2013-31476

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

[Rules and Regulations]

[Pages 5807-6075]

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

[FR Doc No: 2013-31476]

[[Page 5807]]

Vol. 79

Friday,

No. 21

January 31, 2014

Part III

Commodity Futures Trading Commission

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17 CFR Part 75

Prohibitions and Restrictions on Proprietary Trading and Certain

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

Funds; Final Rule

Federal Register / Vol. 79 , No. 21 / Friday, January 31, 2014 /

Rules and Regulations

[[Page 5808]]

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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 75

RIN 3038-AD05

Prohibitions and Restrictions on Proprietary Trading and Certain

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

Funds

AGENCY: Commodity Futures Trading Commission.

ACTION: Final rule.

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

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

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

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

restrictions on the ability of a banking entity and nonbank financial

company supervised by the Board of Governors of the Federal Reserve

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

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

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

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

and the Securities and Exchange Commission to also issue regulations

implementing section 619 and directs the CFTC and those four agencies

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

developing and issuing the implementing rules, for the purposes of

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

provide for consistent application and implementation. To that end,

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

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

worked closely together to develop the same rule text and supplementary

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

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

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

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

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

relationship to other authorities with respect to the Commission.

Furthermore, it is noted that the supplementary information generally

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

and considerations in developing the final rule by the CFTC together

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

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

adopted.

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

FOR FURTHER INFORMATION CONTACT: Erik Remmler, Deputy Director,

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

418-7630, [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.

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\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).

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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.

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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.

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\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.

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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.

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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.

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\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.

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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.

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

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

SEC.

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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\

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

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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).

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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\

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

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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\

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

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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.

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

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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.

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\50\ See final rule Sec. 75.5.

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

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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.

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\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.

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\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.''

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\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.

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

(statement of Sen. Hagan).

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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.

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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.

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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\

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\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.

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\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.

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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.

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[[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\

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\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.

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\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).

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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\

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\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\

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\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\

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\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).

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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).

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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\

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

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

at 8352.

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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.

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\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).

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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.

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[[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).

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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.''

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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).

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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).

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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.

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\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.

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\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.

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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\

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

FR at 68867; CFTC Proposal, 77 FR at 8353.

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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\

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\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).

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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\

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\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.

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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\

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\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.

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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\

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\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).

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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\

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\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).

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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\

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\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.

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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.

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\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).

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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\

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\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.

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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\

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\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\

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\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.

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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.

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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\

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\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.

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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\

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\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.

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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.

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\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\

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\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\

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\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.

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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\

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\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.

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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\

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\519\ See Wellington; Paul Volcker; Better Markets (Feb. 2012);

Occupy.

\520\ See Wellington.

\521\ See Paul Volcker.

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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\

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\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).

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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\

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\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\

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\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.

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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.

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\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)'').

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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.

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\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.

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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).

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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.

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[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\

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\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.

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[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.

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[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.

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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\

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\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\

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\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).

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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.

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\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.

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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.

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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.

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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\

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\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.

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\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\

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\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\

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\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).

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\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.

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\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.

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\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.

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\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.

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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.

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\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).

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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.

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\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.

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\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.

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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.

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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\

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\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.

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\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.

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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.

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\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.

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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\

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\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).

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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.

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\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.

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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\

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\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\

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\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.

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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.

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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.

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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.

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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.

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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.

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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).

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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.

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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\

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\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).

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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).

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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.

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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.

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\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.

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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.

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\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.

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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\

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\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).

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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.

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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\

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\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.

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\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).

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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\

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\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\

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\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.

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\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).

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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\

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\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.

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\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.

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\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.

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\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\

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\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.

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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.

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\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.

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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).

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\978\ See final rule Sec. 75.4(b)(2)(iii)(E).

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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.

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\979\ See ICI (Feb. 2012).

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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\

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\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.

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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.

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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\

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\988\ See BoA; SIFMA (Asset Mgmt.) (Feb. 2012).

\989\ See Goldman (Prop. Trading).

\990\ See BoA.

\991\ See SIFMA (Asset Mgmt.) (Feb. 2012).

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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.

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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\

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\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.

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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).

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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.

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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\

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\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).

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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\

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\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).

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[[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\

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\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.

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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\

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\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.

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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).

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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).

