed total revenues
[[Page 5795]]
derived from the business of the banking entity in the United States;
or
(3) Total net income derived from the business of the banking
entity outside of the United States exceeds total net income derived
from the business of the banking entity in the United States.
(3) An ownership interest in a covered fund is not offered for sale
or sold to a resident of the United States for purposes of paragraph
(b)(1)(iii) of this section only if it is sold or has been sold
pursuant to an offering that does not target residents of the United
States.
(4) An activity or investment occurs solely outside of the United
States for purposes of paragraph (b)(1)(iv) of this section only if:
(i) The banking entity acting as sponsor, or engaging as principal
in the acquisition or retention of an ownership interest in the covered
fund, is not itself, and is not controlled directly or indirectly by, a
banking entity that is located in the United States or organized under
the laws of the United States or of any State;
(ii) The banking entity (including relevant personnel) that makes
the decision to acquire or retain the ownership interest or act as
sponsor to the covered fund is not located in the United States or
organized under the laws of the United States or of any State;
(iii) The investment or sponsorship, including any transaction
arising from risk-mitigating hedging related to an ownership interest,
is not accounted for as principal directly or indirectly on a
consolidated basis by any branch or affiliate that is located in the
United States or organized under the laws of the United States or of
any State; and
(iv) No financing for the banking entity's ownership or sponsorship
is provided, directly or indirectly, by any branch or affiliate that is
located in the United States or organized under the laws of the United
States or of any State.
(5) For purposes of this section, a U.S. branch, agency, or
subsidiary of a foreign bank, or any subsidiary thereof, is located in
the United States; however, a foreign bank of which that branch,
agency, or subsidiary is a part is not considered to be located in the
United States solely by virtue of operation of the U.S. branch, agency,
or subsidiary.
(c) Permitted covered fund interests and activities by a regulated
insurance company. The prohibition contained in Sec. ----.10(a) of
this subpart does not apply to the acquisition or retention by an
insurance company, or an affiliate thereof, of any ownership interest
in, or the sponsorship of, a covered fund only if:
(1) The insurance company or its affiliate acquires and retains the
ownership interest solely for the general account of the insurance
company or for one or more separate accounts established by the
insurance company;
(2) The acquisition and retention of the ownership interest is
conducted in compliance with, and subject to, the insurance company
investment laws, regulations, and written guidance of the State or
jurisdiction in which such insurance company is domiciled; and
(3) The appropriate Federal banking agencies, after consultation
with the Financial Stability Oversight Council and the relevant
insurance commissioners of the States and foreign jurisdictions, as
appropriate, have not jointly determined, after notice and comment,
that a particular law, regulation, or written guidance described in
paragraph (c)(2) of this section is insufficient to protect the safety
and soundness of the banking entity, or the financial stability of the
United States.
Sec. ----.14 Limitations on relationships with a covered fund.
(a) Relationships with a covered fund. (1) Except as provided for
in paragraph (a)(2) of this section, no banking entity that serves,
directly or indirectly, as the investment manager, investment adviser,
commodity trading advisor, or sponsor to a covered fund, that organizes
and offers a covered fund pursuant to Sec. ----.11 of this subpart, or
that continues to hold an ownership interest in accordance with Sec.
----.11(b) of this subpart, and no affiliate of such entity, may enter
into a transaction with the covered fund, or with any other covered
fund that is controlled by such covered fund, that would be a covered
transaction as defined in section 23A of the Federal Reserve Act (12
U.S.C. 371c(b)(7)), as if such banking entity and the affiliate thereof
were a member bank and the covered fund were an affiliate thereof.
(2) Notwithstanding paragraph (a)(1) of this section, a banking
entity may:
(i) Acquire and retain any ownership interest in a covered fund in
accordance with the requirements of Sec. ----.11, Sec. ----.12, or
Sec. ----.13 of this subpart; and
(ii) Enter into any prime brokerage transaction with any covered
fund in which a covered fund managed, sponsored, or advised by such
banking entity (or an affiliate thereof) has taken an ownership
interest, if:
(A) The banking entity is in compliance with each of the
limitations set forth in Sec. ----.11 of this subpart with respect to
a covered fund organized and offered by such banking entity (or an
affiliate thereof);
(B) The chief executive officer (or equivalent officer) of the
banking entity certifies in writing annually to [Agency] (with a duty
to update the certification if the information in the certification
materially changes) that the banking entity does not, directly or
indirectly, guarantee, assume, or otherwise insure the obligations or
performance of the covered fund or of any covered fund in which such
covered fund invests; and
(C) The Board has not determined that such transaction is
inconsistent with the safe and sound operation and condition of the
banking entity.
(b) Restrictions on transactions with covered funds. A banking
entity that serves, directly or indirectly, as the investment manager,
investment adviser, commodity trading advisor, or sponsor to a covered
fund, or that organizes and offers a covered fund pursuant to Sec. --
--.11 of this subpart, or that continues to hold an ownership interest
in accordance with Sec. ----.11(b) of this subpart, shall be subject
to section 23B of the Federal Reserve Act (12 U.S.C. 371c-1), as if
such banking entity were a member bank and such covered fund were an
affiliate thereof.
(c) Restrictions on prime brokerage transactions. A prime brokerage
transaction permitted under paragraph (a)(2)(ii) of this section shall
be subject to section 23B of the Federal Reserve Act (12 U.S.C. 371c-1)
as if the counterparty were an affiliate of the banking entity.
Sec. ----.15 Other limitations on permitted covered fund activities.
(a) No transaction, class of transactions, or activity may be
deemed permissible under Sec. Sec. ----.11 through ----.13 of this
subpart if the transaction, class of transactions, or activity would:
(1) Involve or result in a material conflict of interest between
the banking entity and its clients, customers, or counterparties;
(2) Result, directly or indirectly, in a material exposure by the
banking entity to a high-risk asset or a high-risk trading strategy; or
(3) Pose a threat to the safety and soundness of the banking entity
or to the financial stability of the United States.
(b) Definition of material conflict of interest. (1) For purposes
of this section, a material conflict of interest between a banking
entity and its clients, customers, or counterparties exists if the
banking entity engages in any transaction, class of transactions, or
activity that would involve or result in the banking entity's interests
being materially adverse to the interests of its client, customer, or
counterparty with
[[Page 5796]]
respect to such transaction, class of transactions, or activity, and
the banking entity has not taken at least one of the actions in
paragraph (b)(2) of this section.
(2) Prior to effecting the specific transaction or class or type of
transactions, or engaging in the specific activity, the banking entity:
(i) Timely and effective disclosure. (A) Has made clear, timely,
and effective disclosure of the conflict of interest, together with
other necessary information, in reasonable detail and in a manner
sufficient to permit a reasonable client, customer, or counterparty to
meaningfully understand the conflict of interest; and
(B) Such disclosure is made in a manner that provides the client,
customer, or counterparty the opportunity to negate, or substantially
mitigate, any materially adverse effect on the client, customer, or
counterparty created by the conflict of interest; or
(ii) Information barriers. Has established, maintained, and
enforced information barriers that are memorialized in written policies
and procedures, such as physical separation of personnel, or functions,
or limitations on types of activity, that are reasonably designed,
taking into consideration the nature of the banking entity's business,
to prevent the conflict of interest from involving or resulting in a
materially adverse effect on a client, customer, or counterparty. A
banking entity may not rely on such information barriers if, in the
case of any specific transaction, class or type of transactions or
activity, the banking entity knows or should reasonably know that,
notwithstanding the banking entity's establishment of information
barriers, the conflict of interest may involve or result in a
materially adverse effect on a client, customer, or counterparty.
(c) Definition of high-risk asset and high-risk trading strategy.
For purposes of this section:
(1) High-risk asset means an asset or group of related assets that
would, if held by a banking entity, significantly increase the
likelihood that the banking entity would incur a substantial financial
loss or would pose a threat to the financial stability of the United
States.
(2) High-risk trading strategy means a trading strategy that would,
if engaged in by a banking entity, significantly increase the
likelihood that the banking entity would incur a substantial financial
loss or would pose a threat to the financial stability of the United
States.
Sec. ----.16 [Reserved]
Sec. ----.17 [Reserved]
Sec. ----.18 [Reserved]
Sec. ----.19 [Reserved]
Subpart D--Compliance Program Requirement; Violations
Sec. ----.20 Program for compliance; reporting
(a) Program requirement. Each banking entity shall develop and
provide for the continued administration of a compliance program
reasonably designed to ensure and monitor compliance with the
prohibitions and restrictions on proprietary trading and covered fund
activities and investments set forth in section 13 of the BHC Act and
this part. The 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.
