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2013-31476

  • Federal Register, Volume 79 Issue 21 (Friday, January 31, 2014)[Federal Register Volume 79, Number 21 (Friday, January 31, 2014)]

    [Rules and Regulations]

    [Pages 5807-6075]

    From the Federal Register Online via the Government Printing Office [www.gpo.gov]

    [FR Doc No: 2013-31476]

    [[Page 5807]]

    Vol. 79

    Friday,

    No. 21

    January 31, 2014

    Part III

    Commodity Futures Trading Commission

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    17 CFR Part 75

    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 5808]]

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    COMMODITY FUTURES TRADING COMMISSION

    17 CFR Part 75

    RIN 3038-AD05

    Prohibitions and Restrictions on Proprietary Trading and Certain

    Interests in, and Relationships with, Hedge Funds and Private Equity

    Funds

    AGENCY: Commodity Futures Trading Commission.

    ACTION: Final rule.

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    SUMMARY: The Commodity Futures Trading Commission (``CFTC'' or

    ``Commission'') is adopting a final rule to implement Section 619 of

    the Dodd-Frank Wall Street Reform and Consumer Protection Act (the

    ``Dodd-Frank Act''), which contains certain prohibitions and

    restrictions on the ability of a banking entity and nonbank financial

    company supervised by the Board of Governors of the Federal Reserve

    System (the ``Board'') to engage in proprietary trading and have

    certain interests in, or relationships with, a hedge fund or private

    equity fund. Section 619 also requires the Board, the Federal Deposit

    Insurance Corporation, the Office of the Comptroller of the Currency,

    and the Securities and Exchange Commission to also issue regulations

    implementing section 619 and directs the CFTC and those four agencies

    to consult and coordinate with each other, as appropriate, in

    developing and issuing the implementing rules, for the purposes of

    assuring, to the extent possible, that such rules are comparable and

    provide for consistent application and implementation. To that end,

    although the Commission is adopting a final rule that is not a joint

    rule with the other agencies, the CFTC and the other agencies have

    worked closely together to develop the same rule text and supplementary

    information, except for information specific to the CFTC or the other

    agencies, as applicable. In particular, the CFTC's final rule is

    numbered as part 75 of the Commission's regulations, the rule text

    refers to the ``Commission'' instead of the ``[Agency]'' and one

    section of the regulations addresses authority, purpose, scope, and

    relationship to other authorities with respect to the Commission.

    Furthermore, it is noted that the supplementary information generally

    refers to the ``Agencies'' collectively when referring to deliberations

    and considerations in developing the final rule by the CFTC together

    with the other four agencies and references to the ``final rule''

    should be deemed to refer to the final rule of the Commission as herein

    adopted.

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

    FOR FURTHER INFORMATION CONTACT: Erik Remmler, Deputy Director,

    Division of Swap Dealer and Intermediary Oversight (``DSIO''), (202)

    418-7630, eremmler@cftc.gov; Paul Schlichting, Assistant General

    Counsel, Office of the General Counsel (``OGC''), (202) 418-5884,

    pschlichting@cftc.gov; Mark Fajfar, Assistant General Counsel, OGC,

    (202) 418-6636, mfajfar@cftc.gov; Michael Barrett, Attorney-Advisor,

    DSIO, (202) 418-5598, mbarrett@cftc.gov; Stephen Kane, Research

    Economist, Office of the Chief Economist (``OCE''), (202) 418-5911,

    skane@cftc.gov; or Stephanie Lau, Research Economist, OCE, (202) 418-

    5218, slau@cftc.gov; Commodity Futures Trading Commission, Three

    Lafayette Centre, 1155 21st Street NW., Washington, DC 20581.

    SUPPLEMENTARY INFORMATION:

    Table of Contents

    I. Background

    II. Notice of Proposed Rulemaking: Summary of General Comments

    III. Scope

    IV. CFTC-Specific Comments

    V. 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

    VI. Final Rule

    A. Subpart B--Proprietary Trading Restrictions

    1. Section 75.3: 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 75.4(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

    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 75.4(b): Market-Making Exemption

    a. Introduction

    b. Overview

    1. Proposed Market-Making Exemption

    2. Comments on the Proposed Market-Making Exemption

    [[Page 5809]]

    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 75.5: 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 75.6(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 75.6(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 75.6(d): Permitted Trading by a Regulated Insurance

    Company

    8. Section 75.6(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 75.7: 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 75.10: 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

    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''

    1. Definition of Sponsor With Respect to Securitizations

    [[Page 5810]]

    2. Section 75.11: 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 75.12: 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 75.13: 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 75.14: 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 75.15: Other Limitations on Permitted Covered Fund

    Activities

    C. Subpart D and Appendices A and B--Compliance Program,

    Reporting, and Violations

    1. Section 75.20: 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 75.20(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 75.21: Termination of Activities or Investments;

    Authorities for Violations

    VII. Administrative Law Matters

    A. Paperwork Reduction Act Analysis

    B. Regulatory Flexibility Act Analysis

    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

    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

    [[Page 5811]]

    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.

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

    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 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 61758 (Oct. 6, 2010). Approximately

    8,000 comments were received from the public, including from members

    of Congress, trade associations, individual banking entities,

    consumer groups, and individuals.

    \15\ See FSOC study at 5-6.

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

    In formulating this final rule, the Agencies carefully reviewed all

    comments submitted in connection with the rulemaking and considered the

    suggestions and issues they raise in light of the statutory

    restrictions and provisions as well as the FSOC study. The Agencies

    have sought to reasonably respond to all of the significant issues

    commenters raised. The Agencies believe they have succeeded in doing so

    notwithstanding the complexities involved. The Agencies also carefully

    considered different options suggested by commenters in light of

    potential costs and benefits in order to effectively implement section

    13 of the BHC Act. The Agencies made numerous changes to the final rule

    in response to the issues and information provided by commenters. These

    modifications to the rule and explanations that address comments are

    described in more detail in the section-by-section description of the

    final rule. To enhance uniformity in both rules that implement section

    13 and administration of the requirements of that section, the Agencies

    have been regularly consulting with each other in the development of

    this final rule.

    Some commenters requested that the Agencies repropose the rule and/

    or delay adoption pending the collection of

    [[Page 5812]]

    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 61758 (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\

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

    \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 Conformance Period for

    Entities Engaged in Prohibited Proprietary Trading or Private Equity

    Fund or Hedge Fund Activities, 76 FR 8265 (Feb. 14, 2011) (citing

    156 Cong. Rec. S5898 (daily ed. July 15, 2010) (statement of Sen.

    Merkley)).

    \21\ See, Board Order Approving Extension of Conformance Period,

    available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20131210b1.pdf.

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

    Commenters have differing views on the overall economic impacts of

    section 13 of the BHC Act.

    Some commenters remarked that proprietary trading restrictions will

    have detrimental impacts on the economy such as: Reduction in

    efficiency of markets, economic growth, and in employment due to a loss

    in liquidity.\22\ In particular, a commenter expressed concern that

    there may be high transition costs as non-banking entities replace some

    of the trading activities currently performed by banking entities.\23\

    Another commenter focused on commodity markets remarked about the

    potential reduction in commercial output and curtailed resource

    exploration due to a lack of hedging counterparties.\24\ Several

    commenters stated that section 13 of the BHC Act will reduce access to

    debt markets--especially for smaller companies--raising the costs of

    capital for firms and lowering the returns on certain investments.\25\

    Further, some commenters mentioned that U.S. banks may be competitively

    disadvantaged relative to foreign banks due to proprietary trading

    restrictions and compliance costs.\26\

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

    \22\ See, e.g., Oliver Wyman (Dec. 2011); Chamber (Dec. 2011);

    Thakor Study; Prof. Duffie; IHS.

    \23\ See Prof. Duffie.

    \24\ See IHS.

    \25\ See, e.g., Chamber (Dec. 2011); Thakor Study; Oliver Wyman

    (Dec. 2011); IHS.

    \26\ See, e.g., RBC; Citigroup (Feb. 2012); Goldman (Covered

    Funds).

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

    [[Page 5813]]

    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.\36\

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

    \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.

    \36\ This CFTC Rule is being promulgated exclusively under

    section 13 of the BHC. Therefore, the Commission did not conduct a

    cost benefit consideration under Section 15(a) of the Commodity

    Exchange Act. Similarly, Executive Orders 12866 and 13563,

    referenced by some commenters, do not impose obligations on the

    CFTC.

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

    III. Scope

    Under section 13 of the BHCA, the CFTC's final rule will be

    applicable to a banking entity for which the CFTC is a ``primary

    financial regulatory agency'' for that banking entity, as the term is

    defined by section 2(12) of the Dodd-Frank Act. Accordingly, the final

    rule may apply to banking entities \37\ that are, for example,

    registered swap dealers,\38\ futures commission merchants, commodity

    trading advisors and commodity pool operators. The CFTC's final rule

    may also apply to other types of CFTC registrants that are banking

    entities, but it is likely that many such other registrants will have

    little or no activities that would implicate the provisions of the

    final rule. For example, registered introducing brokers are not likely

    to undertake proprietary trading or invest in covered funds because

    their activities are generally limited to brokering. Furthermore, the

    CFTC's final rule will not apply to CFTC registrants who are not

    banking entities. In addition, it is noted that the CFTC may have

    overlapping jurisdiction with other Agencies in exercising authority

    under each Agency's respective final rules. Finally, it is important to

    note that the jurisdictional scope of the final rule does not limit the

    regulatory authority of the CFTC or the other Agencies under other

    applicable provisions of law.

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

    \37\ See final rule Sec. 75.2(c).

    \38\ The CFTC notes that provisionally registered swap dealers

    are registered swap dealers subject to all of the regulatory

    requirements applicable to registered swap dealers except as may

    otherwise be expressly provided in the CFTC's regulations.

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

    The CFTC believes that many affiliated banking entities would

    undertake some or all of the compliance activities under the final rule

    on an affiliated enterprise-wide basis. As of the adoption of the final

    rule, the CFTC estimates that there are approximately 110 registered

    swap dealers and futures commission merchants that would be banking

    entities individually and that grouping these banking entities together

    based on legal affiliation would result in about 45 different business

    enterprises.

    IV. CFTC-specific comments

    In addition to the information sought both by the other Agencies

    and the CFTC, the CFTC's proposal \39\ included 15 additional questions

    specifically regarding the approach the CFTC should take in regards to

    certain sections of the rule. The relevant sections included provisions

    that were either directly related to the CFTC (e.g., definition of

    commodity pool, clearing exemption) and others that appeared not to be

    (e.g., underwriting, market making of SEC entities, securitization).

    Many commenters sent general responses that touched on issues related

    to these 15 CFTC-specific questions, while other commenters organized

    their responses by question.\40\ The CFTC has considered these

    commenters' views, and has responded as set forth in the relevant

    sections below.

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

    \39\ See 77 FR 8332 (Feb 14, 2012).

    \40\ See, e.g., SIFMA (March Letter); Alfred Brock; Occupy the

    SEC.

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

    V. 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,

    [[Page 5814]]

    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 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 75.3 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.\41\

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

    \41\ See final rule Sec. 75.3(a).

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

    The final rule's definition of trading account also is consistent

    with the statutory definition.\42\ 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.\43\ 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).\44\

    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.\45\ 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.\46\

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

    \42\ See final rule Sec. 75.3(b).

    \43\ See final rule Sec. 75.3(b)(1)(i).

    \44\ See final rule Sec. 75.3(b)(2).

    \45\ See final rule Sec. 75.3(b)(1)(ii).

    \46\ See final rule Sec. 75.3(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

    [[Page 5815]]

    lending transactions and securities acquired or taken for bona fide

    liquidity management purposes.\47\

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

    \47\ See final rule Sec. 75.3(d).

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

    In section 75.3, 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.\48\

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

    \48\ See final rule Sec. 75.3(c).

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

    In section 75.4, 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 entity's trading activity is limited to underwriting and market

    making-related activities and does not include prohibited proprietary

    trading.\49\ These requirements are also intended to work together to

    ensure that banking entities identify, monitor and limit the risks

    associated with these activities.

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

    \49\ See final rule Sec. 75.4(a), (b).

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

    In section 75.5, the final rule implements the statutory exemption

    for risk-mitigating hedging. As with the underwriting and market-making

    exemptions, Sec. 75.5 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.\50\ Section 75.5 also requires banking

    entities to document, at the time the transaction is executed, the

    hedging rationale for certain transactions that present heightened

    compliance risks.\51\ 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.

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

    \50\ See final rule Sec. 75.5.

    \51\ See final rule Sec. 75.5(c).

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

    In section 75.6, 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

    75.6(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.\52\ Section

    75.6(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.\53\

    Section 75.6(c) of the final rule describes permitted trading on behalf

    of customers and identifies the types of transactions that would

    qualify for the exemption.\54\ Section 75.6(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.\55\ Finally, Sec. 75.6(e) of the final rule

    describes trading permitted outside of the United States by a foreign

    banking entity.\56\ 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.

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

    \52\ See final rule Sec. 75.6(a).

    \53\ See final rule Sec. 75.6(b).

    \54\ See final rule Sec. 75.6(c).

    \55\ See final rule Sec. 75.6(d).

    \56\ See final rule Sec. 75.6(e).

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

    In section 75.7, 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.\57\ This section also describes the terms material conflict of

    interest, high-risk asset, and high-risk trading strategy for these

    purposes.

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

    \57\ See final rule Sec. 75.7.

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

    C. Restrictions on Covered Fund Activities and Investments

    Subpart C of the final rule implements the statutory prohibition

    on, directly or indirectly, acquiring and retaining an ownership

    interest in, or having certain relationships with, a covered fund, as

    well as the various exemptions to this prohibition included in the

    statute. Section 75.10 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.''\58\ 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.\59\

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

    \58\ See final rule Sec. 75.10(b).

    \59\ 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.

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

    [[Page 5816]]

    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.\60\ 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.\61\ Section 75.10 of the final rule also

    defines a number of other relevant terms, including the terms ``prime

    brokerage transaction,'' ``sponsor,'' and ``trustee.''

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

    \60\ See final rule Sec. 75.10(d)(6).

    \61\ See final rule Sec. 75.10(b)(6)(ii).

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

    In section 75.11, 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 75.11(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.\62\ The requirements are discussed in detail in Part

    VI.B.2. of this Supplementary Information. Section 75.11 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.

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

    \62\ See 156 Cong. Rec. S5889 (daily ed. July 15, 2010)

    (statement of Sen. Hagan).

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

    In section 75.12, the final rule permits a banking entity to

    acquire and 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. 75.11.\63\ 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 75.12

    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. 75.12 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 75.12 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.

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

    \63\ See final rule Sec. 75.12.

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

    In section 75.13, 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.\64\

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

    \64\ See final rule Sec. 75.13(a)-(c).

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

    In section 75.14, 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.\65\

    Section 75.14(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 75.14(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,\66\ 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.

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

    \65\ See 12 U.S.C. 371c; see also final rule Sec. 75.14.

    \66\ 12 U.S.C. 371c-1.

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

    In section 75.15, 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.\67\ This

    section also describes material conflict of interest, high-risk asset,

    and high-risk trading strategy for these purposes.

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

    \67\ See final rule Sec. 75.15.

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

    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

    [[Page 5817]]

    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.\68\

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

    \68\ See final rule Sec. 75.20(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.

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

    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.\69\ 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.\70\ 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.\71\

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

    \69\ See final rule Sec. 75.20.

    \70\ See final rule Sec. 75.20(f)(1).

    \71\ See final rule Sec. 75.20(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.

    VI. Final Rule

    A. Subpart B--Proprietary Trading Restrictions

    1. Section 75.3: 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.\72\ 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.\73\

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

    \72\ 12 U.S.C. 1851(a)(1)(A).

    \73\ 12 U.S.C. 1851(h)(4).

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

    Section 75.3(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. 75.4 through 75.6 of the proposed rule. Section 75.3(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.\74\

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

    \74\ See Joint Proposal, 76 FR at 68857.

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

    Several commenters expressed concern about the breadth of the ban

    on proprietary trading.\75\ 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.\76\ 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-

    [[Page 5818]]

    taking to the shadow banking system.\77\ Others urged the Agencies to

    determine that trading as agent, broker, or custodian for an affiliate

    was not proprietary trading.\78\

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

    \75\ 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.

    \76\ See Ass'n. of Institutional Investors (Feb. 2012); GE (Feb.

    2012); Invesco; Sen. Corker; Chamber (Feb. 2012).

    \77\ See Chamber (Feb. 2012).

    \78\ 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 \79\ or make the prohibition easier to apply in practice.\80\

    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.\81\ 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.\82\ 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

    financial instruments.\83\ 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.\84\ 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.\85\ For similar

    reasons, the Agencies are not adopting a bright-line definition of

    proprietary trading.\86\

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

    \79\ 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.

    \80\ See Public Citizen.

    \81\ See Sens. Merkley & Levin (Feb. 2012).

    \82\ 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.

    \83\ See final rule Sec. 75.3(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. 75.3(c), 75.2(u), (x).

    \84\ See, e.g., Ass'n. of Institutional Investors (Feb. 2012);

    GE (Feb. 2012); Invesco; Sen. Corker; Chamber (Feb. 2012); JPMC.

    \85\ 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.'').

    \86\ 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; \87\ (ii) wider spreads or

    otherwise increased trading costs; \88\ (iii) higher borrowing costs

    for businesses or increased cost of capital; \89\ and/or (iv) greater

    market volatility.\90\ 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 VI.A.2. and VI.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.\91\ 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.

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

    \87\ 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).

    \88\ 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.

    \89\ 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.

    \90\ 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.

    \91\ 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.\92\

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

    \92\ See final rule Sec. 75.3(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.\93\

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

    \93\ See 12 U.S.C. 1851(h)(6).

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

    The proposed rule defined trading account to include three separate

    accounts. First, the proposed definition

    [[Page 5819]]

    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'').\94\ 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.\95\

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

    \94\ See proposed rule Sec. 75.3(b)(2)(i)(A).

    \95\ See proposed rule Sec. 75.3(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'').\96\ ``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.

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

    \96\ See proposed rule Sec. Sec. 75.3(b)(2)(i)(B); 75.3(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 security-based swap dealer to acquire or take positions in

    connection with its dealing activities (the ``dealer trading

    account'').\97\ 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.\98\

    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).\99\

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

    \97\ See proposed rule Sec. 75.3(b)(2)(i)(C).

    \98\ See proposed rule Sec. 75.3(b)(2)(i)(C)(5).

    \99\ See Joint Proposal, 76 FR 68860.

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

    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.\100\

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

    \100\ See proposed rule Sec. 75.3(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.\101\ However, a

    few commenters raised concerns regarding the treatment of arbitrage

    trading under the proposed rule.\102\ Several commenters asserted that

    the proposed definition of trading account was too broad and covered

    trading not intended to be covered by the statute.\103\ 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.\104\ 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.\105\ 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.\106\ 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.\107\ A few commenters requested the Agencies define the

    phrase ``short term'' in the rule.\108\

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

    \101\ See ABA (Keating); JPMC.

