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, [email protected]; Paul Schlichting, Assistant General
Counsel, Office of the General Counsel (``OGC''), (202) 418-5884,
[email protected]; Mark Fajfar, Assistant General Counsel, OGC,
(202) 418-6636, [email protected]; Michael Barrett, Attorney-Advisor,
DSIO, (202) 418-5598, [email protected]; Stephen Kane, Research
Economist, Office of the Chief Economist (``OCE''), (202) 418-5911,
[email protected]; or Stephanie Lau, Research Economist, OCE, (202) 418-
5218, [email protected]; 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.
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The proposed rules invited comment on a multi-faceted regulatory
framework to implement section 13 consistent with the statutory
language. In addition, the Agencies invited comments on the potential
economic impacts of the proposed rule and posed a number of questions
seeking information on the costs and benefits associated with each
aspect of the proposal, as well as on any significant alternatives that
would minimize the burdens or amplify the benefits of the proposal in a
manner consistent with the statute. The Agencies also encouraged
commenters to provide quantitative information and data about the
impact of the proposal on entities subject to section 13, as well as on
their clients, customers, and counterparties, specific markets or asset
classes, and any other entities potentially affected by the proposed
rule, including non-financial small and mid-size businesses.
The Agencies received over 18,000 comments addressing a wide
variety of aspects of the proposal, including definitions used by the
proposal and the exemptions for market making-related activities, risk-
mitigating hedging activities, covered fund activities and investments,
the use of quantitative metrics, and the reporting proposals. The vast
majority of these comments were from individuals using a version of a
short form letter to express support for the proposed rule. More than
600 comment letters were unique comment letters, including from members
of Congress, domestic and foreign banking entities and other financial
services firms, trade groups representing banking, insurance, and the
broader financial services industry, U.S. state and foreign
governments, consumer and public interest groups, and individuals. To
improve understanding of the issues raised by commenters, the Agencies
met with a number of these commenters to discuss issues relating to the
proposed rule, and summaries of these meetings are available on each of
the Agency's public Web sites.\12\ The CFTC staff also hosted a public
roundtable on the proposed rule.\13\ Many of the commenters generally
expressed support for the broader goals of the proposed rule. At the
same time, many commenters expressed concerns about various aspects of
the proposed rule. Many of these commenters requested that one or more
aspects of the proposed rule be modified in some manner in order to
reflect their viewpoints and to better accommodate the scope of
activities that they argued were encompassed within section 13 of the
BHC Act. The comments addressed all major sections of the proposed
rule.
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\12\ See http://www.regulations.gov/#!docketDetail;D=OCC-2011-
0014 (OCC); http://www.federalreserve.gov/newsevents/reform_systemic.htm (Board); http://www.fdic.gov/regulations/laws/federal/2011/11comAD85.html (FDIC); http://www.sec.gov/comments/s7-41-11/s74111.shtml (SEC); and http://www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_28_VolckerRule/index.htm (CFTC).
\13\ See Commodity Futures Trading Commission, CFTC Staff to
Host a Public Roundtable to Discuss the Proposed Volcker Rule (May
24, 2012), available at http://www.cftc.gov/PressRoom/PressReleases/pr6263-12; transcript available at http://www.cftc.gov/idc/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.
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In formulating this final rule, the Agencies carefully reviewed all
comments submitted in connection with the rulemaking and considered the
suggestions and issues they raise in light of the statutory
restrictions and provisions as well as the FSOC study. The Agencies
have sought to reasonably respond to all of the significant issues
commenters raised. The Agencies believe they have succeeded in doing so
notwithstanding the complexities involved. The Agencies also carefully
considered different options suggested by commenters in light of
potential costs and benefits in order to effectively implement section
13 of the BHC Act. The Agencies made numerous changes to the final rule
in response to the issues and information provided by commenters. These
modifications to the rule and explanations that address comments are
described in more detail in the section-by-section description of the
final rule. To enhance uniformity in both rules that implement section
13 and administration of the requirements of that section, the Agencies
have been regularly consulting with each other in the development of
this final rule.