(b) Contents of compliance program. Except as provided in paragraph
(f) of this section, the compliance program required by paragraph (a)
of this section, at a minimum, shall include:
(1) Written policies and procedures reasonably designed to
document, describe, monitor and limit trading activities subject to
subpart B (including those permitted under Sec. Sec. ----.3 to ----.6
of subpart B), including setting, monitoring and managing required
limits set out in Sec. ----4 and Sec. ----5, and activities and
investments with respect to a covered fund subject to subpart C
(including those permitted under Sec. Sec. ----.11 through ----.14 of
subpart C) conducted by the banking entity to ensure that all
activities and investments conducted by the banking entity that are
subject to section 13 of the BHC Act and this part comply with section
13 of the BHC Act and this part;
(2) A system of internal controls reasonably designed to monitor
compliance with section 13 of the BHC Act and this part and to prevent
the occurrence of activities or investments that are prohibited by
section 13 of the BHC Act and this part;
(3) A management framework that clearly delineates responsibility
and accountability for compliance with section 13 of the BHC Act and
this part and includes appropriate management review of trading limits,
strategies, hedging activities, investments, incentive compensation and
other matters identified in this part or by management as requiring
attention;
(4) Independent testing and audit of the effectiveness of the
compliance program conducted periodically by qualified personnel of the
banking entity or by a qualified outside party;
(5) Training for trading personnel and managers, as well as other
appropriate personnel, to effectively implement and enforce the
compliance program; and
(6) Records sufficient to demonstrate compliance with section 13 of
the BHC Act and this part, which a banking entity must promptly provide
to [Agency] upon request and retain for a period of no less than 5
years or such longer period as required by [Agency].
(c) Additional standards. In addition to the requirements in
paragraph (b) of this section, the compliance program of a banking
entity must satisfy the requirements and other standards contained in
Appendix B, if:
(1) The banking entity engages in proprietary trading permitted
under subpart B and is required to comply with the reporting
requirements of paragraph (d) of this section;
(2) The banking entity has reported total consolidated assets as of
the previous calendar year end of $50 billion or more or, in the case
of a foreign banking entity, has total U.S. assets as of the previous
calendar year end of $50 billion or more (including all subsidiaries,
affiliates, branches and agencies of the foreign banking entity
operating, located or organized in the United States); or
(3) [Agency] notifies the banking entity in writing that it must
satisfy the requirements and other standards contained in Appendix B to
this part.
(d) Reporting requirements under Appendix A to this part. (1) A
banking entity engaged in proprietary trading activity permitted under
subpart B shall comply with the reporting requirements described in
Appendix A, if:
(i) The banking entity (other than a foreign banking entity as
provided in paragraph (d)(1)(ii) of this section) has, together with
its affiliates and subsidiaries, trading assets and liabilities
(excluding trading assets and liabilities involving obligations of or
guaranteed by the United States or any agency of the United States) the
average gross sum of which (on a worldwide consolidated basis) over the
previous consecutive four quarters, as measured as of the last day of
each of the four prior calendar quarters, equals or exceeds the
threshold established in paragraph (d)(2) of this section;
(ii) In the case of a foreign banking entity, the average gross sum
of the trading assets and liabilities of the combined U.S. operations
of the foreign banking entity (including all subsidiaries, affiliates,
branches and agencies of the foreign banking entity
[[Page 5797]]
operating, located or organized in the United States and excluding
trading assets and liabilities involving obligations of or guaranteed
by the United States or any agency of the United States) over the
previous consecutive four quarters, as measured as of the last day of
each of the four prior calendar quarters, equals or exceeds the
threshold established in paragraph (d)(2) of this section; or
(iii) [Agency] notifies the banking entity in writing that it must
satisfy the reporting requirements contained in Appendix A.
(2) The threshold for reporting under paragraph (d)(1) of this
section shall be $50 billion beginning on June 30, 2014; $25 billion
beginning on April 30, 2016; and $10 billion beginning on December 31,
2016.
(3) Frequency of reporting: Unless [Agency] notifies the banking
entity in writing that it must report on a different basis, a banking
entity with $50 billion or more in trading assets and liabilities (as
calculated in accordance with paragraph (d)(1) of this section) shall
report the information required by Appendix A for each calendar month
within 30 days of the end of the relevant calendar month; beginning
with information for the month of January 2015, such information shall
be reported within 10 days of the end of each calendar month. Any other
banking entity subject to Appendix A shall report the information
required by Appendix A for each calendar quarter within 30 days of the
end of that calendar quarter unless [Agency] notifies the banking
entity in writing that it must report on a different basis.
(e) Additional documentation for covered funds. Any banking entity
that has more than $10 billion in total consolidated assets as reported
on December 31 of the previous two calendar years shall maintain
records that include:
(1) Documentation of the exclusions or exemptions other than
sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940
relied on by each fund sponsored by the banking entity (including all
subsidiaries and affiliates) in determining that such fund is not a
covered fund;
(2) For each fund sponsored by the banking entity (including all
subsidiaries and affiliates) for which the banking entity relies on one
or more of the exclusions from the definition of covered fund provided
by Sec. Sec. ----.10(c)(1),----.10(c)(5), ----.10(c)(8), --
--.10(c)(9), or ----.10(c)(10) of subpart C, documentation supporting
the banking entity's determination that the fund is not a covered fund
pursuant to one or more of those exclusions;
(3) For each seeding vehicle described in Sec. ----.10(c)(12)(i)
or (iii) of subpart C that will become a registered investment company
or SEC-regulated business development company, a written plan
documenting the banking entity's determination that the seeding vehicle
will become a registered investment company or SEC-regulated business
development company; the period of time during which the vehicle will
operate as a seeding vehicle; and the banking entity's plan to market
the vehicle to third-party investors and convert it into a registered
investment company or SEC-regulated business development company within
the time period specified in Sec. ----.12(a)(2)(i)(B) of subpart C;
(4) For any banking entity that is, or is controlled directly or
indirectly by a banking entity that is, located in or organized under
the laws of the United States or of any State, if the aggregate amount
of ownership interests in foreign public funds that are described in
Sec. ----.10(c)(1) of subpart C owned by such banking entity
(including ownership interests owned by any affiliate that is
controlled directly or indirectly by a banking entity that is located
in or organized under the laws of the United States or of any State)
exceeds $50 million at the end of two or more consecutive calendar
quarters, beginning with the next succeeding calendar quarter,
documentation of the value of the ownership interests owned by the
banking entity (and such affiliates) in each foreign public fund and
each jurisdiction in which any such foreign public fund is organized,
calculated as of the end of each calendar quarter, which documentation
must continue until the banking entity's aggregate amount of ownership
interests in foreign public funds is below $50 million for two
consecutive calendar quarters; and
(5) For purposes of paragraph (e)(4) of this section, a U.S.
branch, agency, or subsidiary of a foreign banking entity is located in
the United States; however, the foreign bank that operates or controls
that branch, agency, or subsidiary is not considered to be located in
the United States solely by virtue of operating or controlling the U.S.
branch, agency, or subsidiary.
(f) Simplified programs for less active banking entities--(1)
Banking entities with no covered activities. A banking entity that does
not engage in activities or investments pursuant to subpart B or
subpart C (other than trading activities permitted pursuant to Sec. --
--.6(a) of subpart B) may satisfy the requirements of this section by
establishing the required compliance program prior to becoming engaged
in such activities or making such investments (other than trading
activities permitted pursuant to Sec. ----.6(a) of subpart B).
(2) Banking entities with modest activities. A banking entity with
total consolidated assets of $10 billion or less as reported on
December 31 of the previous two calendar years that engages in
activities or investments pursuant to subpart B or subpart C (other
than trading activities permitted under Sec. ----.6(a) of subpart B)
may satisfy the requirements of this section by including in its
existing compliance policies and procedures appropriate references to
the requirements of section 13 of the BHC Act and this part and
adjustments as appropriate given the activities, size, scope and
complexity of the banking entity.
Sec. ----.21 Termination of activities or investments; penalties for
violations.
(a) Any banking entity that engages in an activity or makes an
investment in violation of section 13 of the BHC Act or this part, or
acts in a manner that functions as an evasion of the requirements of
section 13 of the BHC Act or this part, including through an abuse of
any activity or investment permitted under subparts B or C, or
otherwise violates the restrictions and requirements of section 13 of
the BHC Act or this part, shall, upon discovery, promptly terminate the
activity and, as relevant, dispose of the investment.
(b) Whenever [Agency] finds reasonable cause to believe any banking
entity has engaged in an activity or made an investment in violation of
section 13 of the BHC Act or this part, or engaged in any activity or
made any investment that functions as an evasion of the requirements of
section 13 of the BHC Act or this part, [Agency] may take any action
permitted by law to enforce compliance with section 13 of the BHC Act
and this part, including directing the banking entity to restrict,
limit, or terminate any or all activities under this part and dispose
of any investment.
Appendix A to Part ------Reporting and Recordkeeping Requirements for
Covered Trading Activities
I. Purpose
a. This appendix sets forth reporting and recordkeeping
requirements that certain banking entities must satisfy in
connection with the restrictions on proprietary trading set forth in
subpart B (``proprietary trading restrictions''). Pursuant to Sec.
