United States: An Overview Of The Volcker Rule

Last Updated: September 14 2017
Article by Eric S. Yoon


This practice note provides an overview of the Volcker Rule, which was enacted in 2010 as Section 619 of the comprehensive Dodd- Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) and codified as the new Section 13 of the Bank Holding Company Act of 1956 (BHC Act), 12 U.S.C. §1851. The final regulations implementing the Volcker Rule, which were proposed by the responsible U.S. federal agencies—the Board of Governors of the Federal Reserve System (Federal Reserve), the Commodity Futures Trading Commission (CFTC), the Securities and Exchange Commission (SEC), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC)—were promulgated on December 10, 2013, and became effective on April 1, 2014. 12 C.F.R. Parts 44, 248 and 351; 17 C.F.R. Parts 75 and 255.

The Volcker Rule essentially contains two prohibitions aimed at "banking entities": A banking entity may not (1) engage in "proprietary trading" or (2) as principal, directly or indirectly, acquire or retain any ownership interest in, or sponsor, "covered funds," which essentially are private equity funds and hedge funds. The Rule is named after former Federal Reserve chairman Paul A. Volcker Jr., who proposed these restrictions under the stated belief that certain types of speculative activities—namely, the types intended to be covered under the Rule—had contributed to the onset of the financial crisis of 2007–2010.

The following banking entities are subject to the Volcker Rule:

  • Any insured depository institution (i.e., any bank or savings association the deposits of which are insured by the FDIC)
  • Any company that controls an insured depository institution
  • Any company that is treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978 (i.e., any foreign banking organization that is a registered bank holding company or has a U.S. branch, agency, or commercial lending company subsidiary, but not merely a representative office)
  • Any affiliate or subsidiary of any of the foregoing entities

As the last bullet indicates, the definition of a banking entity encompasses a surprisingly broad range of entities. It may not seem intuitive to include some of these entities within such definition. For instance, suppose your client is a foreign insurance company with no U.S. presence, and the ultimate parent of this insurance company is a foreign holding company that has a local bank subsidiary with a small branch in New York City. That holding company and each of its subsidiaries worldwide, including your client insurance company, is a banking entity within the meaning of the Volcker Rule and therefore is subject to the Volcker Rule prohibitions and restrictions described in this practice note.

"Proprietary trading," the first of the two restricted activities under the Volcker Rule, is defined very broadly to cover purchase or sale, as principal, of "financial instruments" (again, defined rather broadly) by a banking entity for one of its "trading accounts." Similarly, the second Volcker Rule-mandated restriction—direct or indirect acquisition or retention of any "ownership interest" in, or sponsorship of, a "covered fund" by banking entities—on its face curbs a bewildering array of fund formation / investment management activities. Moreover, each banking entity must have in place a compliance program reasonably designed to ensure and monitor compliance with the prohibitions and restrictions under the Volcker Rule. The compliance program must include, among other things, written policies and procedures reasonably designed to document, describe, monitor, and limit the activities in question;

a system of internal controls reasonably designed to monitor compliance; independent testing and audit; and a minimum five- year record maintenance requirement. In counseling your banking entity clients regarding the risk of noncompliance, you should also remind them that because the Volcker Rule has been codified as part of the BHC Act, this statute's civil and criminal sanctions regime could apply to contraventions and violations of the Rule.

Recognizing the risk of overregulation, as well as the heightened compliance burden, associated with this vastly complicated rule, Congress and the federal agencies charged with implementing and enforcing the Volcker Rule have attempted to lessen the unintended consequences of the Volcker Rule in two principal ways. First, there are definitional exclusions, both statutory and regulatory, from broadly defined terms such as "financial instrument," "trading account," "covered fund," and "ownership interest." Second, there is a fairly broad array of exemptions for certain types of activities and investments—presumably those that fall safely outside the speculation-curbing intent behind this regime—that remain within the defined proscriptions and therefore would otherwise be impermissible for banking entities. This practice note provides a general summary of the definitional exclusions and policy-driven exemptions regarding (1) proprietary trading and (2) investment in and sponsorship of covered funds, in that order.

Legislative and Regulatory Update

Financial CHOICE Act. The Financial CHOICE Act (CHOICE Act), a bill that was introduced to Congress in April 2017 (H.R. 10), would, if enacted in its current form, bring about significant changes to the U.S. financial regulatory system by rolling back many provisions of the Dodd-Frank Act. One of the stated goals of the CHOICE Act, according to an executive summary published by the House Financial Services Committee, is to "unleash opportunities for small businesses, innovators, and job creators by facilitating capital formation." https://financialservices.house.gov/uploadedfiles/financial_choice_act_executive_summary_final.pdf. The bill aims to achieve this goal by repealing, in their entirety, various sections of the Dodd-Frank Act that "limit or inhibit capital formation," including the Volcker Rule.

