The Volcker Rule defines 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.” Under both the 2013 regulations implementing the Volcker Rule (2013 Final Rule) and the 2019 Final Rule, trading account is defined using a three-prong test:

Under the 2013 Final Rule, trading desk was defined 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.” Consistent with the 2018 Proposal, the revised trading desk definition introduces a multi-factor approach that seeks to align the definition with the criteria used to establish trading desks for other operational, management, and compliance purposes.

Additionally, the revised definition includes a second prong that requires banking entities subject to the market risk capital rule (or that are consolidated affiliates for regulatory reporting purposes of a banking entity subject to the market risk capital rule) to adopt the same delineation of trading desks for purposes of the Volcker Rule as they adopt under the market risk capital rule. Although the current market risk capital rule does not include a definition of trading desk, the federal banking agencies indicated that they expect to implement the Basel Committee on Banking Supervision’s revised market risk capital standards, which include this definition.

The 2019 Final Rule provides for exclusions to the proprietary trading definition relating to:

The 2013 Final Rule provided an exemption from the prohibition against proprietary trading for risk-mitigating hedging activities that are designed to reduce the specific risks to a banking entity in connection with, and related to, individual or aggregated positions, contracts, or other holdings. In response to comments that the requirements to conduct “correlation analysis” and to show that risk-mitigating hedging activity “demonstrably reduces or otherwise significantly mitigates” specific risks were too onerous, the 2019 Final Rule gives banking entities additional flexibility.

Banking entities with significant trading assets and liabilities now may justify their reliance on the exemption using any type of analysis and independent testing designed to ensure that risk-mitigating hedging activities are reasonably expected to reduce or otherwise significantly mitigate specific risks to the banking entity. Other banking entities no longer must undertake this analysis to justify their reliance on the exemption.

Further, the 2019 Final Rule removes language requiring that banking entities show that risk-mitigating hedging activities “demonstrably” reduce or otherwise significantly mitigate specific risk, instead merely requiring that hedging activity be reasonably expected to reduce such risk. For all banking entities, however, hedging activities still must be subject to ongoing recalibration to ensure compliance with the exemption.

The 2019 Final Rule also tailors compliance requirements to a banking entity’s trading activities. These changes are most favorable for banking entities without significant trading assets and liabilities. For these banking entities, the 2019 Final Rule eliminates the requirements for:

For banking entities with significant trading assets and liabilities, compliance requirements also are streamlined, but to a lesser extent. These banking entities still must comply with enhanced documentation requirements regarding their cross-desk and aggregated hedges. However, the 2019 Final Rule adds an exception to the enhanced documentation requirements for financial instruments identified on a written list of pre-approved financial instruments commonly used by the trading desk for the specific type of hedging activity at issue, as long as the hedging activity complies with appropriate written, pre-approved limits for that trading desk at the time a financial instrument is purchased or sold. Banking entities with less than significant trading assets and liabilities will not be required to comply with these enhanced documentation requirements.

The Volcker Rule permits certain foreign banking entities to engage in proprietary trading activities that occur solely outside of the US. The 2013 Final Rule included several conditions to use the TOTUS exemption. In particular:

The 2019 Final Rule eliminates some of these conditions, including the own ANE and counterparty ANE limitations, refocusing the TOTUS exemption on where decisions are made as compared to where personnel who are engaged in arranging and negotiating transactions are based. In particular, a foreign banking entity may trade in reliance on the TOTUS exemption if both:

The 2019 Final Rule therefore also eliminates the 2013 Final Rule’s requirement that no financing for the banking entity’s purchases or sales is provided, directly or indirectly, by any branch or affiliate that is located in the US or organized under US law. Further, the TOTUS exemption does not preclude a foreign banking entity from engaging a non-affiliated US investment adviser, as long as the actions and decisions of the banking entity as principal occur outside of the US. These modifications provide greater flexibility to foreign banking entities that rely on the TOTUS exemption, thereby implementing the statute’s extraterritorial limit for the Volcker Rule.

The 2013 Final Rule provided an exemption to the covered fund prohibition for underwriting or market-making in covered fund ownership interests provided that certain conditions were satisfied. One condition required the banking entity to incorporate the aggregate value of all ownership interests of a third-party covered fund in its aggregate 3% of tier 1 capital limit and capital deduction requirement.