----.20(d), this appendix generally applies to a banking entity
that, together with its affiliates and subsidiaries, has significant
trading assets and liabilities. These entities are required to
[[Page 5798]]
(i) furnish periodic reports to [Agency] regarding a variety of
quantitative measurements of their covered trading activities, which
vary depending on the scope and size of covered trading activities,
and (ii) create and maintain records documenting the preparation and
content of these reports. The requirements of this appendix must be
incorporated into the banking entity's internal compliance program
under Sec. ----.20 and Appendix B.
b. The purpose of this appendix is to assist banking entities
and [Agency] in:
(i) Better understanding and evaluating the scope, type, and
profile of the banking entity's covered trading activities;
(ii) Monitoring the banking entity's covered trading activities;
(iii) Identifying covered trading activities that warrant
further review or examination by the banking entity to verify
compliance with the proprietary trading restrictions;
(iv) Evaluating whether the covered trading activities of
trading desks engaged in market making-related activities subject to
Sec. ----.4(b) are consistent with the requirements governing
permitted market making-related activities;
(v) Evaluating whether the covered trading activities of trading
desks that are engaged in permitted trading activity subject to
Sec. Sec. ----.4, ----.5, or ----.6(a)-(b) (i.e., underwriting and
market making-related related activity, risk-mitigating hedging, or
trading in certain government obligations) are consistent with the
requirement that such activity not result, directly or indirectly,
in a material exposure to high-risk assets or high-risk trading
strategies;
(vi) Identifying the profile of particular covered trading
activities of the banking entity, and the individual trading desks
of the banking entity, to help establish the appropriate frequency
and scope of examination by [Agency] of such activities; and
(vii) Assessing and addressing the risks associated with the
banking entity's covered trading activities.
c. The quantitative measurements that must be furnished pursuant
to this appendix are not intended to serve as a dispositive tool for
the identification of permissible or impermissible activities.
d. In order to allow banking entities and the Agencies to
evaluate the effectiveness of these metrics, banking entities must
collect and report these metrics for all trading desks beginning on
the dates established in Sec. ----.20 of the final rule. The
Agencies will review the data collected and revise this collection
requirement as appropriate based on a review of the data collected
prior to September 30, 2015.
e. In addition to the quantitative measurements required in this
appendix, a banking entity may need to develop and implement other
quantitative measurements in order to effectively monitor its
covered trading activities for compliance with section 13 of the BHC
Act and this part and to have an effective compliance program, as
required by Sec. ----.20 and Appendix B to this part. The
effectiveness of particular quantitative measurements may differ
based on the profile of the banking entity's businesses in general
and, more specifically, of the particular trading desk, including
types of instruments traded, trading activities and strategies, and
history and experience (e.g., whether the trading desk is an
established, successful market maker or a new entrant to a
competitive market). In all cases, banking entities must ensure that
they have robust measures in place to identify and monitor the risks
taken in their trading activities, to ensure that the activities are
within risk tolerances established by the banking entity, and to
monitor and examine for compliance with the proprietary trading
restrictions in this part.
f. On an ongoing basis, banking entities must carefully monitor,
review, and evaluate all furnished quantitative measurements, as
well as any others that they choose to utilize in order to maintain
compliance with section 13 of the BHC Act and this part. All
measurement results that indicate a heightened risk of impermissible
proprietary trading, including with respect to otherwise-permitted
activities under Sec. Sec. ----.4 through ----.6(a) and (b), or
that result in a material exposure to high-risk assets or high-risk
trading strategies, must be escalated within the banking entity for
review, further analysis, explanation to [Agency], and remediation,
where appropriate. The quantitative measurements discussed in this
appendix should be helpful to banking entities in identifying and
managing the risks related to their covered trading activities.
II. Definitions
The terms used in this appendix have the same meanings as set
forth in Sec. Sec. ----.2 and ----.3. In addition, for purposes of
this appendix, the following definitions apply:
Calculation period means the period of time for which a
particular quantitative measurement must be calculated.
Comprehensive profit and loss means the net profit or loss of a
trading desk's material sources of trading revenue over a specific
period of time, including, for example, any increase or decrease in
the market value of a trading desk's holdings, dividend income, and
interest income and expense.
Covered trading activity means trading conducted by a trading
desk under Sec. Sec. ----.4, ----.5, ----.6(a), or ----.6(b). A
banking entity may include trading under Sec. Sec. ----.3(d), --
--.6(c), ----.6(d) or ----.6(e).
Measurement frequency means the frequency with which a
particular quantitative metric must be calculated and recorded.
Trading desk means 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.
III. Reporting and Recordkeeping of Quantitative Measurements
a. Scope of Required Reporting
General scope. Each banking entity made subject to this part by
Sec. ----.20 must furnish the following quantitative measurements
for each trading desk of the banking entity, calculated in
accordance with this appendix:
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
b. Frequency of Required Calculation and Reporting
A banking entity must calculate any applicable quantitative
measurement for each trading day. A banking entity must report each
applicable quantitative measurement to [Agency] on the reporting
schedule established in Sec. ----.20 unless otherwise requested by
[Agency]. All quantitative measurements for any calendar month must
be reported within the time period required by Sec. ----.20.
c. Recordkeeping
A banking entity must, for any quantitative measurement
furnished to [Agency] pursuant to this appendix and Sec. --
--.20(d), create and maintain records documenting the preparation
and content of these reports, as well as such information as is
necessary to permit [Agency] to verify the accuracy of such reports,
for a period of 5 years from the end of the calendar year for which
the measurement was taken.
IV. Quantitative Measurements
a. Risk-Management Measurements
1. Risk and Position Limits and Usage
i. Description: For purposes of this appendix, Risk and Position
Limits are the constraints that define the amount of risk that a
trading desk is permitted to take at a point in time, as defined by
the banking entity for a specific trading desk. Usage represents the
portion of the trading desk's limits that are accounted for by the
current activity of the desk. Risk and position limits and their
usage are key risk management tools used to control and monitor risk
taking and include, but are not limited, to the limits set out in
Sec. ----.4 and Sec. ----.5. A number of the metrics that are
described below, including ``Risk Factor Sensitivities'' and
``Value-at-Risk and Stress Value-at-Risk,'' relate to a trading
desk's risk and position limits and are useful in evaluating and
setting these limits in the broader context of the trading desk's
overall activities, particularly for the market making activities
under Sec. ----.4(b) and hedging activity under Sec. ----.5.
Accordingly, the limits required under Sec. ----.4(b)(2)(iii) and
Sec. ----.5(b)(1)(i) must meet the applicable requirements under
Sec. ----.4(b)(2)(iii) and Sec. ----.5(b)(1)(i) and also must
include appropriate metrics for the trading desk limits including,
at a minimum, the ``Risk Factor Sensitivities'' and ``Value-at-Risk
and Stress Value-at-Risk'' metrics 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.
ii. General Calculation Guidance: Risk and Position Limits must
be reported in the format used by the banking entity for the
purposes of risk management of each trading
[[Page 5799]]
desk. Risk and Position Limits are often expressed in terms of risk
measures, such as VaR and Risk Factor Sensitivities, but may also be
expressed in terms of other observable criteria, such as net open
positions. When criteria other than VaR or Risk Factor Sensitivities
are used to define the Risk and Position Limits, both the value of
the Risk and Position Limits and the value of the variables used to
assess whether these limits have been reached must be reported.
iii. Calculation Period: One trading day.
iv. Measurement Frequency: Daily.
2. Risk Factor Sensitivities
i. Description: For purposes of this appendix, Risk Factor
Sensitivities are changes in a trading desk's Comprehensive Profit
and Loss that are expected to occur in the event of a change in one
or more underlying variables that are significant sources of the
trading desk's profitability and risk.
ii. General Calculation Guidance: A banking entity must report
the Risk Factor Sensitivities that are monitored and managed as part
of the trading desk's overall risk management policy. The underlying
data and methods used to compute a trading desk's Risk Factor
Sensitivities will depend on the specific function of the trading
desk and the internal risk management models employed. The number
and type of Risk Factor Sensitivities that are monitored and managed
by a trading desk, and furnished to [Agency], will depend on the
explicit risks assumed by the trading desk. In general, however,
reported Risk Factor Sensitivities must be sufficiently granular to
account for a preponderance of the expected price variation in the
trading desk's holdings.
A. Trading desks must take into account any relevant factors in
calculating Risk Factor Sensitivities, including, for example, the
following with respect to particular asset classes:
Commodity derivative positions: risk factors with
respect to the related commodities set out in 17 CFR 20.2, the
maturity of the positions, volatility and/or correlation
sensitivities (expressed in a manner that demonstrates any
significant non-linearities), and the maturity profile of the
positions;
Credit positions: risk factors with respect to credit
spreads that are sufficiently granular to account for specific
credit sectors and market segments, the maturity profile of the
positions, and risk factors with respect to interest rates of all
relevant maturities;
Credit-related derivative positions: risk factor
sensitivities, for example credit spreads, shifts (parallel and non-
parallel) in credit spreads--volatility, and/or correlation
sensitivities (expressed in a manner that demonstrates any
significant non-linearities), and the maturity profile of the
positions;
Equity derivative positions: risk factor sensitivities
such as equity positions, volatility, and/or correlation
sensitivities (expressed in a manner that demonstrates any
significant non-linearities), and the maturity profile of the
positions;
Equity positions: risk factors for equity prices and
risk factors that differentiate between important equity market
sectors and segments, such as a small capitalization equities and
international equities;
Foreign exchange derivative positions: risk factors
with respect to major currency pairs and maturities, exposure to
interest rates at relevant maturities, volatility, and/or
correlation sensitivities (expressed in a manner that demonstrates
any significant non-linearities), as well as the maturity profile of
the positions; and
Interest rate positions, including interest rate
derivative positions: risk factors with respect to major interest
rate categories and maturities and volatility and/or correlation
sensitivities (expressed in a manner that demonstrates any
significant non-linearities), and shifts (parallel and non-parallel)
in the interest rate curve, as well as the maturity profile of the
positions.