    \102\ See AFR et al. (Feb. 2012); Paul Volcker; Credit Suisse

    (Seidel); ISDA (Feb. 2012); Japanese Bankers Ass'n.

    \103\ 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).

    \104\ See ABA (Keating); JPMC; SIFMA et al. (Prop. Trading)

    (Feb. 2012); State Street (Feb. 2012).

    \105\ See ABA (Keating); Credit Suisse (Seidel).

    \106\ 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.

    \107\ See ABA (Keating).

    \108\ 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.\109\ 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.\110\ One commenter thought that the market risk rule trading

    account was redundant because it includes only positions that have

    short-term trading intent.\111\ 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.\112\

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

    \109\ See ABA; BoA; Goldman (Prop. Trading); ISDA (Feb. 2012);

    JPMC; SIFMA et al. (Prop. Trading) (Feb. 2012).

    \110\ See BoA; SIFMA et al. (Prop. Trading) (Feb. 2012).

    \111\ See ISDA (Feb. 2012).

    \112\ 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 53060 (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.\113\ 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.\114\ 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.\115\ 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

    [[Page 5820]]

    and treat U.S. swap dealers consistently.\116\

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

    \113\ 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).

    \114\ 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).

    \115\ See ABA (Keating); Am. Express; Goldman (Prop. Trading);

    ISDA (Feb. 2012); JPMC.

    \116\ 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,\117\ or should be simplified.\118\ 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.\119\ One commenter supported

    the proposed definition of trading account.\120\ 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.\121\

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

    \117\ See Sens. Merkley & Levin (Feb. 2012); Occupy.

    \118\ See, e.g., Public Citizen.

    \119\ See AFR et al. (Feb. 2012).

    \120\ See Alfred Brock.

    \121\ 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.\122\ 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.\123\ These

    commenters argued that new definitions in the proposed rule, like

    trading account, would require foreign banking entities to develop new

    and complex procedures and expensive systems.\124\

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

    \122\ See ABA (Keating); Goldman (Prop. Trading); NAIB et al.

    \123\ See Japanese Bankers Ass'n.; Norinchukin.

    \124\ 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,\125\ 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.\126\ 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.\127\

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

    \125\ See Alfred Brock.

    \126\ See AFR et al. (Feb. 2012); Paul Volcker.

    \127\ See NAIB et al. See infra Part VI.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.\128\ 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.\129\ 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.\130\ 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.\131\

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

    \128\ 12 U.S.C. 1851(h)(6).

    \129\ 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.

    \130\ 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.

    \131\ 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 VI.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.\132\ 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.\133\ 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.

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

    \132\ See Joint Proposal, 76 FR at 68857-68858.

    \133\ 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

    [[Page 5821]]

    account, or should only consider them as non-determinative

    factors.\134\ 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.\135\

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

    \134\ See ISDA (Feb. 2012); JPMC; ABA (Keating); BoA; SIFMA et

    al. (Prop. Trading) (Feb. 2012).

    \135\ 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.'' \136\ 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.

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

    \136\ 12 CFR 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 activities by establishing a clear, bright-

    line rule for determining that a trade is within the trading

    account.\137\

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

    \137\ 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.\138\ 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.

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

    \138\ See Joint Proposal, 76 FR at 68860.

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

    The final rule adopts the dealer trading account substantially as

    proposed,\139\ 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.\140\

    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. 75.3(b)(1)(i) or (ii).\141\

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

    \139\ See final rule Sec. 75.3(b)(1)(iii).

    \140\ 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. 75.3(b)(1)(i) or the market risk rule

    trading account under Sec. 75.3(b)(1)(ii) of the final rule.

    \141\ See final rule Sec. Sec. 75.3(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.\142\ 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.\143\

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

    \142\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

    Goldman (Prop. Trading).

    \143\ 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,\144\ 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.\145\

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

    \144\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; Allen

    & Overy (on behalf of Large Int'l Banks with U.S. Operations).

    \145\ See final rule Sec. 75.6(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.\146\ 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. 75.6(e) of the final rule.

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

    \146\ See Japanese Bankers Ass'n.

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

    [[Page 5822]]

    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.\147\ 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.\148\

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

    \147\ See ABA (Keating).

    \148\ See Joint Proposal, 76 FR at 68859.

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

    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. 75.3(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 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,\149\

    or extending the period to 90 days,\150\ to several months,\151\ or to

    one year.\152\ Some of these commenters argued that specifying an

    overly short holding period would be contrary to the statute, invite

    gamesmanship,\153\ and miss speculative positions held for longer than

    the specified period.\154\ Commenters also suggested turning the

    presumption into a safe harbor \155\ or into guidance.\156\

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

    \149\ See Japanese Bankers Ass'n.

    \150\ See Capital Group.

    \151\ See AFR et al. (Feb. 2012).

    \152\ See Sens. Merkley & Levin (Feb. 2012); Public Citizen

    (arguing that one-year demarks tax law covering short term capital

    gains).

    \153\ See Sens. Merkley & Levin (Feb. 2012).

    \154\ See Occupy.

    \155\ See Capital Group.

    \156\ 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.\157\ For example, these commenters argued that the presumption

    had no statutory basis; \158\ was arbitrary; \159\ was not supported by

    data, facts, or analysis; \160\ would dampen market-making and

    underwriting activity; \161\ or did not take into account the nature of

    trading in different types of securities.\162\ Some commenters also

    questioned whether the Agencies would interpret rebuttals of the

    presumption consistently,\163\ and stressed the difficulty and

    costliness of rebutting the presumption,\164\ such as enhanced

    documentation or other administrative burdens.\165\ 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.\166\ 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.\167\

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

    \157\ See ABA (Keating); Am. Express; Business Roundtable;

    Capital Group; ICI (Feb. 2012); Investure; JPMC; Liberty Global;

    STANY; Chamber (Feb. 2012).

    \158\ See ABA (Keating); JPMC; Chamber (Feb. 2012).

    \159\ See Am. Express; ICI (Feb. 2012).

    \160\ See ABA (Keating); Chamber (Feb. 2012).

    \161\ 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.

    \162\ 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.

    \163\ See ABA (Keating). As discussed below in Part VI.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.

    \164\ See ABA (Keating); AllianceBernstein; Capital Group;

    Japanese Bankers Ass'n.; Liberty Global; JPMC.

    \165\ See NAIB et al.; Capital Group.

    \166\ 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. 75.6(e).

    \167\ 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.\168\ 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.\169\ 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.\170\

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

    \168\ See final rule Sec. 75.3(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.

    \169\ See, e.g., Am. Express; Capital Group; Sens. Merkley &

    Levin (Feb. 2012).

    \170\ 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

    [[Page 5823]]

    presumption, the Agencies will allow a banking entity to rebut the

    presumption for a group of related positions.\171\

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

    \171\ 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.'' \172\ 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.\173\

    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.\174\

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

    \172\ See, e.g., ABA (Keating); Clearing House Ass'n.; JPMC.

    \173\ 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. 75.3(b)(2). See

    also Public Citizen.

    \174\ 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.

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

    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.\175\ 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.\176\ 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.\177\

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

    \175\ See 12 U.S.C. 1851(h)(4).

    \176\ See proposed rule Sec. 75.3(c)(3)(i).

    \177\ See proposed rule Sec. 75.3(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.\178\ 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.

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

    \178\ See proposed rule Sec. 75.2(l), (q), (w); Sec.

    75.3(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.\179\

    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); \180\ (iii) any agreement, contract, or

    transaction in foreign currency described in section 2(c)(2)(C)(i) of

    the Commodity Exchange Act; \181\ (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; \182\ and (v) any

    transactions authorized under section 19 of the Commodity Exchange

    Act.\183\ 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)).

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

    \179\ See 7 U.S.C. 1a(47) (defining ``swap''); 15 U.S.C.

    78c(a)(68) (defining ``security-based swap'').

    \180\ 7 U.S.C. 1a(24), (25).

    \181\ 7 U.S.C. 2(c)(2)(C)(i).

    \182\ 7 U.S.C. 2(c)(2)(D)(i).

    \183\ 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.\184\ 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.\185\ One commenter argued that the proposed

    definition of covered financial position was effective and recommended

    that the definition should not be expanded.\186\ 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.\187\ Another commenter argued that covered

    financial positions used in interaffiliate transactions should

    expressly be excluded because they are used for

    [[Page 5824]]

    internal risk management purposes and not for proprietary trading.\188\

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

    \184\ See Sens. Merkley & Levin (Feb. 2012); Public Citizen;

    Occupy.

    \185\ 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).

    \186\ See Alfred Brock.

    \187\ See Credit Suisse (Seidel).

    \188\ 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.\189\ 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.\190\ 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.\191\

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

    \189\ See JPMC; BoA; Citigroup (Feb. 2012).

    \190\ See Govt. of Japan/Bank of Japan; Japanese Bankers Ass'n.;

    see also Norinchukin.

    \191\ 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.\192\ This

    commenter alleged that these instruments are not derivatives but 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.\193\

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

    \192\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

    \193\ 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.\194\ 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.\195\

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

    \194\ See SIFMA et al. (Prop. Trading) (Feb. 2012); ISDA (Feb.

    2012).

    \195\ 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; \196\ (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.\197\ The final rule excludes from the

    definition of financial instrument: (i) A loan; \198\ (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.\199\ An excluded

    commodity is defined to have the same meaning as in section 1a(19) of

    the Commodity Exchange Act.

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

    \196\ The definition of security under the final rule is the

    same as under the proposal. See final rule Sec. 75.2(y).

    \197\ See final rule Sec. 75.3(c)(1).

    \198\ The definition of loan, as well as comments received

    regarding that definition, is discussed in detail below in Part

    VI.B.1.c.8.a.

    \199\ See final rule Sec. 75.3(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 \200\ or loans,\201\ 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.\202\ Similarly,

    while some commenters requested that certain other instruments, such as

    foreign exchange swaps and forwards, be excluded from the definition of

    financial instrument,\203\ 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.

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

    \200\ See Sens. Merkley & Levin (Feb. 2012); Public Citizen;

    Occupy.

    \201\ See Occupy.

    \202\ 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).

    \203\ 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.\204\ 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,\205\ the CFTC and SEC have subsequently finalized

    those definitions after receiving extensive public comment on the

    rulemakings.\206\ The

    [[Page 5825]]

    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.

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

    \204\ See final rule Sec. 75.2(h), (y).

    \205\ See SIFMA et al. (Prop. Trading) (Feb. 2012); ISDA (Feb.

    2012).

    \206\ 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

    48208 (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 VI.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 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,\207\ 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.\208\ 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.\209\

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

    \207\ See proposed rule Sec. 75.3(b)(2)(iii)(A).

    \208\ See proposed rule Sec. 75.3(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.

    \209\ See Joint Proposal, 76 FR at 68862.

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

    Several commenters expressed support for these exclusions and

    requested that the Agencies expand them.\210\ For example, one

    commenter requested clarification that all types of repurchase

    transactions qualify for the exclusion.\211\ Some commenters requested

    expanding this exclusion to cover all positions financed by, or

    transactions related to, repurchase and reverse repurchase

    agreements.\212\ 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.\213\ 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.\214\ 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.\215\

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

    \210\ 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 VI.A.d.10. for the

    discussion of commenters' requests for additional exclusions from

    the trading account.

    \211\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

    \212\ See FIA; SIFMA et al. (Prop. Trading) (Feb. 2012).

    \213\ See Goldman (Prop. Trading); JPMC; UBS.

    \214\ 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).

    \215\ 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.\216\ Some of these commenters argued

    that repurchase agreements could be used for prohibited proprietary

    trading \217\ 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.\218\ These

    [[Page 5826]]

    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.\219\ 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.\220\ 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.\221\

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

    \216\ See AFR et al. (Feb. 2012); Occupy; Public Citizen; Sens.

    Merkley & Levin (Feb. 2012).

    \217\ See AFR et al. (Feb. 2012).

    \218\ See Public Citizen.

    \219\ See Public Citizen.

    \220\ See AFR et al. (Feb. 2012); Occupy.

    \221\ 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 trading.\222\ The Agencies will,

    however, monitor these transactions to ensure this exclusion is not

    used to engage in prohibited proprietary trading activities.

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

    \222\ 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,\223\ 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.\224\ Similarly, short positions

    resulting from securities lending agreements cannot rely upon this

    exclusion and may involve proprietary trading.

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

    \223\ See Goldman (Prop. Trading); JPMC; UBS.

    \224\ See CFTC Proposal, 77 FR at 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.\225\ 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.\226\

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

    \225\ See proposed rule Sec. 75.3(b)(2)(iii)(C).

    \226\ 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.\227\

    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.\228\

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

    \227\ See proposed rule Sec. 75.3(b)(2)(iii)(C)(1)-(5).

    \228\ See Joint Proposal, 76 FR at 68862.

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

    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.\229\ 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.\230\ 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.\231\ 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,\232\ and

    would limit banking entities' ability to manage liquidity.\233\

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

    \229\ See ABA (Keating); BoA; CH/ABASA; JPMC. See supra Part

    VI.A.1.b. (discussing the rebuttable presumption under Sec.

    75.3(b)(2) of the final rule); see also supra Part VI.A.1.a.

    (discussing the market risk rule trading account under Sec.

    75.3(b)(1)(ii) of the final rule).

    \230\ See CH/ABASA; Wells Fargo (Prop. Trading).

    \231\ See CH/ABASA; JPMC; State Street (Feb. 2012); Wells Fargo

    (Prop. Trading). See also BaFin/Deutsche Bundesbank.

    \232\ See BoA; JPMC; RBC.

    \233\ 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.\234\ 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.\235\ 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.\236\

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

    \234\ See ABA (Keating); CH/ABASA; JPMC.

    \235\ See ABA (Keating); BoA; CH/ABASA; JPMC.

    \236\ See ABA (Keating); Allen & Overy (on behalf of Canadian

    Banks); BoA; CH/ABASA.

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

    [[Page 5827]]

    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.\237\ 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.\238\

    Commenters also urged that the final rule not prohibit interaffiliate

    transactions essential to the ALM function.\239\

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

    \237\ See T. Rowe Price.

    \238\ See State Street (Feb. 2012).

    \239\ See State Street (Feb. 2012); JPMC. See also Part

    VI.A.1.d.10. (discussing commenter requests to exclude inter-

    affiliate transactions).

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

    In contrast, other commenters supported the liquidity management

    exclusion criteria \240\ 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.\241\ Other commenters argued that the

    exclusion for liquidity management should be eliminated.\242\ One

    commenter argued that there was no need to provide a special exemption

    for liquidity management or ALM activities given the exemptions for

    trading in government obligations and risk-mitigating hedging

    activities.\243\

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

    \240\ See AFR et al. (Feb. 2012); Occupy.

    \241\ See Occupy.

    \242\ See Sens. Merkley & Levin (Feb. 2012).

    \243\ 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.\244\

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

    \244\ 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 76678 at

    76682 (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.\245\ 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.\246\ 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.\247\ 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.

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

    \245\ 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.

    \246\ 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).

    \247\ 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 71818 (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.\248\

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

    \248\ 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

    [[Page 5828]]

    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.\249\ 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.

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

    \249\ 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 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.\250\ 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.\251\

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

    \250\ See proposed rule Sec. 75.3(b)(2)(iii)(D).

    \251\ See Joint Proposal, 76 FR at 68863.

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

    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.\252\

    One commenter recommended expanding the exclusion to non-U.S. central

    counterparties \253\ 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).\254\

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

    \252\ See Allen & Overy (Clearing); Goldman (Prop. Trading);

    SIFMA et al. (Prop. Trading) (Feb. 2012); State Street (Feb. 2012).

    \253\ See IIB/EBF.

    \254\ 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.\255\ In response to

    comments,\256\ 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,\257\ 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.

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

    \255\ ``Clearing agency'' is defined in the final rule with

    reference to the definition of this term in the Exchange Act. See

    final rule Sec. 75.3(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.

    \256\ See IIB/EBF; BNY Mellon et al.; SIFMA et al. (Prop.

    Trading) (Feb. 2012); Allen & Overy (Clearing); Goldman (Prop.

    Trading).

    \257\ 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.\258\ These commenters noted that the proposed definition of

    ``trading account'' provides an exclusion for positions taken by

    registered derivatives clearing organizations and registered clearing

    agencie s\259\ 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'').\260\

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

    \258\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Allen &

    Overy (Clearing); Goldman (Prop. Trading); State Street (Feb. 2012).

    \259\ See proposed rule Sec. 75.3(b)(2)(iii)(D).

    \260\ 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.\261\ 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; \262\ (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; \263\ and (v) imposing certain

    obligations on clearing members upon exhaustion of a guaranty

    fund.\264\

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

    \261\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Allen &

    Overy (Clearing); State Street (Feb. 2012). See also ISDA (Feb.

    2012).

    \262\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Allen &

    Overy (Clearing).

    \263\ See Allen & Overy (Clearing).

    \264\ 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

    [[Page 5829]]

    the dealer prong of the definition of ``trading account'' may cause

    certain of these activities to be considered proprietary trading.\265\

    Some commenters suggested alternative avenues for permitting such

    clearing-related activity under the rules.\266\ 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.\267\

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

    \265\ 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).

    \266\ See Goldman (Prop. Trading); SIFMA et al. (Prop. Trading)

    (Feb. 2012); ISDA (Feb. 2012).

    \267\ 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) \268\ and trade crossing, a mechanism employed by 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.\269\

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

    \268\ See Allen & Overy (Clearing).

    \269\ 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.\270\ In particular,

    central clearing reduces counterparty credit risk,\271\ 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.\272\

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

    \270\ 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 23732 (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 66220, 66,283 (Nov. 2,

    2012).

    \271\ 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.

    \272\ See Proposed Rule, Cross-Border Security-Based Swap

    Activities, Exchange Act Release No. 69490 (May 1, 2013), 78 FR

    30968, 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.\273\ ``Excluded clearing

    activities'' is defined in the rule to identify particular core

    clearing-related activities, many of which were raised by

    commenters.\274\ 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; \275\ 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.\276\

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

    \273\ See final rule Sec. 75.3(d)(5).

    \274\ See final rule Sec. 75.3(e)(7).

    \275\ 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).

    \276\ 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,\277\ 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.

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

    \277\ 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.\278\ These commenters alleged that a banking

    entity engages in this activity for purposes other than to

    [[Page 5830]]

    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.

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

    \278\ 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.\279\ In certain circumstances, SEC-

    registered broker-dealers are required to take such action under SEC

    rules.\280\ In addition, buy-in procedures of a clearing agency,

    securities exchange, or national securities association may require a

    banking entity to deliver securities if a party with a fail to receive

    position takes certain action.\281\ 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.\282\ 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.