Some commenters requested that the Agencies repropose the rule and/
or delay adoption pending the collection of
[[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\
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\18\ If any provision of this rule, or the application thereof
to any person or circumstance, is held to be invalid, such
invalidity shall not affect other provisions or application of such
provisions to other persons or circumstances that can be given
effect without the invalid provision or application.
---------------------------------------------------------------------------
Finally, the Board has determined, in accordance with section 13 of
the BHC Act, to provide banking entities with additional time to
conform their activities and investments to the statute and the final
rule. The restrictions and prohibitions of section 13 of the BHC Act
became effective on July 21, 2012.\19\ The statute provided banking
entities a period of two years to conform their activities and
investments to the requirement of the statute, until July 21, 2014.
Section 13 also permits the Board to extend this conformance period,
one year at a time, for a total of no more than three additional
years.\20\ Pursuant to this authority and in connection with this
rulemaking, the Board has in a separate action extended the conformance
period for an additional year until July 21, 2015.\21\ The Board will
continue to monitor developments to determine whether additional
extensions of the conformance period are in the public interest,
consistent with the statute. Accordingly, the Agencies do not believe
that a reproposal or further delay is necessary or appropriate.
---------------------------------------------------------------------------
\19\ See 12 U.S.C. 1851(c)(1).
\20\ See 12 U.S.C. 1851(c)(2); see also Conformance Period for
Entities Engaged in Prohibited Proprietary Trading or Private Equity
Fund or Hedge Fund Activities, 76 FR 8265 (Feb. 14, 2011) (citing
156 Cong. Rec. S5898 (daily ed. July 15, 2010) (statement of Sen.
Merkley)).
\21\ See, Board Order Approving Extension of Conformance Period,
available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20131210b1.pdf.
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Commenters have differing views on the overall economic impacts of
section 13 of the BHC Act.
Some commenters remarked that proprietary trading restrictions will
have detrimental impacts on the economy such as: Reduction in
efficiency of markets, economic growth, and in employment due to a loss
in liquidity.\22\ In particular, a commenter expressed concern that
there may be high transition costs as non-banking entities replace some
of the trading activities currently performed by banking entities.\23\
Another commenter focused on commodity markets remarked about the
potential reduction in commercial output and curtailed resource
exploration due to a lack of hedging counterparties.\24\ Several
commenters stated that section 13 of the BHC Act will reduce access to
debt markets--especially for smaller companies--raising the costs of
capital for firms and lowering the returns on certain investments.\25\
Further, some commenters mentioned that U.S. banks may be competitively
disadvantaged relative to foreign banks due to proprietary trading
restrictions and compliance costs.\26\
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\22\ See, e.g., Oliver Wyman (Dec. 2011); Chamber (Dec. 2011);
Thakor Study; Prof. Duffie; IHS.
\23\ See Prof. Duffie.
\24\ See IHS.
\25\ See, e.g., Chamber (Dec. 2011); Thakor Study; Oliver Wyman
(Dec. 2011); IHS.
\26\ See, e.g., RBC; Citigroup (Feb. 2012); Goldman (Covered
Funds).
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[[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\
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\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\
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\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\
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\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).
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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.
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C. Restrictions on Covered Fund Activities and Investments
Subpart C of the final rule implements the statutory prohibition
on, directly or indirectly, acquiring and retaining an ownership
interest in, or having certain relationships with, a covered fund, as
well as the various exemptions to this prohibition included in the
statute. Section 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\
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\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.
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[[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).
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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.
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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).
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c. Final Requirement That the Banking Entity Act as an Underwriter for
a Distribution of Securities and the Trading Desk's Underwriting
Position Be Related to Such Distribution
The final rule requires that the banking entity act as an
underwriter for a distribution of securities and the trading desk's
underwriting position be related to such distribution.\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\
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\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\
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\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\
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\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).
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v. Activities Conducted ``in Connection With'' a Distribution
As discussed above, several commenters expressed concern that the
proposed underwriting exemption would not allow a banking entity to
engage in certain auxiliary activities that may be conducted in
connection with acting as an underwriter for a distribution of
securities in the normal course. These commenters' concerns generally
arose from the use of the word ``solely'' in Sec. 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.
