FDIC Board to Consider Volcker Rule Proposal on October 11th

The FDIC's Board will consider Proposed Rulemaking on the Volcker Rule at its next meeting on Tuesday, October 11, 2011 at 10:00 AM. The FDIC is the first Agency (the others are the Federal Reserve Board, OCC, SEC and CFTC) to consider a Volcker Rule proposal. Industry sources indicate a 60-day comment period is likely. Under Dodd-Frank, the three banking agencies, the SEC and CFTC are to consult and coordinate with each other to ensure consistent application and interpretation of the rules they issue. The three banking agencies are to issue their rules jointly.

What to Expect -- Complexity

Rumors of selected content of the Volcker Rule Proposal have been the subject of recent stories in the financial press with references to a confidential multi-agency 174-page staff document. The one thing that everyone can be sure of is that the rules will be complex. The Volcker Section 619 of Dodd-Frank is one of the most challenging financial regulatory provisions ever written, dealing with highly technical complex legal matters crossing banking, capital markets and investment management rules. The proposal has been anxiously awaited because it is the type of legislation where a definition or phrase interpreted one way or the other can have significant impact. While on its own Section 619 would be a worthy study for Talmudic scholars, complicate this with five agencies having to write the rules and you have geometric expansion of complexity.

Based on our informal soundings with interested private parties, and with the warning that everything is subject to change, there is some optimism on the hedge fund and PE fund investment side that the agencies may be inclined to interpret "hedge fund" to exclude acquisition vehicles, joint ventures, wholly-owned subs and other entities clearly inappropriate to cover, but doubts persist about how far the agencies may be willing to go on excluding foreign funds and other entities for which industry was seeking exclusion from coverage. Better news seems to be that the Agencies may not press hard initially on inclusion of "similar funds" and may be more willing to narrow PE fund reach. Super 23A may be adjusted to cure circularity of definitions under BHC Act, but basically has been left in the hands of the Fed and its expertise and experience in this area. Definition of customer for limited hedge fund "asset management" exception may include some elements of the substantive pre-existing relationship favored by industry and afford some leeway. Some optimism on exemption of BOLI/ COLI from hedge fund definition due to intense and widespread industry opposition. Less optimism on prop trading ban, since a lot of pressure from some on capitol hill to interpret very narrowly. Likelihood that fine lines will have to be drawn between permissible market-making, hedging and underwriting and when these activities provide indicia of proprietary trading.

SEC Proposal on Conflicts in Securitizations Also Grapples with Defining Hedging and Market-Making and Possible Alignment with Volcker Rule

The SEC issued a proposed rule in late September to implement Section 621 of DF Act prohibiting material conflicts of interest in certain securitizations. The focus of the SEC definition of material conflict of interest is intended to prohibit activities in which a securitization participant engages in transactions through which it benefits when the related ABS fails or performs adversely or has that potential and a reasonable investor would consider the fact of such benefit important to his or investment decision. The SEC notes that the DF Act provides exceptions to the prohibitions in Section 621 for risk-mitigating, hedging activities and bona-fide market making. The SEC requests comment specifically on whether aspects of the Volcker rule in Section 619 and the exemptions in Section 621 should be aligned -- the SEC indicates its own view that the exceptions for hedging and bona-fide market-making in 621 should be viewed "no less narrowly" than in Volcker. The SEC views the Volcker Rule and Section 621 as both aimed at preventing conflicts of interest -- a logical view for an agency charged with market regulation and investor protection. The focus of the banking agencies on Volcker has been more on reducing risk to the financial system -- their key role. The Volcker proposal is thus likely to capture these different approaches with perhaps more deference to the banking agencies on risk and to the SEC and CFTC on market conduct aspects.

  • The SEC's interpretation of hedging. Among the activities viewed as not qualifying for hedging in the SEC's discussion of the exception in Section 621 are (i) trading to establish new positions designed to earn a profit, (ii) over-hedged exposure which may be indicative of a proprietary position, (iii) intermittent activity (hedging only when one chooses to act) as being indicative of proprietary trading, (iv)the hedge should not be significantly greater than actual exposure to the underlying assets, and (v) activity would not qualify as hedging if the length of time the hedge and related position were held would result in the securitization participant earning appreciably more from the hedge than the losses incurred from their ABS exposure. The SEC seeks comments on these and other issues under hedging in Section 621.
  • The SEC's interpretation of market-making. The SEC lays out a series of principles that it considers "characteristic of bona fide market-making in ABS:
  • It includes purchasing and selling the ABS from or to investors in the secondary market
  • It includes holding oneself out as willing and available to provide liquidity on both sides of the market (i.e., regardless of the direction of the transaction)
  • It is driven by customer trading, customer liquidity needs, customer investment needs, or risk management by customers or market-makers.
  • It generally is initiated by a counterparty and if a customer initiated a customized transaction, it may include hedging if there is no matching offset.
  • It does not include activity that is related to speculative selling strategies or investment purposes of a dealer, or that is disproportionate to the usual market-making patterns or practices of the dealer with respect to that ABS.
  • Absent a change in a pattern of customer driven transactions, it typically does not result in a number of open positions that far exceed the open positions in the historical normal course of business
  • It generally does not include actively accumulating a long or short position other than to facilitate customer trading interest.
  • It generally does not include accumulating positions that remain open and exposed to gains or losses for a period of time instead of being closed out promptly. In contrast, an aged open position taken to facilitate customer trading interest would be hedged rather than exposed to gains and losses for a period of time.

The SEC also notes that whether trading is carried out in a market-making account or desk would not be determinative.

For more information on PwC's Financial Services Regulatory Practice, visit www.pwcregulatory.com.

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