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

    \279\ 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.

    \280\ 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).

    \281\ See, e.g., NSCC Rule 11, NASDAQ Rule 11810, FINRA Rule

    11810.

    \282\ 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.\283\ A banking entity may also be obligated to purchase or sell

    a financial instrument in connection with a judicial or arbitration

    proceeding.\284\ Such transactions do not represent trading for short-

    term profit or gain and do not constitute proprietary trading under the

    statute.

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

    \283\ 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).

    \284\ 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.\285\ 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.\286\

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

    \285\ See proposed rule Sec. 75.3(b)(1).

    \286\ 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.\287\ 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.

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

    \287\ 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. 75.3(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.\288\

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

    \288\ 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

    [[Page 5831]]

    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.\289\

    Commenters argued that acquiring and 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.

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

    \289\ 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.\290\

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

    \290\ See final rule Sec. 75.3(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.\291\ 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.\292\ This

    exclusion will allow banking entities to comply with existing

    regulatory requirements regarding the divestiture of collateral taken

    in satisfaction of a debt.

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

    \291\ 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).

    \292\ See SEC Proposed Rule, Capital, Margin, Segregation,

    Reporting and Recordkeeping Requirements for Security-Based Swap

    Dealers, Exchange Act Release No. 68071, 77 FR 70214 (Nov. 23,

    2012); CFTC Proposed Rule, Margin Requirements for Uncleared Swaps

    for Swap Dealers and Major Swap Participants, 76 FR 23732 (Apr. 28,

    2011); Banking Agencies' Proposed Rule, Margin and Capital

    Requirements for Covered Swap Entities, 76 FR 27564 (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.\293\ 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.

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

    \293\ 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 75.4(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.\294\

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

    \294\ 12 U.S.C. 1851(d)(1)(B).

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

    Section 75.4(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

    [[Page 5832]]

    in more detail below, the proposed underwriting exemption required

    that: (i) A banking entity establish a compliance program under Sec.

    75.20; (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.\295\ 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 part of, or mischaracterized as, underwriting

    activity.\296\

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

    \295\ See proposed rule Sec. 75.4(a).

    \296\ See Joint Proposal, 76 FR at 68866; CFTC Proposal, 77 FR

    at 8352.

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

    2. Comments on Proposed Underwriting Exemption

    As a general matter, a few commenters expressed overall support for

    the proposed underwriting exemption.\297\ Some commenters indicated

    that the proposed exemption is too narrow and may negatively impact

    capital markets.\298\ 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.

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

    \297\ 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.

    \298\ See, e.g., Lord Abbett; BoA; Fidelity; Chamber (Feb.

    2012).

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

    Several commenters suggested alternative approaches to implementing

    the statutory exemption for underwriting activities.\299\ More

    specifically, commenters recommended that the Agencies: (i) Provide a

    safe harbor for low risk, standard underwritings; \300\ (ii) better

    incorporate the statutory limitations on high-risk activity or

    conflicts of interest; \301\ (iii) prohibit banking entities from

    underwriting illiquid securities; \302\ (iv) prohibit banking entities

    from participating in private placements; \303\ (v) place greater

    emphasis on adequate internal compliance and risk management

    procedures; \304\ or (vi) make the exemption as broad as possible.\305\

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

    \299\ See Sens. Merkley & Levin (Feb. 2012); BoA; Fidelity;

    Occupy; AFR et al. (Feb. 2012).

    \300\ 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).

    \301\ 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).

    \302\ 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).

    \303\ See Occupy.

    \304\ 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).

    \305\ 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.\306\

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

    \306\ See infra Part VI.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.\307\

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

    \307\ See infra Part VI.A.2.c.1.c. The term ``trading desk'' is

    defined in final rule Sec. 75.3(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.\308\

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

    \308\ See final rule Sec. Sec. 75.4(a)(2)(i), 75.4(a)(3),

    75.4(a)(4); see also infra Part VI.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.\309\

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

    \309\ See final rule Sec. 75.4(a)(2)(ii); see also infra Part

    VI.A.2.c.2.c.

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

    [[Page 5833]]

    [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 increase to a trading desk's limit(s), and

    independent review of such demonstrable analysis and approval.\310\

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

    \310\ See final rule Sec. 75.4(a)(2)(iii); see also infra Part

    VI.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.\311\

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

    \311\ See final rule Sec. 75.4(a)(2)(iv); see also infra Part

    VI.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.\312\

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

    \312\ See final rule Sec. 75.4(a)(2)(v); see also infra Part

    VI.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.\313\ 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.\314\

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

    \313\ 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. 75.7 of

    the final rules, and this provision will apply to underwriting

    activities, as well as all other exempted activities.

    \314\ See final rule Sec. 75.4(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,\315\ 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.\316\ 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.\317\

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

    \315\ See AFR et al. (Feb. 2012).

    \316\ See Joint Proposal, 76 FR at 68859 n.101 (explaining why

    the Agencies declined to incorporate certain accounting standards in

    the proposed rule); CFTC Proposal, 77 FR at 8344 n.107.

    \317\ See infra Part VI.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.\318\ 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.\319\

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

    \318\ See BoA.

    \319\ 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.\320\ 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.

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

    \320\ 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 75.4(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

    [[Page 5834]]

    underwriter.\321\ 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.\322\

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

    \321\ See proposed rule Sec. 75.4(a)(2)(iii).

    \322\ See proposed rule Sec. 75.4(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.\323\ 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.'' \324\ 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.\325\ The Agencies noted that ``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.\326\

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

    \323\ See Joint Proposal, 76 FR at 68866-68867; CFTC Proposal,

    77 FR at 8352; 17 CFR 242.101; proposed rule Sec. 75.4(a)(3).

    \324\ See proposed rule Sec. 75.4(a)(3).

    \325\ See Joint Proposal, 76 FR at 68867 (``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 at 8352; Review of

    Antimanipulation Regulation of Securities Offering, Exchange Act

    Release No. 33924 (Apr. 19, 1994), 59 FR 21681, 21684-21685 (Apr.

    26, 1994).

    \326\ See Joint Proposal, 76 FR at 68867; CFTC Proposal, 77 FR

    at 8352.

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

    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.\327\ 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.\328\

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

    \327\ See Joint Proposal, 76 FR at 68866-68867; CFTC Proposal,

    77 FR at 8352; 17 CFR 242.101; proposed rule Sec. 75.4(a)(4).

    \328\ See proposed rule Sec. 75.4(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 at 68867; CFTC Proposal, 77 FR at 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.\329\

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

    \329\ See Joint Proposal, 76 FR at 68867; CFTC Proposal, 77 FR

    at 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.\330\

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

    \330\ See id.

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

    iii. Proposed Requirement That the Covered Financial Position Be a

    Security

    Pursuant to Sec. 75.4(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.\331\ The proposal stated that this requirement

    was meant to reflect the common usage and understanding of the term

    ``underwriting.'' \332\ 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).\333\

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

    \331\ See proposed rule Sec. 75.4(a)(2)(ii).

    \332\ See Joint Proposal, 76 FR at 68866; CFTC Proposal, 77 FR

    at 8352.

    \333\ See Joint Proposal, 76 FR at 68866 n.132; CFTC Proposal,

    77 FR at 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. 75.4(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.\334\

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

    \334\ 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,\335\ while one commenter stated that

    the proposed definition is too broad.\336\ 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

    [[Page 5835]]

    efforts and selling methods'' or ``magnitude.''\337\ In particular,

    these commenters stated that the proposed definition of

    ``distribution'' may preclude a banking entity from participating in

    commercial paper issuances,\338\ bridge loans,\339\ ``at-the-market''

    offerings or ``dribble out'' programs conducted off issuer shelf

    registrations,\340\ offerings in response to reverse inquiries,\341\

    offerings through an automated execution system,\342\ small private

    offerings,\343\ or selling security holders' sales of securities of

    issuers with large market capitalizations that are executed as

    underwriting transactions in the normal course.\344\

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

    \335\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

    (Prop. Trading); Wells Fargo (Prop. Trading); RBC.

    \336\ See Occupy.

    \337\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

    (Prop. Trading); Wells Fargo (Prop. Trading); RBC.

    \338\ 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).

    \339\ See Goldman (Prop. Trading); Wells Fargo (Prop. Trading);

    RBC; LSTA (Feb. 2012).

    \340\ See Goldman (Prop. Trading).

    \341\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

    \342\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

    \343\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

    (Prop. Trading); Wells Fargo (Prop. Trading).

    \344\ See RBC.

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

    Several commenters suggested that the proposed definition be

    modified to include some or all of these types of offerings.\345\ For

    example, two commenters requested that the definition explicitly

    include all offerings of securities by an issuer.\346\ 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.\347\ 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.\348\ 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.\349\ 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.\350\

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

    \345\ See Goldman (Prop. Trading); SIFMA et al. (Prop. Trading)

    (Feb. 2012); RBC.

    \346\ 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).

    \347\ 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.

    \348\ See RBC.

    \349\ 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).

    \350\ 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.\351\

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

    \351\ See Occupy.

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

    ii. Definition of ``Underwriter''

    Several commenters stated that the proposed definition of

    ``underwriter'' is too narrow.\352\ Other commenters, however, stated

    that the proposed definition is too broad, particularly due to the

    proposed inclusion of selling group members.\353\

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

    \352\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

    (Prop. Trading); Wells Fargo (Prop. Trading).

    \353\ 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.\354\ 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.\355\ 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.\356\ 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).\357\

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

    \354\ 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.

    \355\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

    (Prop. Trading); Wells Fargo (Prop. Trading).

    \356\ See Goldman (Prop. Trading).

    \357\ See SIFMA et al. (Prop. Trading) (Feb. 2012). This

    commenter also requested a technical amendment to proposed rule

    Sec. 75.4(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.\358\

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

    \358\ 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

    [[Page 5836]]

    time when it is initially launched.\359\ 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.\360\

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

    \359\ 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.

    \360\ 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, 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.\361\

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

    \361\ 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.\362\ 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.\363\ 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,\364\ may reduce future innovation in the capital-raising

    process,\365\ and could create market disruptions.\366\

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

    \362\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

    (Prop. Trading); BoA; Wells Fargo (Prop. Trading); Comm. on Capital

    Markets Regulation.

    \363\ See Goldman (Prop. Trading).

    \364\ See Goldman (Prop. Trading); Wells Fargo (Prop. Trading);

    SIFMA et al. (Prop. Trading) (Feb. 2012).

    \365\ See Goldman (Prop. Trading).

    \366\ 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.\367\ 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;\368\ (ii) creating a

    stabilizing bid;\369\ (iii) acquiring positions via overallotments\370\

    or trading in the market to close out short positions in connection

    with an overallotment option or in connection with other stabilization

    activities;\371\ (iv) using call spread options in a convertible debt

    offering to mitigate dilution of existing shareholders;\372\ (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;\373\ (vi) purchasing debt securities of

    comparable issuers as a price discovery mechanism in connection with

    underwriting a new debt security;\374\ (vii) hedging the underwriter's

    exposure to a derivative strategy engaged in with an issuer;\375\

    (viii) organizing and assembling a resecuritized product, including,

    for example, sourcing bond collateral over a period of time in

    anticipation of issuing new securities;\376\ and (ix) selling a

    security to an intermediate entity as part of the creation of certain

    structured products.\377\

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

    \367\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

    (Prop. Trading); Wells Fargo (Prop. Trading); RBC.

    \368\ 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).

    \369\ 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.'').

    \370\ See RBC.

    \371\ See Goldman (Prop. Trading).

    \372\ 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'').

    \373\ 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.

    \374\ See Wells Fargo (Prop. Trading).

    \375\ See Goldman (Prop. Trading).

    \376\ 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).

    \377\ 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 at 68868-68869 (question 78); CFTC

    Proposal, 77 FR at 8354 (question 78).

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

    c. Final Requirement That the Banking Entity Act as an Underwriter for

    a Distribution of Securities and the Trading Desk's Underwriting

    Position Be Related to Such Distribution

    The final rule requires that the banking entity act as an

    underwriter for a distribution of securities and the trading desk's

    underwriting position be related to such distribution.\378\ This

    requirement is substantially similar to the proposed rule,\379\ but

    with five key refinements. First, to address commenters' confusion

    about whether

    [[Page 5837]]

    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.

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

    \378\ Final rule Sec. 75.4(a)(2)(i). The terms ``distribution''

    and ``underwriter'' are defined in final rule Sec. 75.4(a)(3) and

    Sec. 75.4(a)(4), respectively.

    \379\ Proposed rule Sec. 75.4(a)(2)(iii) required that ``[t]he

    purchase or sale is effected solely in connection with a

    distribution of securities for which the covered banking entity is

    acting as underwriter.''

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

    i. Definition of ``Underwriting Position''

    In response to commenters' concerns about transaction-by-

    transaction analyses,\380\ the Agencies are modifying 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. 75.4(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.

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

    \380\ 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.\381\ 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.

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

    \381\ See infra Part VI.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.\382\ 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.

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

    \382\ See supra note 307 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.\383\ 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

    [[Page 5838]]

    with an alternative prong for registered offerings under the Securities

    Act.\384\

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

    \383\ Final rule Sec. 75.4(a)(3).

    \384\ Proposed rule Sec. 75.4(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.\385\ As

    proposed, the Agencies will rely on the same factors considered under

    Regulation M to analyze the presence of special selling efforts and

    selling methods.\386\ 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.\387\ 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 \388\

    and, to the extent the commercial paper being offered is a security,

    commercial paper offerings that involve the underwriter receiving

    special compensation.\389\

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

    \385\ 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.

    \386\ See Joint Proposal, 76 FR at 68867; CFTC Proposal, 77 FR

    at 8352.

    \387\ See Joint Proposal, 76 FR at 68867; CFTC Proposal, 77 FR

    at 8352; Review of Antimanipulation Regulation of Securities

    Offering, Exchange Act Release No. 33924 (Apr. 19, 1994), 59 FR

    21681, 21684-21685 (Apr. 26, 1994).

    \388\ 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.

    \389\ 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 VI.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.\390\ 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.\391\ 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),\392\ bought

    deals,\393\ at the market offerings,\394\ debt offerings, asset-backed

    security offerings, initial public offerings, and other registered

    offerings. An offering can be a distribution for purposes of either

    Sec. 75.4(a)(3)(i) or Sec. 75.4(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.\395\

    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.\396\

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

    \390\ 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).

    \391\ 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.

    \392\ See Securities Offering Reform, Securities Act Release No.

    8591 (July 19, 2005), 70 FR 44722 (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.

    \393\ 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.

    \394\ 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.

    \395\ 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).

    \396\ 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.

    [[Page 5839]]

    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.\397\

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

    \397\ See final rule Sec. 75.4(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 to participate in the distribution.\398\ 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.

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

    \398\ 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.\399\ 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.

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

    \399\ 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. 75.4(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.\400\

    \400\ See Joint Proposal, 76 FR at 68867; CFTC Proposal, 77 FR

    at 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.\401\ 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.''

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

    \401\ See infra Part VI.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.\402\ A ``selling security

    holder'' is defined as ``any person, other than an issuer, on whose

    behalf a distribution is made.''\403\ This definition is consistent

    with the

    [[Page 5840]]

    definition of ``selling security holder'' found in the SEC's Regulation

    M.\404\

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

    \402\ See final rule Sec. 75.3(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).

    \403\ Final rule Sec. 75.4(a)(5).

    \404\ See 17 CFR 242.100(b).

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

    v. Activities Conducted ``in Connection With'' a Distribution

    As discussed above, several commenters expressed concern that the

    proposed underwriting exemption would not allow a banking entity to

    engage in certain auxiliary activities that may be conducted in

    connection with acting as an underwriter for a distribution of

    securities in the normal course. These commenters' concerns generally

    arose from the use of the word ``solely'' in Sec. 75.4(a)(2)(iii) of

    the proposed rule, which commenters noted was not included in the

    statute's underwriting exemption.\405\ 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.\406\

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

    \405\ See supra Part VI.A.2.c.1.b.iii.

    \406\ See supra notes 362, 363, 368-77 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 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,\407\ syndicate

    shorting and aftermarket short covering,\408\ 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,\409\ 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).\410\ 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,\411\ 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.\412\ 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.

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

    \407\ 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.'').

    \408\ 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 75774, 75780 (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.'').

    \409\ See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; BoA;

    BDA (Feb. 2012).

    \410\ See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; Goldman

    (Prop. Trading).

    \411\ See final rule Sec. 75.4(a)(2)(ii); infra Part

    VI.A.2.c.2.c. (discussing the requirement to make reasonable efforts

    to sell or otherwise reduce the underwriting position).

    \412\ See final rule Sec. 75.4(a)(2)(iii)(B); infra Part

    VI.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.\413\ 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.\414\ 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.\415\ A banking entity

    must comply with the hedging exemption for such activity.

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

    \413\ 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.

    \414\ 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 VI.A.2.c.2.

    \415\ 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

    [[Page 5841]]

    finance product,\416\ 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.\417\ 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.

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

    \416\ See ICI (Feb. 2012); AFR et al. (Feb. 2012); Occupy;

    Alfred Brock.

    \417\ A banking entity may accumulate loans in anticipation of

    securitization because loans are not financial instruments under the

    final rule. See supra Part VI.A.1.c.

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

    2. Near Term Customer Demand Requirement

    a. Proposed Near Term Customer Demand Requirement

    Like the statute, Sec. 75.4(a)(2)(v) of the proposed rule required

    that the underwriting activities of the banking entity with respect to

    the covered financial position be designed not to exceed the reasonably

    expected near term demands of clients, customers, or

    counterparties.\418\

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

    \418\ See proposed rule Sec. 75.4(a)(2)(v); Joint Proposal, 76

    FR at 68867; CFTC Proposal, 77 FR at 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.''

    \419\ 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.\420\ 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.\421\ 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.''\422\

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

    \419\ See supra Part VI.A.2.c.2.a.

    \420\ 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.

    \421\ 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).

    \422\ 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.\423\ 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,'' \424\ rights offerings,\425\

    and fixed-income offerings.\426\ 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\427\ and bridge loans.\428\ 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.\429\

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

    \423\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; BDA

    (Feb. 2012); RBC.

    \424\ 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.

    \425\ 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).

    \426\ 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.

    \427\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA.

    \428\ 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).

    \429\ 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.\430\ 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.\431\ 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.\432\ One of these commenters recommended the

    Agencies use a metric to monitor the size of residual positions

    retained by an underwriter,\433\ 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.\434\ 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

    [[Page 5842]]

    poses heightened financial risk at the top of economic cycles.\435\

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

    \430\ 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.

    \431\ See AFR et al. (Feb. 2012); CalPERS; Occupy; Public

    Citizen; Alfred Brock.

