[Federal Register Volume 76, Number 215 (Monday, November 7, 2011)]
[Proposed Rules]
[Pages 68846-68972]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-27184]
[[Page 68845]]
Vol. 76
Monday,
No. 215
November 7, 2011
Part II
Department of the Treasury
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Office of the Comptroller of the Currency
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12 CFR Part 44
Board of Governors of the Federal Reserve System
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12 CFR Part 248
Federal Deposit Insurance Corporation
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12 CFR Part 351
Securities and Exchange Commission
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17 CFR 255
Prohibitions and Restrictions on Proprietary Trading and Certain
Interests in, and Relationships With, Hedge Funds and Private Equity
Funds; Proposed Rule
Federal Register / Vol. 76 , No. 215 / Monday, November 7, 2011 /
Proposed Rules
[[Page 68846]]
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DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
12 CFR Part 44
[Docket No. OCC-2011-0014]
RIN 1557-AD44
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
12 CFR Part 248
[Docket No. R-1432]
RIN 7100 AD 82
FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Part 351
RIN 3064-AD85
SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 255
[Release No. 34-65545; File No. S7-41-11]
RIN 3235-AL07
Prohibitions and Restrictions on Proprietary Trading and Certain
Interests in, and Relationships With, Hedge Funds and Private Equity
Funds
AGENCY: Office of the Comptroller of the Currency, Treasury (``OCC'');
Board of Governors of the Federal Reserve System (``Board''); Federal
Deposit Insurance Corporation (``FDIC''); and Securities and Exchange
Commission (``SEC'').
ACTION: Notice of proposed rulemaking.
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SUMMARY: The OCC, Board, FDIC, and SEC (individually, an ``Agency,''
and collectively, ``the Agencies'') are requesting comment on a
proposed rule that would implement Section 619 of the Dodd-Frank Wall
Street Reform and Consumer Protection Act (``Dodd-Frank Act'') which
contains certain prohibitions and restrictions on the ability of a
banking entity and nonbank financial company supervised by the Board to
engage in proprietary trading and have certain interests in, or
relationships with, a hedge fund or private equity fund.
DATES: Comments should be received on or before January 13, 2012.
ADDRESSES: Interested parties are encouraged to submit written comments
jointly to all of the Agencies. Commenters are encouraged to use the
title ``Restrictions on Proprietary Trading and Certain Interests in,
and Relationships with, Hedge Funds and Private Equity Funds'' to
facilitate the organization and distribution of comments among the
Agencies. Commenters are also encouraged to identify the number of the
specific question for comment to which they are responding.
Office of the Comptroller of the Currency: Because paper mail in
the Washington, DC area and at the OCC is subject to delay, commenters
are encouraged to submit comments by the Federal eRulemaking Portal or
email, if possible. Please use the title ``Restrictions on Proprietary
Trading and Certain Interests in and Relationships with Hedge Funds and
Private Equity Funds'' to facilitate the organization and distribution
of the comments. You may submit comments by any of the following
methods:
Federal eRulemaking Portal--``Regulations.gov'': Go to
http://www.regulations.gov. Select ``Document Type'' of ``Proposed
Rules,'' and in the ``Enter Keyword or ID Box,'' enter Docket ID ``OCC-
2011-14,'' and click ``Search.'' On ``View By Relevance'' tab at the
bottom of screen, in the ``Agency'' column, locate the Proposed Rule
for the OCC, in the ``Action'' column, click on ``Submit a Comment'' or
``Open Docket Folder'' to submit or view public comments and to view
supporting and related materials for this rulemaking action.
Click on the ``Help'' tab on the Regulations.gov home page
to get information on using Regulations.gov, including instructions for
submitting or viewing public comments, viewing other supporting and
related materials, and viewing the docket after the close of the
comment period.
Email: [email protected].
Mail: Office of the Comptroller of the Currency, 250 E
Street SW., Mail Stop 2-3, Washington, DC 20219.
Fax: (202) 874-5274.
Hand Delivery/Courier: 250 E Street SW., Mail Stop 2-3,
Washington, DC 20219.
Instructions: You must include ``OCC'' as the agency name and
``Docket ID OCC-2011-14'' in your comment. In general, OCC will enter
all comments received into the docket and publish them on the
Regulations.gov Web site without change, including any business or
personal information that you provide such as name and address
information, email addresses, or phone numbers. Comments received,
including attachments and other supporting materials, are part of the
public record and subject to public disclosure. Do not enclose any
information in your comment or supporting materials that you consider
confidential or inappropriate for public disclosure.
You may review comments and other related materials that pertain to
this proposed rulemaking by any of the following methods:
Viewing Comments Electronically: Go to http://www.regulations.gov. Select ``Document Type'' of ``Public
Submissions,'' and in the ``Enter Keyword or ID Box,'' enter Docket ID
``OCC-2011-14,'' and click ``Search.'' Comments will be listed under
``View By Relevance'' tab at the bottom of screen. If comments from
more than one agency are listed, the ``Agency'' column will indicate
which comments were received by the OCC.
Viewing Comments Personally: You may personally inspect
and photocopy comments at the OCC, 250 E Street SW., Washington, DC
20219. For security reasons, the OCC requires that visitors make an
appointment to inspect comments. You may do so by calling (202) 874-
4700. Upon arrival, visitors will be required to present valid
government-issued photo identification and submit to security screening
in order to inspect and photocopy comments.
Docket: You may also view or request available background documents
and project summaries using the methods described above.
Board of Governors of the Federal Reserve System:
You may submit comments, identified by Docket No. R-1432 and RIN
7100 AD 82, by any of the following methods:
Agency Web site: http://www.federalreserve.gov. Follow the
instructions for submitting comments at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
Email: [email protected]. Include the
docket number in the subject line of the message.
Fax: (202) 452-3819 or (202) 452-3102.
