Key Takeaways from the Long Awaited Final Volcker Rule
After nearly three and one-half years, various federal agencies have issued final regulations regarding the Volcker Rule. Investment managers and banking entities will need to implement various programs to address these rules by July 1, 2014 with the conformance period extended until July 21, 2015. This Alert focuses on the three key takeaways: (1) banking entities are prohibited from engaging in proprietary trading; (2) banking entities are generally prohibited from owning and sponsoring hedge and private equity funds (known as "covered funds"); and (3) banking entities must make good faith efforts to start developing and implementing compliance programs and preparing for the various applicable reporting requirements.
A. Proprietary Trading
Banking entities may not engage as a principal for the trading account of the banking entity in the purchase or sale of financial instruments. • "Bank Entity" means a bank, a company controlled by a bank and/or any of its affiliates. This definition includes foreign entities under certain circumstances. • "Trading Account" means an account used to take positions principally for the purpose of profiting from short term resale or for hedging another account position. • "Financial Instruments" means securities, options, derivatives, commodities and futures. The definition does not include loans, non-derivative commodities, foreign exchange and currency instruments.
There are a number of permitted activities which a banking entity may engage in:
• Underwriting for distributions of public and private offerings so long as the position does not exceed the reasonably expected short term demands of customers. • Market making activities for the purpose of meeting short term demands of clients, customers and counterparties. • Risk mitigation hedging. • Trading in certain government obligations. • Trading by certain foreign banking entities.
The final rules clarify certain activities which are not considered proprietary trading:
• Trading solely as agent, broker or custodian. • Trading through a deferred compensation plan. • Trading to satisfy previously contracted debts. • Liquidation management in accordance with a documented plan. • Clearing activities. • Satisfaction of certain legal obligations.
B. Prohibitions on Covered Fund Activities
Banking entities are generally prohibited from owning and sponsoring covered funds.
• A "Covered Fund" is generally defined as: (a) an entity that would be an "investment company" but for Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, as amended; (b) a commodity pool for which the commodity pool operator has claimed an exemption under Section 4.7 or (c) a foreign fund sponsored or owned directly or indirectly by a U.S. banking entity. • Joint ventures, acquisition vehicles, SEC registered investment companies and bank development companies are not considered covered funds. A banking entity may engage in various permitted activities relating to covered funds, including: • Underwriting or market making activities. • Certain types of risk mitigation hedging activities that occur solely outside the U.S. • Certain insurance company activities. • Taking action on behalf of customers as agent, broker, custodian, trustee, through deferred compensation plans or in the ordinary course of collecting debts.
Additionally, a bank entity may invest in, or sponsor a covered fund in connection with organizing and offering the fund in an amount less than (a) 3% of the total number or value of a fund's ownership interests (and under certain circumstances a larger % for a short period of time) and (b) 3% of the bank entity's Tier I Capital.
C. Reporting/Compliance/Timing The final rules require banking entities to establish an internal compliance program designed to monitor compliance with the rules. Larger banking entities ($50 billion and more of consolidated trading assets and liabilities) ("Larger Banks") are expected to establish more detailed programs and are required to have its CEO attest that there is a compliance program in place to monitor compliance. Additionally, all banking entities subject to the Volcker Rule will need to maintain documentation so that the federal agencies can monitor such entities' activities.
Finally, all banking entities will be required to report certain quantitative measurements designed to monitor trading activities. Such measurements include:
• Risk and position limits usage; • Risk factor sensitivities; • VAR and stress VAR; • Comprehensive profit and loss attribution; • Inventory turnover and aging; and • Customer facing trade ratio.
These reporting requirements will be phased in over the next few years based on the size of the banking entity.
• Larger banks will need to start reporting these measurements beginning June 30, 2014. • Banks with consolidated trading assets and liabilities between $25-$50 billion must start preparing these reports as of April 30, 2016. • Banks with consolidated trading assets and liabilities between $10-$25 billion must start preparing these reports as of December 31, 2016.
The final rules comprise nearly 900 pages, with a lot of details relating to the investment fund industry. There are many rules still under analysis, as well as various issues raised by the banking community that need to be addressed by the various federal agencies. Please reach out to your Sadis & Goldberg contact for further clarification on how these changes affect you or for assistance in complying with the new rule. We will keep you apprised of any new developments and clarifications as they become available.