    \432\ 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).

    \433\ See AFR et al. (Feb. 2012).

    \434\ See Occupy (stating that the meaning of the term

    ``substantial'' would depend on the circumstances of the particular

    offering).

    \435\ 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.\436\

    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.\437\

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

    \436\ 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).

    \437\ See Goldman (Prop. Trading).

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

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

    commenter expressed the view that the rule should not require

    documentation with respect to residual positions held by an

    underwriter.\438\ 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.\439\

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

    \438\ See Japanese Bankers Ass'n.

    \439\ 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.\440\ 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.\441\ 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.\442\

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

    \440\ See AFR et al. (Feb. 2012); Sens. Merkley & Levin (Feb.

    2012).

    \441\ See AFR et al. (Feb. 2012).

    \442\ 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.\443\ 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.\444\

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

    \443\ See Banco de M[eacute]xico.

    \444\ 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.\445\ 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.\446\ The

    Agencies are making certain modifications to the proposed approach in

    response to comments.

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

    \445\ Final rule Sec. 75.4(a)(2)(ii).

    \446\ 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.

    75.4(a)(2)(v).

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

    In particular, the Agencies are clarifying the operation of this

    requirement, particularly with respect to unsold allotments.\447\ 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.\448\ 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.\449\ However, the

    [[Page 5843]]

    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.\450\

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

    \447\ See supra Part VI.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).

    \448\ 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.

    \449\ 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. 75.3(e)(9), or a selling security holder, as

    defined in final rule Sec. 75.4(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 VI.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. 75.4(a)(7).

    \450\ 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.

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

    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.\451\ An unsold allotment is,

    however, subject to the requirement to make reasonable efforts to sell

    or otherwise reduce the underwriting position.\452\ 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.\453\

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

    \451\ 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).

    \452\ 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.

    \453\ 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 at 68867 (``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 at 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 \454\ or

    would negatively impact certain types of securities offerings (e.g.,

    bought deals, rights offerings, and fixed-income offerings).\455\ Other

    commenters, however, expressed concern that the proposed exemption

    would allow a banking entity to retain a portion of a distribution for

    speculative purposes.\456\

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

    \454\ See Goldman (Prop. Trading); Fidelity.

    \455\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; RBC.

    \456\ 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.\457\ 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.\458\ 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

    [[Page 5844]]

    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.\459\ 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 hedging exemption in Sec. 75.5 of the final rule.

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

    \457\ 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.

    \458\ See Goldman (Prop. Trading); Fidelity; SIFMA et al. (Prop.

    Trading) (Feb. 2012); RBC.

    \459\ See AFR et al. (Feb. 2012); CalPERS; Occupy.

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

    The Agencies emphasize that the requirement to make reasonable

    efforts to sell or otherwise reduce the underwriting position applies

    to the entirety of the trading desk's underwriting position. As a

    result, this requirement applies to a number of different scenarios in

    which an underwriter may hold a long or short position in the

    securities that are the subject of a distribution for a period of time.

    For example, if an underwriter is facilitating a distribution of

    securities for which there is sufficient investor demand to purchase

    the securities at the offering price, this requirement would prevent

    the underwriter from retaining a portion of the allotment for its own

    account instead of selling the securities to interested investors. If

    instead there was insufficient investor demand at the time of the

    initial offering, this requirement would recognize that it may be

    appropriate for the underwriter to hold an unsold allotment for a

    reasonable period of time. Under these circumstances, the underwriter

    would need to make reasonable efforts to sell the unsold allotment when

    there is sufficient market demand for the securities.\460\ 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.\461\ 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.

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

    \460\ 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.

    \461\ See supra note 408.

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

    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.\462\ 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.

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

    \462\ 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 75.4(a)(2)(i) of the proposed exemption required a banking

    entity to establish an internal compliance program, as required by

    Sec. 75.20 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.\463\ 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.\464\

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

    \463\ See proposed rule Sec. 75.4(a)(2)(i).

    \464\ See Joint Proposal, 76 FR at 68866; CFTC Proposal, 77 FR

    at 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. 75.20 of the proposed rule are

    discussed in Part VI.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 \465\ identifying and addressing: (i) The

    products, instruments or exposures each trading desk may purchase,

    sell, or manage as part of its underwriting activities; \466\ (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;

    \467\ (iii) internal controls and ongoing monitoring and analysis of

    each trading desk's compliance with its limits; \468\ 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

    [[Page 5845]]

    such demonstrable analysis and approval.\469\

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

    \465\ The independent testing standard is discussed in more

    detail in Part VI.C., which discusses the compliance program

    requirement in Sec. 75.20 of the final rule.

    \466\ See final rule Sec. 75.4(a)(2)(iii)(A).

    \467\ See final rule Sec. 75.4(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.

    \468\ See final rule Sec. 75.4(a)(2)(iii)(C).

    \469\ See final rule Sec. 75.4(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.\470\ 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. 75.4(a) of the final rule. Each of

    the requirements in paragraphs (a)(2)(iii)(A) through (D) must be

    appropriately tailored to the individual trading activities and

    strategies of each trading desk.

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

    \470\ See Joint Proposal, 76 FR at 68963-68967 (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.\471\ 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.

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

    \471\ See final rule Sec. Sec. 75.4(a)(2)(iii),

    75.4(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.\472\

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

    \472\ See final rule Sec. 75.5.

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

    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.\473\ 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).

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

    \473\ See final rule Sec. 75.4(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.\474\ 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. 75.20(b)(6).

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

    \474\ See final rule Sec. 75.4(a)(2)(iii)(D).

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

    As discussed in more detail in Part VI.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.\475\

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

    \475\ See Part VI.C. (discussing the compliance program

    requirement in Sec. 75.20 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.\476\ 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.\477\

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

    \476\ See proposed rule Sec. 75.4(a)(2)(vii); Joint Proposal,

    76 FR at 68868; CFTC Proposal, 77 FR at 8353.

    \477\ 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.\478\

    Specifically, one

    [[Page 5846]]

    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.\479\ Finally, one commenter suggested that the term

    ``designed'' should be removed from this provision.\480\

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

    \478\ See Occupy; AFR et al. (Feb. 2012); Better Markets (Feb.

    2012).

    \479\ See AFR et al. (Feb. 2012).

    \480\ 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 designed not to reward or incentivize prohibited

    proprietary trading.\481\ The Agencies do not intend to preclude an

    employee of an underwriting desk from being compensated for successful

    underwriting, which involves some risk-taking.

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

    \481\ See final rule Sec. 75.4(a)(2)(iv); proposed rule Sec.

    75.4(a)(2)(vii). This is consistent with the final compensation

    requirements in the market-making and hedging exemptions. See final

    rule Sec. 75.4(b)(2)(v); final rule Sec. 75.5(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.\482\ 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.\483\ 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.\484\ 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.

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

    \482\ See AFR et al. (Feb. 2012); supra Part VI.A.2.c.2.c.

    (discussing the requirement to make reasonable efforts to sell or

    otherwise reduce the underwriting position).

    \483\ See AFR et al. (Feb. 2012).

    \484\ See Occupy.

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

    5. Registration Requirement

    a. Proposed Registration Requirement

    Section 75.4(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.\485\ 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.

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

    \485\ See proposed rule Sec. 75.4(a)(2)(iv); Joint Proposal, 76

    FR at 68867; CFTC Proposal, 77 FR at 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 at 68867; CFTC Proposal, 77 FR at 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 VI.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. 75.4(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. 75.4(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.\486\

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

    \486\ See Part VI.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.\487\ To the

    extent that a banking entity relies on the underwriting exemption in

    [[Page 5847]]

    connection with a distribution of municipal securities or government

    securities, rather than the exemption in Sec. 75.6(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.

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

    \487\ 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 businesses.\488\ 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.

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

    \488\ See infra Part VI.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. 75.4(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.\489\ 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.\490\ 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.\491\

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

    \489\ See proposed rule Sec. 75.4(a)(2)(vi); Joint Proposal, 76

    FR at 68867-68868; CFTC Proposal, 77 FR at 8353.

    \490\ See Joint Proposal, 76 FR at 68867-68868 n.142; CFTC

    Proposal, 77 FR at 8353 n.148.

    \491\ See Joint Proposal, 76 FR at 68867-68868; CFTC Proposal,

    77 FR at 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.\492\ 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.\493\

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

    \492\ See Goldman (Prop. Trading); Occupy; Sens. Merkley & Levin

    (Feb. 2012).

    \493\ 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.\494\ 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.\495\

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

    \494\ See Goldman (Prop. Trading).

    \495\ 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.'' \496\ 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.\497\

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

    \496\ 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).

    \497\ 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.

    75.4(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 \498\ or may impact primary dealer activities.\499\ 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.

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

    \498\ See Goldman (Prop. Trading).

    \499\ 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

    [[Page 5848]]

    circumstances, which would be inconsistent with other provisions of the

    exemption.\500\ 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.\501\ 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.\502\ Further, one commenter

    recommended a revenue requirement directed at securitization activities

    to prevent banking entities from accumulating large and risky positions

    with significant market exposure.\503\ 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.\504\

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

    \500\ See Occupy; supra Part VI.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).

    \501\ See AFR et al. (Feb. 2012); Public Citizen.

    \502\ See supra Part VI.A.2.c.2.

    \503\ See Sens. Merkley & Levin (Feb. 2012).

    \504\ See final rule Sec. 75.4(a)(2)(ii). Further, as noted

    above, this exemption does not permit the accumulation of assets for

    securitization. See supra Part VI.A.2.c.1.c.v.

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

    3. Section 75.4(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.\505\ 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.

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

    \505\ As discussed in Part VI.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.\506\

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

    \506\ 12 U.S.C. 1851(d)(1)(B).

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

    Section 75.4(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. 75.20 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.\507\

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

    \507\ See Joint Proposal, 76 FR at 68869; CFTC Proposal, 77 FR

    at 8354-8355.

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

    2. Comments on the Proposed Market-Making Exemption

    The Agencies received significant comment regarding the proposed

    market-making exemption. In this Part, the Agencies highlight the main

    issues, concerns, and suggestions raised by commenters with respect to

    the proposed market-making exemption. As discussed in greater detail

    below, commenters' views on the effectiveness of the proposed exemption

    varied. Commenters discussed a broad range of topics related to the

    proposed market-making exemption including, among others: The overall

    scope of the proposed exemption and potential restrictions on market

    making in certain markets or asset classes; the potential market impact

    of the proposed market-making exemption; the appropriate level of

    analysis for compliance with the proposed exemption; the effectiveness

    of the individual requirements of the proposed exemption; and specific

    activities that should or should not be considered permitted market

    making-related activity under the rule.

    a. Comments on the Overall Scope of the Proposed Exemption

    With respect to the general scope of the exemption, a number of

    commenters expressed concern that the proposed approach to implementing

    the market-making exemption is too narrow or restrictive, particularly

    with respect to less liquid markets. These commenters expressed concern

    that the proposed exemption would not be workable in many markets and

    asset classes and does not take into account how market-making services

    are provided in those markets and asset classes.\508\ Some

    [[Page 5849]]

    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).\509\ Several

    commenters stated that the proposed exemption would create too much

    uncertainty regarding compliance \510\ and, further, may have a

    chilling effect on banking entities' market making-related

    activities.\511\ 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.\512\ 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.\513\

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

    \508\ 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).

    \509\ 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).

    \510\ 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.

    \511\ 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.

    \512\ 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.

    \513\ See, e.g., NASP; Wellington; JPMC; Morgan Stanley; Credit

    Suisse (Seidel); BoA; Goldman (Prop. Trading); Citigroup (Feb.

    2012); STANY; SIFMA (Asset Mgmt.) (Feb. 2012); Chamber (Feb. 2012);

    Putnam; ICI (Feb. 2012); Wells Fargo (Prop. Trading); NYSE Euronext;

    Sen. Corker; Invesco.

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

    Other commenters, however, stated that the proposed exemption was

    too broad and recommended that the rule place greater restrictions on

    market making, particularly in illiquid, nontransparent markets.\514\

    Many of these commenters suggested that the exemption should only be

    available for traditional market-making activity in relatively safe,

    ``plain vanilla'' instruments.\515\ Two commenters represented that the

    proposed exemption would have little to no impact on banking entities'

    current market making-related services.\516\

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

    \514\ See, e.g., Better Markets (Feb. 2012); Sens. Merkley &

    Levin (Feb. 2012); Occupy; AFR et al. (Feb. 2012); Public Citizen;

    Johnson & Prof. Stiglitz.

    \515\ See, e.g., Johnson & Prof. Stiglitz; Sens. Merkley & Levin

    (Feb. 2012); Occupy; AFR et al. (Feb. 2012); Public Citizen.

    \516\ 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.\517\

    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.\518\

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

    \517\ 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.

    \518\ 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.\519\ 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.\520\ 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.\521\

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

    \519\ See Wellington; Paul Volcker; Better Markets (Feb. 2012);

    Occupy.

    \520\ See Wellington.

    \521\ 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.\522\

    Commenters appeared to attribute these concerns to language in the

    proposed exemption referring to a ``purchase or sale of a [financial

    instrument]'' \523\ or to language in Appendix B indicating that the

    Agencies may assess certain factors and criteria at different levels,

    including a ``single significant transaction.'' \524\ With respect to

    the burdens of a transaction-by-transaction analysis,

    [[Page 5850]]

    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.\525\ 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.\526\ 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.\527\ One commenter elaborated on this point

    by stating that ``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.'' \528\ 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.\529\ Two commenters suggested that the

    requirements in the market-making exemption be applied at the portfolio

    level rather than the trade level.\530\

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

    \522\ 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 VI.A.3.c.1.c., infra.

    \523\ 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.

    \524\ See, e.g., Goldman (Prop. Trading); Wellington.

    \525\ 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'').

    \526\ See, e.g., ICI (Feb. 2012); Barclays; Goldman (Prop.

    Trading).

    \527\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

    Goldman (Prop. Trading).

    \528\ SIFMA et al. (Prop. Trading) (Feb. 2012).

    \529\ 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'').

    \530\ See ACLI (Feb. 2012); Fixed Income Forum/Credit

    Roundtable.

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

    Moreover, commenters also set forth their views on the

    organizational level at which the requirements of the proposed market-

    making exemption should apply.\531\ 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\532\ or at each trading unit.\533\

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

    \531\ 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 VI.A.3.c.1.c.,

    infra.

    \532\ See Wellington. This commenter did not provide greater

    specificity about how it would define ``trading desk'' or

    ``aggregation unit.'' See id.

    \533\ See Morgan Stanley (stating that ``trading unit'' should

    be defined as ``each organizational unit that is used to structure

    and control the aggregate risk-taking activities and employees that

    are engaged in the coordinated implementation of a customer-facing

    revenue generation strategy and that participate in the execution of

    any covered trading activity''); SIFMA et al. (Prop. Trading) (Feb.

    2012). One of these commenters discussed its suggested definition of

    ``trading unit'' in the context of the proposed requirement to

    record and report certain quantitative measurements, but it is

    unclear that the commenter was also suggesting that this definition

    be used for purposes of the market-making exemption. For example,

    this commenter expressed support for a multi-level approach to

    defining ``trading unit,'' and it is not clear how a definition that

    captures multiple organizational levels across a banking

    organization would work in the context of the market-making

    exemption. See SIFMA et al. (Prop. Trading) (Feb. 2012) (suggested

    that ``trading unit'' be defined ``at a level that presents its

    activities in the context of the whole'' and noting that the

    appropriate level may differ depending on the structure of the

    banking entity).

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

    Several commenters suggested alternative or additive means of

    implementing the statutory exemption for market making-related

    activity.\534\ Commenters' recommended approaches varied, but a number

    of commenters requested approaches involving one or more of the

    following elements: (i) Safe harbors,\535\ bright lines,\536\ 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); \537\ (ii) a focus on metrics or other objective

    factors; \538\ (iii) guidance on permitted market making-related

    activity, rather than rule requirements; \539\ (iv) risk management

    structures and/or risk limits; \540\ (v) adding a new customer-facing

    criterion or focusing on client-related activities; \541\ (vi) capital

    and liquidity requirements; \542\ (vii) development of individualized

    plans for each banking entity, in coordination with regulators; \543\

    (viii) ring fencing affiliates engaged in market making-related

    activity; \544\ (ix) margin requirements; \545\ (x) a compensation-

    focused approach; \546\ (xi) permitting all swap dealing activity;

    \547\ (xii) additional provisions regarding material conflicts of

    interest and high-risk assets and trading strategies; \548\ and/or

    (xiii) making the exemption as broad as possible under the

    statute.\549\

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

    \534\ 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 VI.A.3.b.3., infra.

    \535\ 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).

    \536\ See, e.g., Flynn & Fusselman; Prof. Colesanti et al.

    \537\ 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).

    \538\ See, e.g., Goldman (Prop. Trading); Morgan Stanley;

    Barclays; Wellington; CalPERS; BlackRock; SSgA (Feb. 2012); Invesco.

    \539\ 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).

    \540\ See, e.g., Japanese Bankers Ass'n.; Citigroup (Feb. 2012).

    \541\ See, e.g., Morgan Stanley; Stephen Roach.

    \542\ See, e.g., Prof. Duffie; CalPERS; STANY; ICE; Vanguard;

    Capital Group.

    \543\ See MetLife; Fixed Income Forum/Credit Roundtable; ACLI

    (Feb. 2012).

    \544\ See, e.g., Prof. Duffie; Shadow Fin. Regulatory Comm. See

    also Wedbush.

    \545\ See WR Hambrecht.

    \546\ See G2 FinTech.

    \547\ See ISDA (Feb. 2012); ISDA (Apr. 2012).

    \548\ 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).

    \549\ 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).

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

    [[Page 5851]]

    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,\550\ wider bid-ask spreads,\551\ increased market

    volatility,\552\ reduced price discovery or price transparency,\553\

    increased costs of raising capital or higher financing costs,\554\

    greater costs for investors or consumers,\555\ and slower execution

    times.\556\ Some commenters expressed particular concern about

    potential impacts on institutional investors (e.g., mutual funds and

    pension funds) \557\ or on small or midsized companies.\558\ 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.\559\

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

    \550\ 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 VI.A.3.b.3., infra.

    \551\ 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).

    \552\ 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.

    \553\ 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.

    \554\ 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.

    \555\ 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.

    \556\ See, e.g., Barclays; FTN; Abbott Labs et al. (Feb. 14,

    2012); Abbott Labs et al. (Feb. 21, 2012).

    \557\ 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).

    \558\ 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.

    \559\ 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.\560\ 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.\561\ 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.\562\ Some commenters cited an economic study

    indicating that the U.S. financial system has become less efficient in

    generating economic growth

    [[Page 5852]]

    in recent years, despite increased trading volumes.\563\

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

    \560\ See, e.g., Paul Volcker; AFR et al. (Feb. 2012); Public

    Citizen; Prof. Richardson; Johnson & Prof. Stiglitz; Better Markets

    (Feb. 2012); Prof. Johnson.