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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\

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\1033\ See proposed rule Sec. 75.4(b)(2)(iv); Joint Proposal,

76 FR at 68872; CFTC Proposal, 77 FR at 8357-8358.

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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\

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\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).

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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\

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\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.

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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).

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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.

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\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.

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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.

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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\

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\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\

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\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\

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\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).

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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.

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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\

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\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.

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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\

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\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.

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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\

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\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\

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\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\

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\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).

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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.

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\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.

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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.

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\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 (Feb. 2012); Occupy; Andrea

Psoras.

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The final rule retains the proposal's requirement that a banking

entity establish an internal compliance program that is designed to

ensure the banking entity limits its hedging activities to hedging that

is risk-mitigating.\1211\ The final rule largely retains the proposal's

approach to the compliance program requirement, except to the extent

that, as requested by some commenters,\1212\ the final rule modifies

the proposal to provide additional detail regarding the elements that

must be included in a compliance program. Similar to the proposal, the

final rule contemplates that the scope and detail of a compliance

program will reflect the size, activities, and complexity of banking

entities in order to ensure that banking entities engaged in more

active trading have enhanced compliance programs without imposing undue

burden on smaller organizations and entities that engage in little or

no trading activity.\1213\ The final rule also requires, like the

proposal, that the banking entity implement, maintain, and enforce the

program.\1214\

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\1211\ See final rule Sec. 75.5(b)(1). The final rule retains

the proposal's requirement that the compliance program include,

among other things, written hedging policies.

\1212\ See, e.g., BoA; ICI (Feb. 2012); ISDA (Feb. 2012); JPMC;

Morgan Stanley; PNC; SIFMA et al. (Prop. Trading) (Feb. 2012).

\1213\ See final rule Sec. 75.20(a) (stating that ``[t]he

terms, scope and detail of [the] compliance program shall be

appropriate for the types, size, scope and complexity of activities

and business structure of the banking entity''). The Agencies

believe this helps address some commenters' concern that the hedging

exemption would be too limiting and burdensome for community and

regional banks. See ICBA; M&T Bank.

\1214\ Many of these policies and procedures were contained as

part of the proposed rule's compliance program requirements under

Appendix C. They have been moved, and in some cases modified, in

order to more clearly demonstrate how they are incorporated into the

requirements of the hedging exemption.

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In response to commenter concerns about ensuring the appropriate

level of senior management involvement in establishing these

policies,\1215\ the final rule requires that the written policies and

procedures be developed and implemented by a banking entity at the

appropriate level of organization and expressly address the banking

entity's requirements for escalation procedures, supervision, and

governance related to hedging activities.\1216\

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\1215\ See Better Markets (Feb. 2012). The final rule does not

require affirmative certification of each hedge, as suggested by

this commenter, because the Agencies believe it would unnecessarily

slow legitimate transactions. The Agencies believe the final rule's

required management framework and escalation procedures achieve the

same objective as the commenter's suggested approach, while imposing

fewer burdens on legitimate risk-mitigating hedging activity.

\1216\ See final rule Sec. Sec. 75.20(b), 75.5(b). This

approach builds on the proposal's requirement that senior management

and intermediate managers be accountable for the effective

implementation of the compliance program.

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[[Page 5903]]

Like the proposal, the final rule specifies that a banking entity's

compliance regime must include reasonably designed written policies and

procedures regarding the positions, techniques and strategies that may

be used for hedging, including documentation indicating what positions,

contracts or other holdings a trading desk may use in its risk-

mitigating hedging activities.\1217\ The focus on policies and

procedures governing risk identification and mitigation, analysis and

testing of position limits and hedging strategies, and internal

controls and ongoing monitoring is expected to limit use of the hedging

exception to risk-mitigating hedging. The final rule adds to the

proposed compliance program approach by requiring that the banking

entity's written policies and procedures include position and aging

limits with respect to such positions, contracts, or other

holdings.\1218\ The final rule, similar to the proposed rule, also

requires that the compliance program contain internal controls and

ongoing monitoring, management, and authorization procedures, including

relevant escalation procedures.\1219\ Further, the final rule retains

the proposed requirement that the compliance program provide for the

conduct of analysis and independent testing designed to ensure that the

positions, techniques, and strategies that may be used for hedging may

reasonably be expected to demonstrably reduce or otherwise

significantly mitigate the specific, identifiable risks being

hedged.\1220\

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\1217\ This approach is generally consistent with some

commenters' suggested approach of limiting the instruments that can

be used for hedging purposes; although the final rules provide

banking entities with discretion to determine the types of

positions, contracts, or other holdings that will mitigate specific

risks of individual or aggregated holdings and thus may be used for

risk-mitigating hedging activity. See Sens. Merkley & Levin (Feb.