Mail: Address to Jennifer J. Johnson, Secretary, Board of
Governors of the Federal Reserve System, 20th Street and Constitution
Avenue NW., Washington, DC 20551.
All public comments will be made available on the Board's Web site
at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as
submitted, unless modified for technical reasons. Accordingly, comments
will not be edited to remove any identifying or contact information.
Public
[[Page 68847]]
comments may also be viewed electronically or in paper in Room MP-500
of the Board's Martin Building (20th and C Streets NW.,) between 9 a.m.
and 5 p.m. on weekdays.
Federal Deposit Insurance Corporation: You may submit comments,
identified by RIN number, by any of the following methods:
Agency Web site: http://www.fdic.gov/regulations/laws/federal/propose.html. Follow instructions for submitting comments on
the Agency Web site.
Email: [email protected]. Include the RIN 3064-AD85 on the
subject line of the message.
Mail: Robert E. Feldman, Executive Secretary, Attention:
Comments, Federal Deposit Insurance Corporation, 550 17th Street NW.,
Washington, DC 20429.
Hand Delivery: Comments may be hand delivered to the guard
station at the rear of the 550 17th Street Building (located on F
Street) on business days between 7 a.m. and 5 p.m.
Public Inspection: All comments received must include the agency
name and RIN 3064-AD85 for this rulemaking. All comments received will
be posted without change to http://www.fdic.gov/regulations/laws/federal/propose.html, including any personal information provided.
Paper copies of public comments may be ordered from the FDIC Public
Information Center, 3501 North Fairfax Drive, Room E-I002, Arlington,
VA 22226 by telephone at 1 (877) 275-3342 or 1 (703) 562-2200.
Securities and Exchange Commission: You may submit comments by the
following method:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
Send an email to [email protected]. Please include
File Number S7-41-11 on the subject line; or
Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street NE.,
Washington, DC 20549-1090.
All submissions should refer to File Number S7-41-11. This file
number should be included on the subject line if email is used. To help
us process and review your comments more efficiently, please use only
one method. The Commission will post all comments on the Commission's
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments
are also available for Web site viewing and printing in the
Commission's Public Reference Room, 100 F Street NE., Washington, DC
20549, on official business days between the hours of 10 a.m. and 3
p.m. All comments received will be posted without change; we do not
edit personal identifying information from submissions. You should
submit only information that you wish to make available publicly.
FOR FURTHER INFORMATION CONTACT: OCC: Deborah Katz, Assistant Director,
or Ursula Pfeil, Counsel, Legislative and Regulatory Activities
Division, (202) 874-5090; Roman Goldstein, Senior Attorney, Securities
and Corporate Practices Division, (202) 874-5210; Kurt Wilhelm,
Director for Financial Markets Group, (202) 874-4660; Stephanie Boccio,
Technical Expert for Asset Management Group, or Joel Miller, Group
Leader for Asset Management Group, (202) 874-4660, Office of the
Comptroller of the Currency, 250 E Street SW., Washington, DC 20219.
Board: Jeremy R. Newell, Counsel, (202) 452-3239, or Christopher M.
Paridon, Counsel, Legal Division, (202) 452-3274; Sean D. Campbell,
Deputy Associate Director, Division of Research and Statistics, (202)
452-3760; David Lynch, Manager, Division of Bank Supervision and
Regulation, (202) 452-2081, Board of Governors of the Federal Reserve
System, 20th and C Streets, NW., Washington, DC 20551.
FDIC: Bobby R. Bean, Acting Associate Director, Capital Markets
(202) 898-6705, or Karl R. Reitz, Senior Capital Markets Specialist,
(202) 898-6775, Division of Risk Management Supervision; Michael B.
Phillips, Counsel, (202) 898-3581, or Gregory S. Feder, Counsel, (202)
898-8724, Legal Division, Federal Deposit Insurance Corporation, 550
17th Street NW., Washington, DC 20429-0002.
SEC: Josephine Tao, Assistant Director, Elizabeth Sandoe, Senior
Special Counsel, David Bloom, Branch Chief, Anthony Kelly, Special
Counsel, Angela Moudy, Attorney Advisor, or Daniel Staroselsky,
Attorney Advisor, Office of Trading Practices, Division of Trading and
Markets, (202) 551-5720; David Blass, Chief Counsel, or Gregg Berman,
Senior Advisor to the Director, Division of Trading and Markets; Daniel
S. Kahl, Assistant Director, Tram N. Nguyen, Branch Chief, Michael J.
Spratt, Senior Counsel, or Parisa Haghshenas, Law Clerk, Office of
Investment Adviser Regulation, Division of Investment Management, (202)
551-6787; David Beaning, Special Counsel, Office of Structured Finance,
Division of Corporation Finance, (202) 551-3850; John Harrington,
Special Counsel, Office of Capital Market Trends, Division of
Corporation Finance, (202) 551-3860; Richard Bookstaber, Senior Policy
Advisor, or Jennifer Marietta-Westberg, Assistant Director, Office of
the Sell Side; or Adam Yonce, Financial Economist, Division of Risk
Strategy and Financial Innovation, (202) 551-6600, U.S. Securities and
Exchange Commission, 100 F Street NE., Washington, DC 20549.
SUPPLEMENTARY INFORMATION:
I. Background
The Dodd-Frank Act was enacted on July 21, 2010.\1\ Section 619 of
the Dodd-Frank Act added a new section 13 to the Bank Holding Company
Act of 1956 (``BHC Act'') (to be codified at 12 U.S.C. 1851) that
generally prohibits any banking entity \2\ from engaging in proprietary
trading or from acquiring or retaining an ownership interest in,
sponsoring, or having certain relationships with a hedge fund or
private equity fund (``covered fund''), subject to certain
exemptions.\3\ New section 13 of the BHC Act also provides for nonbank
financial companies supervised by the Board that engage in such
activities or have such interests or relationships to be subject to
additional capital requirements, quantitative limits, or other
restrictions.\4\
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\1\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Public Law 111-203, 124 Stat. 1376 (2010).