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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\
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\506\ 12 U.S.C. 1851(d)(1)(B).
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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\
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\507\ See Joint Proposal, 76 FR at 68869; CFTC Proposal, 77 FR
at 8354-8355.
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2. Comments on the Proposed Market-Making Exemption
The Agencies received significant comment regarding the proposed
market-making exemption. In this Part, the Agencies highlight the main
issues, concerns, and suggestions raised by commenters with respect to
the proposed market-making exemption. As discussed in greater detail
below, commenters' views on the effectiveness of the proposed exemption
varied. Commenters discussed a broad range of topics related to the
proposed market-making exemption including, among others: The overall
scope of the proposed exemption and potential restrictions on market
making in certain markets or asset classes; the potential market impact
of the proposed market-making exemption; the appropriate level of
analysis for compliance with the proposed exemption; the effectiveness
of the individual requirements of the proposed exemption; and specific
activities that should or should not be considered permitted market
making-related activity under the rule.
a. Comments on the Overall Scope of the Proposed Exemption
With respect to the general scope of the exemption, a number of
commenters expressed concern that the proposed approach to implementing
the market-making exemption is too narrow or restrictive, particularly
with respect to less liquid markets. These commenters expressed concern
that the proposed exemption would not be workable in many markets and
asset classes and does not take into account how market-making services
are provided in those markets and asset classes.\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.
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Other commenters, however, stated that the proposed exemption was
too broad and recommended that the rule place greater restrictions on
market making, particularly in illiquid, nontransparent markets.\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.
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Moreover, commenters also set forth their views on the
organizational level at which the requirements of the proposed market-
making exemption should apply.\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\
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\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).
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[[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\
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\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.
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\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.
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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.
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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\
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\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.
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[[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.
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[[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.
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\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.
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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.
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\899\ See final rule Sec. 75.4(b)(2)(iii)(B), (C).
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The following is an example of the interplay between a trading
desk's market-maker inventory and financial exposure. An airline
company customer may seek to hedge its long-term exposure to price
fluctuations in jet fuel by asking a banking entity to create a
structured ten-year, $1 billion jet fuel swap for which there is no
liquid market. A trading desk that makes a market in energy swaps may
service its customer's needs by executing a custom jet fuel swap with
the customer and holding the swap in its market-maker inventory, if the
resulting transaction does not cause the trading desk to exceed its
market-maker inventory limit on the applicable class of instrument, or
the trading desk has received approval to increase the limit in
accordance with the authorization and escalation procedures under
paragraph (b)(2)(iii)(E). In keeping with the market-making exemption
as provided in the final rule, the trading desk would be required to
hedge the risk from this swap, either individually or as part of a set
of aggregated positions, if the trade would result in a financial
exposure that exceeds the desk's financial exposure limits. The trading
desk may hedge the risk of the swap, for example, by entering into one
or more futures or swap positions that are identified as permissible
hedging products, instruments, or exposures in the trading desk's
compliance program and that analysis, including correlation analysis as
appropriate, indicates would demonstrably reduce or otherwise
significantly mitigate risks associated with the financial exposure
from its market-making activities. Alternatively, if the trading desk
also acts as a market maker in crude oil futures, then the desk's
exposures arising from its market-making activities may naturally hedge
the jet fuel swap (i.e., it may reduce its financial exposure levels
resulting from such instruments).\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.
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As discussed above, several commenters expressed concern that the
near-term customer demand requirement is too restrictive and that it
could impede a market maker's ability to build or retain inventory,
particularly in less liquid markets where demand is intermittent.\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.
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\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\
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\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.
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The Agencies believe this definition is generally consistent with
the proposed interpretation of ``customer'' in the proposal. The
proposal generally provided that, for purposes of market making on an
exchange or other organized trading facility, a customer is any person
on behalf of whom a buy or sell order has been submitted. In the
context of the over-the-counter market, a customer was generally
considered to be a market participant that makes use of the market
maker's intermediation services, either by requesting such services or
entering into a continuing relationship for such services.\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.
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[[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\
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\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).