B. The methods used by a banking entity to calculate
sensitivities to a common factor shared by multiple trading desks,
such as an equity price factor, must be applied consistently across
its trading desks so that the sensitivities can be compared from one
trading desk to another.
iii. Calculation Period: One trading day.
iv. Measurement Frequency: Daily.
3. Value-at-Risk and Stress Value-at-Risk
i. Description: For purposes of this appendix, Value-at-Risk
(``VaR'') is the commonly used percentile measurement of the risk of
future financial loss in the value of a given set of aggregated
positions over a specified period of time, based on current market
conditions. For purposes of this appendix, Stress Value-at-Risk
(``Stress VaR'') is the percentile measurement of the risk of future
financial loss in the value of a given set of aggregated positions
over a specified period of time, based on market conditions during a
period of significant financial stress.
ii. General Calculation Guidance: Banking entities must compute
and report VaR and Stress VaR by employing generally accepted
standards and methods of calculation. VaR should reflect a loss in a
trading desk that is expected to be exceeded less than one percent
of the time over a one-day period. For those banking entities that
are subject to regulatory capital requirements imposed by a Federal
banking agency, VaR and Stress VaR must be computed and reported in
a manner that is consistent with such regulatory capital
requirements. In cases where a trading desk does not have a
standalone VaR or Stress VaR calculation but is part of a larger
aggregation of positions for which a VaR or Stress VaR calculation
is performed, a VaR or Stress VaR calculation that includes only the
trading desk's holdings must be performed consistent with the VaR or
Stress VaR model and methodology used for the larger aggregation of
positions.
iii. Calculation Period: One trading day.
iv. Measurement Frequency: Daily.
b. Source-of-Revenue Measurements
1. Comprehensive Profit and Loss Attribution
i. Description: For purposes of this appendix, Comprehensive
Profit and Loss Attribution is an analysis that attributes the daily
fluctuation in the value of a trading desk's positions to various
sources. First, the daily profit and loss of the aggregated
positions is divided into three categories: (i) profit and loss
attributable to a trading desk's existing positions that were also
positions held by the trading desk 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. The
sum of (i), (ii), and (iii) must equal the trading desk's
comprehensive profit and loss at each point in time. In addition,
profit and loss measurements must calculate volatility of
comprehensive profit and loss (i.e., the standard deviation of the
trading desk's one-day profit and loss, in dollar terms) for the
reporting period for at least a 30-, 60- and 90-day lag period, from
the end of the reporting period, and any other period that the
banking entity deems necessary to meet the requirements of the rule.
A. The comprehensive profit and loss associated with existing
positions must reflect changes in the value of these positions on
the applicable day. The comprehensive profit and loss from existing
positions must be further attributed, as applicable, to changes in
(i) the specific Risk Factors and other factors that are monitored
and managed as part of the trading desk's overall risk management
policies and procedures; and (ii) any other applicable elements,
such as cash flows, carry, changes in reserves, and the correction,
cancellation, or exercise of a trade.
B. The comprehensive profit and loss attributed to new positions
must reflect commissions and fee income or expense and market gains
or losses associated with transactions executed on the applicable
day. New positions include purchases and sales of financial
instruments and other assets/liabilities and negotiated amendments
to existing positions. The comprehensive profit and loss from new
positions may be reported in the aggregate and does not need to be
further attributed to specific sources.
C. The portion of comprehensive profit and loss that cannot be
specifically attributed to known sources must be allocated to a
residual category identified as an unexplained portion of the
comprehensive profit and loss. Significant unexplained profit and
loss must be escalated for further investigation and analysis.
ii. General Calculation Guidance: The specific categories used
by a trading desk in the attribution analysis and amount of detail
for the analysis should be tailored to the type and amount of
trading activities undertaken by the trading desk. The new position
attribution must be computed by calculating the difference between
the prices at which instruments were bought and/or sold and the
prices at which those instruments are marked to market at the close
of business on that day multiplied by the notional or principal
amount of each purchase or sale. Any fees, commissions, or other
payments received (paid) that are associated with transactions
executed on that day must be added (subtracted) from such
difference. These factors must be measured consistently over time to
facilitate historical comparisons.
iii. Calculation Period: One trading day.
[[Page 5800]]
iv. Measurement Frequency: Daily.
c. Customer-Facing Activity Measurements
1. Inventory Turnover
i. Description: For purposes of this appendix, Inventory
Turnover is a ratio that measures the turnover of a trading desk's
inventory. The numerator of the ratio is the absolute value of all
transactions over the reporting period. The denominator of the ratio
is the value of the trading desk's inventory at the beginning of the
reporting period.
ii. General Calculation Guidance: For purposes of this appendix,
for derivatives, other than options and interest rate derivatives,
value means gross notional value, for options, value means delta
adjusted notional value, and for interest rate derivatives, value
means 10-year bond equivalent value.
iii. Calculation Period: 30 days, 60 days, and 90 days.
iv. Measurement Frequency: Daily.
2. Inventory Aging
i. Description: For purposes of this appendix, Inventory Aging
generally describes a schedule of the trading desk's aggregate
assets and liabilities and the amount of time that those assets and
liabilities have been held. Inventory Aging should measure the age
profile of the trading desk's assets and liabilities.
ii. General Calculation Guidance: In general, Inventory Aging
must be computed using a trading desk's trading activity data and
must identify the value of a trading desk's aggregate assets and
liabilities. Inventory Aging must include two schedules, an asset-
aging schedule and a liability-aging schedule. Each schedule must
record the value of assets or liabilities held over all holding
periods. For derivatives, other than options, and interest rate
derivatives, value means gross notional value, for options, value
means delta adjusted notional value and, for interest rate
derivatives, value means 10-year bond equivalent value.
iii. Calculation Period: One trading day.
iv. Measurement Frequency: Daily.
3. Customer-Facing Trade Ratio--Trade Count Based and Value Based
i. Description: For purposes of this appendix, the Customer-
Facing Trade Ratio is a ratio comparing (i) the transactions
involving a counterparty that is a customer of the trading desk to
(ii) the transactions involving a counterparty that is not a
customer of the trading desk. A trade count based ratio must be
computed that records the number of transactions involving a
counterparty that is a customer of the trading desk and the number
of transactions involving a counterparty that is not a customer of
the trading desk. A value based ratio must be computed that records
the value of transactions involving a counterparty that is a
customer of the trading desk and the value of transactions involving
a counterparty that is not a customer of the trading desk.
ii. General Calculation Guidance: For purposes of calculating
the Customer-Facing Trade Ratio, a counterparty is considered to be
a customer of the trading desk if the counterparty is a market
participant that makes 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. However, a trading desk or other organizational
unit of another banking entity would not be a client, customer, or
counterparty of the trading desk if the other entity has trading
assets and liabilities of $50 billion or more as measured in
accordance with Sec. ----.20(d)(1) unless the trading desk
documents how and why a particular trading desk or other
organizational unit of the entity should be treated as a client,
customer, or counterparty of the trading desk. Transactions
conducted anonymously on an exchange or similar trading facility
that permits trading on behalf of a broad range of market
participants would be considered transactions with customers of the
trading desk. For derivatives, other than options, and interest rate
derivatives, value means gross notional value, for options, value
means delta adjusted notional value, and for interest rate
derivatives, value means 10-year bond equivalent value.
iii. Calculation Period: 30 days, 60 days, and 90 days.
iv. Measurement Frequency: Daily.
Appendix B to Part ------Enhanced Minimum Standards for Compliance
Programs
I. Overview
Section ----.20(c) requires certain banking entities to
establish, maintain, and enforce an enhanced compliance program that
includes the requirements and standards in this Appendix as well as
the minimum written policies and procedures, internal controls,
management framework, independent testing, training, and
recordkeeping provisions outlined in Sec. ----.20. This Appendix
sets forth additional minimum standards with respect to the
establishment, oversight, maintenance, and enforcement by these
banking entities of an enhanced internal compliance program for
ensuring and monitoring compliance with the prohibitions and
restrictions on proprietary trading and covered fund activities and
investments set forth in section 13 of the BHC Act and this part.
a. This compliance program must:
1. Be reasonably designed to identify, document, monitor, and
report the permitted trading and covered fund activities and
investments of the banking entity; identify, monitor and promptly
address the risks of these covered activities and investments and
potential areas of noncompliance; and prevent activities or
investments prohibited by, or that do not comply with, section 13 of
the BHC Act and this part;
2. Establish and enforce appropriate limits on the covered
activities and investments of the banking entity, including limits
on the size, scope, complexity, and risks of the individual
activities or investments consistent with the requirements of
section 13 of the BHC Act and this part;
3. Subject the effectiveness of the compliance program to
periodic independent review and testing, and ensure that the
entity's internal audit, corporate compliance and internal control
functions involved in review and testing are effective and
independent;
4. Make senior management, and others as appropriate,
accountable for the effective implementation of the compliance
program, and ensure that the board of directors and chief executive
officer (or equivalent) of the banking entity review the
effectiveness of the compliance program; and
5. Facilitate supervision and examination by the Agencies of the
banking entity's permitted trading and covered fund activities and
investments.