The CHOICE Act bill passed the House of Representatives on June 8, 2017, essentially along party lines, with 233 Republicans voting in favor of passage, and 185 Democrats (and one Republican) voting against it. The bill next goes to the Senate, where its prospects for passage are unclear at the time of this update to this practice note (July 5, 2017).

In a related development, the U.S. Treasury Department issued in June 2017 a document titled "A Financial System That Creates Economic Opportunities Banks and Credit Unions." http://c.ymcdn.com/sites/www.iib.org/resource/resmgr/Executive_ Orders/20170612EO13772Report.pdf. This document was a report in response to President Trump's Executive Order 13772 of February 3, 2017, which established the policy of his administration to regulate the U.S. financial system in a manner consistent with a set of "Core Principles" set forth therein. The Treasury report identified laws, treaties, regulations, guidance, reporting and record keeping requirements, and other government policies that it said "inhibit Federal regulation of the U.S. financial system."

The Treasury report contains a detailed list of recommendations to Congress and federal agencies to further this aim. Some of the salient recommendations in the report for "improving the Volcker Rule" include revisions to the following provisions (all of which are discussed below in this practice note):

  • Exempt from the Volcker Rule banking entities with $10 billion or less in assets.
  • Exempt from the proprietary trading prohibitions of the Volcker Rule banking entities with over $10 billion in assets that are not subject to the market risk capital rules.
  • Eliminate the 60-day rebuttable presumption from the definition of proprietary trading.
  • Regulators should give banks additional flexibility to adjust their determinations of the reasonable amount of market-making inventory:
  • For illiquid securities, banks should have greater leeway to anticipate changes in markets.
  • For over-the-counter derivatives, regulators should focus more on ensuring that banks appropriately hedge the positions they maintain.
  • Banks that have not yet established a market-making presence in a particular asset class should have more discretion to meet the reasonably expected near-term demands (RENTD) condition.
  • Banking entities should be able to enter into block trades even if they involve a trading volume outside of historical averages.
  • Eliminate the requirement to maintain documentation of the specific assets and risks being hedged.
  • The existing "enhanced" compliance program under the regulations should apply only to those banking entities with at least $10 billion in trading assets and liabilities on a consolidated basis; the current application is to all banking entities with over $50 billion in total consolidated assets.
  • Banks should be given greater ability to tailor their compliance programs to the particular activities engaged in by the bank and the particular risk profile of that activity.
  • Regulators should adopt a simple definition of covered funds that focuses on the characteristics of hedge funds and private equity funds with appropriate additional exemptions as needed.
  • The exemptions in Section 23A of the Federal Reserve Act should be restored in the Volcker Rule so that they apply to banking entities' transactions with their covered funds.
  • The initial "seeding period" exemption from the covered funds investment restriction should be extended to three years, rather than one year, to provide banking entities with additional time to stand up new funds and allow them to establish the track records they need to attract investors.
  • Banking entities other than depository institutions and their holding companies should be permitted to share a name with funds they sponsor, provided that the separate identity of the funds is clearly disclosed to investors.
  • An exemption of the Volcker Rule's definition of banking entity should be provided for foreign funds owned or controlled by a foreign affiliate of a U.S. bank or a foreign bank with U.S. operations.
  • Consideration should be given to permitting a banking entity that is sufficiently well-capitalized—such that the risks posed by its proprietary trading are adequately mitigated by its capital—to opt out of the Volcker Rule altogether, if the institution remains subject to trader mandates and ongoing supervision and examination to reduce risks to the safety net.

If the CHOICE Act can be likened to a blunt instrument in its approach to "reform" the Volcker Rule—that is, to repeal it in its entirety— then the Treasury report takes a more surgical approach while leaving the general regulatory architecture of the Rule intact. Also, in preparing the report the Treasury consulted not only with member agencies of the Financial Stability Oversight Council (including the Federal Reserve), but also with a wide range of stakeholders such as trade groups, financial services firms, consumer and other advocacy groups, academics, financial markets utilities, and rating agencies and, as such, the document likely reflects a broader consensus among various interested parties. For these reasons, lawyers who represent financial institutions would be well- advised to monitor in the coming months, if not years, how some of Treasury's recommendations in the report may evolve into legislative and regulatory proposals.

Coordinated Reviews for Qualifying Foreign Excluded Funds. On July 21, 2017, five federal financial regulatory agencies, including the Federal Reserve, announced that they are coordinating their respective reviews of the treatment of certain foreign funds under the Volcker Rule. These "foreign excluded funds" are investment funds organized and offered outside of the United States that are excluded from the definition of "covered fund" and, as such, the restrictions of the Volcker Rule generally would not apply to investments in, or sponsorship of, such funds by a foreign banking entity.