\2\ Application of the proposed rule to smaller, less-complex
banking entities is discussed below in Part II.F of this
Supplemental Information.
\3\ The term ``banking entity'' is defined in section 13(h)(1)
of the BHC Act, as amended by section 619 of the Dodd-Frank Act. See
12 U.S.C. 1851(h)(1). The statutory definition includes any insured
depository institution (other than certain limited purpose trust
institutions), 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
(12 U.S.C. 3106), and any affiliate or subsidiary of any of the
foregoing. Section 13 of the BHC Act defines the terms ``hedge
fund'' and ``private equity fund'' as an issuer that would be an
investment company, as defined under the Investment Company Act of
1940 (15 U.S.C. 80a-1 et seq.), but for section 3(c)(1) or 3(c)(7)
of that Act, or any such similar funds as the appropriate Federal
banking agencies (i.e., the Board, OCC, and FDIC), the SEC, and the
CFTC may, by rule, determine should be treated as a hedge fund or
private equity fund. See 12 U.S.C. 1851(h)(2).
\4\ See 12 U.S.C. 1851(a)(2) and (f)(4). A ``nonbank financial
company supervised by the Board'' is a nonbank financial company or
other company that the Financial Stability Oversight Council
(``Council'') has determined, under section 113 of the Dodd-Frank
Act, shall be subject to supervision by the Board and prudential
standards. The Board is not proposing at this time any additional
capital requirements, quantitative limits, or other restrictions on
nonbank financial companies pursuant to section 13 of the BHC Act,
as it believes doing so would be premature in light of the fact that
the Council has not yet finalized the criteria for designation of,
nor yet designated, any nonbank financial company.
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[[Page 68848]]
A. Rulemaking Framework
Section 13 of the BHC Act requires that implementation of its
provisions occur in several stages. First, the Council was required to
conduct a study (``Council study'') and make recommendations by January
21, 2011 on the implementation of section 13 of the BHC Act. The
Council study was issued on January 18, 2011, and included a detailed
discussion of key issues related to implementation of section 13 and
recommended that the Agencies consider taking a number of specified
actions in issuing rules under section 13 of the BHC Act.\5\ The
Council study also recommended that the Agencies adopt a four-part
implementation and supervisory framework for identifying and preventing
prohibited proprietary trading, which included a programmatic
compliance regime requirement for banking entities, analysis and
reporting of quantitative metrics by banking entities, supervisory
review and oversight by the Agencies, and enforcement procedures for
violations.\6\ The Agencies have carefully considered the Council study
and its recommendations, and have consulted with staff of the Commodity
Futures Trading Commission (``CFTC''), in formulating this proposal.\7\
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\5\ See Financial Stability Oversight Council, Study and
Recommendations on Prohibitions on Proprietary Trading and Certain
Relationships with Hedge Funds and Private Equity Funds (Jan. 18,
2011), available at http://www.treasury.gov/initiatives/Documents/Volcker%20sec%20619%20study%20final%201%2018%2011%20rg.pdf. See 12
U.S.C. 1851(b)(1). Prior to publishing its study, the Council
requested public comment on a number of issues to assist the Council
in conducting its study. See 75 FR 61,758 (Oct. 6, 2010).
Approximately 8,000 comments were received from the public,
including from members of Congress, trade associations, individual
banking entities, consumer groups, and individuals. As noted in the
issuing release for the Council Study, these comments were carefully
considered by the Council when drafting the Council study.
\6\ See Council study at 5-6. The Agencies have implemented this
recommendation through the proposed compliance program requirements
contained in Subpart D of this proposal with respect to both
proprietary trading and covered fund activities and investments.
\7\ The Agencies also received a number of comment letters
concerning implementation of section 13 of the BHC Act in advance of
this proposal. The Agencies have carefully considered these comments
in formulating this proposal.
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Authority for developing and adopting regulations to implement the
prohibitions and restrictions of section 13 of the BHC Act is divided
between the Agencies in the manner provided in section 13(b)(2) of the
BHC Act.\8\ The statute also requires the Agencies, in developing and
issuing implementing rules, to consult and coordinate with each other,
as appropriate, for the purposes of assuring, to the extent possible,
that such rules are comparable and provide for consistent application
and implementation of the applicable provisions of section 13 of the
BHC Act.\9\ Such coordination will assist in ensuring that advantages
are not unduly provided to, and that disadvantages are not unduly
imposed upon, companies affected by section 13 of the BHC Act and that
the safety and soundness of banking entities and nonbank financial
companies supervised by the Board are protected. The statute requires
the Agencies to implement rules under section 13 not later than 9
months after the Council completes its study (i.e., not later than
October 18, 2011).\10\ The restrictions and prohibitions of section 13
of the BHC Act become effective 12 months after issuance of final rules
by the Agencies, or July 21, 2012, whichever is earlier.\11\
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\8\ See 12 U.S.C. 1851(b)(2). Under section 13(b)(2)(B) of the
BHC Act, rules implementing section 13's prohibitions and
restrictions must be issued by: (i) The appropriate Federal banking
agencies (i.e., the Board, the OCC, and the FDIC), jointly, with
respect to insured depository institutions; (ii) the Board, with
respect to any company that controls an insured depository
institution, or that is treated as a bank holding company for
purposes of section 8 of the International Banking Act, any nonbank
financial company supervised by the Board, and any subsidiary of any
of the foregoing (other than a subsidiary for which an appropriate
Federal banking agency, the SEC, or the CFTC is the primary
financial regulatory agency); (iii) the CFTC with respect to any
entity for which it is the primary financial regulatory agency, as
defined in section 2 of the Dodd-Frank Act; and (iv) the SEC with
respect to any entity for which it is the primary financial
regulatory agency, as defined in section 2 of the Dodd-Frank Act.
See id.