II. Enhanced Compliance Program
a. Proprietary Trading Activities. A banking entity must
establish, maintain and enforce a compliance program that includes
written policies and procedures that are appropriate for the types,
size, and complexity of, and risks associated with, its permitted
trading activities. The compliance program may be tailored to the
types of trading activities conducted by the banking entity, and
must include a detailed description of controls established by the
banking entity to reasonably ensure that its trading activities are
conducted in accordance with the requirements and limitations
applicable to those trading activities under section 13 of the BHC
Act and this part, and provide for appropriate revision of the
compliance program before expansion of the trading activities of the
banking entity. A banking entity must devote adequate resources and
use knowledgeable personnel in conducting, supervising and managing
its trading activities, and promote consistency, independence and
rigor in implementing its risk controls and compliance efforts. The
compliance program must be updated with a frequency sufficient to
account for changes in the activities of the banking entity, results
of independent testing of the program, identification of weaknesses
in the program, and changes in legal, regulatory or other
requirements.
1. Trading Desks: The banking entity must have written policies
and procedures governing each trading desk that include a
description of:
i. The process for identifying, authorizing and documenting
financial instruments each trading desk may purchase or sell, with
separate documentation for market making-related activities
conducted in reliance on Sec. ----.4(b) and for hedging activity
conducted in reliance on Sec. ----.5;
ii. A mapping for each trading desk to the division, business
line, or other organizational structure that is responsible for
managing and overseeing the trading desk's activities;
iii. The mission (i.e., the type of trading activity, such as
market-making, trading in sovereign debt, etc.) and strategy (i.e.,
methods for conducting authorized trading activities) of each
trading desk;
iv. The activities that the trading desk is authorized to
conduct, including (i) authorized instruments and products, and (ii)
authorized hedging strategies, techniques and instruments;
v. The types and amount of risks allocated by the banking entity
to each trading desk to
[[Page 5801]]
implement the mission and strategy of the trading desk, including an
enumeration of material risks resulting from the activities in which
the trading desk is authorized to engage (including but not limited
to price risks, such as basis, volatility and correlation risks, as
well as counterparty credit risk). Risk assessments must take into
account both the risks inherent in the trading activity and the
strength and effectiveness of controls designed to mitigate those
risks;
vi. How the risks allocated to each trading desk will be
measured;
vii. Why the allocated risks levels are appropriate to the
activities authorized for the trading desk;
viii. The limits on the holding period of, and the risk
associated with, financial instruments under the responsibility of
the trading desk;
ix. The process for setting new or revised limits, as well as
escalation procedures for granting exceptions to any limits or to
any policies or procedures governing the desk, the analysis that
will be required to support revising limits or granting exceptions,
and the process for independently reviewing and documenting those
exceptions and the underlying analysis;
x. The process for identifying, documenting and approving new
products, trading strategies, and hedging strategies;
xi. The types of clients, customers, and counterparties with
whom the trading desk may trade; and
xii. The compensation arrangements, including incentive
arrangements, for employees associated with the trading desk, which
may not be designed to reward or incentivize prohibited proprietary
trading or excessive or imprudent risk-taking.
2. Description of risks and risk management processes: The
compliance program for the banking entity must include a
comprehensive description of the risk management program for the
trading activity of the banking entity. The compliance program must
also include a description of the governance, approval, reporting,
escalation, review and other processes the banking entity will use
to reasonably ensure that trading activity is conducted in
compliance with section 13 of the BHC Act and this part. Trading
activity in similar financial instruments should be subject to
similar governance, limits, testing, controls, and review, unless
the banking entity specifically determines to establish different
limits or processes and documents those differences. Descriptions
must include, at a minimum, the following elements:
i. A description of the supervisory and risk management
structure governing all trading activity, including a description of
processes for initial and senior-level review of new products and
new strategies;
ii. A description of the process for developing, documenting,
testing, approving and reviewing all models used for valuing,
identifying and monitoring the risks of trading activity and related
positions, including the process for periodic independent testing of
the reliability and accuracy of those models;
iii. A description of the process for developing, documenting,
testing, approving and reviewing the limits established for each
trading desk;
iv. A description of the process by which a security may be
purchased or sold pursuant to the liquidity management plan,
including the process for authorizing and monitoring such activity
to ensure compliance with the banking entity's liquidity management
plan and the restrictions on liquidity management activities in this
part;
v. A description of the management review process, including
escalation procedures, for approving any temporary exceptions or
permanent adjustments to limits on the activities, positions,
strategies, or risks associated with each trading desk; and
vi. The role of the audit, compliance, risk management and other
relevant units for conducting independent testing of trading and
hedging activities, techniques and strategies.
3. Authorized risks, instruments, and products. The banking
entity must implement and enforce limits and internal controls for
each trading desk that are reasonably designed to ensure that
trading activity is conducted in conformance with section 13 of the
BHC Act and this part and with the banking entity's written policies
and procedures. The banking entity must establish and enforce risk
limits appropriate for the activity of each trading desk. These
limits should be based on probabilistic and non-probabilistic
measures of potential loss (e.g., Value-at-Risk and notional
exposure, respectively), and measured under normal and stress market
conditions. At a minimum, these internal controls must monitor,
establish and enforce limits on:
i. The financial instruments (including, at a minimum, by type
and exposure) that the trading desk may trade;
ii. The types and levels of risks that may be taken by each
trading desk; and
iii. The types of hedging instruments used, hedging strategies
employed, and the amount of risk effectively hedged.
4. Hedging policies and procedures. The banking entity must
establish, maintain, and enforce written policies and procedures
regarding the use of risk-mitigating hedging instruments and
strategies that, at a minimum, describe:
i. The positions, techniques and strategies that each trading
desk may use to hedge the risk of its positions;
ii. The manner in which the banking entity will identify the
risks arising in connection with and related to the individual or
aggregated positions, contracts or other holdings of the banking
entity that are to be hedged and determine that those risks have
been properly and effectively hedged;
iii. The level of the organization at which hedging activity and
management will occur;
iv. The manner in which hedging strategies will be monitored and
the personnel responsible for such monitoring;
v. The risk management processes used to control unhedged or
residual risks; and
vi. The process for developing, documenting, testing, approving
and reviewing all hedging positions, techniques and strategies
permitted for each trading desk and for the banking entity in
reliance on Sec. ----.5.
5. Analysis and quantitative measurements. The banking entity
must perform robust analysis and quantitative measurement of its
trading activities that is reasonably designed to ensure that the
trading activity of each trading desk is consistent with the banking
entity's compliance program; monitor and assist in the
identification of potential and actual prohibited proprietary
trading activity; and prevent the occurrence of prohibited
proprietary trading. Analysis and models used to determine, measure
and limit risk must be rigorously tested and be reviewed by
management responsible for trading activity to ensure that trading
activities, limits, strategies, and hedging activities do not
understate the risk and exposure to the banking entity or allow
prohibited proprietary trading. This review should include periodic
and independent back-testing and revision of activities, limits,
strategies and hedging as appropriate to contain risk and ensure
compliance. In addition to the quantitative measurements reported by
any banking entity subject to Appendix A to this part, each banking
entity must develop and implement, to the extent appropriate to
facilitate compliance with this part, additional quantitative
measurements specifically tailored to the particular risks,
practices, and strategies of its trading desks. The banking entity's
analysis and quantitative measurements must incorporate the
quantitative measurements reported by the banking entity pursuant to
Appendix A (if applicable) and include, at a minimum, the following:
i. Internal controls and written policies and procedures
reasonably designed to ensure the accuracy and integrity of
quantitative measurements;
ii. Ongoing, timely monitoring and review of calculated
quantitative measurements;
iii. The establishment of numerical thresholds and appropriate
trading measures for each trading desk and heightened review of
trading activity not consistent with those thresholds to ensure
compliance with section 13 of the BHC Act and this part, including
analysis of the measurement results or other information,
appropriate escalation procedures, and documentation related to the
review; and
iv. Immediate review and compliance investigation of the trading
desk's activities, escalation to senior management with oversight
responsibilities for the applicable trading desk, timely
notification to [Agency], appropriate remedial action (e.g.,
divesting of impermissible positions, cessation of impermissible
activity, disciplinary actions), and documentation of the
investigation findings and remedial action taken when quantitative
measurements or other information, considered together with the
facts and circumstances, or findings of internal audit, independent
testing or other review suggest a reasonable likelihood that the
trading desk has violated any part of section 13 of the BHC Act or
this part.