2012); Occupy; Andrea Psoras. In response to one commenter's request

that the final rule require all hedges to be labeled at inception

and certain detailed information be documented for each hedge, the

Agencies note that the final rules continue to require detailed

documentation for hedging activity that presents a heightened risk

of evasion. See Sens. Merkley & Levin (Feb. 2012); final rule Sec.

75.5(c); infra Part VI.A.4.d.4. The Agencies believe a documentation

requirement targeted at these scenarios balances the need to prevent

evasion of the general prohibition on proprietary trading with the

concern that documentation requirements can slow or impede

legitimate risk-mitigating activity in the normal course.

\1218\ See final rule Sec. 75.5(b)(1)(i). Some commenters

expressed support for the use of risk limits in determining whether

trading activity qualifies for the hedging exemption. See, e.g.,

Barclays; Credit Suisse (Seidel); ICI (Feb. 2012); Morgan Stanley.

\1219\ See final rule Sec. 75.5(b)(1)(ii).

\1220\ See final rule Sec. 75.5(b)(1)(iii). The final rule's

requirement to demonstrably reduce or otherwise significantly

mitigate is discussed in greater detail below.

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The final rule also adds that correlation analysis be undertaken as

part of the analysis of the hedging positions, techniques, and

strategies that may be used. This provision effectively changes the

requirement in the proposed rule that the hedge must maintain

correlation into a requirement that correlation be analyzed as part of

the compliance program before a hedging activity is undertaken. This

provision incorporates the concept in the proposed rule that a hedge

should be correlated (negatively, when sign is considered) to the risk

being hedged. However, the Agencies recognize that some effective

hedging activities, such as deep out-of-the-money puts and calls, may

not be exhibit a strong linear correlation to the risks being hedged

and also that correlation over a period of time between two financial

positions does not necessarily mean one position will in fact reduce or

mitigate a risk of the other. Rather, the Agencies expect the banking

entity to undertake a correlation analysis that will, in many but not

all instances, provide a strong indication of whether a potential

hedging position, strategy, or technique will or will not demonstrably

reduce the risk it is designed to reduce. It is important to recognize

that the rule does not require the banking entity to prove correlation

mathematically or by other specific methods. Rather, the nature and

extent of the correlation analysis undertaken would be dependent on the

facts and circumstances of the hedge and the underlying risks targeted.

If correlation cannot be demonstrated, then the Agencies would expect

that such analysis would explain why not and also how the proposed

hedging position, technique, or strategy is designed to reduce or

significantly mitigate risk and how that reduction or mitigation can be

demonstrated without correlation.

Moreover, the final rule requires hedging activity conducted in

reliance on the hedging exemption be subject to continuing review,

monitoring, and management that is consistent with the banking entity's

written hedging policies and procedures and is designed to reduce or

otherwise significantly mitigate, and demonstrably reduces or otherwise

significantly mitigates, the specific, identifiable risks that develop

over time from hedging activity and underlying positions.\1221\ This

ongoing review should consider market developments, changes in

positions or the configuration of aggregated positions, changes in

counterparty risk, and other facts and circumstances related to the

risks associated with the underlying and hedging positions, contracts,

or other holdings.

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\1221\ The proposal also contained a continuing review,

monitoring, and management requirement. See proposed rule Sec.

75.5(b)(2)(v). The final rule modifies the proposed requirement,

however, by removing the ``reasonable correlation'' requirement and

instead requiring that the hedge demonstrably reduce or otherwise

significantly mitigate specific identifiable risks. Correlation

analysis is, however, a necessary component of the analysis element

in the compliance program requirement of the hedging exemption in

the final rule. See final rule Sec. 75.5(b). This change is

discussed below.

