After more than 760 days since a rule proposal was published in the Federal Register, five regulatory agencies are in the process of voting today on a final version of the Volcker Rule, a long-gestating ban on proprietary trading by banks that was included in the Dodd-Frank Act.

This morning, the Federal Deposit Insurance Corp. and Board of Governors of the Federal Reserve unanimously voted in favor of the final rule. The Securities and Exchange Commission, voting privately vote by paper ballot, approved the rule by a 3-2 vote. The Commodity Futures Trading Commission, which initially planned a public meeting to discuss the rule, instead had members vote by written private ballot due to stormy weather in Washington D.C. The Office of the Comptroller of the Currency also approved the rule.

Aside from advance leaks, the votes provided the first, comprehensive view of what the new rule includes. Some highlights:

What is Prohibited?

The rule prohibits a banking entity from engaging in proprietary trading, defined as the purchase or sale of any security, derivative, option, or commodity contract for near- or short-term price movements. The final rule clarifies the definition of covered funds and makes clear the prohibition on banks' relationships with high-risk securitization structures, such as collateralized debt obligations and structured investment vehicles.

There are Exemptions

The final rule attempts to clearly define the types of trading activities that are exempt from the ban on proprietary trading.

It permits hedging to reduce identified, specific risks from the banking entity's individual or aggregated positions. Permitted hedging activity will be required to be designed to, and demonstrably, reduce or significantly mitigate one or more specific, identifiable risks. The final rule's preamble further states that this activity is not intended to be hedging of generalized risks based on non-position specific modeling or other considerations. Hedging of the general assets and liabilities of the banking entity or a guess as to the direction of the economy will no longer be permitted.

Hedging strategies and positions will subject to a required “correlation analysis,” and ongoing "recalibration" to ensure it is not prohibited proprietary trading.

The rule includes an exemption for market making activities. However, it still prohibits so-called “macro-hedging” that has caused large speculative losses at institutions in the past. The rule is intended to allow cost-effective, risk-reducing hedging while preventing banking entities from entering into speculative transactions under the guise of hedging.

An underwriting exemption would require that a bank act as an underwriter for a distribution of securities (including both public and private offerings) and that the trading desk's underwriting position be related to that distribution. Consistent with the Dodd-Frank Act, the underwriting position must be designed not to exceed the reasonably expected near-term demands of customers.

The final rules would permit a banking entity to continue to engage in proprietary trading in U.S. government, agency, state, and municipal obligations. They also would permit, in more limited circumstances, proprietary trading in the obligations of a foreign sovereign or its political subdivisions.

The rule would not prohibit trading by foreign banking entities, provided the trading decisions and principal risks of the foreign banking entity occur and are held outside of the United States.

Compliance Matters

“The heart of the final rule remains the compliance framework,” said FDIC Chairman Martin Gruenberg during this morning's vote.

The final rule requires boards of directors, CEOs and other senior management at large firms to approve their compliance framework and review its effectiveness on an on-going basis.

In an attempt to minimize the burden on small and community banks, the final rule eases up on compliance requirements for community banks with less than $10 billion in assets.

Banks with assets greater than $10 billion, but less than $50 billion, are required to maintain a compliance program that includes: written policies and procedures that are reasonably designed to ensure compliance with limits on underwriting and market making; a system of internal controls; a management framework with clear accountability for compliance and the review of hedging limits and incentive compensation; independent testing and audits; training for trading personnel and management; and maintaining records that demonstrate compliance for at least five years.

The final rule requires enhanced compliance programs for banks with more than $50 billion in assets that include detailed policies on investment limits, management accountability, and internal audits. Independent testing and analysis of an institution's compliance program will be required. Banks that do not engage in covered trading activities will not need to establish a compliance program.

Developing Metrics

A key to determining when a trade crosses that fuzzy line from hedging to proprietary trading will be metrics that banks will be required to develop.

The final rule requires banking entities with significant trading operations to furnish their appropriate regulators with metrics designed to help firms and regulators monitor and identify prohibited proprietary trading and high risk trading strategies.

Hitting the Wallet

The rule prohibits banks from awarding bonuses or perks as a reward for successful, but now prohibited, proprietary trades.

CEO Accountability

CEOs must certify that their bank does not engage in prohibited behavior and file annual attestations that their institution “has in place processes to establish, maintain, enforce, review, test and modify the compliance program.”

Deadlines

The final rules would become effective April 1, 2014, although the Federal Reserve Board has extended the conformance period until July 21, 2015.

Beginning June 30, 2014, banks with $50 billion or more in consolidated trading assets and liabilities would be required to report quantitative measurements. Banks with at least $25 billion, but less than $50 billion, in consolidated trading assets and liabilities would become subject to this requirement on April 30, 2016. Those with at least $10 billion, but less than $25 billion, in consolidated trading assets and liabilities would become subject to the requirement on Dec. 31, 2016.

Opposition

The three votes against the final rule came from SEC commissioners Michael Piwowar and Daniel Gallagher, and CFTC Commissioner Scott O'Malia.

Piwowar and O'Malia said the final rule is substantially different from what was proposed more than two years ago and urged that the rule be re-proposed with fresh opportunity for public comment.

“In the rush to meet an arbitrary deadline set by the [Obama Administration], what should be a primary concern of any independent agency when adopting a rule – to know precisely what is in the rule and to understand the potential impacts of the rule – was disregarded,” Piwowar said.

According to Piwowar, the rush to approve a final rule meant that it lacked a rigorous economic analysis and commissioners didn't have ample time to review it. “With less than one week until the date of the vote, I still had not received the proposed voting draft of the rule,” he said.

“The nonchalant suggestion to ‘err on the side of' over-regulation is fully in line with the staggering level of hubris reflected throughout this joint rulemaking process, which has culminated with a purely political insistence on a pre-year end vote,” Gallagher said. “Not until five days ago did we have anything even resembling a voting draft. This Commission is effectively being told that we have to vote for the final rule so we can find out what's in it." 

O'Malia decried an “abuse of process.”

“In the implementation of one of the most important mandates issued by Congress in response to the financial crisis, the Commission seems to have forgotten the basics of agency rulemaking,” he said. “The Commission did not receive a near-final draft of the rule, with language agreed to by all five agencies, until just six days prior to the vote, despite repeated requests.”

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