\9\ See 12 U.S.C. 1851(b)(2)(B)(ii). The Secretary of the
Treasury, as Chairperson of the Council, is responsible for
coordinating the Agencies' rulemakings under section 13 of the BHC
Act. See id.
\10\ See id. at 1851(b)(2)(A).
\11\ See id. at 1851(c)(1).
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In addition, the statute required the Board, acting alone, to adopt
rules to implement the provisions of section 13 of the BHC Act that
provide a banking entity or a nonbank financial company supervised by
the Board a period of time after the effective date of section 13 of
the BHC Act to bring the activities, investments, and relationships of
the banking entity into compliance with that section and the Agencies'
implementing regulations.\12\ The Board issued its final conformance
rule as required under section 13(c)(6) of the BHC Act on February 8,
2011 (``Board's Conformance Rule'').\13\ As noted in the issuing
release for the Board's Conformance Rule, this period is intended to
give markets and firms an opportunity to adjust to section 13 of the
BHC Act.\14\
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\12\ See id. at 1851(c)(6).
\13\ See Conformance Period for Entities Engaged in Prohibited
Proprietary Trading or Private Equity Fund or Hedge Fund Activities,
76 FR 8265 (Feb. 14, 2011).
\14\ See id. (citing 156 Cong. Rec. S5898 (daily ed. July 15,
2010) (statement of Sen. Merkley)).
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B. Section 13 of the BHC Act
Section 13 of the BHC Act generally prohibits banking entities from
engaging in proprietary trading or from acquiring or retaining any
ownership interest in, or sponsoring, a covered fund.\15\ However,
section 13(d)(1) of that Act expressly includes exemptions from these
prohibitions for certain permitted activities, including:
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\15\ 12 U.S.C. 1851(a)(1)(A) and (B).
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Trading in certain government obligations;
Underwriting and market making-related activities;
Risk-mitigating hedging activity;
Trading on behalf of customers;
Investments in Small Business Investment Companies
(``SBICs'') and public interest investments;
Trading for the general account of insurance companies;
Organizing and offering a covered fund (including limited
investments in such funds);
Foreign trading by non-U.S. banking entities; and
Foreign covered fund activities by non-U.S. banking
entities.\16\
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\16\ See id. at 1851(d)(1). As described in greater detail in
Part III.B.4 of this Supplementary Information, the proposed rule
applies some of these statutory exemptions only to the proprietary
trading prohibition or the covered fund prohibitions and
restrictions, but not both, where it appears either by plain
language or by implication that the exemption was intended only to
apply to one or the other.
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For purposes of this Supplementary Information, trading activities
subject to section 13 of the BHC Act, including those permitted under a
relevant exemption, are sometimes referred to as ``covered trading
activities.'' Similarly, activities and investments with respect to a
covered fund that are subject to section 13 of the BHC Act, including
those permitted under a relevant exemption, are sometimes referred to
as ``covered fund activities or investments.''
Additionally, section 13 of the BHC Act permits the Agencies to
grant, by rule, other exemptions from the prohibitions on proprietary
trading and acquiring or retaining an ownership interest in, or acting
as sponsor to, a covered fund if the Agencies determine
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that the exemption would promote and protect the safety and soundness
of the banking entity and the financial stability of the United
States.\17\ Furthermore, under the statute, no banking entity may
engage in a permitted activity if that activity would (i) involve or
result in a material conflict of interest or material exposure of the
banking entity to high-risk assets or high-risk trading strategies, or
(ii) pose a threat to the safety and soundness of the banking entity or
to the financial stability of the United States.\18\
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\17\ Id. at 1851(d)(1)(J).
\18\ See id. at 1851(d)(2).
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Section 13(f) of the BHC Act separately prohibits a banking entity
that serves, directly or indirectly, as the investment manager,
investment adviser, or sponsor to a covered fund, and any affiliate of
such a banking entity, from entering into any transaction with the
fund, or any other covered fund controlled by such fund, that would be
a ``covered transaction'' as defined in section 23A of the Federal
Reserve Act (``FR Act''),\19\ as if such banking entity or affiliate
were a member bank and the covered fund were an affiliate thereof,
subject to certain exceptions.\20\ Section 13(f) also provides that a
banking entity may enter into certain prime brokerage transactions with
any covered fund in which a covered fund managed, sponsored, or advised
by the banking entity has taken an equity, partnership, or other
ownership interest, but any such transaction (and any other permitted
transaction with such funds) must be on market terms in accordance with
the provisions of section 23B of the FR Act.\21\
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\19\ See 12 U.S.C. 371c.
\20\ 12 U.S.C. 1851(f).
\21\ 12 U.S.C. 371c-1.
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Section 13 of the BHC Act does not prohibit a nonbank financial
company supervised by the Board from engaging in proprietary trading,
or from having the types of ownership interests in or relationships
with a covered fund that a banking entity is prohibited or restricted
from having under section 13 of the BHC Act. However, section 13 of the
BHC Act provides for the Board or other appropriate Agency to impose
additional capital charges, quantitative limits, or other restrictions
on a nonbank financial company supervised by the Board or their
subsidiaries and affiliates that are engaged in such activities or
maintain such relationships.\22\
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\22\ See 12 U.S.C. 1851(a)(2), (d)(4).