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Some firms, whether or not an AP in a given ETF, may also actively
engage in buying and selling shares of an ETF and its underlying
instruments in the market to maintain price continuity between the ETF
and its underlying instruments, which are exchangeable for one another.
Sometimes these firms will register as market makers on an exchange for
a given ETF, but other times they may not register as market maker.
Regardless of whether or not the firm is registered as a market maker
on any given exchange, this activity not only provides liquidity for
ETFs, but also, and very importantly, helps keep the market price of an
ETF in line with the NAV of the fund. The market-making exemption can
be used to evaluate trading that is intended to maintain price
continuity between these exchangeable instruments by considering how
the firm quotes, maintains risk and exposure limits, manages its
inventory and risk, and, in the case of APs, exercises its ability to
create and redeem shares from the fund. Because customers take
positions in ETFs with an expectation that the price relationship will
be maintained, such trading can be considered to be market making-
related activity.\917\
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\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\
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\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).
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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).
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ii. Impact of the Liquidity, Maturity, and Depth of the Market on the
Analysis
Several commenters expressed concern about the potential impact of
the proposed near term demand requirement on market making in less
liquid markets and requested that the Agencies recognize that near term
customer demand may vary across different markets and asset
classes.\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\
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\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.
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iii. Demonstrable Analysis of Certain Factors
In the proposal, the Agencies stated that permitted market making
includes taking positions in securities in anticipation of customer
demand, so long as any anticipatory buying or 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.
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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\
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\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\
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\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.
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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).
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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.
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A banking entity's written policies and procedures, internal
controls, analysis, and independent testing identifying and addressing
the products, instruments, or exposures and the techniques and
strategies that may be used by each trading desk to manage the risks of
its market making-related activities and inventory must cover both how
the trading desk may establish hedges and how such hedges are removed
once the risk they were mitigating is unwound. With respect to
establishing positions that hedge or otherwise mitigate the risk(s) of
market making-related positions held by the trading desk, the written
policies and procedures may consider the natural hedging and
diversification that occurs in an aggregation of long and short
positions in financial instruments for which the trading desk is a
market maker,\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.
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\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).
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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).
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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.
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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 provided in
Part VI.A.1.d.2 of this SUPPLEMENTARY INFORMATION relating to the
definition of trading account. As explained in that part, the final
rule does not allow use of the hedging exemption for ALM activities
that are outside of the hedging activities specifically permitted by
the final rule.
\1184\ See BoA; JPMC; Morgan Stanley.
\1185\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; PNC
et al.; ICI.
\1186\ See Prof. Richardson; ABA (Keating).
\1187\ See Barclays; BoA; ISDA (Feb. 2012).
\1188\ See Johnson & Prof. Stiglitz.
\1189\ See HSBC.
---------------------------------------------------------------------------
d. Final Rule
The final rule provides a multi-faceted approach to implementing
the hedging exemption that seeks to ensure that hedging activity is
designed to be risk-reducing in nature and not designed to mask
prohibited proprietary trading.\1190\ The final rule includes a number
of modifications in response to comments.
---------------------------------------------------------------------------
\1190\ See final rule Sec. 75.5.