    \561\ 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).

    \562\ See Prof. Richardson.

    \563\ 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.\564\ 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 activity or other

    trading activity.\565\ 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.\566\ 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.\567\

    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.\568\

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

    \564\ 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.

    \565\ 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).

    \566\ See Better Markets (Feb. 2012).

    \567\ See Prof. Johnson.

    \568\ 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.\569\ 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.\570\ 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.\571\ 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.\572\ 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.\573\

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

    \569\ 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).

    \570\ 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.'').

    \571\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

    \572\ See Thakor Study.

    \573\ 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,\574\ including trading for

    price discovery purposes or to test market depth; \575\ (ii) inventory

    management; \576\ (iii) block positioning activity; \577\ (iv) acting

    as an authorized participant or market maker in ETFs; \578\ (v)

    arbitrage or other activities that promote price transparency and

    liquidity; \579\ (vi) primary dealer activity; \580\ (vii) market

    making in futures and options; \581\ (viii) market making in new or

    bespoke products or customized hedging contracts; \582\ and (ix) inter-

    affiliate transactions.\583\ As discussed in more detail in Part

    VI.B.2.c., a number of commenters requested that the market-making

    exemption apply to the restrictions on acquiring or retaining an

    ownership

    [[Page 5853]]

    interest in a covered fund.\584\ Some commenters stated that no other

    activities should be considered permitted market making-related

    activity under the rule.\585\ In addition, a few commenters requested

    clarification that high-frequency trading would not qualify for the

    market-making exemption.\586\

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

    \574\ 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).

    \575\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Chamber

    (Feb. 2012); Goldman (Prop. Trading).

    \576\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

    Credit Suisse (Seidel); Goldman (Prop. Trading); MFA; RBC.

    \577\ See infra Part VI.A.3.c.1.b.ii. (discussing commenters'

    requests for greater clarity regarding the permissibility of block

    positioning activity).

    \578\ 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).

    \579\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit

    Suisse (Seidel); JPMC; Goldman (Prop. Trading); FTN; RBC; ISDA (Feb.

    2012).

    \580\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC;

    Goldman (Prop. Trading); Banco de M[eacute]xico; IIB/EBF.

    \581\ 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. 75.4(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.

    75.6(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).

    \582\ 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.

    \583\ 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).

    \584\ See, e.g., Cleary Gottlieb; JPMC; BoA; Credit Suisse

    (Williams).

    \585\ See, e.g., Occupy; Alfred Brock.

    \586\ 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 a given marketplace, certain characteristics of a market-

    making business may differ among markets and asset classes.\587\ 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.

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

    \587\ 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 at 68870; CFTC Proposal, 77 FR

    at 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.\588\

    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.

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

    \588\ 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.\589\

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

    \589\ See infra Part VI.A.3.c.1.c.ii. See also final rule

    Sec. Sec. 75.4(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.\590\

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

    \590\ See infra Part VI.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. 75.3(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;

    \591\

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

    \591\ See final rule Sec. 75.4(b)(2)(i); infra Part

    VI.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; \592\

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

    \592\ See final rule Sec. 75.4(b)(2)(ii); infra Part

    VI.A.3.c.2.c. In addition, the Agencies are adopting a definition of

    the terms ``client,'' ``customer,'' and ``counterparty'' in Sec.

    75.4(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. 75.4(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

    [[Page 5854]]

    desk to mitigate these risks are and continue to be effective; \593\

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

    \593\ 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 VI.A.3.c.1.c.ii. and

    VI.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 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; \594\

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

    \594\ See final rule Sec. 75.4(b)(2)(iii); infra Part

    VI.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;

    \595\

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

    \595\ See final rule Sec. 75.4(b)(2)(iv).

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

    [cir] The compensation arrangements of persons performing market

    making-related activities are designed not to reward or incentivize

    prohibited proprietary trading; \596\ and

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

    \596\ See final rule Sec. 75.4(b)(2)(v); infra Part VI.A.3.c.5.

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

    The banking entity is licensed or registered to engage in

    market making-related activities in accordance with applicable

    law.\597\

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

    \597\ See final rule Sec. 75.4(b)(2)(vi); infra Part

    VI.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.\598\ As discussed further in Part VI.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.

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

    \598\ See infra Part VI.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.\599\ 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 \600\ 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.\601\ 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.\602\ 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.\603\

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

    \599\ See supra Part VI.A.3.b.2.

    \600\ 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.

    \601\ 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.

    \602\ 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.

    \603\ 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.\604\ 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.\605\ 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

    [[Page 5855]]

    compliance with the market-making exemption.\606\

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

    \604\ See, e.g., Goldman (Prop. Trading); Morgan Stanley;

    Barclays; Wellington; CalPERS; BlackRock; SSgA (Feb. 2012); Invesco.

    \605\ See infra Part VI.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.

    \606\ See infra Part VI.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,\607\ 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.\608\ 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 commenters.\609\

    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.

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

    \607\ See, e.g., Japanese Bankers Ass'n.; Citigroup (Feb. 2012).

    \608\ 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.

    \609\ 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.\610\

    Moreover, as described below, the final market-making exemption

    includes specific substantive changes in response to a wide variety of

    commenter concerns.

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

    \610\ 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. 75.7 of the

    final rule. The limitations in Sec. 75.7 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.\611\ However, commenters disagreed about whether reduced

    liquidity would be beneficial or detrimental to the market, or if any

    such reductions would even materialize.\612\ 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.

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

    \611\ See supra note 550 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.

    \612\ 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 550 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.\613\

    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.\614\ 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.\615\ Volatility is

    [[Page 5856]]

    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.\616\ 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.\617\ Volume in these

    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.

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

    \613\ See supra Part VI.A.3.b.2.b.

    \614\ See supra Part VI.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 VI.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.

    \615\ 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.

    \616\ 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.

    \617\ 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.\618\ 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.\619\ 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.

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

    \618\ 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).

    \619\ 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.\620\ 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.\621\ 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.

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

    \620\ See supra note 522 (discussing commenters' concerns

    regarding a trade-by-trade analysis).

    \621\ 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.\622\ The

    [[Page 5857]]

    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 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.\623\

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

    \622\ See supra notes 565 and 569 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.

    \623\ 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 75.4(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.\624\ 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.\625\

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

    \624\ See proposed rule Sec. 75.4(b)(2)(ii).

    \625\ See Joint Proposal, 76 FR at 68870 (``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 at 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.\626\ 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.

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

    \626\ See Joint Proposal, 76 FR at 68870; CFTC Proposal, 77 FR

    at 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.\627\ 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;

    \628\ (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.\629\

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

    \627\ See Joint Proposal, 76 FR at 68870-68871; CFTC Proposal,

    77 FR at 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 at 68871 n.148;

    CFTC Proposal, 77 FR at 8356 n.155.

    \628\ 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 at 68871 n.149; CFTC Proposal, 77 FR at 8356

    n.156.

    \629\ See Joint Proposal, 76 FR at 68871; CFTC Proposal, 77 FR

    at 8356.

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

    In discussing this proposed requirement, the Agencies stated that

    bona fide market making-related activity may include certain block

    positioning and anticipatory position-taking. More specifically, the

    proposal indicated that the bona fide market making-related activity

    described in Sec. 75.4(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; \630\ 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.\631\

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

    \630\ 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. 75.4(b)(2)(ii) of the proposed rule. See Joint

    Proposal, 76 FR at 68871 n.151; CFTC Proposal, 77 FR at 8356 n.157.

    \631\ See Joint Proposal, 76 FR at 68871; CFTC Proposal, 77 FR

    at 8356-8357.

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

    b. Comments on the Proposed Requirement To Hold Self Out

    Commenters raised many issues regarding Sec. 75.4(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.\632\ A number of

    [[Page 5858]]

    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.

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

    \632\ See Sens. Merkley & Levin (Feb. 2012); Alfred Brock.

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

    Several commenters represented that the proposed requirement was

    too restrictive.\633\ 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.\634\ In

    addition, a few commenters expressed specific concern about how this

    requirement would impact more limited market-making activity conducted

    by banks.\635\

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

    \633\ See infra Part VI.A.3.c.1.c.iii. (addressing these

    concerns).

    \634\ 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).

    \635\ 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).

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

    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.\636\ 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.\637\ 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.\638\ 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.\639\

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

    \636\ This issue is further discussed in Part VI.A.3.c.1.c.iii.,

    infra.

    \637\ 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).

    \638\ See Goldman (Prop. Trading).

    \639\ 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.\640\ 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.\641\ 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; \642\ (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; \643\ or (iii) a historical test of market-making activity, with

    compliance judged on the basis of actual trades.\644\ Finally, two

    commenters stated that this requirement should be moved to Appendix B

    of the rule,\645\ which, according to one of these commenters, would

    provide the Agencies greater flexibility to consider the facts and

    circumstances of a particular activity.\646\

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

    \640\ 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.

    \641\ 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).

    \642\ See SIFMA et al. (Prop. Trading) (Feb. 2012). This

    commenter also suggested that such test be assessed at the ``trading

    unit'' level. See id.

    \643\ See Goldman (Prop. Trading).

    \644\ See FTN.

    \645\ See Flynn & Fusselman; JPMorgan.

    \646\ See JPMC.

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

    Other commenters took the view that the proposed requirement was

    too permissive.\647\ 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.\648\ Some commenters

    suggested the Agencies place greater restrictions on a banking entity's

    ability to rely on the market-making exemption in certain illiquid

    [[Page 5859]]

    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.\649\ 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); \650\ relation

    to the last financial crisis; \651\ lack of important benefits to the

    real economy; \652\ similarity to prohibited proprietary trading; \653\

    and inconsistency with the statute's requirements that market making-

    related activity must be ``designed not to exceed the reasonably

    expected near term demands of clients, customers, or counterparties''

    and must not result in a material exposure to high-risk assets or high-

    risk trading strategies.\654\

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

    \647\ See, e.g., Occupy; AFR et al. (Feb. 2012); Public Citizen;

    Johnson & Prof. Stiglitz; John Reed. See infra note 751 and

    accompanying text (responding to these comments).

    \648\ See Occupy.

    \649\ See Occupy; AFR et al. (Feb. 2012); Public Citizen;

    Johnson & Prof. Stiglitz; Sens. Merkley & Levin (Feb. 2012); John

    Reed.

    \650\ See AFR et al. (Feb. 2012); Occupy.

    \651\ See Occupy.

    \652\ See John Reed.

    \653\ See Johnson & Prof. Stiglitz.

    \654\ 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.\655\ 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.\656\ 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.\657\ In addition, a few commenters suggested that banking

    entities be subject to additional capital charges for market making in

    illiquid products.\658\ 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.\659\ Two

    commenters emphasized that their recommended restrictions on market

    making in illiquid markets should not prohibit banking entities from

    making markets in corporate bonds.\660\

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

    \655\ 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).

    \656\ 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.

    \657\ See Prof. Richardson.

    \658\ 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.

    \659\ 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.

    \660\ 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.\661\ Several commenters

    provided their views regarding the effectiveness of the proposed

    indicia.

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

    \661\ See supra Part VI.A.3.c.1.a.

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

    With respect to the proposed indicia for liquid markets, a few

    commenters expressed support for the proposed indicia.\662\ 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.\663\

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

    \662\ 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.

    \663\ 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.\664\

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

    \664\ 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.\665\

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

    \665\ 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.\666\ 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

    [[Page 5860]]

    that the proposed indicia are effective.\667\

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

    \666\ See supra Part VI.A.3.c.1.a.

    \667\ 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.\668\ 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 requirement.\669\ 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.\670\

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

    \668\ See supra note 634 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).

    \669\ 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.

    \670\ 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.\671\ Several commenters stated

    that trading only by appointment should not qualify as market making

    for purposes of the proposed rule.\672\ 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.\673\

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

    \671\ 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.

    \672\ See, e.g., Sens. Merkley & Levin (Feb. 2012); Johnson &

    Prof. Stiglitz; John Reed; Public Citizen.

    \673\ 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.\674\ 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.\675\ 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).\676\

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

    \674\ See AFR et al. (Feb. 2012); Occupy.

    \675\ See AFR et al. (Feb. 2012)

    \676\ 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.\677\ 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.\678\ 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.\679\

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

    \677\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

    (Prop. Trading); Occupy.

    \678\ See Goldman (Prop. Trading).

    \679\ See Occupy.

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

    ii. Treatment of Block Positioning Activity

    The proposal provided that the activity described in Sec.

    75.4(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.\680\

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

    \680\ See Joint Proposal, 76 FR at 68871.

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

    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).\681\ 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).\682\

    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.\683\ 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.\684\

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

    \681\ See, e.g., RBC; SIFMA (Asset Mgmt.) (Feb. 2012); Goldman

    (Prop. Trading). See also infra note 740 (responding to these

    comments).

    \682\ 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).

    \683\ See Goldman (Prop. Trading).

    \684\ 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.\685\ 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

    [[Page 5861]]

    hedging transactions.\686\ 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.\687\

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

    \685\ 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).

    \686\ See SIFMA (Asset Mgmt.) (Feb. 2012).

    \687\ 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

    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.'' \688\ 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.\689\

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

    \688\ Joint Proposal, 76 FR at 68871; CFTC Proposal, 77 FR at

    8356-8357.

    \689\ 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 VI.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.\690\ One of these commenters indicated

    that the Agencies should not restrict anticipatory trading to such a

    short time period.\691\ To the contrary, the other commenter stated

    that anticipatory accumulation of inventory should be considered to be

    prohibited proprietary trading.\692\ 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.\693\ Several

    commenters recommended that the language be eliminated \694\ or

    modified \695\ to address the concerns discussed above.

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

    \690\ See Goldman (Prop. Trading); Occupy. See also Public

    Citizen (expressing general concern that accumulating positions in

    anticipation of demand opens issues of front running).

    \691\ See Goldman (Prop. Trading).

    \692\ See Occupy.

    \693\ See Goldman (Prop. Trading); ISDA (Feb. 2012); SIFMA et

    al. (Prop. Trading) (Feb. 2012).

    \694\ 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.

    \695\ 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.\696\ 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.\697\ 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.\698\

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

    \696\ See, e.g., Better Markets (Feb. 2012); Occupy; Public

    Citizen.

    \697\ See Better Markets (Feb. 2012). See also infra note 747

    (addressing this issue).

    \698\ See Occupy.

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

    c. Final Requirement To Routinely Stand Ready To Purchase and Sell

    Section 75.4(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.

    75.4(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.\699\

    [[Page 5862]]

    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.''

    \700\ 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.

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

    \699\ See supra Part VI.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.

    \700\ Joint Proposal, 76 FR at 68871; CFTC Proposal, 77 FR at

    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 to meet

    or impractical in the context of many markets, especially less liquid

    markets.\701\ 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,\702\ the Agencies note that it

    is not directly based on an existing definition of market making.\703\

    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.

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

    \701\ 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.

    \702\ 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'').

    \703\ 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.\704\

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

    \704\ See Joint Proposal, 76 FR at 68957; CFTC Proposal, 77 FR

    at 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.\705\ 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.'' \706\ 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.).\707\ 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.\708\ 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.\709\

    [[Page 5863]]

    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 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).

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

    \705\ See Wellington; SIFMA et al. (Prop. Trading) (Feb. 2012).

    \706\ Morgan Stanley.

    \707\ See Joint Proposal, 76 FR at 68957 n.2.

    \708\ 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).

    \709\ 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.\710\ 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.

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

    \710\ See final rule Sec. 75.3(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.\711\ 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.

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

    \711\ 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.\712\ 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.\713\

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

    \712\ See infra note 729 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).

    \713\ See infra note 732 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

    [[Page 5864]]

    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.

    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].'' \714\

    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.\715\ 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.''\716\

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

    \714\ See proposed rule Sec. 75.4(b).

    \715\ Some commenters also contended that language in proposed

    Appendix B raised transaction-by-transaction implications. See supra

    notes 522 to 529 and accompanying text (discussing commenters'

    transaction-by-transaction concerns).

    \716\ 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.\717\

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

    \717\ See Joint Proposal, 76 FR at 68870 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 at 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.\718\ 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.\719\

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

    \718\ See final rule Sec. 75.4(b)(2)(iv).

    \719\ See final rule Sec. 75.4(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.\720\ Those financial instruments in which a trading

    desk acts as market maker must be identified in the trading desk's

    compliance program under Sec. 75.4(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.\721\

    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.

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

    \720\ See final rule Sec. 75.4(b)(5).

    \721\ 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 at 68869

    n.143; CFTC Proposal, 77 FR at 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.\722\ 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

    [[Page 5865]]

    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.

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

    \722\ 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 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 VI.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.\723\

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

    \723\ See infra Part VI.A.3.c.2.c.; final rule Sec.

    75.4(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.\724\ 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.\725\ 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.

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

    \724\ 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.'').

    \725\ 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

    [[Page 5866]]

    making-related activities,\726\ and a banking entity should be able to

    demonstrate that the financial exposure of a trading desk is related to

    its market-making activities.

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

    \726\ See final rule Sec. 75.4(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.''

    \727\ 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 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.

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

    \727\ Final rule Sec. 75.4(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.\728\ 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.

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

    \728\ As discussed in Part VI.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.

    75.4(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.\729\ 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).

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

    \729\ 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.\730\ 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. 75.4(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.\731\ 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.

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

    \730\ See infra Part VI.A.3.c.4.

    \731\ 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. 75.5(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

    [[Page 5867]]

    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.\732\ 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.

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

    \732\ 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.

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

    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.

    75.4(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.\733\ 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.\734\ The

    Agencies understand that the risk-reducing effects of combining large

    diverse portfolios could, in certain instances, mask otherwise

    prohibited proprietary trading.\735\ 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.

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

    \733\ 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 VI.A.3.c.1.c.i. (discussing the determination to

    apply requirements at the trading desk level).

    \734\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012).

    \735\ 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.\736\

    Consistent with the CFTC's and SEC's interpretation of market making in

    swaps and security-based swaps for purposes of the definitions of

    [[Page 5868]]

    ``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.\737\ 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 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.\738\ 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.\739\ 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.\740\

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

    \736\ Indeed, in the most specialized situations, such

    quotations may only be provided upon request. See infra note 740 and

    accompanying text (discussing permissible block positioning).

    \737\ 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)

    \738\ 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.

    \739\ 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.

    \740\ 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. 75.4(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 687 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 VI.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.\741\ 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.\742\ 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. 75.4(b)(2)(i) of the final rule.

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

    \741\ 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).

    \742\ 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.\743\

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

    \743\ 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 VI.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.

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

    [[Page 5869]]

    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 own account in commercially reasonable amounts and

    throughout market cycles.\744\ 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.\745\ 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.

