ADVISORY Dodd-Frank Act
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- Jesse Berry
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1 ADVISORY Ddd-Frank Act BEIJING BRUSSELS LONDON NEW YORK SAN DIEGO SAN FRANCISCO SEOUL SHANGHAI SILICON VALLEY WASHINGTON December 18, 2013 VOLCKER RULE: FINAL REGULATIONS PROPRIETARY TRADING PROVISIONS On December 10, 2013, the Federal Reserve Bard, Cmmdity Futures Trading Cmmissin, Office f the Cmptrller f the Currency, Securities and Exchange Cmmissin, and Federal Depsit Insurance Crpratin (cllectively, the Agencies ) jintly released lng-awaited final regulatins implementing sectin 619 f the Ddd-Frank Wall Street Refrm and Cnsumer Prtectin Act, cmmnly referred t as the Vlcker Rule. 1 The final regulatins will becme effective n April 1, 2014 and, with the exceptin f certain reprting and recrdkeeping requirements described belw, are subject t an extended cnfrmance perid ending n July 21, Each banking entity subject t the Vlcker Rule is expected t engage in gd-faith effrts apprpriate fr its activities and investments that will result in full cnfrmance with the Vlcker Rule by the end f this cnfrmance perid. In additin, banking entities with stand-alne prprietary trading peratins are expected t prmptly terminate r divest thse peratins. The Bard f Gvernrs f the Federal Reserve (the Bard ) may grant an extensin f the cnfrmance perid fr up t tw additinal ne-year perids (either generally r n a case-by-case basis fr individual banking entities) if, in the judgment f the Bard, an extensin is cnsistent with the purpses f the Vlcker Rule and wuld nt be detrimental t the public interest. The Bard may als grant a banking entity ne additinal extensin fr up t five years, t the extent necessary fr the banking entity t fulfill a cntractual bligatin in effect n May 1, 2010 t prvide additinal capital t an illiquid fund. The Vlcker Rule cnsists f tw key restrictins. First, banking entities are prhibited frm engaging in prprietary trading (the Prprietary Trading Prvisins ). Secnd, banking entities are prhibited frm spnsring r investing in specified cvered funds such as private equity r hedge funds, r extending credit t r engaging in ther cvered transactins with affiliated cvered funds (the Cvered Fund Prvisins ). 2 The Prprietary Trading Prvisins are cvered in Subpart B f the final regulatins, and the Cvered Fund Prvisins are cvered in Subpart C f the final regulatins. Cmpliance prgram requirements are cvered in Subpart D f the final regulatins. This client advisry utlines the Prprietary Trading Prvisins. PROHIBITION ON PROPRIETARY TRADING Under the Prprietary Trading Prvisins, banking entities and their affiliates are bradly prhibited frm engaging in prprietary trading, the definitin f which is intended t capture the purchase r 1 A cpy f the final rule is available n the Federal Reserve website at It was accmpanied by a jint release (the Release ) issued by the Agencies which prvides useful discussin f the rule, cmments received by the Agencies, and their reasns fr making certain changes r additins t the prpsed frm f the rule first issued n Octber 11, Fr an verview f the Vlcker Rule, please see ur previus client advisries Final Vlcker Rule Prvisins (July 21, 2010) and Vlcker Rule Study by the Financial Stability Oversight Cuncil (January 31, 2011). 2 Fr an verview f the Cvered Fund Prvisins, please see ur client advisry, Vlcker Rule: Final Regulatins Cvered Fund Prvisins (December 18, 2013).
2 sale, as principal, f financial instruments fr the purpse f shrt-term resale, benefitting frm shrt-term price mvements r realizing shrt-term arbitrage prfits. The Prprietary Trading Prvisins prvide certain exemptins frm the brad prhibitin against prprietary trading, including fr: underwriting securities, market-making activities, risk-mitigating hedging, repurchase and reverse repurchase agreements, securities lending transactins, liquidity management activities, trading in gvernment bligatins, transactins by freign banking entities ccurring utside the U.S., trading n behalf f custmers, and clearance and settlement activities f clearing rganizatins and their members. The brad prhibitin against prprietary trading and the varius exemptins t it are each the subject f cmplex definitinal and substantive prvisins. In additin, the rules mandate extensive internal cmpliance prgrams and the adptin f detailed plicies and prcedures at the individual trading desk level. Finally, larger banking entities will be bligated under the rules t capture and calculate transactin and psitin data n a variety f quantitative metrics n a daily basis and t reprt such data t regulatrs. What activities are prhibited under the Prprietary Trading Prvisins? Banking entities are prhibited frm engaging in prprietary trading, subject t certain exemptins described belw. What is a banking entity? Banking entity includes (i) insured depsitry institutins, (ii) cmpanies that cntrl insured depsitry institutins, (iii) cmpanies that are treated as bank hlding cmpanies fr purpses f sectin 8 f the Internatinal Banking Act f 1978, and (iv) any affiliate r subsidiary f an entity described in (i) thrugh (iii). Banking entity des nt include the fllwing entities, s lng as any such entity is nt itself a banking entity described in (i) thrugh (iii) abve: a cvered fund ; a prtfli cmpany held under a banking entity s authrity t engage in merchant banking r insurance cmpany investment activity under Sectin 4(k)(4)(H) r (I) f the Bank Hlding Cmpany Act f 1956 (the BHC Act ); r a prtfli cncern cntrlled by a small business investment cmpany under Sectin 103(3) f the Small Business Investment Act f Banking entity als des nt include the FDIC, acting in its crprate capacity r as cnservatr r receiver under the Federal Depsit Insurance Act r Title II f the Ddd-Frank Act. Hw is prprietary trading defined? The term prprietary trading means engaging as principal fr the trading accunt f the banking entity in any purchase r sale f ne r mre financial instruments. A financial instrument is (i) a security, including an ptin n a security, (ii) a derivative, including an ptin n a derivative, r (iii) a cntract f sale f a cmmdity fr future delivery, r ptin n a cntract f sale f a cmmdity fr future delivery. The term des nt include (i) a lan, (ii) a cmmdity that is nt an excluded cmmdity as defined under the Cmmdity Exchange Act (ther than freign exchange r currency), a 2