Under the 2019 Final Rule, banking entities no longer are required to include the value of ownership interests in third-party covered funds held as underwriting or market-making positions for purposes of the 3% aggregate limit and capital deduction requirement. The agencies made this change to align more closely the requirements for underwriting or market-making in covered funds interests with the requirements for engaging in these activities with respect to other financial instruments and to mitigate compliance challenges with the 2013 Final Rule’s exemption.

A third-party covered fund for this purpose is one that the banking entity does not sponsor, advise, or acquire or retain an ownership interest in pursuant to the asset management exemption or the asset-backed securities issuer exemption. Under the 2019 Final Rule, directly or indirectly guaranteeing, assuming, or otherwise insuring the obligations or performance of the covered fund (or any covered fund in which such fund invests) would no longer require the banking entity to treat the covered fund as a “related” (not third-party) covered fund for purposes of this exemption.

In response to comments, the agencies will continue to consider whether the approach adopted in the 2019 Final Rule for third-party covered funds should be extended to other covered funds, such as advised funds, and intend to address this issue in a future covered funds proposal. The agencies also will consider comments made regarding the treatment of parallel covered fund investments.

The 2013 Final Rule permitted only hedging activities involving ownership interests in covered funds for hedging of certain employee compensation arrangements and did not include a broader hedging exemption to facilitate customer-facing activity. Under the 2019 Final Rule, banking entities are permitted to acquire or retain an ownership interest in a covered fund as a hedge when acting as an intermediary on behalf of a customer that is not itself a banking entity to facilitate exposure by the customer to the profits and losses of the covered fund. As a result, banking entities are permitted to hold covered fund interests to hedge fund-linked products.

In contrast to statements made when adopting the 2013 Final Rule, the agencies state that they do not believe that this type of hedging activity “necessarily” constitutes a high-risk trading strategy that could threaten the safety and soundness of the banking entity (any activity that meets this standard should be permitted under the so-called prudential backstops). The agencies caution, however, that the exemption is meant only for customer-driven transactions. A banking entity cannot rely on this exemption to solicit customer transactions to facilitate the banking entity’s own exposure to a covered fund.

The 2019 Final Rule also adopts the same amendments to align this exemption with the revised proprietary trading hedging exemption by eliminating the requirement that a risk-mitigating hedging transaction “demonstrably” reduce or otherwise significantly mitigate the relevant risks.

Foreign banking entities benefit from an exemption to the covered funds prohibition for covered fund investments and sponsorship that occurs solely outside of the US. Just as for the TOTUS exemption, the 2019 Final Rule removes the condition that had prohibited a US branch or affiliate from providing financing for the foreign banking entity’s ownership or sponsorship under the SOTUS exemption. The SOTUS exemption does not preclude a foreign banking entity from engaging a non-affiliated US investment adviser, as long as the actions and decisions of the banking entity as principal occur outside of the US.

The 2019 Final Rule also codifies the marketing restriction guidance of the agencies’ Volcker Rule FAQ No. 13 (available at federalreserve.gov), which provides that the SOTUS exemption is available for investing in covered funds, as long as the foreign banking entity does not participate in the offer or sale of ownership interests to US residents. Consistent with FAQ No. 13, if the foreign banking entity sponsors or advises a covered fund, the foreign banking entity would be deemed to participate in any offer or sale of the covered fund ownership interests for purposes of this exemption.

The Volcker Rule includes the so-called Super 23A restriction, which prohibits “covered transactions” (as defined in Section 23A of the Federal Reserve Act) between a banking entity that sponsors, advises, or manages a covered fund (or any of such banking entity’s affiliates) and the covered fund and any covered fund controlled by the first covered fund. The Super 23A provisions in the 2013 Final Rule included an exemption for certain prime brokerage transactions.

One of the conditions to this exemption is that the banking entity’s CEO certify in writing annually that the banking entity does not, directly or indirectly, guarantee, assume, or otherwise insure the obligations or performance of the covered fund or of any covered fund in which the covered fund invests. The 2019 Final Rule codifies the agencies’ Volcker Rule FAQ No. 18 (available at federalreserve.gov) by providing that a banking entity must provide the CEO certification annually no later than March 31 of each year.

For more information on Section 23A covered transactions, see Practice Note, Affiliate Transaction Restrictions for Banks.