However, complexities in the statute and the implementing regulations may result in certain foreign excluded funds becoming subject to the Volcker Rule and, as such, a number of foreign banking entities, foreign government officials, and other market participants have expressed concern about possible unintended consequences and extraterritorial impact. In particular, they have contended that certain foreign excluded funds may fall within the definition of "banking entity" under the Volcker Rule if they are an affiliate of a foreign banking entity under the BHC Act by virtue of typical corporate governance structures for funds sponsored by a foreign banking entity in a foreign jurisdiction or by virtue of investment by the foreign banking entity in the fund. For instance, where a foreign banking entity owns a large amount of the fund, selects the board of directors of the fund, or acts as general partner or trustee of the fund, the foreign bank may be deemed by law to "control" the foreign fund. A foreign fund thus deemed to be controlled by a foreign banking entity would be an affiliate of the foreign bank under the BHC Act, and the statute by its terms subjects an affiliate of a banking entity to the restrictions on covered fund and proprietary trading activities in the United States.

The July 21, 2017 announcement stated that staffs of the five federal agencies are considering ways in which the implementing regulation may be amended, or other appropriate action may be taken, to address any unintended consequences of the Volcker Rule for foreign excluded funds in foreign jurisdictions. The announcement left open the possibility that Congressional action may be necessary to fully address the issue.

The announcement further noted that, in order to provide additional time, the Federal Reserve, the OCC and the FDIC will not propose to take action during the one-year period ending July 21, 2018, against a foreign banking entity based on attribution of the activities and investments of qualifying foreign excluded funds to the foreign banking entity, or against a qualifying foreign excluded fund as a banking entity, in each case where the foreign banking entity's acquisition or retention of any ownership interest in, or sponsorship of, the qualifying foreign excluded fund would meet the requirements for permitted covered fund activities and investments solely outside the United States, as more fully described below in this practice note.

Proprietary Trading

Nature of the Proprietary Trading Prohibition

The first part of the Volcker Rule prohibits a banking entity from engaging in proprietary trading. "Proprietary trading" is defined to mean engaging as principal for the "trading account" of the banking entity in any purchase or sale of one or more financial instruments.

"Financial instrument" includes a security, a derivative, and a contract of sale of a commodity for future delivery, or an option on any of the foregoing. The term "security" includes any note, stock, security future, bond, debenture, certificate of interest, or participation in any profit-sharing agreement, any collateral-trust certificate, certificate of deposit for a security, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities, or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or in general, any instrument commonly known as a "security." The term "derivative" includes any swap (as defined in the Commodity Exchange Act), security-based swap (as defined in the Securities Exchange Act of 1934), purchase or sale of a commodity for deferred delivery that is intended to be physically settled, or any foreign exchange forward or foreign exchange swap. Swaps include ISDA master agreements.

In other words, financial instruments cover an extensive array of financial products and contracts. The term financial instrument, however, does not include:

  • A loan
  • A commodity, unless it is (1) an excluded commodity (other than foreign exchange or currency), (2) a derivative, (3) a contract of sale of a commodity for future delivery, or (4) an option on a contract of sale of a commodity for future delivery
  • Foreign exchange or currency


The term trading account is also defined broadly. If an account meets one of the following three tests, then such account is a trading account under the Volcker Rule:

  • Purpose test. Is the account used to purchase or sell financial instruments principally for the purpose of (1) short-term resale, (2) benefitting from actual or expected short-term price movements, (3) realizing short- term arbitrage profits, or (4) hedging one or more positions resulting from the purchases or sales described in (1) through (3)? The purchase/sale of a financial instrument is presumed to be for the trading account if the banking entity holds the instrument for fewer than 60 days or substantially transfers the risk of the instrument within 60 days of the purchase/sale, unless the banking entity can demonstrate that it did not purchase/sell the instrument principally for any of the aforementioned purposes.
  • Dealer registration test. If the account is used by a banking entity to purchase/sell financial instruments for any purpose, is the banking entity (1) a U.S. licensed or registered securities dealer, swap dealer, or security-based swap dealer, to the extent the instrument is purchased/sold in connection with the activities that require the banking entity to be so licensed or registered; or (2) 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/sold in connection with the activities of such business? If the answer to either of the foregoing questions is yes, then the account in question is a Volcker Rule trading account.
  • Market risk capital rule test. If the account is used to purchase/sell financial instruments that are both market risk capital rule covered positions and trading positions (or hedges of other market risk capital rule covered positions), is the banking entity or any affiliate thereof an FDIC-insured depository institution, bank holding company, or savings and loan holding company that calculates risk-based capital under the market risk capital rule? Again, if the answer to this question is yes, then the account is a trading account.

Exclusions from the "proprietary trading" definition. The following types of transactions are not deemed to constitute proprietary trading and therefore are outside the purview of the Volcker Rule prohibition on the same:

  • Repo and reverse repo transactions
  • Securities lending transactions
  • Purchase/sale pursuant to a liquidity management plan. The liquidity management plan must be documented; specifically contemplate and authorize the particular securities to be so used; and specify the permissible amount, types, and risks of the attendant securities (e.g., must be highly liquid securities).

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