3 derivative, a cntract f sale f a cmmdity fr future delivery r an ptin n a cntract f sale f a cmmdity fr future delivery 3, r (iii) freign exchange r currency. A trading accunt is any accunt that is used by a banking entity t (i) purchase r sell ne r mre financial instruments principally fr the purpse f shrt-term resale, benefitting frm actual r expected shrt-term price mvements, realizing shrt-term arbitrage prfits, r hedging ne r mre psitins resulting frm the freging; (ii) purchase r sell ne r mre financial instruments that are bth market risk capital rule cvered psitins and trading psitins (r hedges f ther market risk capital rule cvered psitins), if the banking entity, r any affiliate theref, is an insured depsitry institutin, bank hlding cmpany, r savings and lan hlding cmpany and calculates risk-based capital ratis under the market risk capital rule, (iii) purchase r sell ne r mre financial instruments fr any purpse, if the banking entity is (r is required t be) licensed r registered t engage in the business f a dealer, swap dealer, r securitybased swap dealer, t the extent that the financial instrument is purchased r sld in cnnectin with the activities requiring such license r registratin, r (iv) purchase r sell ne r mre financial instruments fr any purpse, if the banking entity is engaged in the business f a dealer, swap dealer, r security-based swap dealer utside f the U.S., t the extent the instrument is purchased r sld in cnnectin with the activities f such business. Rebuttable Presumptin. The purchase r sale f a financial instrument by a banking entity is presumed t be fr the trading accunt f such entity if it hlds the instrument fr fewer than 60 days (r substantially transfers the risk f the financial instrument within 60 days f its purchase r sale), unless it can demnstrate that it did nt purchase r sell the financial instrument principally fr any f the prhibited purpses set frth in the definitin f trading accunt abve. Nte: There is n safe harbr, r reverse presumptin, with respect t instruments held fr 60 days r lnger. 4 Rather, the Agencies stated in the adpting release that they wuld evaluate all the facts and circumstances in determining whether particular trading activities cnstitute prprietary trading. 5 Nnetheless, they als indicated that the presumptin with respect t instruments held fr fewer than 60 days was intended primarily t prvide guidance t banking entities that are nt subject t the market risk capital rules r are nt cvered securities r swap dealers and accrdingly may nt have experience evaluating shrt-term trading intent. 6 The Agencies further stated that bth the market risk capital and dealer prngs f the trading accunt definitin were designed t capture trading with shrt-term intent, nting that (i) trading psitins subject t the market risk capital rules are defined as thse held fr shrt-term purpses 7, and (ii) financial instruments purchased r sld by registered dealers in cnnectin with their dealer activity are generally held with shrt-term intent, and activities fr which banking entities require a dealer s license are nt necessarily all f the activities f such entities. 8 Exclusins frm Prprietary Trading. Prprietary trading des nt include: 3 Fr example, the spt purchase f a cmmdity wuld be excluded frm the definitin f financial instrument, but the acquisitin f a futures psitin in the same cmmdity wuld nt be. Release at p Release at pp Release at p Release at p Release at p Release at pp
4 Reps. Any purchase r sale f ne r mre financial instruments by a banking entity that arises under a repurchase r reverse repurchase agreement pursuant t which the banking entity has simultaneusly agreed, in writing, t bth purchase and sell a stated asset, at stated prices, and n stated dates r n demand with the same cunterparty; Securities Lending Transactins. Any purchase r sale f ne r mre financial instruments by a banking entity that arises under a transactin in which the banking entity lends r brrws a security temprarily t r frm anther party pursuant t a written securities lending agreement under which the lender retains the ecnmic interest f an wner f such security, and has the right t terminate the transactin and t recall the laned security; Liquidity Management Transactins. Any purchase r sale f a security by a banking entity fr the purpse f liquidity management in accrdance with a dcumented liquidity management plan that (i) specifically cntemplates and authrizes the particular securities t be used fr liquidity management purpses (utlining the amunts, types, and risks f these securities that are cnsistent with liquidity management), (ii) requires that such purchase r sale is principally fr the purpse f managing liquidity, (iii) requires that such securities are highly liquid and nt reasnably expected t result in appreciable prfits r lsses as a result f shrt-term price mvements, (iv) limits such purchase r sale t an amunt that is cnsistent with the banking entity s near-term funding needs, (v) includes written plicies, prcedures, internal cntrls, analysis and independent testing t ensure cmpliance with the regulatins, and (vi) is cnsistent with the supervisry requirements, guidance and expectatins related t liquidity management f any applicable verseeing federal agency; Nte: The Agencies in adpting this exclusin expressly declined t expand it t cver brader asset-liability management, earnings management, r scenari hedging activities. 