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The Agencies believe that requiring banking entities to develop and

follow detailed compliance policies and procedures related to risk-

mitigating hedging activity will help both banking entities and

examiners understand the risks to which banking entities are exposed

and how these risks are managed in a safe and sound manner. With this

increased understanding, banking entities and examiners will be better

able to evaluate whether banking entities are engaged in legitimate,

risk-reducing hedging activity, rather than impermissible proprietary

trading. While the Agencies recognize there are certain costs

associated with this compliance program requirement,\1222\ we believe

this provision is necessary to ensure compliance with the statute and

the final rule. As discussed in Part VI.C.1., the Agencies have

modified the proposed compliance program structure to reduce burdens on

small banking entities.\1223\

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\1222\ See Barclays.

\1223\ See infra Part VI.C.1. Some commenters expressed concern

that the compliance program requirement would place undue burden on

regional or community banks. See ICBA; M&T Bank.

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

The Agencies note that hedging may occur across affiliates under

the hedging exemption.\1224\ To ensure that hedging across trading

desks or hedging done at a level of the organization outside of the

trading desk does not result in prohibited proprietary trading, the

final rule imposes enhanced documentation requirements on these

activities, which are discussed more fully below. The Agencies also

note that nothing in the final rule limits or restricts the ability of

the appropriate supervisory agency of a banking entity to place limits

on interaffiliate hedging in a manner consistent with their safety and

soundness authority to the extent the

[[Page 5904]]

agency has such authority.\1225\ Additionally, nothing in the final

rule limits or modifies the applicability of CFTC regulations with

respect to the clearing of interaffiliate swaps.\1226\

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\1224\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.

\1225\ In addition, section 608 of the Dodd-Frank Act added

credit exposure arising from securities borrowing and lending or a

derivative transaction with an affiliate to the list of covered

transactions subject to the restrictions of section 23A of the FR

Act, in each case to the extent that such transaction causes a bank

to have credit exposure to the affiliate. See 12 U.S.C. 371c(b)(7)

and (8). As a consequence, interaffiliate hedging activity within a

banking entity may be subject to limitation or restriction under

section 23A of the FR Act.

\1226\ See 17 CFR 50.52.

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2. Hedging of Specific Risks and Demonstrable Reduction of Risk

Section 75.5(b)(2)(ii) of the proposed rule required that a

qualifying 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 a banking

entity.\1227\ This criterion implemented the essential element of the

hedging exemption that the transaction be risk-mitigating.

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\1227\ See proposed rule Sec. 75.5(b)(2)(ii); see also Joint

Proposal, 76 FR at 68875.

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Some commenters expressed support for this provision, particularly

the requirement that a banking entity be able to tie a hedge to a

specific risk.\1228\ One of these commenters stated that a demonstrated

reduction in risk should be a key indicator of whether a hedge is in

fact permitted.\1229\ However, some commenters argued that the list of

risks eligible to be hedged under the proposed rule, which included

risks arising from aggregated positions, could justify transactions

that should be viewed as prohibited proprietary trading.\1230\ Another

commenter contended that the term ``basis risk'' was undefined and

could heighten the potential that this exemption would be used to evade

the prohibition on proprietary trading.\1231\

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\1228\ See AFR (June 2013); Sens. Merkley & Levin (Feb. 2012);

Public Citizen; Johnson & Prof. Stiglitz.

\1229\ See Sens. Merkley & Levin (Feb. 2012).

\1230\ See Public Citizen; see also Occupy.

\1231\ See Occupy.

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Other commenters argued that requiring a banking entity to specify

the particular risk being hedged discourages effective hedging and

increases the risk at banking entities. These commenters contended that

hedging activities must address constantly changing positions and

market conditions.\1232\ Another commenter argued that this requirement

could render a banking entity's hedges impermissible if those hedges do

not succeed in fully hedging or mitigating an identified risk as

determined by a post hoc analysis and could prevent banking entities

from entering into hedging transactions in anticipation of risks that

the banking entity expects will arise (or increase).\1233\ Certain

commenters requested that the hedging exemption provide a safe harbor

for positions that satisfy FASB ASC Topic 815 (formerly FAS 133)

hedging accounting standards, which provides that an entity recognize

derivative instruments, including certain derivative instruments

embedded in other contracts, as assets or liabilities in the statement

of financial position and measure them at fair value.\1234\ Another

commenter suggested that scenario hedges could be identifiable and

subject to review by the Agencies using VaR, Stress VaR, and VaR

Exceedance, as well as revenue metrics.\1235\

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\1232\ See, e.g., Japanese Bankers Ass'n.