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II. Overview of Proposed Rule
A. General Approach
In formulating the proposed rule, the Agencies have attempted to
reflect the structure of section 13 of the BHC Act, which is to
prohibit a banking entity from engaging in proprietary trading or
acquiring or retaining an ownership interest in, or having certain
relationships with, a covered fund, while permitting such entities to
continue to provide client-oriented financial services. However, the
delineation of what constitutes a prohibited or permitted activity
under section 13 of the BHC Act often involves subtle distinctions that
are difficult both to describe comprehensively within regulation and to
evaluate in practice. The Agencies appreciate that while it is crucial
that rules under section 13 of the BHC Act clearly define and implement
its requirements, any rule must also preserve the ability of a banking
entity to continue to structure its businesses and manage its risks in
a safe and sound manner, as well as to effectively deliver to its
clients the types of financial services that section 13 expressly
protects and permits. These client-oriented financial services, which
include underwriting, market making, and traditional asset management
services, are important to the U.S. financial markets and the
participants in those markets, and the Agencies have endeavored to
develop a proposed rule that does not unduly constrain banking entities
in their efforts to safely provide such services. At the same time,
providing appropriate latitude to banking entities to provide such
client-oriented services need not and should not conflict with clear,
robust, and effective implementation of the statute's prohibitions and
restrictions. Given these complexities, the Agencies request comment on
the potential impacts the proposed approach may have on banking
entities and the businesses in which they engage. In particular, and as
discussed further in Part VII of this Supplemental Information, the
Agencies recognize that there are economic impacts that may arise from
the proposed rule and its implementation of section 13 of the BHC Act,
and the Agencies request comment on such impacts, including
quantitative data, where possible.
In light of these larger challenges and goals, the Agencies'
proposal takes a multi-faceted approach to implementing section 13 of
the BHC Act. In particular, the proposed rule includes a framework
that: (i) Clearly describes the key characteristics of both prohibited
and permitted activities; (ii) requires banking entities to establish a
comprehensive programmatic compliance regime designed to ensure
compliance with the requirements of the statute and rule in a way that
takes into account and reflects the unique nature of a banking entity's
businesses; and (iii) with respect to proprietary trading, requires
certain banking entities to calculate and report meaningful
quantitative data that will assist both banking entities and the
Agencies in identifying particular activity that warrants additional
scrutiny to distinguish prohibited proprietary trading from otherwise
permissible activities. This multi-faceted approach, which is
consistent with the implementation and supervisory framework
recommended in the Council study, is intended to strike an appropriate
balance between accommodating prudent risk management and the continued
provision of client-oriented financial services by banking entities
while ensuring that such entities do not engage in prohibited
proprietary trading or restricted covered fund activities or
investments.\23\
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\23\ In recognition of economic impacts that may arise from the
proposed rule and its implementation of section 13 of the BHC Act,
the Agencies are requesting comment on the relative costs and
benefits of the proposal in Part VII of this Supplemental
Information.
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In addition, and consistent with the statutory requirement that the
Agencies' rules under section 13 of the BHC Act be, to the extent
possible, comparable and provide for consistent application and
implementation, the Agencies have proposed a common rule and
appendices. This uniform approach to implementation is intended to
provide the maximum degree of clarity to banking entities and market
participants and ensure that section 13's prohibitions and restrictions
are applied consistently across different types of regulated
entities.\24\
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\24\ Under this uniform approach, each Agency is proposing the
same rule provisions under section 13 of the BHC Act. Each Agency's
proposed rule would apply only to banking entities for which the
Agency has regulatory authority under section 13(b)(2)(B) of the BHC
Act.
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As a matter of structure, the proposed rule is generally divided
into four subparts and contains three appendices, as follows:
Subpart A of the proposed rule describes the authority,
scope, purpose, and relationship to other authorities of the rule and
defines terms used commonly throughout the rule;
Subpart B of the proposed rule prohibits proprietary
trading, defines terms relevant to covered trading activity,
establishes exemptions from
[[Page 68850]]
the prohibition on proprietary trading and limitations on those
exemptions, and requires certain banking entities to report
quantitative measurements with respect to their trading activities;
Subpart C of the proposed rule prohibits or restricts
acquiring or retaining an ownership interest in, and certain
relationships with, a covered fund, defines terms relevant to covered
fund activities and investments, as well as establishes exemptions from
the restrictions on covered fund activities and investments and
limitations on those exemptions;
Subpart D of the proposed rule generally requires banking
entities to establish an enhanced compliance program regarding
compliance with section 13 of the BHC Act and the proposed rule,
including written policies and procedures, internal controls, a
management framework, independent testing of the compliance program,
training, and recordkeeping;
Appendix A of the proposed rule details the quantitative
measurements that certain banking entities may be required to compute
and report with respect to their trading activities; \25\
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\25\ A banking entity must comply with proposed Appendix A's
reporting and recordkeeping requirements only if it has, together
with its affiliates and subsidiaries, trading assets and liabilities
the average gross sum of which (on a worldwide consolidated basis)
is, as measured as of the last day of each of the four prior
calendar quarters, equal to or greater than $1 billion.
---------------------------------------------------------------------------
Appendix B of the proposed rule provides commentary
regarding the factors the Agencies propose to use to help distinguish
permitted market making-related activities from prohibited proprietary
trading; and
Appendix C of the proposed rule details the minimum
requirements and standards that certain banking entities must meet with
respect to their compliance program, as required under subpart D.\26\
---------------------------------------------------------------------------
\26\ In particular, a banking entity must comply with the
minimum standards specified in Appendix C of the proposed rule (i)
with respect to its covered trading activities, if it engages in any
covered trading activities and has, together with its affiliates and
subsidiaries, trading assets and liabilities the average gross sum
of which (on a worldwide consolidated basis), as measured as of the
last day of each of the four prior calendar quarters, (X) is equal
to or greater than $1 billion or (Y) equals 10 percent or more of
its total assets; and (ii) with respect to its covered fund
activities and investments, if it engages in any covered fund
activities and investments and either (X) has, together with its
affiliates and subsidiaries, aggregate investments in covered funds
the average value of which is, as measured as of the last day of
each of the four prior calendar quarters, equal to or greater than
$1 billion or (Y) sponsors and advises, together with its affiliates
and subsidiaries, covered funds the average total assets of which
are, as measured as of the last day of each of the four prior
calendar quarters, equal to or greater than $1 billion.
---------------------------------------------------------------------------
In addition, the Board's proposed rule also contains a subpart E,
to which the provisions of the Board's Conformance Rule under section
13 of the BHC Act will be recodified from their current location in the
Board's Regulation Y.