9 Clearing Organizatin Transactins. Any purchase r sale f ne r mre financial instruments by a banking entity that is a derivatives clearing rganizatin r a clearing agency in cnnectin with clearing financial instruments; Clearing Activities by Clearing Organizatin Members. Any excluded clearing activities by a banking entity that is a member f a clearing agency, a member f a derivatives clearing rganizatin, r a member f a designated financial market utility; Excluded clearing activities means any purchase r sale (i) t crrect trading errrs made by r n behalf f a custmer that is cleared n a derivatives clearing rganizatin, clearing agency, r designated financial market utility, (ii) in cnnectin with and related t the management f a default r threatened imminent default f a custmer r a member f a clearing agency, derivatives clearing rganizatin, r designated financial market utility, r a default r threatened default f such a clearing agency, derivatives clearing rganizatin, r designated financial market utility; r (iv) that is required by the rules r prcedures f a clearing agency, derivatives clearing rganizatin, r designated financial market utility t mitigate the risk t such entity resulting frm the clearing by a member f security-based swaps that reference the member r an affiliate f the member. 9 Release at p
5 Delivery Obligatins. Any purchase r sale f ne r mre financial instruments by a banking entity, s lng as such purchase r sale satisfies an existing delivery bligatin f the banking entity r its custmers (including t prevent r clse ut a failure t deliver) in cnnectin with delivery, clearing, r settlement activity; Judicial and Similar Prceedings. Any purchase r sale f ne r mre financial instruments by a banking entity, s lng as such purchase r sale satisfies an bligatin f the banking entity in cnnectin with a judicial, administrative, selfregulatry rganizatin, r arbitratin prceeding; As Agent, Brker, r Custdian. Any purchase r sale f ne r mre financial instruments by a banking entity that is acting slely as agent, brker, r custdian; Cmpensatin Plans. Any purchase r sale f ne r mre financial instruments by a banking entity thrugh a deferred cmpensatin, stck-bnus, prfit-sharing, r pensin plan f the banking entity, if the purchase r sale is made by the banking entity as a trustee fr the benefit f emplyees f the banking entity; r Debt Cllectins. Any purchase r sale f ne r mre financial instruments by a banking entity in the rdinary curse f cllecting a debt previusly cntracted in gd faith, prvided that the banking entity divests the financial instrument as sn as practicable, and in n event retains such instrument fr lnger than such perid permitted by the applicable federal agency. Nte: This exclusin permits banking entities t take pssessin f margined cllateral upn a custmer default n a margin lan r failure t meet a margin call, prvided it is divested as sn as practicable. 10 EXEMPTIONS FROM PROHIBITIONS ON PROPRIETARY TRADING The final regulatins cntain exemptins frm the prhibitin n prprietary trading fr permitted underwriting activities, market making-related activities, risk-mitigating hedging activities, and certain ther trading activities. Imprtantly, these exemptins define the permitted activities and impse cmpliance and recrdkeeping requirements at the level f the individual trading desk at which such activity is undertaken. Trading desk is defined as the smallest discrete unit f rganizatin f a banking entity that purchases r sells financial instruments fr the trading accunt f the banking entity r an affiliate theref. What activities are exempted frm the prhibitin n prprietary trading? Underwriting Activities. The prhibitin n prprietary trading des nt apply t the purchase r sale f a financial instrument by a banking entity that is made in cnnectin with the banking entity s underwriting activities. Underwriting activities are permitted nly if: 1. The banking entity is acting as an underwriter 11 fr a distributin 12 f securities and the trading desk s underwriting psitin is related t such distributin; 10 Release at p The term underwriter means (a) a persn wh has agreed with an issuer f securities r selling security hlder t purchase securities fr distributin, t engage in a distributin f securities fr r n behalf f such issuer r selling security hlders, r t manage a distributin f securities fr r n behalf f such issuer r selling security hlder, and (b) a persn wh has an agreement with such a persn t engage in distributin f such securities fr r n behalf f the issuer r selling security hlder. 12 The term distributin means an ffering f securities, whether r nt subject t registratin, that is distinguished frm rdinary trading transactins by the presence f special selling effrts and selling methds, r an ffering f securities made pursuant t an effective registratin statement under the Securities Act f
6 2. The amunt and type f the securities in the trading desk s underwriting psitin are designed nt t exceed the reasnably expected near-term demands f clients, custmers, r cunterparties; 3. Reasnable effrts are made t sell r therwise reduce the underwriting psitin within a reasnable perid, taking int accunt the liquidity, maturity, and depth f the market fr the relevant type f security; 4. The banking entity has established an internal cmpliance prgram designed t ensure cmpliance with the regulatins, including detailed plicies and prcedures at the individual trading desk level (see discussin belw); 5. The cmpensatin arrangements f persns perfrming underwriting activities are designed nt t reward r incentivize prhibited prprietary trading; and 6. The banking entity is licensed r registered t engage in such underwriting activities in accrdance with applicable law. Nte: The underwriting exemptin is intended t accmmdate differences in the liquidity f markets and types f underwritten transactins applicable t varius types f securities. While the rule requires a trading desk s underwriting psitin nt t exceed the reasnable near term demand f clients, custmers, and cunterparties (nt including the issuer s desire t sell the securities), the Agencies cnfirmed that an underwriter is nt required t engage in bk-building r ther marketing effrts t determine investr demand, and the time it takes t cmplete a distributin may differ depending n liquidity, maturity, and the depth f the market. The Agencies als cnfirmed that hlding an unsld alltment when market cnditins may make it impracticable t sell the entire alltment at a reasnable price at the time f the distributin and selling such psitin when it is reasnable t d s is permitted. Additinally, the Agencies nted that activities cnducted in cnnectin with underwriting, such as stabilizatin, syndicate shrting, aftermarket shrt cvering, and entering int call-spread ptins with issuers as part f cnvertible debt fferings are permitted under the exemptin. 