6. Other Compliance Matters. In addition to the requirements
specified above, the banking entity's compliance program must:
i. Identify activities of each trading desk that will be
conducted in reliance on
[[Page 5802]]
exemptions contained in Sec. Sec. ----.4 through ----.6, including
an explanation of:
A. How and where in the organization the activity occurs; and
B. Which exemption is being relied on and how the activity meets
the specific requirements for reliance on the applicable exemption;
ii. Include an explanation of the process for documenting,
approving and reviewing actions taken pursuant to the liquidity
management plan, where in the organization this activity occurs, the
securities permissible for liquidity management, the process for
ensuring that liquidity management activities are not conducted for
the purpose of prohibited proprietary trading, and the process for
ensuring that securities purchased as part of the liquidity
management plan are highly liquid and conform to the requirements of
this part;
iii. Describe how the banking entity monitors for and prohibits
potential or actual material exposure to high-risk assets or high-
risk trading strategies presented by each trading desk that relies
on the exemptions contained in Sec. Sec. ----.3(d)(3), and ----.4
through ----.6, which must take into account potential or actual
exposure to:
A. Assets whose values cannot be externally priced or, where
valuation is reliant on pricing models, whose model inputs cannot be
externally validated;
B. Assets whose changes in value cannot be adequately mitigated
by effective hedging;
C. New products with rapid growth, including those that do not
have a market history;
D. Assets or strategies that include significant embedded
leverage;
E. Assets or strategies that have demonstrated significant
historical volatility;
F. Assets or strategies for which the application of capital and
liquidity standards would not adequately account for the risk; and
G. Assets or strategies that result in large and significant
concentrations to sectors, risk factors, or counterparties;
iv. Establish responsibility for compliance with the reporting
and recordkeeping requirements of subpart B and Sec. ----.20; and
v. Establish policies for monitoring and prohibiting potential
or actual material conflicts of interest between the banking entity
and its clients, customers, or counterparties.
7. Remediation of violations. The banking entity's compliance
program must be reasonably designed and established to effectively
monitor and identify for further analysis any trading activity that
may indicate potential violations of section 13 of the BHC Act and
this part and to prevent actual violations of section 13 of the BHC
Act and this part. The compliance program must describe procedures
for identifying and remedying violations of section 13 of the BHC
Act and this part, and must include, at a minimum, a requirement to
promptly document, address and remedy any violation of section 13 of
the BHC Act or this part, and document all proposed and actual
remediation efforts. The compliance program must include specific
written policies and procedures that are reasonably designed to
assess the extent to which any activity indicates that modification
to the banking entity's compliance program is warranted and to
ensure that appropriate modifications are implemented. The written
policies and procedures must provide for prompt notification to
appropriate management, including senior management and the board of
directors, of any material weakness or significant deficiencies in
the design or implementation of the compliance program of the
banking entity.
b. Covered Fund Activities or Investments. A banking entity must
establish, maintain and enforce a compliance program that includes
written policies and procedures that are appropriate for the types,
size, complexity and risks of the covered fund and related
activities conducted and investments made, by the banking entity.
1. Identification of covered funds. The banking entity's
compliance program must provide a process, which must include
appropriate management review and independent testing, for
identifying and documenting covered funds that each unit within the
banking entity's organization sponsors or organizes and offers, and
covered funds in which each such unit invests. In addition to the
documentation requirements for covered funds, as specified under
Sec. ----.20(e), the documentation must include information that
identifies all pools that the banking entity sponsors or has an
interest in and the type of exemption from the Commodity Exchange
Act (whether or not the pool relies on section 4.7 of the
regulations under the Commodity Exchange Act), and the amount of
ownership interest the banking entity has in those pools.
2. Identification of covered fund activities and investments.
The banking entity's compliance program must identify, document and
map each unit within the organization that is permitted to acquire
or hold an interest in any covered fund or sponsor any covered fund
and map each unit to the division, business line, or other
organizational structure that will be responsible for managing and
overseeing that unit's activities and investments.
3. Explanation of compliance. The banking entity's compliance
program must explain how:
i. The banking entity monitors for and prohibits potential or
actual material conflicts of interest between the banking entity and
its clients, customers, or counterparties related to its covered
fund activities and investments;
ii. The banking entity monitors for and prohibits potential or
actual transactions or activities that may threaten the safety and
soundness of the banking entity related to its covered fund
activities and investments; and
iii. The banking entity monitors for and prohibits potential or
actual material exposure to high-risk assets or high-risk trading
strategies presented by its covered fund activities and investments,
taking into account potential or actual exposure to:
A. Assets whose values cannot be externally priced or, where
valuation is reliant on pricing models, whose model inputs cannot be
externally validated;
B. Assets whose changes in values cannot be adequately mitigated
by effective hedging;
C. New products with rapid growth, including those that do not
have a market history;
D. Assets or strategies that include significant embedded
leverage;
E. Assets or strategies that have demonstrated significant
historical volatility;
F. Assets or strategies for which the application of capital and
liquidity standards would not adequately account for the risk; and
G. Assets or strategies that expose the banking entity to large
and significant concentrations with respect to sectors, risk
factors, or counterparties;
4. Description and documentation of covered fund activities and
investments. For each organizational unit engaged in covered fund
activities and investments, the banking entity's compliance program
must document:
i. The covered fund activities and investments that the unit is
authorized to conduct;
ii. The banking entity's plan for actively seeking unaffiliated
investors to ensure that any investment by the banking entity
conforms to the limits contained in Sec. ----.12 or registered in
compliance with the securities laws and thereby exempt from those
limits within the time periods allotted inSec. ----.12; and
iii. How it complies with the requirements of subpart C.
5. Internal Controls. A banking entity must establish, maintain,
and enforce internal controls that are reasonably designed to ensure
that its covered fund activities or investments comply with the
requirements of section 13 of the BHC Act and this part and are
appropriate given the limits on risk established by the banking
entity. These written internal controls must be reasonably designed
and established to effectively monitor and identify for further
analysis any covered fund activity or investment that may indicate
potential violations of section 13 of the BHC Act or this part. The
internal controls must, at a minimum require:
i. Monitoring and limiting the banking entity's individual and
aggregate investments in covered funds;
ii. Monitoring the amount and timing of seed capital investments
for compliance with the limitations under subpart C (including but
not limited to the redemption, sale or disposition requirements) of
Sec. ----.12, and the effectiveness of efforts to seek unaffiliated
investors to ensure compliance with those limits;
iii. Calculating the individual and aggregate levels of
ownership interests in one or more covered fund required by Sec. --
--.12;
iv. Attributing the appropriate instruments to the individual
and aggregate ownership interest calculations above;
v. Making disclosures to prospective and actual investors in any
covered fund organized and offered or sponsored by the banking
entity, as provided under Sec. ----.11(a)(8);
vi Monitoring for and preventing any relationship or transaction
between the banking entity and a covered fund that is prohibited
under Sec. ----.14, including where the banking entity has been
designated as the sponsor, investment manager, investment
[[Page 5803]]
adviser, or commodity trading advisor to a covered fund by another
banking entity; and
vii. Appropriate management review and supervision across legal
entities of the banking entity to ensure that services and products
provided by all affiliated entities comply with the limitation on
services and products contained in Sec. ----.14.
6. Remediation of violations. The banking entity's compliance
program must be reasonably designed and established to effectively
monitor and identify for further analysis any covered fund activity
or investment that may indicate potential violations of section 13
of the BHC Act or this part and to prevent actual violations of
section 13 of the BHC Act and this part. The banking entity's
compliance program must describe procedures for identifying and
remedying violations of section 13 of the BHC Act and this part, and
must include, at a minimum, a requirement to promptly document,
address and remedy any violation of section 13 of the BHC Act or
this part, including Sec. ----.21, and document all proposed and
actual remediation efforts. The compliance program must include
specific written policies and procedures that are reasonably
designed to assess the extent to which any activity or investment
indicates that modification to the banking entity's compliance
program is warranted and to ensure that appropriate modifications
are implemented. The written policies and procedures must provide
for prompt notification to appropriate management, including senior
management and the board of directors, of any material weakness or
significant deficiencies in the design or implementation of the
compliance program of the banking entity.
III. Responsibility and Accountability for the Compliance Program
a. A banking entity must establish, maintain, and enforce a
governance and management framework to manage its business and
employees with a view to preventing violations of section 13 of the
BHC Act and this part. A banking entity must have an appropriate
management framework reasonably designed to ensure that: appropriate
personnel are responsible and accountable for the effective
implementation and enforcement of the compliance program; a clear
reporting line with a chain of responsibility is delineated; and the
compliance program is reviewed periodically by senior management.
The board of directors (or equivalent governance body) and senior
management should have the appropriate authority and access to
personnel and information within the organizations as well as
appropriate resources to conduct their oversight activities
effectively.
1. Corporate governance. The banking entity must adopt a written
compliance program approved by the board of directors, an
appropriate committee of the board, or equivalent governance body,
and senior management.
