June 5, 2018

U.S. Securities and Exchange Commission Inter-Agency Proposal for Amendments to the Volcker Rule

Key Topics & Takeaways

  • Volcker Rule: The proposal was agreed to in a 3-2 vote with Commissioners Stein and Jackson in opposition. The proposal recommends not imposing different regulatory and compliance obligations on different banking entities based on the size of their consolidated trading assets and liabilities, eases the exemptions allowing market-making and underwriting activities, and seeks comment on the definition of covered funds. The proposal pares back the requirements of the Volcker rule, but all banking entities will still be subject to the prohibition on proprietary trading. 

Proposed Amendments to the Volcker Rule

SEC Chairman Clayton began by expressing his gratitude to the SEC staff and briefly covered the three proposals, which were initially on the agenda for this open meeting, the Commission approved yesterday. In the three related releases, the Commission provided a new “notice and access” method of delivering fund shareholder reports, requested comments on improving fund disclosure and requested comments on the fees that intermediaries charge for delivering fund reports.

Clayton then turned to the agenda for this meeting and began by thanking the SEC Staff and other agencies on their collaborative efforts. In 2013, the Federal Reserve, OCC, FDIC, CFTC and SEC adopted a rule that generally prohibits banking entities from engaging in proprietary trading or sponsoring or investing in a hedge fund or a private equity fund. Since adoption of this rule, the banking entities and regulators have gained experience, which led to this opportunity to tailor the implementation of the rule. Clayton stated that to effectively implement Volcker rule, regulators should not assume that one size does fits all and argued they should tailor the rule to the size and risk profile of firms to facilitate compliance.

Over the course of the last week, the proposal considered today has been approved by the Federal Reserve, OCC, FDIC, and CFTC. The proposal seeks to simplify and tailor the 2013 rule. The proposal will reduce compliance for small and mid-size banks, seeks public input on ways to better tailor the rules on definition of “covered funds” and requests comment on all aspects of the proposed revisions and ways to effectively implement Volcker rule. Clayton also discussed his conversation with Pete Driscoll of the Office of Compliance, Inspections and Examinations where Driscoll told Clayton that the proposed amendments reflects their experience examining large firms and would make examinations of internal controls more effective.

Brett Redfearn, the SEC’s Director of the Division of Trading and Markets, stated that the Divisions of Trading and Markets and Investment Management recommend adoption of this proposal. The Volcker rule was adopted to prevent banks from engaging in risky investments and did this by restricting banking entities ability to engage in proprietary trading and investing in and associating with hedge funds and private equity funds. This proposal represents a joint effort between five agencies and corresponds with the goals of S.2155, the Economic Growth, Regulatory Relief, and Consumer Protection Act, which became law on May 24, 2018. Redfearn highlighted that key areas of the proposal will categorize banking entities by trading assets and liabilities, modify the requirements of exemptions for market making and underwriting activities and request comments on the definition of a covered fund and ways to improve the prohibition on investment in covered funds.

Sam Litz of the SEC’s Division of Trading and Markets Staff gave an overview of the proposal’s tailoring of the scope of applicability. The proposal will divide banking entities into three categories based on trading assets and liabilities, each of which is subject to different compliance programs. The “significant” category includes banking entities with $10 billion or more of consolidated assets and liabilities and represents 95% of the trading activity. Entities in this category must establish a robust compliance program and specific compliance program requirements for market making and underwriting exemptions. The “moderate” category includes entities with less than $10 billion but equal to or above $1 billion of consolidated trading assets and liabilities, which combined with the first group, represents 98% of the activities. This group is subject to a reduced compliance program requirement but, along with the first group, retains the CEO attestation requirement. The “limited” category includes entities with consolidated trading assets and liabilities of less than $1 billion. Entities in this group are presumed to be in compliance with the rule and have no obligation to affirmatively demonstrate compliance on an ongoing basis.

Sophia Cotes of the SEC’s Division of Trading and Markets Staff discussed the proprietary trading aspects of the proposal. As under the 2013 rule, the proposed rule provides a multi-prong test to determine whether a financial transaction is within the definition of proprietary trading. The proposal eliminates the short-term intent prong and replaces it with an accounting-based prong that captures a financial instrument trade recorded at fair value. The proposal includes changes to the permitted exemptions to mitigate hedging and market making activities. This tailoring of the rule includes creating a presumption that the banking entity’s market-making and underwriting activities are presumed to meet the reasonably-expected near-term demand (RENTD) requirement if the entity has applicable risk limits. The proposal establishes a new exclusion of the definition of proprietary trading for bona-fide trading error.

Matthew Cook of the SEC’s Division of Investment Management Staff discussed the proposal’s amendments to the covered funds provisions. The proposal removes the requirement that banking entities deduct the value of ownership interests in a covered fund under the underwriting or market making activities exemption. The proposal amends the foreign fund exemption by codifying the issued FAQ guidance that allows covered fund activities conducted solely outside of the US. The proposal requests comments on all aspects of this proposal and on the definition of covered funds and ways to further tailor the rule.