13 Hwever, it is imprtant t bear in mind that lng r shrt psitins created in cnnectin with an underwritten distributin are all deemed part f the underwriting psitin and therefre must be reduced within a reasnable time, and each trading desk is expected t perate under rbust limits n, amng ther things, the amunt, types, and risks f its underwriting psitin and the perid f time a security may be held. 14 Nte that the trading desk fr these purpses may be a syndicate r underwriting desk, and it may manage an underwriting psitin that includes psitins held at different affiliated legal entities and persnnel in different lcatins. 15 Market Making-Related Activities. The prhibitin n prprietary trading des nt apply t the purchase r sale f a financial instrument by a banking entity that is made in cnnectin with the banking entity s market making-related activities. Market making-related activities are permitted nly if: 1. The trading desk that establishes and manages the financial expsure rutinely stands ready t purchase r sell ne r mre types f financial instruments related t its financial expsure and is willing and available t qute, purchase and sell, r therwise enter int lng and shrt psitins in thse types f financial instruments fr its wn accunt, in cmmercially reasnable amunts and thrughut market cycles n a basis 13 Release at p Release at p Release at p
7 apprpriate fr the liquidity, maturity, and depth f the market fr the relevant types f financial instruments; 2. The amunts, types, and risks f the financial instruments in the trading desk s marketmaker inventry are designed nt t exceed, n an nging basis, the reasnably expected near term demands f clients, custmers, r cunterparties; The entity has established an internal cmpliance prgram designed t ensure cmpliance with the regulatins, including detailed plicies and prcedures n an individual trading desk level (see discussin belw); 4. T the extent that any limit established fr the trading desk in relatin t its marketmaking activities is exceeded, the trading desk takes actin t bring itself int cmpliance as prmptly as pssible; 5. The cmpensatin arrangements f persns perfrming market making-related activities are designed nt t reward r incentivize prprietary trading; and 6. The banking entity is licensed r registered t engage in such market-making activities in accrdance with applicable law. Risk-Mitigating Hedging Activities. The prhibitin n prprietary trading des nt apply t the purchase r sale f financial instruments by a banking entity in risk-mitigating hedging transactins that are in cnnectin with and related t individual r aggregated psitins, cntracts, r ther hldings f the banking entity and designed t reduce the specific risks t the banking entity in cnnectin with and related t such psitins, cntracts, r ther hldings. These risk-mitigating hedging activities are permitted nly if: 1. The entity has established an internal cmpliance prgram designed t ensure cmpliance with the regulatins, including detailed plicies and prcedures n an individual trading desk level (see discussin belw); and 2. The risk-mitigating hedging activity (i) is in accrdance with the written plicies, prcedures, and internal cntrls, (ii) at the inceptin f the hedging activity, including any adjustments, is designed t reduce r therwise significantly mitigate and demnstrably reduces r therwise significantly mitigates ne r mre specific, identifiable risks, 17 arising in cnnectin with and related t identified psitins, cntracts, r ther hldings f the banking entity, (iii) des nt give rise at the inceptin f the hedge t any significant new r additinal risk that is nt itself hedged cntempraneusly, (iv) is subject t cntinuing review, mnitring, and management by the banking entity, including nging recalibratin f the hedging activity, and (v) the cmpensatin arrangements f persns perfrming the risk-mitigating hedging activities are designed nt t reward r incentivize prprietary trading. Nte regarding hedging strategies: In their adpting release, the Agencies cnfirmed that certain hedging strategies such as dynamic hedging and anticipatry hedging are permitted if they therwise cmply with the requirements described abve. 18 Hwever, the Agencies nted that the bradest frms f what is ften referred t as prtfli hedging wuld nt meet these requirements. Imprtantly, the rule des 16 Near term demand is required t be assessed n the basis f (i) the liquidity, maturity, and depth f the market fr the relevant types f financial instruments and (ii) demnstrable analysis f histrical custmer demand, current inventry, market and ther factrs regarding the amunt, types, and risks, f r assciated with financial instruments in which the trading desk makes a market, including blck trades. 17 Including market risk, cunterparty r ther credit risk, currency r freign exchange risk, interest rate risk, cmmdity price risk, basis risk, r similar risks. 18 Release at pp