2. Management procedures. The banking entity must establish,
maintain, and enforce a governance framework that is reasonably
designed to achieve compliance with section 13 of the BHC Act and
this part, which, at a minimum, provides for:
i. The designation of appropriate senior management or committee
of senior management with authority to carry out the management
responsibilities of the banking entity for each trading desk and for
each organizational unit engaged in covered fund activities;
ii. Written procedures addressing the management of the
activities of the banking entity that are reasonably designed to
achieve compliance with section 13 of the BHC Act and this part,
including:
A. A description of the management system, including the titles,
qualifications, and locations of managers and the specific
responsibilities of each person with respect to the banking entity's
activities governed by section 13 of the BHC Act and this part; and
B. Procedures for determining compensation arrangements for
traders engaged in underwriting or market making-related activities
under Sec. ----.4 or risk-mitigating hedging activities under Sec.
----.5 so that such compensation arrangements are designed not to
reward or incentivize prohibited proprietary trading and
appropriately balance risk and financial results in a manner that
does not encourage employees to expose the banking entity to
excessive or imprudent risk.
3. Business line managers. Managers with responsibility for one
or more trading desks of the banking entity are accountable for the
effective implementation and enforcement of the compliance program
with respect to the applicable trading desk(s).
4. Board of directors, or similar corporate body, and senior
management. The board of directors, or similar corporate body, and
senior management are responsible for setting and communicating an
appropriate culture of compliance with section 13 of the BHC Act and
this part and ensuring that appropriate policies regarding the
management of trading activities and covered fund activities or
investments are adopted to comply with section 13 of the BHC Act and
this part. The board of directors or similar corporate body (such as
a designated committee of the board or an equivalent governance
body) must ensure that senior management is fully capable,
qualified, and properly motivated to manage compliance with this
part in light of the organization's business activities and the
expectations of the board of directors. The board of directors or
similar corporate body must also ensure that senior management has
established appropriate incentives and adequate resources to support
compliance with this part, including the implementation of a
compliance program meeting the requirements of this appendix into
management goals and compensation structures across the banking
entity.
5. Senior management. Senior management is responsible for
implementing and enforcing the approved compliance program. Senior
management must also ensure that effective corrective action is
taken when failures in compliance with section 13 of the BHC Act and
this part are identified. Senior management and control personnel
charged with overseeing compliance with section 13 of the BHC Act
and this part should review the compliance program for the banking
entity periodically and report to the board, or an appropriate
committee thereof, on the effectiveness of the compliance program
and compliance matters with a frequency appropriate to the size,
scope, and risk profile of the banking entity's trading activities
and covered fund activities or investments, which shall be at least
annually.
6. CEO attestation. Based on a review by the CEO of the banking
entity, the CEO of the banking entity must, annually, attest in
writing to [Agency] that the banking entity has in place processes
to establish, maintain, enforce, review, test and modify the
compliance program established under this Appendix and Sec. ----.20
of this part in a manner reasonably designed to achieve compliance
with section 13 of the BHC Act and this part. In the case of a U.S.
branch or agency of a foreign banking entity, the attestation may be
provided for the entire U.S. operations of the foreign banking
entity by the senior management officer of the United States
operations of the foreign banking entity who is located in the
United States.
IV. Independent Testing
a. Independent testing must occur with a frequency appropriate
to the size, scope, and risk profile of the banking entity's trading
and covered fund activities or investments, which shall be at least
annually. This independent testing must include an evaluation of:
1. The overall adequacy and effectiveness of the banking
entity's compliance program, including an analysis of the extent to
which the program contains all the required elements of this
appendix;
2. The effectiveness of the banking entity's internal controls,
including an analysis and documentation of instances in which such
internal controls have been breached, and how such breaches were
addressed and resolved; and
3. The effectiveness of the banking entity's management
procedures.
b. A banking entity must ensure that independent testing
regarding the effectiveness of the banking entity's compliance
program is conducted by a qualified independent party, such as the
banking entity's internal audit department, compliance personnel or
risk managers independent of the organizational unit being tested,
outside auditors, consultants, or other qualified independent
parties. A banking entity must promptly take appropriate action to
remedy any significant deficiencies or material weaknesses in its
compliance program and to terminate any violations of section 13 of
the BHC Act or this part.
V. Training
Banking entities must provide adequate training to personnel and
managers of the banking entity engaged in activities or investments
governed by section 13 of the BHC Act or this part, as well as other
appropriate supervisory, risk, independent testing, and audit
personnel, in order to effectively implement and enforce the
compliance program. This training should occur with a frequency
appropriate to the size and the risk profile of the banking
[[Page 5804]]
entity's trading activities and covered fund activities or
investments.
VI. Recordkeeping
Banking entities must create and retain records sufficient to
demonstrate compliance and support the operations and effectiveness
of the compliance program. A banking entity must retain these
records for a period that is no less than 5 years or such longer
period as required by [Agency] in a form that allows it to promptly
produce such records to [Agency] on request.
End of Common Rule
List of Subjects
12 CFR Part 44
Banks, Banking, Capital Compensation, Credit, Derivatives,
Government securities, Insurance, Investments, National banks, Federal
savings associations, Federal branches and agencies, Penalties,
Reporting and recordkeeping requirements, Risk, Risk retention,
Securities, Trusts and trustees
12 CFR Part 248
Administrative practice and procedure, Banks and banking, Capital,
Compensation, Conflict of interests, Credit, Derivatives, Foreign
banking, Government securities, Holding companies, Insurance, Insurance
companies, Investments, Penalties, Reporting and recordkeeping
requirements, Risk, Risk retention, Securities, Trusts and trustees.
12 CFR Part 351
Banks, Banking, Capital, Compensation, Conflicts of interest,
Credit, Derivatives, Government securities, Insurance, Insurance
companies, Investments, Penalties, Reporting and recordkeeping
requirements, Risk, Risk retention, Securities, State nonmember banks,
State savings associations, Trusts and trustees.
17 CFR Part 255
Banks, Brokers, Dealers, Investment advisers, Recordkeeping,
Reporting, Securities.
DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
Authority and Issuance
For the reasons stated in the Common Preamble, the Office of the
Comptroller of the Currency hereby amends chapter I of Title 12, Code
of Federal Regulations as follows:
PART 44--PROPRIETARY TRADING AND CERTAIN INTERESTS IN AND
RELATIONSHIPS WITH COVERED FUNDS
0
1. The authority for part 44 is added to read as follows:
Authority: 7 U.S.C. 27 et seq., 12 U.S.C. 1, 24, 92a, 93a, 161,
1461, 1462a, 1463, 1464, 1467a, 1813(q), 1818, 1851, 3101 3102,
3108, 5412.
0
2. Part 44 is added as set forth at the end of the Common Preamble.
0
3. Part 44 is amended by:
0
a. Removing ``[Agency]'' wherever it appears and adding in its place
``the OCC''; and
0
b. Removing ``the [Agency]'' wherever it appears and adding in its
place ``the OCC''.
0
4. Section 44.1 is revised to read as follows:
Sec. 44.1 Authority, purpose, scope, and relationship to other
authorities.
(a) Authority. This part is issued by the OCC under section 13 of
the Bank Holding Company Act of 1956, as amended (12 U.S.C. 1851).
(b) Purpose. Section 13 of the Bank Holding Company Act establishes
prohibitions and restrictions on proprietary trading and on investments
in or relationships with covered funds by certain banking entities,
including national banks, Federal branches and agencies of foreign
banks, Federal savings associations, and certain subsidiaries thereof.
This part implements section 13 of the Bank Holding Company Act by
defining terms used in the statute and related terms, establishing
prohibitions and restrictions on proprietary trading and on investments
in or relationships with covered funds, and explaining the statute's
requirements.
(c) Scope. This part implements section 13 of the Bank Holding
Company Act with respect to banking entities for which the OCC is
authorized to issue regulations under section 13(b)(2) of the Bank
Holding Company Act (12 U.S.C. 1851(b)(2)) and take actions under
section 13(e) of that Act (12 U.S.C. 1851(e)). These include national
banks, Federal branches and Federal agencies of foreign banks, Federal
savings associations, Federal savings banks, and any of their
respective subsidiaries (except a subsidiary for which there is a
different primary financial regulatory agency, as that term is defined
in this part).
(d) Relationship to other authorities. Except as otherwise provided
under section 13 of the Bank Holding Company Act or this part, and
notwithstanding any other provision of law, the prohibitions and
restrictions under section 13 of the Bank Holding Company Act and this
part shall apply to the activities and investments of a banking entity
identified in paragraph (c) of this section, even if such activities
and investments are authorized for the banking entity under other
applicable provisions of law.
(e) Preservation of authority. Nothing in this part limits in any
way the authority of the OCC to impose on a banking entity identified
in paragraph (c) of this section additional requirements or
restrictions with respect to any activity, investment, or relationship
covered under section 13 of the Bank Holding Company Act or this part,
or additional penalties for violation of this part provided under any
other applicable provision of law.
BOARD OF GOVERNORS OF THE FEDERAL RESERVE
Authority and Issuance
For the reasons set forth in the Supplementary Information, the
Board of Governors of the Federal Reserve System is adding the text of
the common rule as set forth at the end of the SUPPLEMENTARY
INFORMATION as Part 248 to 12 CFR Chapter II as follows:
PART 248--PROPRIETARY TRADING AND CERTAIN INTERESTS IN AND
RELATIONSHIPS WITH COVERED FUNDS (Regulation VV)
0
5. The authority for part 248 is added to read as follows:
Authority: 12 U.S.C. 1851, 12 U.S.C. 221 et seq., 12 U.S.C.