---------------------------------------------------------------------------
This multi-faceted approach is intended to permit hedging
activities that are risk-mitigating and to limit potential abuse of the
hedging exemption while not unduly constraining the important risk-
management function that is served by a banking entity's hedging
activities. This approach is also intended to ensure that any banking
entity relying on the hedging exemption has in place appropriate
internal control processes to support its compliance with the terms of
the exemption. While commenters proposed a number of alternative
frameworks for the hedging exemption, the Agencies believe the final
rule's multi-faceted approach most effectively balances commenter
concerns with statutory purpose. In response to commenter requests to
reformulate the proposed rule as supervisory guidance,\1191\ including
the suggestion that the Agencies simply require banking entities to
adopt risk limits and policies and procedures commensurate with
qualitative Agency guidance,\1192\ the Agencies believe that such an
approach would provide less clarity than the adopted approach. Although
a purely guidance-based approach could provide greater flexibility, it
would also provide less specificity, which could make it difficult for
banking entity personnel and the Agencies to determine whether an
activity complies with the rule and could lead to an increased risk of
evasion of the statutory requirements. Further, while a bright-line or
safe harbor approach to the hedging exemption would generally provide a
high degree of certainty about whether an activity qualifies for the
exemption, it would also provide less flexibility to recognize the
differences in hedging activity across markets and asset classes.\1193\
In addition, the use of any bright-line approach would more likely be
subject to gaming and avoidance as new products and types of trading
activities are developed than other approaches to implementing the
hedging exemption. Similarly, the Agencies decline to establish a
presumption of compliance because, in light of the constant innovation
of trading activities and the differences in hedging activity across
markets and asset classes, establishing appropriate parameters for a
presumption of compliance with the hedging exemption would potentially
be less capable of recognizing these legitimate differences than our
current approach.\1194\ Moreover, the Agencies decline to follow a
principles-based approach requiring a banking entity to document its
hedging strategies for submission to its regulator.\1195\ The Agencies
believe that evaluating each banking entity's trading activity based on
an individualized set of documented hedging strategies could be
unnecessarily burdensome and result in unintended competitive impacts
since banking entities would not be subject to one uniform rule. The
Agencies believe the multi-faceted approach adopted in the final rule
establishes a consistent framework applicable to all banking entities
that will reduce the potential for such adverse impacts.
---------------------------------------------------------------------------
\1191\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; PNC
et al.; ICI (Feb. 2012); BoA; Morgan Stanley.
\1192\ 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.
\1193\ Some commenters requested that the Agencies establish a
safe harbor. See Prof. Richardson; ABA (Keating). One commenter
requested that the Agencies adopt a bright-line test. See Johnson &
Prof. Stiglitz.
\1194\ A few commenters requested that the Agencies establish a
presumption of compliance. See Barclays; BoA; ISDA (Feb. 2012).
\1195\ One commenter suggested this principles-based approach.
See HSBC.
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Further, the Agencies believe the scope of the final hedging
exemption is appropriate because it permits risk-mitigating hedging
activities, as mandated by section 13 of the BHC Act,\1196\ while
requiring a robust compliance program and other internal controls to
help ensure that only genuine risk-mitigating hedges can be used in
reliance on the exemption.\1197\ In response to concerns that the
proposed hedging exemption would reduce legitimate hedging activity and
thus impact market liquidity and the banking entity's willingness to
engage in permissible customer-related activity,\1198\ the Agencies
note that the requirements of the final hedging exemption are designed
to permit banking entities to properly mitigate specific risk
exposures, consistent with the statute. In addition, hedging related to
market-making activity conducted by a market-making desk is subject to
the requirements of the market-making exemption, which are designed to
permit banking entities to continue providing valuable intermediation
and liquidity services, including related risk-management
activity.\1199\ Thus, the final hedging exemption will not negatively
impact the safety and soundness of banking entities or the
[[Page 5902]]
financial system or have a chilling effect on a banking entity's
willingness to engage in other permitted activities, such as market
making.\1200\
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\1196\ Section 13(d)(1)(C) of the BHC Act permits ``risk-
mitigating hedging activities in connection with and related to
individual or aggregated positions, contracts, or other holdings of
a banking entity that are designed to reduce the specific risks to
the banking entity in connection with and related to such positions,
contracts, or other holdings.'' 12 U.S.C. 1851(d)(1)(C).
\1197\ Some commenters were concerned that the proposed hedging
exemption was too broad and that all proprietary trading could be
designated as a hedge. See, e.g., Occupy.
\1198\ See, e.g., Australian Bankers Ass'n. (Feb. 2012); BoA;
Barclays; Credit Suisse (Seidel); Goldman (Prop. Trading); HSBC;
Japanese Bankers Ass'n.; JPMC; Morgan Stanley; Chamber (Feb. 2012);
Wells Fargo (Prop. Trading); Rep. Bachus et al.; RBC; SIFMA et al.
(Prop. Trading) (Feb. 2012).
\1199\ See supra Part VI.A.3.c.4.
\1200\ Some commenters believed that restrictions on hedging
would have a chilling effect on banking entities' willingness to
engage in market making, and may result in customers experiencing
difficulty in hedging their risks or force customers to retain risk.