8 permit the hedging f aggregated psitins; hwever, the hedging activity must be related t, and mitigate, identifiable risks f specific, identifiable psitins, cntracts, r ther hldings. Mre generalized risks faced by trading desks r the banking entity as a whle based n nn-psitin-specific mdeling r general risks t revenues r prfits frm market mvements r ecnmic cnditins are nt cvered by the risk-mitigating hedging exemptin. 19 Nte regarding hedging acrss trading desks and entities: Additinal dcumentatin is required fr any risk-mitigating hedging that is (i) nt established by the specific trading desk establishing the underlying psitins being hedged, (ii) established by the specific trading desk that is establishing the underlying psitins but that is effected thrugh a financial instrument, expsure, technique, r strategy that is nt specifically identified in the trading desk s written plicies and prcedures, r (iii) established t hedge aggregate psitins acrss tw r mre trading desks. The additinal dcumentatin must recrd the specific, identifiable risk(s) f the identified psitins being hedged, the specific risk-mitigating strategy being used, and the trading desk r ther business unit that is establishing and respnsible fr the hedge. Other Exempted Trading Activities. Dmestic Gvernment Obligatins. The prhibitin des nt apply t the purchase r sale by a banking entity f a financial instrument that is an bligatin, participatin, r ther instrument f, r issued r guaranteed by, the United States, the Gvernment Natinal Mrtgage Assciatin, Federal Natinal Mrtgage Assciatin, Federal Hme Lan Mrtgage Crpratin, a Federal Hme Lan Bank, the Federal Agricultural Mrtgage Crpratin, r a Farm Credit System institutin; an bligatin f any state r plitical subdivisin theref, including any municipal security; r an bligatin f the FDIC fr the purpse f facilitating the dispsal f assets acquired r held by the FDIC in its crprate capacity r as cnservatr r receiver under the Federal Depsit Insurance Act r Title II f the Ddd-Frank Act. Nte: Prprietary trading in derivatives n U.S. gvernment and agency bligatins, such as Treasury futures, is nt permitted, unless therwise in cmpliance with the market making r risk-mitigating hedging exemptins. In the adpting release, the Agencies nte the rle f primary dealers in the U.S. Treasury market and cnfirm that they may treat the U.S. gvernment as a client, custmer, r cunterparty fr purpses f the market-making exemptin. 20 Freign Gvernment Obligatins. The prhibitin des nt apply t: Freign Banking Entities Trading in Hme Cuntry Obligatins. The purchase r sale by a banking entity f a financial instrument that is an bligatin f, r issued r guaranteed by, a freign svereign (including any multinatinal central bank f which the freign svereign is a member), r any agency r plitical subdivisin theref, s lng as (i) the banking entity is rganized under, r directly r indirectly cntrlled by a banking entity rganized under, the laws f such freign svereign, (ii) the banking entity is nt cntrlled by a tp-tier banking entity rganized under U.S. laws, and (iii) the purchase r sale as principal is nt made by an insured depsitry institutin; and Freign Subsidiaries f U.S. Banks Trading in Hst Cuntry Obligatins. The purchase r sale by a freign entity that is wned r cntrlled by a U.S. banking 19 Release at p Release at pp
9 entity f a financial instrument that is an bligatin f, r issued r guaranteed by, a freign svereign (including any multinatinal central bank f which the freign svereign is a member), r any agency r plitical subdivisin theref, s lng as (i) the freign entity is a freign bank as defined by the Bard in Regulatin K, r is regulated by the freign svereign as a securities dealer, (ii) the financial instrument is an bligatin f, r issued r guaranteed by, the freign svereign under which the freign entity is rganized (including any multinatinal central bank f which the freign svereign is a member), r any agency r plitical subdivisin theref, and (iii) the financial instrument is wned by the freign entity and is nt financed by an affiliate that is lcated in the United States r rganized under U.S. laws. Transactins n Behalf f Custmers. The prhibitin des nt apply t the purchase r sale f a financial instrument by a banking entity n behalf f a custmer if (i) the banking entity is acting as trustee r in a similar fiduciary capacity fr the custmer, the transactin is fr the accunt f r n behalf f the custmer, and the banking entity des nt have r retain beneficial wnership f the financial instrument; r (ii) the banking entity is acting as riskless principal in a transactin in which the banking entity, after receiving an rder t purchase r sell a financial instrument frm a custmer, purchases r sells the financial instrument fr its wn accunt t ffset a cntempraneus sale t r purchase frm the custmer. Regulated Insurance Cmpanies. The prhibitin des nt apply t the purchase r sale f a financial instrument by an insurance cmpany r any affiliate f an insurance cmpany if (i) the insurance cmpany r its affiliate purchases r sells the financial instrument slely fr the general accunt f the insurance cmpany r a separate accunt established by the insurance cmpany, and (ii) the purchase r sale is cnducted in cmpliance with, and subject t, the insurance cmpany investment laws, regulatins, and written guidance f the state r jurisdictin in which the insurance cmpany is dmiciled. Trading Activities f Freign Banking Entities. The prhibitin des nt apply t the purchase r sale f a financial instrument by a banking entity if (i) the banking entity is nt rganized, r directly r indirectly cntrlled by a banking entity that is rganized, under U.S. laws, (ii) the purchase r sale is cnducted pursuant t paragraph 9 r 13 f sectin 4(c) f the BHC Act, 21 and (iii) the purchase r sale is cnducted in accrdance with the fllwing additinal requirements: 1. The banking entity engaging as principal in the purchase r sale (including any persnnel f the banking entity r its affiliates that arrange, negtiate, r execute the purchase r sale) is nt lcated in the United States r rganized under U.S. laws; 2. The banking entity (including relevant persnnel) that makes the decisin t purchase r sell