B. Proprietary Trading Restrictions
Subpart B of the proposed rule implements the statutory prohibition
on proprietary trading and the various exemptions to this prohibition
included in the statute. Section --.3 of the proposed rule contains the
core prohibition on proprietary trading and defines a number of related
terms, including ``proprietary trading'' and ``trading account.'' The
proposed rule's definition of proprietary trading generally parallels
the statutory definition, and includes engaging as principal for the
trading account of a banking entity in any transaction to purchase or
sell certain types of financial positions.\27\
---------------------------------------------------------------------------
\27\ See proposed rule Sec. --.3(b)(1).
---------------------------------------------------------------------------
The proposed rule's definition of trading account generally
parallels the statutory definition, and provides further guidance
regarding the circumstances in which a position will be considered to
have been taken principally for the purpose of short-term resale or
benefiting from actual or expected short-term price movements,
recognizing the importance of providing as much clarity as possible
regarding this term, which ultimately defines the scope of accounts
subject to the prohibition on proprietary trading.\28\ In particular,
the proposed definition of trading account identifies three classes of
positions that would cause an account to be a trading account. First,
the definition includes positions taken principally for the purpose of
short-term resale, benefitting from short-term price movements,
realizing short-term arbitrage profits, or hedging another trading
account position.\29\ As described in this notice, this language is
substantially similar to language for a ``trading position'' used in
the Federal banking agencies' current market risk capital rules, as
proposed to be revised (``Market Risk Capital Rules''),\30\ and the
Agencies propose to interpret this language in a similar manner.
Second, with respect to a banking entity subject to the Federal banking
agencies' Market Risk Capital Rules, the definition includes all
positions in financial instruments subject to the prohibition on
proprietary trading that are treated as ``covered positions'' under
those capital rules, other than certain foreign exchange and
commodities positions. Third, the definition includes all positions
acquired or taken by certain registered securities and derivatives
dealers (or, in the case of financial institutions \31\ that are
government securities dealers, that have filed notice with an
appropriate regulatory agency) in connection with their activities that
require such registration or notice.\32\ The definition of trading
account also contains clarifying exclusions for certain positions that
do not appear to involve the requisite short-term trading intent, such
as positions arising under certain repurchase and reverse repurchase
arrangements or securities lending transactions, positions acquired or
taken for bona fide liquidity management purposes, and certain
positions of derivatives clearing organizations or clearing
agencies.\33\
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\28\ See proposed rule Sec. --.3(b)(2).
\29\ See proposed rule Sec. --.3(b)(2)(i)(A).
\30\ See 76 FR 1890 (Jan. 11, 2011).
\31\ In the context of regulation of government securities
dealers under the Securities Exchange Act of 1934 (``Exchange
Act''), the term ``financial institution'' as defined in section
3(a)(46) of the Exchange Act includes a bank (as defined in section
3(a)(36) of the Exchange Act) and a foreign bank (as defined in the
International Banking Act of 1978). See 15 U.S.C. 78c(a)(46).
\32\ See proposed rule Sec. --.3(b)(2)(i)(B).
\33\ See proposed rule Sec. --.3(b)(2)(iii).
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Section --.3 of the proposed rule also defines a number of other
relevant terms, including the term ``covered financial position.'' This
term is used to define the scope of financial instruments subject to
the prohibition on proprietary trading. Consistent with the statutory
language, such covered financial positions include positions (including
long, short, synthetic and other positions) in securities, derivatives,
commodity futures, and options on such instruments, but do not include
positions in loans, spot foreign exchange or spot commodities.\34\
---------------------------------------------------------------------------
\34\ See proposed rule Sec. --.3(b)(3).
---------------------------------------------------------------------------
Section --.4 of the proposed rule implements the statutory
exemptions for underwriting and market making-related activities. For
each of these permitted activities, the proposed rule provides a number
of requirements that must be met in order for a banking entity to rely
on the applicable exemption. These requirements are generally designed
to ensure that the activities, revenues and other characteristics of
the banking entity's trading activity are consistent with underwriting
and market making-related activities, respectively, and not prohibited
proprietary trading.\35\ These requirements are intended to support and
augment other parts of the proposed rule's approach to implementing the
prohibition on proprietary trading, including the compliance program
[[Page 68851]]
requirement and the reporting of quantitative measurements, in order to
assist banking entities and the Agencies in identifying prohibited
trading activities that may be conducted in the context of, or
mischaracterized as, permitted underwriting or market making-related
activities.
---------------------------------------------------------------------------
\35\ See proposed rule Sec. --.4(a), (b).
---------------------------------------------------------------------------
Section --.5 of the proposed rule implements the statutory
exemption for risk-mitigating hedging. As with the underwriting and
market-making exemptions, proposed Sec. --.5 contains a number of
requirements that must be met in order for a banking entity to rely on
the exemption. These requirements are generally designed to ensure that
the banking entity's trading activity is truly risk-mitigating hedging
in purpose and effect.\36\ Proposed Sec. --.5 also requires banking
entities to document, at the time the transaction is executed, the
hedging rationale for certain transactions that present heightened
compliance risks.\37\ As with the exemptions for underwriting and
market making-related activity, these requirements form part of a
broader implementation approach that also includes the compliance
program requirement and the reporting of quantitative measurements.
---------------------------------------------------------------------------
\36\ See proposed rule Sec. Sec. --.5(b)(1), (2).
\37\ See proposed rule Sec. --.5(b)(3).