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

    \744\ See, e.g., Occupy; Better Markets (Feb. 2012).

    \745\ 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.\746\ 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.\747\ For

    example, a trading desk should be facilitating customer needs in both

    upward and downward moving markets.

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

    \746\ As discussed below, this may include providing quotes in

    the interdealer trading market.

    \747\ 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 VI.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.\748\ 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 \749\

    and the need to have certain risk and inventory limits.\750\

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

    \748\ See final rule Sec. 75.4(b)(2)(iii)(A).

    \749\ See final rule Sec. 75.4(b)(2)(ii).

    \750\ See final rule Sec. 75.4(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.\751\ 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,\752\ 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.

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

    \751\ 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 656 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 at

    68859 n.101 (explaining why the Agencies declined to incorporate

    certain accounting standards in the proposed rule); CFTC Proposal,

    77 FR at 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.

    \752\ 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,\753\ 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.\754\ The Agencies believe this approach is generally

    consistent with the comments the Agencies received on this issue.\755\

    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.\756\

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

    \753\ Joint Proposal, 76 FR at 68871 (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 at 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).

    \754\ See final rule Sec. 75.4(b)(2)(ii); infra Part

    VI.A.3.c.2.c.

    \755\ 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).

    \756\ 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

    VI.A.3.c.2.c.iii.

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

    [[Page 5870]]

    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.\757\ 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 purported

    market making-related activities.\758\

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

    \757\ See proposed rule Sec. 75.4(b)(2)(iii).

    \758\ See Joint Proposal, 76 FR at 68871; CFTC Proposal, 77 FR

    at 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.\759\

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

    \759\ 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.\760\

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

    \760\ See Joint Proposal, 76 FR at 68871-68872; CFTC Proposal,

    77 FR at 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.\761\ Some commenters expressed general support for this

    requirement.\762\ 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.\763\ Several other commenters expressed concern that the

    proposed requirement is too restrictive \764\ because, for example, it

    may impede a market maker's ability to build or retain inventory \765\

    or may impact a market maker's willingness to engage in block

    trading.\766\ 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.

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

    \761\ See supra Part VI.A.3.c.2.a.

    \762\ See, e.g., Sens. Merkley & Levin (Feb. 2012); Flynn &

    Fusselman; Better Markets (Feb. 2012).

    \763\ See Better Markets (Feb. 2012); Sens. Merkley & Levin

    (Feb. 2012).

    \764\ 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.

    \765\ 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 VI.A.3.c.2.c., infra. For a discussion of comments

    regarding inventory management activity conducted in connection with

    market making, see Part VI.A.3.c.2.b.vi., infra.

    \766\ 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 VI.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.\767\ 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.\768\

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

    \767\ See supra Part VI.A.3.c.2.a.

    \768\ 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.\769\ 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.\770\ Another commenter stated that, as a matter of

    organizational efficiency, firms will often restrict arbitrage trading

    [[Page 5871]]

    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.\771\

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

    \769\ 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 VI.A.3.c.2.b.viii. (discussing comments on whether arbitrage

    trading should be permitted under the market-making exemption under

    certain circumstances).

    \770\ 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).

    \771\ 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),\772\ 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.\773\ For example, many

    of these commenters stated that market makers may need to enter market

    or marketable limit orders to: (i) Build or reduce inventory; \774\

    (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; \775\ (v)

    test the depth of the markets; (vi) ensure that ETFs, American

    depositary receipts (``ADRs''), options, and other instruments remain

    appropriately priced; \776\ and (vii) respond to movements in prices in

    the markets.\777\ 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.\778\

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

    \772\ See Joint Proposal, 76 FR at 68871-68,872; CFTC Proposal,

    77 FR at 8357.

    \773\ 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 VI.A.3.c.8.b., infra. This

    issue is addressed in note 944 and its accompanying text, infra.

    \774\ 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).

    \775\ See NYSE Euronext.

    \776\ See Goldman (Prop. Trading).

    \777\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

    \778\ 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.\779\ 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.\780\ 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.\781\

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

    \779\ See NYSE Euronext; SIFMA et al. (Prop. Trading) (Feb.

    2012); Goldman (Prop. Trading); Occupy. See also infra notes 945 to

    946 and accompanying text (addressing these comments).

    \780\ 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).

    \781\ 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.\782\ 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.\783\ 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.\784\

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

    \782\ 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 945 (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.

    \783\ 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).

    \784\ 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.\785\ 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.\786\ 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.\787\ 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.\788\ Many commenters requested

    certain modifications to the proposed requirement to limit its impact

    on

    [[Page 5872]]

    market maker inventory.\789\ Commenters' views on the importance of

    permitting inventory management activity in connection with market

    making are discussed below in Part VI.A.3.c.2.b.vi.

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

    \785\ 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 VI.A.3.c.2.c., infra.

    \786\ See, e.g., SIFMA (Asset Mgmt.) (Feb. 2012); T. Rowe Price;

    CIEBA; ICI (Feb. 2012); RBC.

    \787\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

    Chamber (Feb. 2012).

    \788\ 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.

    \789\ 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.\790\ 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.\791\ 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.\792\

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

    \790\ 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 VI.A.3.c.2.c.ii., infra.

    \791\ 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.

    \792\ 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.\793\ For example, two commenters suggested

    ways in which a banking entity could predict near term customer

    demand.\794\ 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.\795\ 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.\796\

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

    \793\ 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

    VI.A.3.c.2.c.iii., infra.

    \794\ See Sens. Merkley & Levin (Feb. 2012); FTN.

    \795\ 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.

    \796\ 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.\797\

    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.\798\ 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.\799\

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

    \797\ See MetLife; Chamber (Feb. 2012); RBC; CIEBA; Wellington;

    ICI (Feb. 2012); Alfred Brock. This issue is addressed in Part

    VI.A.3.c.2.c.iii., infra.

    \798\ See ICI (Feb. 2012); CIEBA; RBC; Wellington; Invesco.

    \799\ 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.\800\ 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.\801\ Commenters

    expressed varying views on the proposed interpretations in the proposal

    and on whether these terms should be defined in the final rule.\802\

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

    \800\ See Joint Proposal, 76 FR at 68960; CFTC Proposal, 77 FR

    at 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 at 68960 n.2; CFTC

    Proposal, 77 FR at 8439 n.2.

    \801\ See Joint Proposal, 76 FR at 68874; CFTC Proposal, 77 FR

    at 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.

    \802\ Comments on this issue are addressed in Part

    VI.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

    [[Page 5873]]

    providing liquidity to other brokers and dealers into the rule

    text.\803\ 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.\804\

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

    \803\ 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'').

    \804\ 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.\805\ Other commenters indicated that further

    definition of these terms would be appropriate.\806\ Some of these

    commenters suggested that there should be greater limitations on who

    can be considered a ``customer'' under the rule.\807\ 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.\808\ 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.\809\ 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; \810\ or (ii) engages in transactions driven

    by algorithmic trading strategies.\811\ Three commenters requested more

    permissive definitions of these terms.\812\ According to one of these

    commenters, because these terms are listed in the disjunctive in the

    statute, the broadest term--a ``counterparty''--should prevail.\813\

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

    \805\ See FTN; ISDA (Feb. 2012); Alfred Brock.

    \806\ See Japanese Bankers Ass'n.; Credit Suisse (Seidel);

    Occupy; AFR et al. (Feb. 2012); Public Citizen.

    \807\ 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.

    \808\ 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).

    \809\ See AFR et al. (Feb. 2012) (providing a similar definition

    for the term ``client'' as well); Public Citizen.

    \810\ 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).

    \811\ See AFR et al. (Feb. 2012).

    \812\ 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).

    \813\ 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.\814\ As a

    general matter, commenters attributed these concerns to statements in

    proposed Appendix B \815\ or to the Customer-Facing Trade Ratio metric

    in proposed Appendix A.\816\ A number of commenters requested that the

    rule be modified to clearly recognize interdealer trading as a

    component of permitted market making-related activity \817\ and

    suggested ways in which this could be accomplished (e.g., through a

    definition of ``customer'' or ``counterparty'').\818\

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

    \814\ 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 VI.A.3.c.2.c.i., infra.

    \815\ See infra Part VI.A.3.c.8.

    \816\ 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).

    \817\ 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).

    \818\ 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; \819\ more

    efficient matching of customer order flow; \820\ greater hedging

    options to reduce risks; \821\ 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; \822\ and general price discovery among

    dealers.\823\ 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

    [[Page 5874]]

    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.\824\ 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.\825\

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

    \819\ See Prof. Duffie; MetLife; ACLI (Feb. 2012); BDA (Feb.

    2012).

    \820\ 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

    from their own customers that may induce them to trade with the

    market maker).

    \821\ See MetLife; ACLI (Feb. 2012); Goldman (Prop. Trading);

    Morgan Stanley; Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012).

    \822\ 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).

    \823\ See Chamber (Feb. 2012); Goldman (Prop. Trading).

    \824\ 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.

    \825\ 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).

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

    As noted above, a few commenters stated that market makers may use

    interdealer trading for price discovery purposes.\826\ 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.\827\ Commenters indicated that price

    discovery-related trading results in certain market benefits, including

    enhancing the accuracy of prices for customers,\828\ increasing price

    efficiency, preventing market instability,\829\ improving market

    liquidity, and reducing overall costs for market participants.\830\ 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.\831\ One

    commenter further requested that trading to test market depth likewise

    be permitted under the market-making exemption.\832\ 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.\833\

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

    \826\ See Chamber (Feb. 2012); Goldman (Prop. Trading).

    \827\ 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).

    \828\ 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).

    \829\ See Goldman (Prop. Trading).

    \830\ See Chamber (Feb. 2012).

    \831\ See id.

    \832\ 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.

    \833\ 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.\834\ 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.\835\ A few commenters cited legislative history

    in support of allowing banking entities to hold and manage inventory in

    connection with market making-related activities.\836\ 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; \837\ accommodating customer transactions more quickly and at

    favorable prices; reducing near term price volatility (in the case of

    selling a customer block position); \838\ 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); \839\ ensuring that markets continue to

    have sufficient liquidity; \840\ fostering a two-way market; and

    establishing a market-making presence.\841\ 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) \842\ and in anticipation of an index rebalance.\843\

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

    \834\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

    Credit Suisse (Seidel); Goldman (Prop. Trading); MFA; RBC. Inventory

    management is addressed in Part VI.A.3.c.2.c., infra.

    \835\ 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).

    \836\ 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).

    \837\ See, e.g., RBC.

    \838\ See Goldman (Prop. Trading).

    \839\ See id.

    \840\ See MFA.

    \841\ See RBC.

    \842\ See Goldman (Prop. Trading); BoA.

    \843\ 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

    [[Page 5875]]

    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.\844\ 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.\845\ One commenter represented that a trading unit's

    inventory management practices could be monitored with the Inventory

    Risk Turnover metric, in conjunction with other metrics.\846\

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

    \844\ See Credit Suisse (Seidel).

    \845\ 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.

    \846\ 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.\847\ 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; \848\ (ii) trading to maintain price alignment between the

    ETF shares and the underlying components; \849\ (iii) traditional

    market-making activity; \850\ (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; \851\ (v) ``create to lend'' transactions, where an AP enters

    a creation transaction with the ETF issuer and lends the ETF shares to

    an investor; \852\ and (vi) hedging.\853\ 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.\854\ 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.\855\

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

    \847\ 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 VI.A.3.c.2.c.i., infra.

    \848\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; ICI

    (Feb. 2012) ICI Global; Vanguard; SSgA (Feb. 2012).

    \849\ See JPMC; Goldman (Prop. Trading); SIFMA et al. (Prop.

    Trading) (Feb. 2012); SSgA (Feb. 2012); ICI (Feb. 2012) ICI Global.

    \850\ See ICI Global; ICI (Feb. 2012) SIFMA et al. (Prop.

    Trading) (Feb. 2012); BoA.

    \851\ See BoA; ICI (Feb. 2012); ICI Global.

    \852\ 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).

    \853\ See ICI Global; ICI (Feb. 2012).

    \854\ 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).

    \855\ 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,\856\ the proposed source of revenue requirement,\857\ and

    language in the proposal regarding arbitrage trading.\858\ 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.\859\ 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.\860\ 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.\861\

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

    \856\ See BoA; Vanguard (stating that this determination may be

    particularly difficult in the case of a new ETF).

    \857\ 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.

    \858\ 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 VI.A.3.c.2.a.

    (discussing the proposal's proposed interpretation regarding

    arbitrage trading).

    \859\ See BoA; Vanguard (stating that this determination may be

    particularly difficult in the case of a new ETF).

    \860\ See ICI Global; ICI (Feb. 2012).

    \861\ See ICI (Feb. 2012) ICI Global. These commenters provided

    suggested rule text on this issue and suggested that the Agencies

    could require a banking entity's compliance policies and internal

    controls to take a comprehensive approach to the entirety of an AP's

    trading activity, which would facilitate easy monitoring of the

    activity to ensure compliance. See id.

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

    viii. Arbitrage or Other Activities That Promote Price Transparency and

    Liquidity

    In response to a question in the proposal,\862\ a number of

    commenters

    [[Page 5876]]

    stated that certain types of arbitrage activity should be permitted

    under the market-making exemption.\863\ 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) \864\ or to the extent that demand is predicated on specific

    price relationships between instruments (e.g., ETFs, ADRs) that market

    makers must maintain.\865\ Similarly, another commenter suggested that

    arbitrage activity that aligns prices should be permitted, such as

    index arbitrage, ETF arbitrage, and event arbitrage.\866\ 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.\867\ Commenters stated that

    arbitrage trading provides certain market benefits, including enhanced

    price transparency,\868\ increased market efficiency,\869\ greater

    market liquidity,\870\ and general benefits to customers.\871\ A few

    commenters noted that certain types of hedging activity may appear to

    have characteristics of arbitrage trading.\872\

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

    \862\ See Joint Proposal, 76 FR at 68873 (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 at 8359.

    \863\ 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

    VI.A.3.c.2.c.i., infra.

    \864\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

    \865\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.

    \866\ See Credit Suisse (Seidel).

    \867\ See RBC.

    \868\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

    \869\ See Credit Suisse (Seidel); RBC.

    \870\ See RBC.

    \871\ 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).

    \872\ 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.\873\ 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.\874\

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

    \873\ See FTN.

    \874\ 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.\875\ 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.\876\

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

    \875\ 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).

    \876\ 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.\877\ 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,\878\ and bidding on each issuance of the relevant

    jurisdiction's sovereign debt.\879\ Commenters expressed concern that a

    banking entity's trading activity as primary dealer may not comply with

    the proposed near term customer demand requirement \880\ or the

    proposed source of revenue requirement.\881\ 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.\882\ 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.\883\

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

    \877\ 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).

    \878\ See Goldman (Prop. Trading).

    \879\ See Banco de M[eacute]xico.

    \880\ 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.

    \881\ 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).

    \882\ See Goldman (Prop. Trading).

    \883\ 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.\884\ Many of these

    commenters

    [[Page 5877]]

    emphasized the role such transactions play in helping customers hedge

    the unique risks they face.\885\ 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.\886\ 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.\887\

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

    \884\ 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

    VI.A.3.c.1.c.iii., supra, and Part VI.A.3.c.2.c.iii., infra.

    \885\ See Credit Suisse (Seidel); Goldman (Prop. Trading); SIFMA

    (Asset Mgmt.) (Feb. 2012).

    \886\ See Goldman (Prop. Trading); SIFMA (Asset Mgmt.) (Feb.

    2012).

    \887\ 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 customized derivatives.\888\ 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. 75.6(b)(1)(ii) of the proposed

    rule. According to this commenter, such an approach would not impact

    the end user customer.\889\ 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. 75.4(b)(2)(ii) of the

    proposed rule and to demonstrate the purchase and the sale of such an

    instrument.\890\

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

    \888\ See AFR et al. (Feb. 2012); Public Citizen.

    \889\ See AFR et al. (Feb. 2012).

    \890\ See Public Citizen.

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

    c. Final Near Term Customer Demand Requirement

    Consistent with the statute, Sec. 75.4(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.\891\ As

    discussed above in Part VI.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.\892\ 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.

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

    \891\ 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. 75.4(b)(2)(iii).

    \892\ See supra Part VI.A.3.c.1.c.ii.; final rule Sec.

    75.4(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.\893\

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

    \893\ See infra Part VI.A.3.c.3. (discussing the compliance

    program requirements); final rule Sec. 75.4(b)(2)(iii).

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

    To clarify the application of this standard in response to

    comments,\894\ 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),\895\ 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.\896\

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

    \894\ See supra Part VI.A.3.c.2.b.i.

    \895\ 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 VI.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.

    \896\ See infra Part VI.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.

    [[Page 5878]]

    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.\897\ In addition, as discussed below, this

    requirement is not intended to impede a trading desk's ability to

    engage in 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.\898\ 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.

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

    \897\ 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).

    \898\ The formation of structured finance products and

    securitizations is discussed in detail in Part VI.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.\899\ 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.

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

    \899\ See final rule Sec. 75.4(b)(2)(iii)(B), (C).

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

    The following is an example of the interplay between a trading

    desk's market-maker inventory and financial exposure. An airline

    company customer may seek to hedge its long-term exposure to price

    fluctuations in jet fuel by asking a banking entity to create a

    structured ten-year, $1 billion jet fuel swap for which there is no

    liquid market. A trading desk that makes a market in energy swaps may

    service its customer's needs by executing a custom jet fuel swap with

    the customer and holding the swap in its market-maker inventory, if the

    resulting transaction does not cause the trading desk to exceed its

    market-maker inventory limit on the applicable class of instrument, or

    the trading desk has received approval to increase the limit in

    accordance with the authorization and escalation procedures under

    paragraph (b)(2)(iii)(E). In keeping with the market-making exemption

    as provided in the final rule, the trading desk would be required to

    hedge the risk from this swap, either individually or as part of a set

    of aggregated positions, if the trade would result in a financial

    exposure that exceeds the desk's financial exposure limits. The trading

    desk may hedge the risk of the swap, for example, by entering into one

    or more futures or swap positions that are identified as permissible

    hedging products, instruments, or exposures in the trading desk's

    compliance program and that analysis, including correlation analysis as

    appropriate, indicates would demonstrably reduce or otherwise

    significantly mitigate risks associated with the financial exposure

    from its market-making activities. Alternatively, if the trading desk

    also acts as a market maker in crude oil futures, then the desk's

    exposures arising from its market-making activities may naturally hedge

    the jet fuel swap (i.e., it may reduce its financial exposure levels

    resulting from such instruments).\900\ The trading desk must continue

    to appropriately manage risks of its financial exposure over time in

    accordance with its financial exposure limits.

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

    \900\ This natural hedge with futures would introduce basis risk

    which, like other risks of the trading desk, must be managed within

    the desk's limits.