as principal is nt lcated in the United States r rganized under U.S. laws; 21 A purchase r sale is deemed t be cnducted pursuant t paragraph (9) r (13) if (i) with respect t a banking entity that is a freign banking rganizatin, the banking entity meets the qualifying freign banking rganizatin requirements f Sectin (a), (c) r (e) f the Bard s Regulatin K, r (ii) with respect t a banking entity that is nt a freign banking rganizatin, the banking entity meets at least tw f the fllwing requirements n a fully-cnslidated basis: (1) the banking entity s ttal assets held utside f the United States exceed the ttal assets held in the United States; (2) ttal revenues frm the banking entity s business utside f the United States exceed ttal revenues frm the banking entity s business within the United States; r (3) ttal net incme frm the banking entity s business utside f the United States exceeds ttal net incme frm the banking entity s business within the United States. 9
10 3. The purchase r sale, including any transactin arising frm risk-mitigating hedging related t the instruments purchased r sld, is nt accunted fr as principal directly r n a cnslidated basis by any branch r affiliate that is lcated in the United States r rganized under U.S. laws; 4. N financing fr the banking entity s purchases r sales is prvided, directly r indirectly, by any branch r affiliate that is lcated in the United States r rganized under U.S. laws; and 5. The purchase r sale is nt cnducted with r thrugh any U.S. entity 22 ther than (i) a purchase r sale with the freign peratins f a U.S. entity if n persnnel f such entity lcated in the United States are invlved in the arrangement, negtiatin, r executin f such purchase r sale; (ii) a purchase r sale with an unaffiliated market intermediary 23 acting as principal, prvided the purchase r sale is prmptly cleared and settled thrugh a clearing agency r derivatives clearing rganizatin acting as a central cunterparty; r (iii) a purchase r sale thrugh an unaffiliated market intermediary acting as agent, prvided the purchase r sale is cnducted annymusly n an exchange r similar trading facility and is prmptly cleared and settled thrugh a clearing agency r derivatives clearing rganizatin acting as a central cunterparty. What verarching limitatins apply t the exemptins utlined abve? The activities exempted frm the prhibitin n prprietary trading utlined abve are nnetheless subject t three brad limitatins: Material Cnflicts f Interest. N transactin r activity is permissible if it wuld invlve r result in a material cnflict f interest between the banking entity and its clients, custmers, r cunterparties. A material cnflict f interest exists if the banking entity engages in any transactin, class f transactins, r activity that wuld invlve r result in the banking entity s interests being materially adverse t the interests f its client, custmer, r cunterparty with respect t such transactin, class r transactins, r activity, unless the banking entity (1) prir t engaging therein, makes a clear, timely, and effective disclsure f the cnflict with sufficient infrmatin t permit the client, custmer, r cunterparty t meaningfully understand the cnflict and prvides it with the pprtunity t negate, r substantially negate, any materially adverse effect created by the cnflict, r (2) the banking entity establishes, maintains, and enfrces infrmatin barriers that are reasnably designed t prevent the cnflict frm invlving r resulting in a materially adverse effect n a client, custmer, r cunterparty. Material Expsures t High-Risk Assets r Trading Strategies. N transactin r activity is permissible if it wuld result, directly r indirectly, in a material expsure by the banking entity t a high-risk asset r a high-risk trading strategy. A high-risk asset means an asset r grup f related assets that wuld, if held by the banking entity, significantly increase the likelihd that the banking entity wuld 22 A U.S. entity is any entity that is, r is cntrlled by, r acting n behalf f r at the directin f, any entity lcated in the United States r rganized under U.S. laws. A U.S. branch, agency, r subsidiary f a freign banking entity is cnsidered t be lcated in the United States; hwever, the freign bank that perates r cntrls it is nt slely by virtue f perating r cntrlling the U.S. branch, agency, r subsidiary. 23 An unaffiliated market intermediary means an unaffiliated entity, acting as intermediary, that is a registered brker, swap dealer, security-based swap dealer, r futures cmmissin merchant (r exempt r excluded frm registering as such). 10
11 incur a substantial financial lss r pse a threat t the financial stability f the United States. A high-risk trading strategy is a trading strategy that wuld, if engaged in by a banking entity, significantly increase the likelihd that the banking entity wuld incur a substantial financial lss r pse a threat t the financial stability f the United States. Threats t Safety and Sundness. N transactin r activity is permissible if it wuld pse a threat t the safety and sundness f the banking entity r t the financial stability f the United States. COMPLIANCE PROGRAM REQUIREMENTS Each banking entity is required t develp a prgram reasnably designed t ensure and mnitr cmpliance with the prhibitins n prprietary trading activities and investments. The terms, scpe, and detail f the cmpliance prgram must be apprpriate fr the types, size, scpe, and cmplexity f activities and business structure f the entity. What internal cmpliance prgrams are required? Minimum Requirements. The rules mandate an internal cmpliance prgram fr banking entities with minimum requirements that include (i) written plicies and prcedures reasnably designed t dcument, describe, mnitr, and limit trading activities subject t the final rules, (ii) a system f internal cntrls reasnably designed t mnitr cmpliance with the rules and t prevent the ccurrence f prhibited activities r investments, (iii) a management framewrk that