Chyhe Becker, the SEC’s Acting Chief Economist and Acting Director of the Division of Economic Risk and Analysis (DERA) gave a brief overview of DERA’s analysis on the amendments to reduce compliance and reporting requirement and scope for certain entities. Becker stated that the Volcker has led to complex compliance review and the current prohibitions and restrictions may include some participants that do not pose serious risks. With this proposal, all banking entities will continue to be subject to proprietary trading prohibition and the proposed amendments will ease market-making, underwriting and foreign entity activities. Becker stated that these changes could facilitate risk taking but will reduce burdens on some entities and may increase competition.

Commissioner Stein began with a quote, which she later revealed to be from DERA’s analysis, which stated that the proposed amendment could increase moral hazard by allowing banks to engage in proprietary trading activities that are economically equivalent to what led to the financial crisis.

Commissioner Stein then gave a historical overview of previous times of market stress in the past three decades where the Federal Reserve had to intervene to stop contagion. Stein initially discussed Black Monday, where the markets suffered a 20% drop partially caused by rapid trading related to portfolio insurance which was sold to funds as hedging strategy. This compounded trading when risk-arbitragers, mutual funds and holders of portfolio insurance were all forced to sell. In September 1998, the Federal Reserve had to intervene once again due to Long-Term Capital Management’s risky trading strategies and highly leveraged incorrect assumptions for its arbitrage strategies. This intervention lead to moral hazard from the market expecting the Federal Reserve to intervene during all times of market stress. Stein Placed the Federal Reserve’s and Treasury’s actions in 2008 in this historical context to argue against the rule.  Stein recapped this history to help refresh the events that led to the passage and enactment of Dodd Frank and the Volcker rule to limit banks’ ability to place risky bets with customer deposits.

Commissioner Stein stated that this proposed amendment eases banks’ ability to take on greater trading activities and will likely lead to another financial crisis and then discussed her three major concerns with the proposal. First, Stein believes the proposed amendment allows banks to engage in risking trading strategies by expanding the exemptions for hedging activity. Stein stated that the proposal allowing banks to easily classify any trade a hedge, regardless whether it reduces risk, runs counter of the basic objectives of the Volcker rule and banks must be required to prove that its hedge reduces or mitigates its risk.  Second, Stein is concerned with burdening competition by allowing institutions with access to FDIC insurance and Federal Reserve funding to be able to engage in risky trading activities. Third, Stein does not think its effective to presume that banks are in compliance because the presumption reduces the likelihood of actual compliance.

Commissioner Stein stated that she cannot support the proposal because she believes this proposal could increase moral hazard. Stein quoted DERA’s analysis, which stated that this proposal allows positions that are economically the same as prior to adoption of the Volcker rule. Stein stated that many participants will claim that this proposal “tailors” and “streamlines” the rule but expressed her belief that this is a significant change that should not be enacted.

Commissioner Piwowar thanked the staff for the work on this proposal and spent his time speaking on the other items that were on the original agenda. Piwowar expressed his support of Rule 30e-3 of the Investment Company Act, which was approved by the Commission.

Commissioner Jackson reiterated Commissioner Stein’s concerns and opposed this proposal as it will “muddy the waters” for three reasons. First, Jackson opposes this proposal because it runs counter to Congressional intent to ban proprietary trading. Second, Jackson opposes pulling back the Volcker rule three years after requiring full compliance (in July 2015). Third, Jackson believes that putting depositors and taxpayers’ money at risk does not make sense, and that regulators should not provide incentives for people to take risks.

Commissioner Jackson expressed his support for separating risk-taking activities from those backed by the government and recommends enacting Section 956 of Dodd-Frank to adjust pay practices to reduce taking excessive risk before paring back parts of the rule. Jackson stated that any attempts to weaken the Volcker rule will increase risk and that policymakers should instead focus on prohibiting paying traders based on proprietary trading profits. Additionally, Jackson stated that the Commission’s analysis of costs should address how markets will respond to this proposal rather than the cost of the compliance.

Commissioner Peirce expressed her support for the proposal of the adoption of Rule 30e-3 and discussed the current proposal and then expressed her shared concerns that Volcker seeks to prevent excessive risk taking and financial contagion but thinks there is a better way to do this than the current version of the Volcker rule. Peirce stated that the Volcker rule created complexity and lead to market participants avoiding permitted activities due to the uncertainty and difficulty in separating permitted from prohibited activities. Peirce discussed the importance of market making and hedging activities and stated that during periods of market stress we can see the harm from having fewer market makers. Additionally, Peirce stated that the cost of compliance with the Volcker causes firms to spend significant amounts of money to comply and creates a missed opportunity to invest in other areas.

Peirce expressed her support for this proposal because these important improvements mitigates the negative effects of the rule and will ultimately improve the economy, but this proposal does not absolve her concerns with the rule. The proposal modifies the metrics for underwriting and market making activities which creates more burdensome requirements that lack adequate justification for why the data is necessary rather than convenient or interesting. Notwithstanding these concerns, Peirce expressed her support for this proposal to avoid creating a regulatory frame-work that adds risk to the ecosystem.

The Commission then voted 3-2 to approve the proposal with Chairman Clayton and Commissioners Piwowar and Peirce voting yes and Commissioners Stein and Jackson voting no.

For more information on this meeting, please click here.