---------------------------------------------------------------------------
Section --.6 of the proposed rule implements statutory exemptions
for trading in certain government obligations, trading on behalf of
customers, trading by a regulated insurance company, and trading by
certain foreign banking entities outside the United States. Section
--.6(a) of the proposed rule describes the government obligations in
which a banking entity may trade notwithstanding the prohibition on
proprietary trading, which include U.S. government and agency
obligations, obligations and other instruments of certain government
sponsored entities, and State and municipal obligations.\38\ Section
--.6(b) of the proposed rule describes permitted trading on behalf of
customers and identifies three categories of transactions that would
qualify for the exemption.\39\ These categories include: (i)
Transactions conducted by a banking entity as investment adviser,
commodity trading advisor, trustee, or in a similar fiduciary capacity
for the account of a customer where the customer, and not the banking
entity, has beneficial ownership of the related positions; (ii)
riskless principal transactions; and (iii) transactions conducted by a
banking entity that is a regulated insurance company for the separate
account of insurance policyholders, subject to certain conditions.
Section --.6(c) of the proposed rule describes permitted trading by a
regulated insurance company for its general account, and generally
parallels the statutory language governing this exemption.\40\ Finally,
Sec. --.6(d) of the proposed rule describes permitted trading outside
of the United States by a foreign banking entity.\41\ The proposed
exemption clarifies when a foreign banking entity will be considered to
engage in such trading pursuant to sections 4(c)(9) or 4(c)(13) of the
BHC Act, as required by the statute, including with respect to a
foreign banking entity not currently subject to section 4 of the BHC
Act. The exemption also clarifies when trading will be considered to
have occurred solely outside of the United States, as required by the
statute, and provides a number of specific criteria for determining
whether that standard is met.
---------------------------------------------------------------------------
\38\ See proposed rule Sec. --.6(a).
\39\ See proposed rule Sec. --.6(b).
\40\ See proposed rule Sec. --.6(c).
\41\ See proposed rule Sec. --.6(d).
---------------------------------------------------------------------------
Section --.7 of the proposed rule requires certain banking entities
with significant covered trading activities to comply with the
reporting and recordkeeping requirements specified in Appendix A of the
proposed rule. In addition, Sec. --.7 requires that a banking entity
comply with the recordkeeping requirements in Sec. --.20 of the
proposed rule, including, where applicable, the recordkeeping
requirements in Appendix C of the proposed rule. Section --.7 of the
proposed rule also requires a banking entity to comply with any other
reporting or recordkeeping requirements that an Agency may impose to
evaluate the banking entity's compliance with the proposed rule.\42\
Proposed Appendix A requires those banking entities with significant
covered trading activities to furnish periodic reports to the relevant
Agency regarding a variety of quantitative measurements of its covered
trading activities and maintain records documenting the preparation and
content of these reports. These proposed reporting and recordkeeping
requirements vary depending on the scope and size of covered trading
activities, and a banking entity must comply with proposed Appendix A's
reporting and recordkeeping requirements only if it has, together with
its affiliates and subsidiaries, trading assets and liabilities the
average gross sum of which (on a worldwide consolidated basis) is, as
measured as of the last day of each of the four prior calendar
quarters, equal to or greater than $1 billion. These thresholds are
designed to reduce the burden on smaller, less complex banking
entities, which generally engage in limited market-making and other
trading activities. Other provisions of the proposal, and in particular
the compliance program requirement in Sec. --.20 of the proposed rule,
are likely to be less burdensome and equally effective methods for
ensuring compliance with section 13 of the BHC Act by smaller, less
complex banking entities.
---------------------------------------------------------------------------
\42\ See proposed rule Sec. --.7.
---------------------------------------------------------------------------
The quantitative measurements that must be furnished under the
proposed rule are generally designed to reflect, and provide meaningful
information regarding, certain characteristics of trading activities
that appear to be particularly useful to help differentiate permitted
market making-related activities from prohibited proprietary trading
and to identify whether certain trading activities result in a material
exposure to high-risk assets or high-risk trading strategies. In
addition, proposed Appendix B contains a detailed commentary regarding
identification of permitted market making-related activities and
distinguishing such activities from trading activities that constitute
prohibited proprietary trading.
As described in Part II.B.5 of the Supplementary Information below,
the Agencies expect to utilize the conformance period provided in
section 13(c)(2) of the BHC Act to further refine and finalize the
reporting requirements, reflecting the substantial public comment,
practical experience, and revision that will likely be required to
ensure appropriate, effective use of reported quantitative data in
practice.
Section --.8 of the proposed rule prohibits a banking entity from
relying on any exemption to the prohibition on proprietary trading if
the permitted activity would involve or result in a material conflict
of interest, result in a material exposure to high-risk assets or high-
risk trading strategies, or pose a threat to the safety and soundness
of the banking entity or to the financial stability of the United
States.\43\ This section also defines material conflict of interest,
high-risk asset, and high-risk trading strategy for these purposes.
---------------------------------------------------------------------------
\43\ See proposed rule Sec. --.8.
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C. Covered Fund Activities and Investments
Subpart C of the proposed rule implements the statutory prohibition
on, as principal, directly or indirectly, acquiring and retaining an
ownership
[[Page 68852]]
interest in, or having certain relationships with, a covered fund, as
well as the various exemptions to this prohibition included in the
statute. Section --.10 of the proposed rule contains the core
prohibition on covered fund activities and investments and defines a
number of related terms, including ``covered fund'' and ``ownership
interest.'' The proposed rule's definition of covered fund generally
parallels the statutory definition of ``hedge fund'' and ``private
equity fund,'' and explains the universe of entities that would be
considered a ``covered fund'' (including those entities determined by
the Agencies to be ``such similar funds'') and, thus, subject to the
general prohibition.\44\
---------------------------------------------------------------------------
\44\ See proposed rule Sec. --.10(b)(1).
---------------------------------------------------------------------------
The definition of ``ownership interest'' provides further guidance
regarding the types of interests that would be considered to be an
ownership interest in a covered fund.\45\ As described in this
Supplementary Information, these interests may take various forms. The
definition of ownership interest also explicitly excludes from the
definition ``carried interest'' whereby a banking entity may share in
the profits of the covered fund solely as performance compensation for
services provided to the covered fund by the banking entity (or an
affiliate, subsidiary, or employee thereof).\46\
---------------------------------------------------------------------------
\45\ See proposed rule Sec. --.10(b)(3).