clearly delineates respnsibility and accuntability fr cmpliance, and includes apprpriate management review f trading limits, strategies, hedging activities, investments, incentive cmpensatin, and ther matters, (iv) independent testing and audit f the effectiveness f the cmpliance prgram cnducted by qualified persnnel f the banking entity r by a qualified utside party, (v) training fr trading persnnel and managers, as well as ther apprpriate persnnel, t effectively implement and enfrce the cmpliance prgram, and (vi) making and keeping recrds sufficient t demnstrate cmpliance, which the banking entity must prmptly prvide t the apprpriate federal agency upn request and retain fr at least five years. Written Plicies and Prcedures fr Trading Desks. The rules that permit underwriting, market-making, and risk-mitigating hedging activities specify that the banking entity establish, maintain, and enfrce written plicies and prcedures specifically gverning each f such activities, addressing the risks assciated with it, and tailred fr the individual trading desk undertaking it. The rules delineate elements that must be addressed in the plicies and prcedures related t each f such activities, such as the permitted types f securities and transactins that may be undertaken by a particular trading desk and psitin and risk limits that must be bserved by it. Enhanced Cmpliance Requirements fr Certain Banking Entities. Certain banking entities are subject t detailed enhanced cmpliance prgram requirements with respect t their prprietary trading activities, which are cntained in Appendix B t the final regulatins. In additin t the detailed Appendix B requirements addressing mechanical and ther aspects f the cmpliance plicies and prcedures fr specific activities, the Appendix als prescribes a gvernance and management framewrk as described belw. Banking Entities Subject t Enhanced Cmpliance Requirements. These banking entities generally include: any banking entity (ther than a freign banking entity) that engages in permitted prprietary trading and that has, tgether with its affiliates and subsidiaries, trading 11
12 assets and liabilities (excluding trading assets and liabilities invlving bligatins f r guaranteed by the United States r any agency f the United States) the average grss sum f which (n a wrldwide cnslidated basis) ver the previus cnsecutive fur quarters, equals r exceeds $50 billin beginning n June 30, 2014, $25 billin beginning n April 20, 2016, and $10 billin beginning n December 31, 2016; any freign banking entity that engages in permitted prprietary trading and whse cmbined U.S. peratins (including all subsidiaries, affiliates, branches, and agencies f the freign banking entity perating, lcated, r rganized in the United States, and excluding trading assets and liabilities invlving bligatins f r guaranteed by the United States r any agency f the United States) have trading assets and liabilities the average grss sum f which ver the previus cnsecutive fur quarters, equals r exceeds $50 billin beginning n June 30, 2014, $25 billin beginning n April 20, 2016, and $10 billin beginning n December 31, 2016; any banking entity (ther than a freign banking entity) that has reprted ttal cnslidated assets f $50 billin r mre; any freign banking entity that has ttal U.S. assets (including all subsidiaries, affiliates, branches, and agencies f the freign banking entity perating, lcated, r rganized in the United States) f $50 billin r mre; and any banking entity that is ntified by the apprpriate federal agency in writing that it must satisfy such additinal cmpliance requirements. Gvernance and Management Framewrk. Banking entities which are required t establish enhanced cmpliance prgrams must establish, maintain, and enfrce a gvernance and management framewrk that is reasnably designed t ensure that apprpriate persnnel are respnsible and accuntable fr the effective implementatin and enfrcement f the cmpliance prgram, a clear reprting line with a chain f respnsibility is delineated, and the cmpliance prgram is reviewed peridically by senir management. Accuntability fr Business Line Managers. Managers with respnsibility fr ne r mre trading desks f the banking entity are accuntable fr the effective implementatin and enfrcement f the cmpliance prgram with respect t the applicable trading desks. Accuntability fr Bard f Directrs and Senir Management. The bard f directrs, r similar crprate bdy, and senir management are respnsible fr setting and cmmunicating an apprpriate culture f cmpliance with sectin 619 f the Ddd-Frank Act and the final regulatins, and ensuring that apprpriate plicies regarding the management f trading activities and cvered fund activities r investments are adpted t cmply with sectin 619 f the Ddd-Frank Act and the final regulatins. The final regulatins als impse several specific new duties n the bard f directrs and senir management regarding the implementatin and enfrcement f the banking entity s enhanced cmpliance prgram. CEO Attestatin. Based n a review by the CEO f the banking entity, the CEO f the banking entity must annually attest in writing t the apprpriate federal agency that the banking entity has in place prcesses t establish, maintain, enfrce, review, test, and mdify the banking entity s enhanced cmpliance prgram in a manner reasnably designed t achieve cmpliance with sectin 619 f the Ddd-Frank Act. In the case f a U.S. branch r agency f a freign banking entity, the attestatin may be prvided fr the entire U.S. peratins f the freign banking entity by the senir 12