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

    As discussed above, several commenters expressed concern that the

    near-term customer demand requirement is too restrictive and that it

    could impede a market maker's ability to build or retain inventory,

    particularly in less liquid markets where demand is intermittent.\901\

    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.

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

    \901\ See SIFMA (Asset Mgmt.) (Feb. 2012); T. Rowe Price; CIEBA;

    ICI (Feb. 2012) RBC.

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

    i. Definition of ``client,'' ``customer,'' and ``counterparty''

    In response to comments requesting further definition of the terms

    ``client,'' ``customer,'' and ``counterparty'' for purposes of this

    standard,\902\ the Agencies have defined these terms in the final rule.

    In particular, the final

    [[Page 5879]]

    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.'' \903\ However, for

    purposes of the analysis supporting the market-maker inventory held to

    meet the reasonably expected near-term demands of clients, customer 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. 75.20(d)(1),\904\

    unless the 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.\905\

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

    \902\ See Japanese Bankers Ass'n.; Credit Suisse (Seidel);

    Occupy; AFR et al. (Feb. 2012); Public Citizen.

    \903\ Final rule Sec. 75.4(b)(3).

    \904\ See final rule Sec. 75.4(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.

    \905\ See final rule Sec. 75.4(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 at 68964. While the proposed

    approach would not have necessarily prevented any of these entities

    from being considered a customer of the trading desk, it would have

    required enhanced documentation and justification for treating any

    of these entities as a customer. The final rule's exclusion from the

    definition of client, customer, and counterparty is similar to the

    proposed approach, but is more narrowly focused on firms that have

    $50 billion or more trading assets and liabilities because, as noted

    above, the Agencies believe firms engaged in such substantial

    trading activity are less likely to act as customers to market

    makers than smaller regional firms.

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

    The Agencies believe this definition is generally consistent with

    the proposed interpretation of ``customer'' in the proposal. The

    proposal generally provided that, for purposes of market making on an

    exchange or other organized trading facility, a customer is any person

    on behalf of whom a buy or sell order has been submitted. In the

    context of the over-the-counter market, a customer was generally

    considered to be a market participant that makes use of the market

    maker's intermediation services, either by requesting such services or

    entering into a continuing relationship for such services.\906\ 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.\907\ 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 \908\ or preventing any

    banking entity from being a client, customer, or counterparty.\909\ 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.

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

    \906\ See Joint Proposal, 76 FR at 68960; CFTC Proposal, 77 FR

    at 8439.

    \907\ See, e.g., Goldman (Prop. Trading) (explaining generally

    how exchange-based market makers operate).

    \908\ 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.

    \909\ See AFR et al. (Feb. 2012); Occupy; Public Citizen.

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

    The Agencies further note that, with respect to a banking entity

    that acts as a primary dealer (or functional equivalent) for a

    sovereign government, the sovereign government and its central bank are

    each a client, customer, or counterparty for purposes of the market-

    making exemption as well as the underwriting exemption.\910\ 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.\911\

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

    \910\ 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.

    \911\ See Goldman (Prop. Trading). See also supra Part

    VI.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.

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

    [[Page 5880]]

    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 (or

    equivalent structure).\912\ 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.\913\ 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.\914\ 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.\915\ 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.\916\

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

    \912\ 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 at 68873 (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 at

    8359 (question 91); supra Part VI.A.3.c.2.b.vii. (discussing

    comments on this issue).

    \913\ 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

    VI.A.3.c.7.c. (discussing the new approach to assessing a trading

    desk's pattern of profit and loss).

    \914\ 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.

    \915\ 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.

    \916\ See SSgA (Feb. 2012).

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

    Some firms, whether or not an AP in a given ETF, may also actively

    engage in buying and selling shares of an ETF and its underlying

    instruments in the market to maintain price continuity between the ETF

    and its underlying instruments, which are exchangeable for one another.

    Sometimes these firms will register as market makers on an exchange for

    a given ETF, but other times they may not register as market maker.

    Regardless of whether or not the firm is registered as a market maker

    on any given exchange, this activity not only provides liquidity for

    ETFs, but also, and very importantly, helps keep the market price of an

    ETF in line with the NAV of the fund. The market-making exemption can

    be used to evaluate trading that is intended to maintain price

    continuity between these exchangeable instruments by considering how

    the firm quotes, maintains risk and exposure limits, manages its

    inventory and risk, and, in the case of APs, exercises its ability to

    create and redeem shares from the fund. Because customers take

    positions in ETFs with an expectation that the price relationship will

    be maintained, such trading can be considered to be market making-

    related activity.\917\

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

    \917\ 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.\918\ 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

    [[Page 5881]]

    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,\919\ 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, converted,

    or exercised for or into another instrument.\920\

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

    \918\ 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.

    \919\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.

    \920\ 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.\921\

    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.\922\ 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).\923\

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

    \921\ See MetLife; ACLI (Feb. 2012); Goldman (Prop. Trading);

    Morgan Stanley; Chamber (Feb. 2012); Prof. Duffie; Oliver Wyman

    (Dec. 2011); Oliver Wyman (Feb. 2012).

    \922\ 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.

    \923\ 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.\924\ 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.

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

    \924\ Provided it is consistent with the requirements of the

    market-making exemption, including the near term customer demand

    requirement, a trading desk may trade for purposes of determining

    how to price a financial instrument a customer seeks to trade with

    the trading desk or to determine the depth of the market for a

    financial instrument a customer seeks to trade with the trading

    desk. See Goldman (Prop. Trading).

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

    ii. Impact of the Liquidity, Maturity, and Depth of the Market on the

    Analysis

    Several commenters expressed concern about the potential impact of

    the proposed near term demand requirement on market making in less

    liquid markets and requested that the Agencies recognize that near term

    customer demand may vary across different markets and asset

    classes.\925\ 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.\926\ 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.\927\ 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.\928\

    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,

    [[Page 5882]]

    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.\929\

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

    \925\ 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.

    \926\ See supra Part VI.A.3.c.2.b.ii. (discussing comments on

    this issue).

    \927\ See final rule Sec. 75.4(b)(2)(ii)(A).

    \928\ 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.

    75.4(b)(2)(ii), (iii)(C).

    \929\ The Agencies agree, as suggested by one commenter, it may

    be appropriate for a market maker in a new asset class or market to

    look to reasonably expected future developments on the basis of the

    trading desk's customer relationships. See Morgan Stanley. As

    discussed further below, the Agencies recognize that a trading desk

    could encounter similar issues if it is a new entrant in an existing

    market.

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

    iii. Demonstrable Analysis of Certain Factors

    In the proposal, the Agencies stated that permitted market making

    includes taking positions in securities in anticipation of customer

    demand, so long as any anticipatory buying or selling activity is

    reasonable and related to clear, demonstrable trading interest of

    clients, customers, or counterparties.\930\ 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.\931\ 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.

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

    \930\ See Joint Proposal, 76 FR at 68871; CFTC Proposal, 77 FR

    at 8356-8357.

    \931\ 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,\932\ particularly in markets where trades occur

    infrequently and customer demand is hard to predict \933\ or when a

    banking entity is entering a new market.\934\ 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.

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

    \932\ See SIFMA et al. (Prop. Trading) (Feb. 2012); MetLife;

    Chamber (Feb. 2012); RBC; CIEBA; Wellington; ICI (Feb. 2012) Alfred

    Brock.

    \933\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

    \934\ 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 \935\ and any events that are

    reasonably expected to occur in the near term that would likely impact

    demand.\936\ 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.\937\ 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.\938\

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

    \935\ 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.

    \936\ 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 843 (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).

    \937\ 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).

    \938\ 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.

    75.4(b)(2)(ii)(B) should account for, among other things, how the

    market factors discussed in Sec. 75.4(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.\939\ Other potential

    [[Page 5883]]

    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 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.\940\

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

    \939\ 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.

    \940\ See supra Part VI.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.\941\ 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).\942\ 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.\943\ 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.

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

    \941\ 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.

    \942\ 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

    VI.A.3.c.1.c.iii.

    \943\ 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.\944\ 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.\945\ 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.\946\

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

    \944\ 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.

    \945\ 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

    VI.A.3.c.6.; final rule Sec. 75.4(b)(2)(vi).

    \946\ 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. 75.4(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

    [[Page 5884]]

    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,\947\ 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 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.

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

    \947\ 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. 75.4(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.\948\ 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.\949\

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

    \948\ See Appendix A.

    \949\ 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.\950\ 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.

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

    \950\ See final rule Sec. 75.4(b)(2)(iii); infra Part

    VI.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. 75.4(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.\951\

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

    \951\ See proposed rule Sec. 75.4(b)(2)(i); Joint Proposal, 76

    FR at 68870; CFTC Proposal, 77 FR at 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. 75.20 of the proposed

    rule as effective.\952\ For example, one commenter stated that the

    requirement ``keeps a strong focus on the bank's own workings and

    allows banks to self-monitor.'' \953\ One commenter indicated that a

    comprehensive compliance program is a ``cornerstone of effective

    corporate governance,'' but cautioned against placing ``undue

    reliance'' on compliance programs.\954\ As discussed further below in

    Parts VI.C.1. and VI.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.\955\

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

    \952\ See Flynn & Fusselman; Morgan Stanley.

    \953\ See Flynn & Fusselman.

    \954\ See Occupy.

    \955\ 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.\956\

    This provision further requires that the compliance program include

    particular written policies and procedures, internal controls,

    analysis, and independent testing identifying and addressing:

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

    \956\ The independent testing standard is discussed in more

    detail in Part VI.C., which discusses the compliance program

    requirement in Sec. 75.20 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

    [[Page 5885]]

    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;

    [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. 75.4(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.\957\

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

    \957\ See final rule Sec. 75.4(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.\958\ 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.

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

    \958\ 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.\959\ 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.

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

    \959\ See final rule Sec. 75.4(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.

    75.4(b)(2)(i) of the final rule); final rule Sec.

    75.4(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.\960\ 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

    [[Page 5886]]

    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.\961\

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

    \960\ 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. 75.4(b)(3) of the proposed rule; and, to some

    extent, the proposed source of revenue requirement in Sec.

    75.4(b)(2)(v) of the proposed rule. See Joint Proposal, 76 FR at

    68960; CFTC Proposal, 77 FR at 8439-8440; proposed rule Sec.

    75.4(b)(3); Joint Proposal, 76 FR at 68873; CFTC Proposal, 77 FR at

    8358; Wellington; Credit Suisse (Seidel); Morgan Stanley; PUC Texas;

    CIEBA; SSgA (Feb. 2012); AllianceBernstein; 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.

    \961\ 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. 75.5 of the

    final rule, including the documentation requirement in Sec.

    75.5(c). As recognized in Part VI.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.

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

    As discussed in Part VI.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.\962\ 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.\963\

    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.\964\ 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.

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

    \962\ See supra Part VI.A.3.c.2.c. (discussing the final near

    term demand requirement).

    \963\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

    Credit Suisse (Seidel); Goldman (Prop. Trading); MFA; RBC.

    \964\ 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.\965\ 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.\966\ 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.

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

    \965\ See Joint Proposal, 76 FR at 68873; CFTC Proposal, 77 FR

    at 8358.

    \966\ 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. 75.5 of the rule, including the

    documentation requirement in Sec. 75.5(c). See supra Part

    VI.A.3.c.1.c.ii.

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

    A banking entity's written policies and procedures, internal

    controls, analysis, and independent testing identifying and addressing

    the products, instruments, or exposures and the techniques and

    strategies that may be used by each trading desk to manage the risks of

    its market making-related activities and inventory must cover both how

    the trading desk may establish hedges and how such hedges are removed

    once the risk they were mitigating is unwound. With respect to

    establishing positions that hedge or otherwise mitigate the risk(s) of

    market making-related positions held by the trading desk, the written

    policies and procedures may consider the natural hedging and

    diversification that occurs in an aggregation of long and short

    positions in financial instruments for which the trading desk is a

    market maker,\967\ 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.\968\ 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.\969\ The amount of time that an anticipatory hedge

    may precede the establishment of the position to be hedged will depend

    on market factors,

    [[Page 5887]]

    such as the liquidity of the hedging position.

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

    \967\ 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.

    \968\ See Joint Proposal, 76 FR at 68875; CFTC Proposal, 77 FR

    at 8361.

    \969\ 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.

    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.\970\ 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.

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

    \970\ See final rule Sec. 75.4(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.\971\ 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.\972\ 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.\973\ 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.

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

    \971\ See final rule Sec. 75.4(b)(2)(iii)(C).

    \972\ 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).

    \973\ See final rule Sec. 75.4(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

    [[Page 5888]]

    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, 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.\974\ 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.

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

    \974\ See final rule Sec. 75.4(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.\975\

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

    \975\ 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.\976\ 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).\977\ 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.

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

    \976\ See final rule Sec. 75.4(b)(2)(iii)(D).

    \977\ 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 937 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.\978\ 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.

    75.4(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.

    75.20(b)(6).

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

    \978\ See final rule Sec. 75.4(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.'' \979\ 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 VI.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

    [[Page 5889]]

    the safety and soundness of banking entities and the financial

    stability of the United States.

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

    \979\ 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

    section 13(d)(1)(B) of the BHC Act.\980\ To qualify for the market-

    making exemption, a hedging transaction would have been required to

    meet certain requirements under Sec. 75.4(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. 75.5(b) of the proposed hedging exemption and, where applicable,

    Sec. 75.5(c) of the proposal.\981\ 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. 75.4(b)(3) of the proposed rule.\982\

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

    \980\ See Joint Proposal, 76 FR at 68873; CFTC Proposal, 77 FR

    at 8358.

    \981\ See proposed rule Sec. 75.4(b)(3); Joint Proposal, 76 FR

    at 68873; CFTC Proposal, 77 FR at 8358.

    \982\ See Joint Proposal, 76 FR at 68870 n.146; CFTC Proposal,

    77 FR at 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.\983\ 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.\984\ Other commenters emphasized the need for

    flexibility to permit a market maker to choose the most effective

    hedge.\985\ 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.\986\ 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.'' \987\

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

    \983\ 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 VI.A.3.c.4.c.,

    infra.

    \984\ 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).

    \985\ 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.

    \986\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit

    Suisse (Seidel); NYSE Euronext; MFA; Japanese Bankers Ass'n.; RBC.

    \987\ 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.\988\

    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.\989\ 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 \990\ 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.\991\

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

    \988\ See BoA; SIFMA (Asset Mgmt.) (Feb. 2012).

    \989\ See Goldman (Prop. Trading).

    \990\ See BoA.

    \991\ See SIFMA (Asset Mgmt.) (Feb. 2012).

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

    One commenter, however, stated that the proposed approach is

    effective.\992\ 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.

    75.5 of the proposed rule for its hedging activity.\993\

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

    \992\ See Alfred Brock.

    \993\ 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.\994\ 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.\995\

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

    \994\ See infra notes 1073 to 1075 and accompanying text.

    \995\ 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.\996\ 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.\997\ 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

    [[Page 5890]]

    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.\998\ Further, this approach addresses commenters' concerns

    about the impact of certain requirements of the hedging exemption on

    market making-related activities.\999\

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

    \996\ See, e.g., Japanese Bankers Ass'n.; SIFMA et al. (Prop.

    Trading) (Feb. 2012); Credit Suisse (Seidel); FTN; RBC; NYSE

    Euronext; MFA.

    \997\ See final rule Sec. 75.4(b)(2)(iii)(B); supra Part

    VI.A.3.c.3.c.

    \998\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit

    Suisse (Seidel); NYSE Euronext; MFA; Japanese Bankers Ass'n.; RBC.

    \999\ 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 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.'' \1000\

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

    \1000\ See Joint Proposal, 76 FR at 68961.

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

    The Agencies recognize that some banking entities may manage the

    risks associated with market making at a different level than the

    individual trading desk.\1001\ 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.\1002\ As discussed in

    Part VI.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.

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

    \1001\ 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).

    \1002\ See final rule Sec. 75.5(c).

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

    5. Compensation Requirement

    a. Proposed Compensation Requirement

    Section 75.4(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.\1003\ 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.

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

    \1003\ See proposed rule Sec. 75.4(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.\1004\

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

    \1004\ See Joint Proposal, 76 FR at 68872; CFTC Proposal, 77 FR

    at 8358.

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

    b. Comments Regarding the Proposed Compensation Requirement

    Several commenters recommended certain revisions to the proposed

    compensation requirement.\1005\ Two commenters stated that the proposed

    requirement is effective,\1006\ while one commenter stated that it

    should be removed from the rule.\1007\ Moreover, in addressing this

    proposed requirement, commenters provided views on: identifiable

    characteristics of compensation arrangements that incentivize

    prohibited proprietary trading,\1008\ methods of monitoring compliance

    with this requirement,\1009\ and potential negative incentives or

    outcomes this requirement could cause.\1010\

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

    \1005\ 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.

    \1006\ See FTN; Alfred Brock.

    \1007\ See Japanese Bankers Ass'n.

    \1008\ See Occupy.

    \1009\ See Occupy; Goldman (Prop. Trading).

    \1010\ 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.\1011\ For example, two commenters

    stated that compensation should be restricted to particular sources,

    such as fees, commissions, and spreads.\1012\ 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.\1013\

    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.\1014\ 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.\1015\ 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.\1016\ Some commenters also

    recommended that compensation be risk adjusted.\1017\

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

    \1011\ 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 1032, infra.

    \1012\ See Better Markets (Feb. 2012); Public Citizen.

    \1013\ See AFR et al. (Feb. 2012)

    \1014\ See Occupy.

    \1015\ 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).

    \1016\ See John Reed.

    \1017\ See Johnson & Prof. Stiglitz; John Reed; Sens. Merkley &

    Levin (Feb. 2012).

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

    [[Page 5891]]

    A few commenters indicated that the proposed approach may be too

    restrictive.\1018\ Two of these commenters stated that the compensation

    requirement should instead be set forth as guidance in Appendix

    B.\1019\ 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, which also involve proprietary

    trading.\1020\

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

    \1018\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC;

    Morgan Stanley.

    \1019\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.

    \1020\ 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.\1021\ 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.\1022\ 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.\1023\ For similar purposes, another commenter

    suggested that compensation incentives should be based on a metric that

    meaningfully accounts for the risk underlying profitability.\1024\

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

    \1021\ See Occupy; Alfred Brock.

    \1022\ See Occupy. The Agencies respond to this comment in Part

    VI.A.3.c.5.c., infra.

    \1023\ See Goldman (Prop. Trading).

    \1024\ 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.\1025\ 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.\1026\ 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.\1027\

    Another commenter expressed the view that profitability-based

    compensation arrangements encourage traders to exercise due care

    because such arrangements create incentives to avoid losses.\1028\

    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.\1029\

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

    \1025\ See AllianceBernstein; Investure; Prof. Duffie; STANY.