\1233\ See Barclays.

\1234\ See ABA (Keating); Wells Fargo (Prop. Trading). Although

certain accounting standards, such as FASB ASC Topic 815 hedge

accounting standards, address circumstances in which a transaction

may be considered a hedge of another transaction, the final rule

does not refer to or expressly rely on these accounting standards

because such standards: (i) are designed for financial statement

purposes, not to identify proprietary trading; and (ii) change often

and are likely to change in the future without consideration of the

potential impact on section 13 of the BHC Act.

\1235\ See JPMC.

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The Agencies have considered these comments carefully in light of

the statute. Section 13(d)(1)(C) of the BHC Act provides an exemption

from the prohibition on proprietary trading only for hedging activity

that is ``designed to reduce the specific risks to the banking entity

in connection with and related to'' individual or aggregated positions,

contracts, or other holdings of the banking entity.\1236\ Thus, while

the statute permits hedging of individual or aggregated positions (as

discussed more fully below), the statute requires that, to be exempt

from the prohibition on proprietary trading, hedging transactions be

designed to reduce specific risks.\1237\ Moreover, it requires that

these specific risks be in connection with or related to the individual

or aggregated positions, contracts, or other holdings of the banking

entity.

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\1236\ 12 U.S.C. 1851(d)(1)(C).

\1237\ Some commenters expressed support for the requirement

that a banking entity tie a hedge to a specific risk. See AFR (June

2012); Sens. Merkley & Levin (Feb. 2012); Public Citizen; Johnson &

Prof. Stiglitz.

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The final rule implements these requirements. To ensure that exempt

hedging activities are designed to reduce specific risks, the final

rule requires that the hedging activity at inception of the hedging

activity, including, without limitation, any adjustments to the hedging

activity, be designed to reduce or otherwise significantly mitigate and

demonstrably reduces or otherwise significantly mitigates one or more

specific, identifiable risks, including market risk, counterparty or

other credit risk, currency or foreign exchange risk, interest rate

risk, commodity price risk, basis risk, or similar risks, arising in

connection with and related to identified individual or aggregated

positions, contracts, or other holdings of the banking entity, based

upon the facts and circumstances of the individual or aggregated

underlying and hedging positions, contracts, or other holdings of the

banking entity and the risks and liquidity thereof.\1238\ Hedging

activities and limits should be based on analysis conducted by the

banking entity of the appropriateness of hedging instruments,

strategies, techniques, and limits. As discussed above, this analysis

must include analysis of correlation between the hedge and the specific

identifiable risk or risks that the hedge is designed to reduce or

significantly mitigate.\1239\

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\1238\ See final rule Sec. 75.5(b)(2)(ii).

\1239\ See final rule Sec. 75.5(b)(1)(iii).

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

This language retains the focus of the statute and the proposed

rule on reducing or mitigating specific and identified risks.\1240\ As

discussed more fully above, banking entities are required to describe

in their compliance policies and procedures the types of strategies,

techniques, and positions that may be used for hedging.

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

\1240\ Some commenters represented that the proposed list of

risks eligible to be hedged could justify transactions that should

be considered proprietary trading. See Public Citizen; Occupy. One

commenter was concerned about the proposed inclusion of ``basis

risk'' in this list. See Occupy. As noted in the proposal, the

Agencies believe the inclusion of a list of eligible risks,

including basis risk, helps implement the essential element of the

statutory hedging exemption--i.e., that the transaction is risk-

reducing in connection with a specific risk. See Joint Proposal, 76

FR at 68875. See also 12 U.S.C. 1851(d)(1)(C). Further, the Agencies

believe the other requirements of the final hedging exemption,

including requirements regarding internal controls and a compliance

program, help to ensure that only legitimate hedging activity

qualifies for the exemption.

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The final rule does not prescribe the hedging strategy that a

banking entity must employ. While one commenter urged that the final

rule require each banking entity to adopt the ``best hedge'' for every

transaction,\1241\ the Agencies believe that the complexity of

positions, market conditions at the time of a transaction, availability

of hedging

[[Page 5905]]

transactions, costs of hedging, and other circumstances at the time of

the transaction make a requirement that a banking entity always adopt

the ``best hedge'' impractical, unworkable, and subjective.