13 management fficer f the U.S. peratins f the freign banking entity wh is lcated in the United States. Banking Entities With Mdest Activities. A banking entity with ttal cnslidated assets f $10 billin r less, as reprted n December 31 f the previus tw calendar years, that engages in prprietary trading (ther than permitted trading in U.S., State, r municipal gvernment bligatins and specified FDIC bligatins) r spnsrs r invests in cvered funds may satisfy its cmpliance prgram requirements by including in its existing cmpliance plicies and prcedures apprpriate references t the requirements in Sectin 619 f the Ddd-Frank Act and the final regulatins, with adjustments as apprpriate given the activities, size, scpe, and cmplexity f the banking entity. Banking Entities With N Cvered Activities. If a banking entity des nt engage in prprietary trading (ther than permitted trading in U.S., State, r municipal gvernment bligatins and specified FDIC bligatins) r spnsr r invest in cvered funds, the entity may satisfy the cmpliance prgram requirements by establishing the required cmpliance prgram prir t becming engaged in such activities. What recrdkeeping and reprting bligatins are impsed? Reprting and Recrdkeeping. A banking entity engaged in any prprietary trading activity permitted under the final regulatins is required t cmply with specific reprting and recrdkeeping requirements (which are set frth in Appendix A f the final regulatins) if: the banking entity (ther than a freign banking entity) has, tgether with affiliates and subsidiaries, trading assets and liabilities (excluding trading assets and liabilities invlving bligatins f r guaranteed by the United States r an agency theref) the average grss sum f which (n a wrldwide cnslidated basis) ver the previus cnsecutive fur quarters, equals r exceeds $50 billin beginning n June 30, 2014, $25 billin beginning n April 20, 2016, and $10 billin beginning n December 31, 2016; in the case f a freign banking entity, the cmbined U.S. peratins (including all subsidiaries, affiliates, branches, and agencies f the freign banking entity perating, lcated, r rganized in the United States, and excluding trading assets and liabilities invlving bligatins f r guaranteed by the United States r any agency f the United States) have trading assets and liabilities the average grss sum f which ver the previus cnsecutive fur quarters, equals r exceeds $50 billin beginning n June 30, 2014, $25 billin beginning n April 20, 2016, and $10 billin beginning n December 31, 2016; r the banking entity is ntified by the apprpriate federal agency in writing that it must satisfy such additinal reprting requirements. 24 Banking entities with $50 billin r mre in trading assets and liabilities must reprt the infrmatin required fr each calendar mnth within 30 days f the end f the relevant mnth; hwever, beginning with the infrmatin fr the mnth f January 2015, such reprts must be made within 10 days f the end f each calendar mnth. Other banking entities subject t the Appendix A reprting requirements will make their reprts within 30 days f the end f the calendar quarter. 24 Federal agencies may require ther banking entities nt meeting these tests t als cmply with these recrdkeeping and reprting bligatins. 13
14 Appendix A requires that the fllwing quantitative measurements be calculated each day fr the calculatin perids indicated and included in reprts made t the Agencies n the reprting schedule described abve: Measurement Descriptin Calculatin Perid Risk and Psitin Limits and Usage Risk Factr Sensitivities Value-at-Risk Stress Value-at-Risk Cmprehensive Prfit and Lss Attributin Inventry Turnver Inventry Aging Custmer-Facing Trade Rati (Trade Cunt Based and Value Based) The amunt f risk that a trading desk is permitted t take at a pint in time. Usage represents the prtin f the trading desk s limits that are accunted fr by the current activity f the desk. Changes in a trading desk s cmprehensive prfit and lss that are expected t ccur in the event f a change in ne r mre underlying variables that are significant surces f the trading desk s prfitability and risk. The cmmnly used percentile measurement f the risk f future financial lss in the value f a given set f aggregated psitins ver a specific perid f time, based n current market cnditins. The percentile measurement f the risk f future financial lss in the value f a given set f aggregated psitins ver a specified perid f time, based n market cnditins during a perid f significant financial stress. Analysis that attributes daily fluctuatin in the value f a trading desk s psitins t varius surces. These measurements must als calculate vlatility f cmprehensive prfit and lss fr the reprting perid fr at least a 30-, 60- and 90-day lag perid, frm the end f the reprting perid. A rati that measures the turnver f a trading desk s inventry. A schedule f the trading desk s aggregate assets and liabilities and the amunt f time that thse assets and liabilities have been held. A rati cmparing (i) the transactins invlving a cunterparty that is a custmer f the trading desk t (ii) the transactins invlving a cunterparty that is nt a custmer f the trading desk. A trade cunt based rati is calculated based n the number f transactins. A value based rati is calculated based n the value f such transactins. One trading day One trading day One trading day One trading day One trading day 30, 60, and 90 days One trading day 30, 60, and 90 days 14
15 If yu wuld like t discuss the final regulatins, please cntact the fllwing lawyers in ur firm: Frederick Knecht (c-authr) fknecht@cv.cm Warren Caywd (c-authr) wcaywd@cv.cm Carey Rberts (c-authr) crberts@cv.cm Bruce Bennett bbennett@cv.cm Jhn Dugan jdugan@cv.cm Keith Nreika knreika@cv.cm Daniel Nazar (c-authr) dnazar@cv.cm This infrmatin is nt intended as legal advice. Readers shuld seek specific legal advice befre acting with regard t the subjects mentined herein. Cvingtn & Burling LLP, an internatinal law firm, prvides crprate, litigatin and regulatry expertise t enable clients t achieve their gals. This cmmunicatin is intended t bring relevant develpments t ur clients and ther interested clleagues. Please send an t unsubscribe@cv.cm if yu d nt wish t receive future s r electrnic alerts Cvingtn & Burling LLP, 1201 Pennsylvania Avenue, NW, Washingtn, DC All rights reserved. 15
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