See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit Suisse
(Seidel); Barclays; Goldman (Prop. Trading); BoA; IHS.
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These limits and requirements are designed to prevent the type of
activity conducted by banking entities in the past that involved taking
large positions using novel strategies to attempt to profit from
potential effects of general economic or market developments and
thereby potentially offset the general effects of those events on the
revenues or profits of the banking entity. The documentation
requirements in the final rule support these limits by identifying
activity that occurs in reliance on the risk-mitigating hedging
exemption at an organizational level or desk that is not responsible
for establishing the risk or positions being hedged.
1. Compliance Program Requirement
The first criterion of the proposed hedging exemption required a
banking entity to establish an internal compliance program designed to
ensure the banking entity's compliance with the requirements of the
hedging exemption and conduct its hedging activities in compliance with
that program. While the compliance program under the proposal was
expected to be appropriate for the size, scope, and complexity of each
banking entity's activities and structure, the proposal would have
required each banking entity with significant trading activities to
implement robust, detailed hedging policies and procedures and related
internal controls and independent testing designed to prevent
prohibited proprietary trading in the context of permitted hedging
activity.\1201\ These enhanced programs for banking entities with large
trading activity were expected to include written hedging policies at
the trading unit level and clearly articulated trader mandates for each
trader designed to ensure that hedging strategies mitigated risk and
were not for the purpose of engaging in prohibited proprietary trading.
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\1201\ These aspects of the compliance program requirement are
described in further detail in Part VI.C. of this SUPPLEMENTARY
INFORMATION.
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Commenters, including industry groups, generally expressed support
for requiring policies and procedures to monitor the safety and
soundness, as well as appropriateness, of hedging activity.\1202\ Some
of these commenters advocated that the final rule presume that a
banking entity is in compliance with the hedging exemption if the
banking entity's hedging activity is done in accordance with the
written policies and procedures required under its compliance
program.\1203\ One commenter represented that the proposed compliance
framework was burdensome and complex.\1204\
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\1202\ See SIFMA et al. (Prop. Trading) (Feb. 2012).
\1203\ See BoA; Barclays; HSBC; JPMC; Morgan Stanley; see also
Goldman (Prop. Trading); RBC; Barclays; ICI (Feb. 2012); ISDA (Apr.
2012); PNC; SIFMA et al. (Prop. Trading) (Feb. 2012). See the
discussion of why the Agencies decline to take a presumption of
compliance approach above.
\1204\ See Barclays.
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Other commenters expressed concerns that the hedging exemption
would be too limiting and burdensome for community and regional
banks.\1205\ Some commenters argued that foreign banking entities
should not be subject to the requirements of the hedging exemption for
transactions that do not introduce risk into the U.S. financial
system.\1206\ Other commenters stated that coordinated hedging through
and by affiliates should qualify as permitted risk-mitigating hedging
activity.\1207\
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\1205\ See ICBA; M&T Bank.
\1206\ See, e.g., Bank of Canada; Allen & Overy (on behalf of
Canadian Banks). Additionally, foreign banking entities engaged in
hedging activity may be able to rely on the exemption for trading
activity conducted by foreign banking entities in lieu of the
hedging exemption, provided they meet the requirements of the
exemption for trading by foreign banking entities under Sec.
75.6(e) of the final rule. See infra Part VI.A.8.
\1207\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.
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Some commenters urged the Agencies to adopt detailed limitations on
hedging activities. For example, one commenter urged that all hedging
trades be labeled as such at the inception of the trade and detailed
information regarding the trader, manager, and supervisor authorizing
the trade be kept and reviewed.\1208\ Another commenter suggested that
the hedging exemption contain a requirement that the banking entity
employee who approves a hedge affirmatively certify that the hedge
conforms to the requirements of the rule and has not been put in place
for the direct or indirect purpose or effect of generating speculative
profits.\1209\ A few commenters requested limitations on instruments
that can be used for hedging purposes.\1210\
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\1208\ See Sens. Merkley & Levin (Feb. 2012).
\1209\ See Better Markets (Feb. 2012).
\1210\ See Sens. Merkley & Levin (F