    This issue is addressed in note 1032, infra.

    \1026\ See AllianceBernstein; Investure.

    \1027\ See Prof. Duffie.

    \1028\ See STANY.

    \1029\ 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.\1030\ The language of the final compensation

    requirement has been modified in response to comments expressing

    concern about the proposed language regarding ``proprietary risk-

    taking.'' \1031\ 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.

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

    \1030\ See final rule Sec. 75.4(b)(2)(v).

    \1031\ 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.\1032\ 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.

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

    \1032\ 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 VI.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. 75.4(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.\1033\

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

    \1033\ See proposed rule Sec. 75.4(b)(2)(iv); Joint Proposal,

    76 FR at 68872; CFTC Proposal, 77 FR at 8357-8358.

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

    b. Comments on the Proposed Registration Requirement

    A few commenters stated that the proposed dealer registration

    requirement is effective.\1034\ However, a number of commenters opposed

    the proposed dealer registration requirement in whole or in part.\1035\

    [[Page 5892]]

    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.\1036\ For example,

    several commenters stated that many non-U.S. markets do not provide

    substantive regulation of dealers for all asset classes.\1037\ In

    addition, two 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.\1038\ Several

    of these commenters requested, at a minimum, that the dealer

    registration requirement not apply to dealers in non-U.S.

    jurisdictions.\1039\

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

    \1034\ See Occupy; Alfred Brock.

    \1035\ 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).

    \1036\ 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.

    \1037\ See Goldman (Prop. Trading); RBC; SIFMA et al. (Prop.

    Trading) (Feb. 2012).

    \1038\ See JPMC; Goldman (Prop. Trading).

    \1039\ 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.\1040\ 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.\1041\ 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.\1042\ 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.\1043\

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

    \1040\ 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.

    \1041\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

    \1042\ See Goldman (Prop. Trading).

    \1043\ 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.\1044\ 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.\1045\ Another commenter

    stated that incorporating the proposed definitions of ``swap dealer''

    and ``security-based swap dealer'' is contrary to the Administrative

    Procedure Act.\1046\

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

    \1044\ See ISDA (Feb. 2012); SIFMA et al. (Prop. Trading) (Feb.

    2012).

    \1045\ See ISDA (Feb. 2012).

    \1046\ 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.\1047\ The

    Agencies have considered comments regarding the dealer registration

    requirement in the proposed rule.\1048\ 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.\1049\ 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.

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

    \1047\ See final rule Sec. 75.4(b)(2)(vi).

    \1048\ See supra Part VI.A.3.c.5.b. One commenter expressed

    concern that the instruments listed in Sec. 75.4(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.

    75.4(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.

    \1049\ 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.\1050\ 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.\1051\ 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,\1052\ unless the

    [[Page 5893]]

    banking entity is exempt from registration or excluded from regulation

    as a swap dealer or security-based swap dealer.\1053\ 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,\1054\ the Agencies continue to

    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.\1055\ As noted

    above, compliance with applicable law is an essential indicator that a

    banking entity is engaged in market-making activities.

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

    \1050\ 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.

    \1051\ 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. 75.6(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.

    \1052\ 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 1051.

    \1053\ 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.

    \1054\ See ISDA (Feb. 2012); SIFMA et al. (Prop. Trading) (Feb.

    2012).

    \1055\ 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.\1056\

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

    \1056\ 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.\1057\ 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.\1058\

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

    \1057\ See proposed rule Sec. 75.4(b)(2)(v).

    \1058\ See Joint Proposal, 76 FR at 68872; CFTC Proposal, 77 FR

    at 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.\1059\ 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.\1060\

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

    \1059\ These concerns are addressed in Part VI.A.3.c.7.c.,

    infra.

    \1060\ 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.\1061\ 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).\1062\ 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.\1063\ 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),\1064\ facilitate large trades, and

    hedge positions acquired in the course of market making.\1065\

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

    \1061\ 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.

    \1062\ 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.

    \1063\ See Capital Group.

    \1064\ See NYSE Euronext; CIEBA (stating that if the rule

    discourages market makers from holding inventory, there will be

    reduced liquidity for investors and issuers).

    \1065\ 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 VI.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.\1066\ 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.\1067\ Other commenters represented that the

    proposed source of revenue requirement would compel market makers to

    hedge their exposure

    [[Page 5894]]

    to price movements, which would likely increase the cost of

    intermediation.\1068\

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

    \1066\ See, e.g., Wellington; CIEBA; MetLife; ACLI (Feb. 2012);

    SSgA (Feb. 2012); PUC Texas; ICI (Feb. 2012) BoA.

    \1067\ See MetLife; ACLI (Feb. 2012); ICI (Feb. 2012) SSgA (Feb.

    2012).

    \1068\ 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.\1069\ One commenter indicated that this concern may be

    heightened in times of market stress.\1070\ Further, a few commenters

    expressed the view that the proposed requirement would cause banking

    entities to exit the market-making business due to restrictions on

    their ability to make a profit from market-making activities.\1071\

    Moreover, in one commenter's opinion, the proposed requirement would

    effectively compel market makers to trade on an agency basis.\1072\

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

    \1069\ See ICI (Feb. 2012) SSgA (Feb. 2012); SIFMA (Asset Mgmt.)

    (Feb. 2012); BoA.

    \1070\ 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).

    \1071\ 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).

    \1072\ 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.\1073\ In particular, several commenters emphasized that matched

    or perfect hedges are generally unavailable for most types of

    positions.\1074\ 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.\1075\ 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.\1076\

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

    \1073\ 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.

    \1074\ See Morgan Stanley; Credit Suisse (Seidel); SSgA (Feb.

    2012); PUC Texas; Wellington; AllianceBernstein; Investure.

    \1075\ 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.

    \1076\ 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.\1077\ For example, one commenter

    expressed the opinion that the difference between the bid-ask spread

    and price appreciation is ``metaphysical'' in some sense,\1078\ 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.\1079\ 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.\1080\

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

    \1077\ 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.

    \1078\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

    \1079\ 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).

    \1080\ 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; \1081\ the markets for commodities, derivatives,

    securitized products, and emerging market securities; \1082\ equity and

    physical commodity derivatives markets; \1083\ and customized swaps

    used by customers of banking entities for hedging purposes.\1084\

    Another commenter expressed general concern about extremely volatile

    markets, where market makers often see large upward or downward price

    swings over time.\1085\

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

    \1081\ 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.

    \1082\ 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.

    \1083\ 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.

    \1084\ 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).

    \1085\ 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

    [[Page 5895]]

    guidance on this point apply equally to certain non-derivative

    positions.\1086\

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

    \1086\ 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 at

    68960; CFTC Proposal, 77 FR at 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 to provide ``immediacy'' to its customer.\1087\ 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.\1088\

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

    \1087\ See Prof. Duffie; NYSE Euronext; Capital Group; RBC;

    Goldman (Prop. Trading). See also Thakor Study (discussing market

    makers' role of providing ``immediacy'' in general).

    \1088\ 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 \1089\ or removed from the rule entirely.\1090\ With respect

    to suggested changes, some commenters stated that the Agencies should

    modify the rule text,\1091\ use a metrics-based approach to focus on

    customer revenues,\1092\ or replace the proposed requirement with

    guidance.\1093\ 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 \1094\ or market makers can take short-term positions that may

    ultimately result in a profit or loss.\1095\ As discussed below, some

    commenters stated that the Agencies should modify the proposed

    requirement to place greater restrictions on market maker revenue.

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

    \1089\ See, e.g., JPMC; Barclays; Goldman (Prop. Trading); BoA;

    CFA Inst.; ICI (Feb. 2012) Flynn & Fusselman.

    \1090\ 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).

    \1091\ 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.

    \1092\ 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.

    \1093\ 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).

    \1094\ See CFA Inst.

    \1095\ 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.\1096\ 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.\1097\ 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.\1098\ 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.\1099\

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

    \1096\ See Sens. Merkley & Levin (Feb. 2012); Better Markets

    (Feb. 2012); FTN; Public Citizen; Occupy; Alfred Brock.

    \1097\ 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).

    \1098\ 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.

    \1099\ 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.\1100\ 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.\1101\ For enforcement purposes, a few commenters suggested

    that the Agencies require banking entities to disgorge any profit

    obtained from price appreciation.\1102\

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

    \1100\ See Occupy; Better Markets (Feb. 2012). See supra note

    1108 (addressing these comments).

    \1101\ See Occupy.

    \1102\ 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.\1103\ The revenue requirement was

    one of the most commented upon aspects of the market-making exemption

    in the proposal.\1104\

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

    \1103\ See proposed rule Sec. 75.4(b)(2)(v).

    \1104\ See infra Part VI.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)

    [[Page 5896]]

    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.\1105\

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

    \1105\ 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. 75.4(b)(2)(v) of

    the proposed rule and certain of the proposed quantitative

    measurements.\1106\ 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.

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

    \1106\ See supra Part VI.A.3.c.7. and infra Part VI.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.\1107\ 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.\1108\

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

    \1107\ 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 at 68958-68959; CFTC Proposal,

    77 FR at 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).

    \1108\ 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.\1109\ In this proposed Appendix, the

    Agencies provided overviews of permitted market making-related activity

    and prohibited proprietary trading activity.\1110\

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

    \1109\ See proposed rule Sec. 75.4(b)(2)(vi).

    \1110\ See Joint Proposal, 76 FR at 68873, 68960-68961; CFTC

    Proposal, 77 FR at 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

    [[Page 5897]]

    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-taking (``compensation incentives

    factor'').\1111\

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

    \1111\ See Joint Proposal, 76 FR at 68873, 68961-68963; CFTC

    Proposal, 77 FR at 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 \1112\ or appropriately accounts for differences

    among asset classes.\1113\ Other commenters indicated that the appendix

    is too strict or narrow.\1114\ 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,\1115\ providing presumptions of activity that will be treated as

    permitted market making-related activity,\1116\ re-formulating the

    appendix as nonbinding guidance,\1117\ or moving certain requirements

    of the proposed exemption to the appendix.\1118\ 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.\1119\

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

    \1112\ See MetLife; ACLI (Feb. 2012).

    \1113\ 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).

    \1114\ 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).

    \1115\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

    \1116\ 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.

    \1117\ See Morgan Stanley; Flynn & Fusselman.

    \1118\ See JPMC. In support of such an approach, the commenter

    argued that sometimes proposed Sec. 75.4(b) and Appendix B

    addressed the same topic and, when this occurs, it is unclear

    whether compliance with Appendix B constitutes compliance with Sec.

    75.4(b) or if additional compliance steps are required. See id.

    \1119\ 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 \1120\ or will

    generate regulatory uncertainty.\1121\ As discussed below, other

    commenters opposed proposed Appendix B because of its level of

    granularity \1122\ or due to perceived restrictions on interdealer

    trading or generating revenue from retained principal positions or

    risks in the proposed appendix.\1123\ 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.\1124\

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

    \1120\ See NYSE Euronext; Morgan Stanley.

    \1121\ See IAA.

    \1122\ See Wellington; Goldman (Prop. Trading); SIFMA (Asset

    Mgmt.) (Feb. 2012).

    \1123\ See Morgan Stanley; Chamber (Feb. 2012); Goldman (Prop.

    Trading).

    \1124\ 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.\1125\ 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.\1126\

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

    \1125\ 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 at 68961; CFTC Proposal, 77 FR at 8441. The Agencies address

    commenters' trade-by-trade concerns in Part VI.A.3.c.1.c.ii., infra.

    \1126\ 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.\1127\ 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; \1128\ (ii) conduct price discovery to inform the

    prices a market maker can offer to customers; \1129\ (iii) unwind or

    sell positions acquired from

    [[Page 5898]]

    customers; \1130\ (iv) establish or acquire positions to meet

    reasonably expected near term customer demand; \1131\ (v) hedge; \1132\

    and (vi) sell a financial instrument when there are more buyers than

    sellers for the instrument at that time.\1133\ 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.'' \1134\

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

    \1127\ 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 at 68961; CFTC Proposal, 77 FR at 8440. Commenters' concerns

    regarding interdealer trading are addressed in Part VI.A.3.c.2.c.i.,

    infra.

    \1128\ See Morgan Stanley; Goldman (Prop. Trading).

    \1129\ See Morgan Stanley; Goldman (Prop. Trading); Chamber

    (Feb. 2012).

    \1130\ 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).

    \1131\ See Morgan Stanley; Chamber (Feb. 2012).

    \1132\ See Goldman (Prop. Trading).

    \1133\ See Chamber (Feb. 2012).

    \1134\ See Goldman (Prop. Trading).

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

    In addition, a few commenters expressed concern about statements in

    proposed Appendix B about a market maker's source of revenue.\1135\

    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.\1136\ As discussed above with respect to the source of

    revenue requirement in Sec. 75.4(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.\1137\

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

    \1135\ 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 at

    68960; CFTC Proposal, 77 FR at 8440. The Agencies address

    commenters' concerns about proposed requirements regarding a market

    maker's source of revenue in Part VI.A.3.c.7.c., infra.

    \1136\ See Morgan Stanley.

    \1137\ See supra note 1086 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.\1138\ With respect to the proposed factors, one commenter

    indicated that they are appropriate,\1139\ while another commenter

    stated that they are complex and their effectiveness is

    uncertain.\1140\ 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.'' \1141\

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

    \1138\ See supra note 1111 and accompanying text.

    \1139\ See Alfred Brock.

    \1140\ See Japanese Bankers Ass'n.

    \1141\ Sens. Merkley & Levin (Feb. 2012).

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

    In response to the proposed risk management factor,\1142\ 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.\1143\ 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.\1144\

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

    \1142\ 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 at 68961-68962; CFTC Proposal, 77 FR at 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.

    \1143\ See Chamber (Feb. 2012).

    \1144\ See Credit Suisse (Seidel).

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

    Two commenters expressed concern about the proposed source of

    revenue factor.\1145\ One commenter stated that this factor does not

    accurately reflect how market making occurs in a majority of markets

    and asset classes.\1146\ The other commenter expressed concern that

    this factor shifted the emphasis of Sec. 75.4(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.\1147\

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

    \1145\ See Goldman (Prop. Trading); Morgan Stanley.

    \1146\ See Morgan Stanley.

    \1147\ 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.\1148\ Some commenters,

    however, expressed concern about using these factors to differentiate

    permitted market making-related activity from prohibited proprietary

    trading.\1149\ These commenters stated that volatile risk-taking and

    revenue can be a natural result of principal market-making

    activity.\1150\ One commenter noted that customer flows are often

    ``lumpy'' due to, for example, a market maker's facilitation of large

    trades.\1151\

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

    \1148\ See Occupy (stating that these factors are important and

    will provide invaluable information about the nature of the banking

    entity's trading activity).

    \1149\ See Morgan Stanley; Credit Suisse (Seidel); Oliver Wyman

    (Feb. 2012); Oliver Wyman (Dec. 2011).

    \1150\ 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.

    \1151\ 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.\1152\ According to another

    commenter, however, a banking entity's non-customer facing trades

    should be required to be matched with existing customer

    counterparties.\1153\ 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.\1154\

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

    \1152\ See Morgan Stanley; Goldman (Prop. Trading).

    \1153\ See Public Citizen.

    \1154\ See Oliver Wyman (Feb. 2012).

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

    Some commenters expressed concern about the payment of fees,

    commissions,

    [[Page 5899]]

    and spreads factor.\1155\ One commenter appeared to support this

    proposed factor.\1156\ 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 stocks.\1157\ 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.\1158\

    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.\1159\

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

    \1155\ See NYSE Euronext; Morgan Stanley.

    \1156\ See Public Citizen.

    \1157\ See NYSE Euronext.

    \1158\ See Morgan Stanley.

    \1159\ 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.\1160\

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

    \1160\ 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.\1161\ 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.

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

    \1161\ See infra Part VI.C.3.; final rule Appendix A.

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

    4. Section 75.5: Permitted Risk-Mitigating Hedging Activities

    Section 75.5 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.\1162\ 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 75.5

    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.

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

    \1162\ See 12 U.S.C. 1851(d)(1)(C); proposed rule Sec. 75.5.

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

    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. 75.5(b)(1) and 75.5(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.

    75.5(b)(1). Next, Sec. 75.5(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. 75.5(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.

    75.5(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 75.5(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. 75.5(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. 75.5(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.\1163\ 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.\1164\ The final

    rule modifies the proposal by generally replacing references to a

    ``purchase or sale'' in the Sec. 75.5(b) requirements with ``risk-

    mitigating hedging activity.'' The Agencies believe this approach is

    consistent with the statute, which refers to ``risk-mitigating hedging

    activity.'' \1165\

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

    \1163\ 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.

    \1164\ See Barclays.

    \1165\ See 12 U.S.C. 1851(d)(1)(C) (stating that ``risk-

    mitigating hedging activities'' are permitted under certain

    circumstances).

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

    [[Page 5900]]

    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.''

    \1166\ 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.

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

    \1166\ 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 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.\1167\

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

    \1167\ See Part VI.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.\1168\

    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.\1169\

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

    \1168\ See, e.g., AFR et al. (Feb. 2012); AFR (June 2013);

    Better Markets (Feb. 2012); Sens. Merkley & Levin (Feb. 2012).

    \1169\ 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.\1170\ 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.\1171\

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

    \1170\ 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.

    \1171\ 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,\1172\ dynamic hedging,\1173\ anticipatory

    hedging,\1174\ or scenario hedging.\1175\ 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.\1176\ 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.\1177\

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

    \1172\ 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).

    \1173\ See Goldman (Prop. Trading); BoA.

    \1174\ 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).

    \1175\ 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 VI.A.4.d.2.

    \1176\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit

    Suisse (Seidel); Barclays; Goldman (Prop. Trading); BoA.

    \1177\ 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.\1178\ 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.\1179\ 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.\1180\ 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

    [[Page 5901]]

    exposures resulting from the imperfect, cheapest hedge.\1181\

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

    \1178\ See Barclays.

    \1179\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit

    Suisse (Seidel).

    \1180\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

    \1181\ 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.\1182\ Many of these commenters also expressed

    concerns that the proposed rule's hedging exemption would not allow so-

    called asset-liability management (``ALM'') activities.\1183\ Some

    commenters proposed that the risk-mitigating hedging exemption

    reference a set of relevant descriptive factors rather than specific

    prescriptive requirements.\1184\ Other alternative frameworks suggested

    by commenters include: (i) Reformulating the proposed requirements as

    supervisory guidance; \1185\ (ii) establishing a safe harbor,\1186\

    presumption of compliance,\1187\ or bright line test; \1188\ or (iii) a

    principles-based approach that would require a banking entity to

    document its risk-mitigating hedging strategies for submission to its

    regulator.\1189\

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

    \1182\ 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.

    \1183\ A detailed discussion of ALM activities is provid