U.S. Volcker Rule places major new demands on compliance
By Nick Paraskeva, for Compliance Complete
NEW YORK, Dec. 17 (Thomson Reuters Accelus) – The Volcker Rule final version adopted on Tuesday by U.S. regulators imposes significant compliance demands on banks, with stricter prohibitions on proprietary trading than the initial proposal two years ago, narrower exemptions for market making and hedging and a requirement that chief executives are now required to annually certify to regulators that such a compliance plan is in place.
“As a foundation, the final Volcker Rule requires banking entities to have a robust compliance program, including defined limits on market making, underwriting and hedging activities as well as continuous monitoring and management of such activities. It also requires reporting to regulators on specific metrics and trading details,” U.S. Commodity Futures Trading Commission Chairman Gary Gensler said as the rule was adopted.
New compliance systems
Large banks will need to create compliance programs or units that are “reasonably designed to ensure and monitor compliance with the rules,” according to the proposal issued by five U.S. financial regulators. Banks would need to regularly report on quantitative measures designed to monitor trading compliance. This will need to describe — at a trading desk level — the process to identify, authorize and document which financial instruments that the desk may buy or sell.
“The exceptionally elusive task of defining, disentangling and dissecting permissible from prohibited activities surely posed a monumental challenge for regulators, but that challenge will be revisited tenfold upon bank customers and on the bankers who must comply with this enormous, highly complex and burdensome rule,” said Frank Keating, president of the American Bankers Association (ABA).
CEOs are required to attest that the program is reasonably designed to achieve compliance with the rule. There is a precedent for such certification — Sarbanes Oxley control reports — and FINRA compliance. For Volcker, the CEO certification is to confirm the firm has a compliance program, not that it has actually complied. It will likely lead to a cascade of similar sign-offs at lower levels in the bank that support the CEO statement.
Compliance requirements vary based on size and complexity. In response to industry comments, smaller entities with limited activity have a simplified compliance regime. Banks that do not conduct any covered activity other than trading in exempt government and municipal issues are not required to establish any compliance program. A separate document was issued to highlight non-application to community banks.
The need to “design” compliance requires it be planned in advance, rather than monitored after the event. A new obligation will be to monitor the expected near-term demands of customers, based on factors such as historical demand and market conditions. A market-making desk may hedge its risks, provided the inventory does not exceed near-term demand and it acts consistently with risk-management procedures.
To meet the underwriting exemption, banks will need to ensure compliance with specified conditions. This applies where a bank acts as underwriter, as long as the trading desk’s underwriting position is related to the distribution. The underwriting position must be designed not to exceed the reasonably expected near-term demands of customers. Independent testing and analysis of compliance programs are also required.
Risk and inventory limits
The rule applies to trading activities of insured banks and to entities affiliated with such banks, including broker-dealers. Compliance requires maintenance and enforcement of risk and inventory limits at a desk level. The policy should also state types of customers, and counterparties with whom the desk may trade.
A surprising new condition states that banks should “facilitate supervision and examination by agencies”.
The rule will be effective in July 2015, representing the Federal Reserve’s extension of the conformance period. Large banks with over $50 billion in trading assets and liabilities need to file quantitative reports from June 2014. Banks between $25 billion-$50 billion assets report from April, 2016, and with $10 billion-$25 billion from December, 2016. The agencies will review data collected by September 2015, and revise collection requirement if appropriate.
The exemption for market-making and related activity only applies where a trading desk “routinely stands ready to purchase and sell” a type of instrument. The desk’s inventory in those types of instrument would also have to be designed so that it does not exceed, on an ongoing basis, the reasonably expected near-term demands of customers.
New conditions applied to “risk-mitigating hedging” appear to be a response to JPMorgan’s $6 billion “London Whale” trading losses. The trades were arguably allowed under the original Volcker proposal as firmwide hedging. The only permissible hedging now is that which is “designed to reduce, and demonstrably reduces or significantly mitigates, specific, identifiable risks of individual or aggregated positions of the banking entity.”
Hedges must “be designed to mitigate and reduce actual risks, and not just by an accidental or collateral effect of the trade,” said CFTC Commissioner Bart Chilton. He cited language to demonstrate that hedging reduces risk and to require continued recalibration of hedging positions to stay valid. He said regulators must be “nimble and quick, to ensure what we do today holds up and that the high roller’s room isn’t re-opened.”
The bank will also need to conduct an analysis, including correlation analysis, which supports its hedging strategy, and the effectiveness of hedges should be monitored and recalibrated as needed on an ongoing basis. The rules also require banks to document, contemporaneously at the time of the trade, the hedging rationale for transactions that may give rise to heightened compliance risks.
Principal trades with customers are exempted only when done in a fiduciary capacity, or riskless principal. A separate Dodd-Frank provision requires the SEC to consider whether broker dealers need to be subject to a fiduciary duty on trades with retail customers, in the same way as advisers. It is unclear whether banks’ trading with all customers is viewed as being in a fiduciary capacity although trades done as agent are exempted.
Cross-border and international
Trading activities of foreign banks are generally permitted by Volcker, if they meet certain conditions. This includes that the foreign bank’s “trading decisions and principal risks occur and are held outside of the United States.” This echoes the recent CFTC cross-border rules which would apply to foreign entities that arrange some part of their swap transactions by staff or agents that are located in the U.S.
Foreign-bank transactions may only involve U.S. entities in certain circumstances, such as those with the foreign operations of U.S. entities. Cleared transactions such as swaps with U.S. entities are also exempt if they are traded via an unaffiliated intermediary or central clearer acting as principal, or the unaffiliated intermediary is acting as agent and the trade is conducted anonymously on an exchange or trade facility.
EU Internal Markets Commissioner Barnier said “overall, I share the concerns expressed which Volcker wants to remedy with regard to banks that are too big to fail, too complex to resolve, too big to save.” While mentioning certain unspecified EU concerns, he announced parallel plans: “I can confirm that we will present in the coming weeks, at the beginning of January, a proposal on the structure of banks”.
“Potential extraterritorial application of the Volcker Rule beyond the original intent of Congress continues to be a concern,” said Sally Miller, CEO of the Institute of International Bankers. IIB last week filed a suit against CFTC cross-border rules, an action that may be repeated for the Volcker Rule. “SIFMA remains concerned an overly restrictive Volcker Rule will inflict serious harm,” said Ken Bentsen, head of another trade group in the suit.
“Agencies have not complied with legal obligations that apply to any rulemaking” said SEC Commissioner Piwowar in a dissent. “In particular, the proposal of the Volcker Rule did not provide sufficient notice to the public of the contents of the rule adopted today” he added. The statement referred to opinions by the D.C. Court of Appeal, which in turn may well be cited in any industry lawsuit to block the Volcker Rule.
(Nick Paraskeva is principal of Reg-Room LLC (www.reg-room.com), which provides regulatory information and consultancy. He covers various facets of the banking and securities industry and delivers exclusive analysis through Thomson Reuters. He can be contacted at (212) 217-0403 and email@example.com. Follow Nick on Twitter@regroom.)
(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)