1818, 12 U.S.C. 1841 et seq., and 12 U.S.C. 3103 et seq.
0
6. Part 248 is added as set forth at the end of the Common Preamble.
0
7. Part 248 is amended by removing ``[Agency]'' wherever it appears and
adding in its place ``the Board.''
0
8. Part 248 is amended by removing ``the [Agency]'' wherever it appears
and adding in its place ``the Board.''
0
9. Section 248.1 is revised to read as follows:
Sec. 248.1 Authority, purpose, scope, and relationship to other
authorities.
(a) Authority. This part (Regulation VV) is issued by the Board
under section 13 of the Bank Holding Company Act of 1956, as amended
(12 U.S.C. 1851), as well as under the Federal Reserve Act, as amended
(12 U.S.C. 221 et seq.); section 8 of the Federal Deposit Insurance
Act, as amended (12 U.S.C. 1818); the Bank Holding Company Act of 1956,
as amended (12 U.S.C. 1841 et seq.); and
[[Page 5805]]
the International Banking Act of 1978, as amended (12 U.S.C. 3101 et
seq.).
(b) Purpose. Section 13 of the Bank Holding Company Act establishes
prohibitions and restrictions on proprietary trading and on investments
in or relationships with covered funds by certain banking entities,
including state member banks, bank holding companies, savings and loan
holding companies, other companies that control an insured depository
institution, foreign banking organizations, and certain subsidiaries
thereof. This part implements section 13 of the Bank Holding Company
Act by defining terms used in the statute and related terms,
establishing prohibitions and restrictions on proprietary trading and
on investments in or relationships with covered funds, and explaining
the statute's requirements.
(c) Scope. This part implements section 13 of the Bank Holding
Company Act with respect to banking entities for which the Board is
authorized to issue regulations under section 13(b)(2) of the Bank
Holding Company Act (12 U.S.C. 1851(b)(2)) and take actions under
section 13(e) of that Act (12 U.S.C. 1851(e)). These include any state
bank that is a member of the Federal Reserve System, any company that
controls an insured depository institution (including a bank holding
company and savings and loan holding company), any company that is
treated as a bank holding company for purposes of section 8 of the
International Banking Act (12 U.S.C. 3106), and any subsidiary of the
foregoing other than a subsidiary for which the OCC, FDIC, CFTC, or SEC
is the primary financial regulatory agency (as defined in section 2(12)
of the Dodd-Frank Wall Street Reform and Consumer Protection Act of
2010 (12 U.S.C. 5301(12)).
(d) Relationship to other authorities. Except as otherwise provided
under section 13 of the BHC Act or this part, and notwithstanding any
other provision of law, the prohibitions and restrictions under section
13 of BHC Act and this part shall apply to the activities of a banking
entity, even if such activities are authorized for the banking entity
under other applicable provisions of law.
(e) Preservation of authority. Nothing in this part limits in any
way the authority of the Board to impose on a banking entity identified
in paragraph (c) of this section additional requirements or
restrictions with respect to any activity, investment, or relationship
covered under section 13 of the Bank Holding Company Act or this part,
or additional penalties for violation of this part provided under any
other applicable provision of law.
FEDERAL DEPOSIT INSURANCE CORPORATION
Authority and Issuance
For the reasons set forth in the Supplementary Information, the
Federal Deposit Insurance Corporation is adding the text of the common
rule as set forth at the end of the Supplementary Information as Part
351 to chapter III of Title 12, Code of Federal Regulations, modified
as follows:
PART 351--PROPRIETARY TRADING AND CERTAIN INTERESTS IN AND
RELATIONSHIPS WITH COVERED FUNDS
0
10. The authority for part 351 is added to read as follows:
Authority: 12 U.S.C. 1851; 1811 et seq.; 3101 et seq.; and 5412.
0
11. Part 351 is added as set forth at the end of the Common Preamble.
0
12. Part 351 is amended by:
0
a. Removing ``[Agency]'' wherever it appears and adding in its place
``the FDIC;'' and
0
b. Removing ``the [Agency]'' wherever it appears and adding in its
place ``the FDIC.''
0
13. Section 351.1 is revised to read as follows:
Sec. 351.1 Authority, purpose, scope, and relationship to other
authorities.
(a) Authority. This part is issued by the FDIC under section 13 of
the Bank Holding Company Act of 1956, as amended (12 U.S.C. 1851).
(b) Purpose. Section 13 of the Bank Holding Company Act establishes
prohibitions and restrictions on proprietary trading and investments in
or relationships with covered funds by certain banking entities,
including any insured depository institution as defined in section
3(c)(2) of the Federal Deposit Insurance Act (12 U.S.C. 1813(c)(2)) and
certain subsidiaries thereof for which the FDIC is the appropriate
Federal banking agency as defined in section 3(q) of the Federal
Deposit Insurance Act (12 U.S.C. 1813(q)). This part implements section
13 of the Bank Holding Company Act by defining terms used in the
statute and related terms, establishing prohibitions and restrictions
on proprietary trading and investments in or relationships with covered
funds, and explaining the statute's requirements.
(c) Scope. This part implements section 13 of the Bank Holding
Company Act with respect to insured depository institutions for which
the FDIC is the appropriate Federal banking agency, as defined in
section 3(q) of the Federal Deposit Insurance Act, and certain
subsidiaries of the foregoing.
(d) Relationship to other authorities. Except as otherwise provided
in under section 13 of the Bank Holding Company Act, and
notwithstanding any other provision of law, the prohibitions and
restrictions under section 13 of Bank Holding Company Act shall apply
to the activities and investments of a banking entity, even if such
activities and investments are authorized for a banking entity under
other applicable provisions of law.
(e) Preservation of authority. Nothing in this part limits in any
way the authority of the FDIC to impose on a banking entity identified
in paragraph (c) of this section additional requirements or
restrictions with respect to any activity, investment, or relationship
covered under section 13 of the Bank Holding Company Act or this part,
or additional penalties for violation of this part provided under any
other applicable provision of law.
SECURITIES AND EXCHANGE COMMISSION
Authority and Issuance
For the reasons stated in the Common Preamble, the Securities and
Exchange Commission is adding the text of the common rule as set forth
at the end of the Supplementary Information as Part 255 to chapter II
of Title 17, Code of Federal Regulations, modified as follows:
PART 255--PROPRIETARY TRADING AND CERTAIN INTERESTS IN AND
RELATIONSHIPS WITH COVERED FUNDS
0
14. The authority for part 255 is added to read as follows:
Authority: 12 U.S.C. 1851.
0
15. Part 255 is added as set forth at the end of the Common Preamble.
0
16. Part 255 is amended by:
0
a. Removing ``[Agency]'' wherever it appears and adding in its place
``the SEC;'' and
0
b. Removing ``the [Agency]'' wherever it appears and adding in its
place ``the SEC.''
0
17. Section 255.1 is revised to read as follows:
Sec. 255.1 Authority, purpose, scope, and relationship to other
authorities.
(a) Authority. This part is issued by the SEC under section 13 of
the Bank Holding Company Act of 1956, as amended (12 U.S.C. 1851).
(b) Purpose. Section 13 of the Bank Holding Company Act establishes
[[Page 5806]]
prohibitions and restrictions on proprietary trading and investments in
or relationships with covered funds by certain banking entities,
including registered broker-dealers, registered investment advisers,
and registered security-based swap dealers, among others identified in
section 2(12)(B) of the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 (12 U.S.C. 5301(12)(B)). This part implements
section 13 of the Bank Holding Company Act by defining terms used in
the statute and related terms, establishing prohibitions and
restrictions on proprietary trading and investments in or relationships
with covered funds, and explaining the statute's requirements.
(c) Scope. This part implements section 13 of the Bank Holding
Company Act with respect to banking entities for which the SEC is the
primary financial regulatory agency, as that term is defined in this
part.
(d) Relationship to other authorities. Except as otherwise provided
under section 13 of the Bank Holding Company Act, and notwithstanding
any other provision of law, the prohibitions and restrictions under
section 13 of Bank Holding Company Act shall apply to the activities
and investments of a banking entity identified in paragraph (c) of this
section, even if such activities and investments are authorized for the
banking entity under other applicable provisions of law.
(e) Preservation of authority. Nothing in this part limits in any
way the authority of the SEC to impose on a banking entity identified
in paragraph (c) of this section additional requirements or
restrictions with respect to any activity, investment, or relationship
covered under section 13 of the Bank Holding Company Act or this part,
or additional penalties for violation of this part provided under any
other applicable provision of law.
Dated: December 10, 2013.
Thomas J. Curry,
Comptroller of the Currency.
By order of the Board of Governors of the Federal Reserve
System, December 23, 2013.
Robert deV. Frierson,
Secretary of the Board.
By order of the Board of Directors.
Dated at Washington, DC this 10th day of December, 2013.
Federal Deposit Insurance Corporation.
Robert E. Feldman,
Executive Secretary
By the Securities and Exchange Commission.
Dated: December 10, 2013.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2013-31511 Filed 1-30-14; 8:45 am]
BILLING CODE 4810-33-P