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\1241\ See, e.g., Occupy.

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Nonetheless, the statute requires that, to be exempt under section

13(d)(1)(C), hedging activity must be risk-mitigating. To ensure that

only risk-mitigating hedging is permitted under this exemption, the

final rule requires that in its written policies and procedures the

banking entity identify the instruments and positions that may be used

in hedging, the techniques and strategies the banking entity deems

appropriate for its hedging activities, as well as position limits and

aging limits on hedging positions. These written policies and

procedures also must specify the escalation and approval procedures

that apply if a trader seeks to conduct hedging activities beyond the

limits, position types, strategies, or techniques authorized for the

trader's activities.\1242\

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\1242\ A banking entity must satisfy the enhanced documentation

requirements of Sec. 75.5(c) if it engages in hedging activity

utilizing positions, contracts, or holdings that were not identified

in its written policies and procedures.

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

As noted above, commenters were concerned that risks associated

with permitted activities and holdings change over time, making a

determination regarding the effectiveness of hedging activities in

reducing risk dependent on the time when risk is measured. To address

this, the final rule requires that the exempt hedging activity be

designed to reduce or otherwise significantly mitigate, and

demonstrably reduces or otherwise significantly mitigates, risk at the

inception of the hedge. As explained more fully below, because risks

and the effectiveness of a hedging strategy may change over time, the

final rule also requires the banking entity to implement a program to

review, monitor, and manage its hedging activity over the period of

time the hedging activity occurs in a manner designed to reduce or

significantly mitigate and demonstrably reduce or otherwise

significantly mitigate new or changing risks that may develop over time

from both the banking entity's hedging activities and the underlying

positions. Many commenters expressed concern that the proposed ongoing

review, monitoring, and management requirement would limit a banking

entity's ability to engage in aggregated position hedging.\1243\ One

commenter stated that because aggregated position hedging may result in

modification of hedging exposures across a variety of underlying risks,

even as the overall risk profile of a banking entity is reduced, it

would become impossible to subsequently review, monitor, and manage

individual hedging transactions for compliance.\1244\ The Agencies note

that the final rule, like the statute, requires that the hedging

activity relate to individual or aggregated positions, contracts or

other holdings being hedged, and accordingly, the review, monitoring

and management requirement would not limit the extent of permitted

hedging provided for in section 13(d)(1)(C) as implied by some

commenters. Further, the final rule recognizes that the determination

of whether hedging activity demonstrably reduces or otherwise

significantly mitigates risks that may develop over time should be

``based upon the facts and circumstances of the underlying and hedging

positions, contracts and other holdings of the banking entity and the

risks and liquidity thereof.'' \1245\

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\1243\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Barclays;

ICI (Feb. 2012); Morgan Stanley.

\1244\ See Barclays.

\1245\ Final rule Sec. 75.5(b)(2)(iv)(B). The Agencies believe

this provision addresses some commenters' concern that the ongoing

review, monitoring, and management requirement would limit hedging

of aggregated positions, and that such ongoing review of individual

hedge transactions with a variety of underlying risks would be

impossible. See SIFMA (Prop. Trading) (Feb. 2012); Barclays; ICI

(Feb. 2012); Morgan Stanley.

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A number of other commenters argued that a legitimate risk-reducing

hedge may introduce new risks at inception.\1246\ A few commenters

contended that a requirement that no new risks be associated with a

hedge would be inconsistent with prudent risk management and greatly

reduce the ability of banking entities to reduce overall risk through

hedging.\1247\ A few commenters stated that the proposed requirement

does not recognize that it is not always possible to hedge a new risk

exposure arising from a hedge in a cost-effective manner.\1248\ With

respect to the timing of the initial hedge and any additional

transactions necessary to reduce significant exposures arising from it,

one of these commenters represented that requiring contemporaneous

hedges is impracticable, would raise transaction costs, and would make

hedging uneconomic.\1249\ Another commenter stated that this

requirement could have a chilling effect on risk managers' willingness

to engage in otherwise permitted hedging activity.\1250\

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\1246\ See ABA (Keating); BoA; Barclays; Credit Suisse (Se