\46\ See proposed rule Sec. --.10(b)(3)(ii).
---------------------------------------------------------------------------
Section --.10 of the proposed rule also defines a number of other
relevant terms, including the terms ``prime brokerage transaction,''
``sponsor,'' and ``trustee.''
Section --.11 of the proposed rule implements the exemption for
organizing and offering a covered fund provided for under section
13(d)(1)(G) of the BHC Act. Section --.11(a) of the proposed rule
outlines the conditions that must be met in order for a banking entity
to organize and offer a covered fund under this authority. These
requirements are contained in the statute and are intended to allow a
banking entity to engage in certain traditional asset management and
advisory businesses in compliance with section 13 of the BHC Act.\47\
The requirements are discussed in detail in Part III.C.2 of this
Supplementary Information.
---------------------------------------------------------------------------
\47\ See 156 Cong. Rec. S5889 (daily ed. July 15, 2010)
(statement of Sen. Hagan).
---------------------------------------------------------------------------
Section --.12 of the proposed rule permits a banking entity to
acquire and retain, as an investment in a covered fund, an ownership
interest in a covered fund that the banking entity organizes and offers
under Sec. --.11.\48\ This section implements section 13(d)(4) of the
BHC Act and related provisions. Section 13(d)(4) of the BHC Act permits
a banking entity to make an investment in a covered fund that the
banking entity organizes and offers pursuant to section 13(d)(1)(G), or
for which it acts as sponsor, for the purposes of (i) establishing the
covered fund and providing the fund with sufficient initial equity for
investment to permit the fund to attract unaffiliated investors, or
(ii) making a de minimis investment in the covered fund in compliance
with applicable requirements. Section --.12 of the proposed rule
implements this authority and related limitations, including
limitations regarding the amount and value of any individual per-fund
investment and the aggregate value of all such permitted
investments.\49\ Proposed Sec. --.12 also clarifies how a banking
entity must calculate its compliance with these investment limitations
(including by deducting such investments from applicable capital, as
relevant), as well as sets forth how a banking entity may request an
extension of the period of time within which it must conform an
investment in a single covered fund.\50\
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\48\ See proposed rule Sec. --.12.
\49\ See proposed rule Sec. --.12(a)(2).
\50\ See proposed rule Sec. Sec. --.12(b), (c), and (d).
---------------------------------------------------------------------------
Section --.13 of the proposed rule implements the statutory
exemptions described in sections 13(d)(1)(C), (E), and (I) of the BHC
Act that permit a banking entity: (i) To acquire and retain an
ownership interest in, or act as sponsor to, one or more SBICs, a
public welfare investment, or certain qualified rehabilitation
expenditures; (ii) to acquire and retain an ownership interest in a
covered fund as a risk-mitigating hedging activity; and (iii) in the
case of a non-U.S. banking entity, to acquire and retain an ownership
interest in, or act as sponsor to, a foreign covered fund.\51\ Section
--.13(a) of the proposed rule permits a banking entity to acquire and
retain an ownership interest in, or act as sponsor to, an SBIC or
certain public interest investments, without limitation as to the
amount of ownership interests it may own, hold, or control with the
power to vote.\52\
---------------------------------------------------------------------------
\51\ See proposed rule Sec. --.13(a)--(c).
\52\ See proposed rule Sec. --.13(a).
---------------------------------------------------------------------------
Section --.13(b) of the proposed rule permits a banking entity to
use an ownership interest in a covered fund to hedge, but only with
respect to individual or aggregated obligations or liabilities of a
banking entity that arise from: (i) The banking entity acting as
intermediary on behalf of a customer that is not itself a banking
entity to facilitate the customer's exposure to the profits and losses
of the covered fund (similar to acting as a ``riskless principal''); or
(ii) a compensation arrangement with an employee of the banking entity
that directly provides investment advisory or other services to that
fund.\53\ Additionally, Sec. --.13(b) of the proposed rule requires
that the hedge represent a substantially similar offsetting exposure to
the same covered fund and in the same amount of ownership interest in
the covered fund arising out of the transaction that the acquisition or
retention of an ownership interest in the covered fund is intended to
hedge or otherwise mitigate.\54\ Proposed Sec. --.13(b) also requires
a banking entity to document, at the time the transaction is executed,
the hedging rationale for all hedging transactions involving an
ownership interest in a covered fund.\55\
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\53\ See proposed rule Sec. --.13(b)(1).
\54\ See proposed rule Sec. Sec. --.13(b)(2)(ii)(C) and (D).
\55\ See proposed rule Sec. --.13(b)(3).
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Section --.13(c) of the proposed rule implements section
13(d)(1)(I) of the BHC Act and permits certain foreign banking entities
to acquire or retain an ownership interest in, or to act as sponsor to,
a covered fund so long as such activity occurs solely outside of the
United States and the entity meets the requirements of sections 4(c)(9)
or 4(c)(13) of the BHC Act. This statutory exemption limits the
extraterritorial application of the statutory restrictions on covered
fund activities and investments to foreign firms that, in the course of
operating outside of the United States, engage in activities permitted
under relevant foreign law outside of the United States, while
preserving national treatment and competitive equality among U.S. and
foreign firms within the United States.\56\ The proposed rule defines
both the type of foreign banking entities that are eligible for the
exemption and the circumstances in which covered fund activities or
investments by such an entity will be considered to have occurred
solely outside of the United States (including clarifying when an
ownership interest will be considered to have been offered for sale or
sold to a resident of the United States). Section --.13(d) of the
proposed rule also implements in part the rule of construction
contained in section 13(g)(2) of the BHC Act, which permits the sale
and securitization of loans.\57\ Proposed Sec. --.13(d) clarifies that
a
[[Page 68853]]
banking entity may acquire and retain an ownership interest in, or act
as sponsor to, a covered fund that is an issuer of asset-backed
securities, the assets or holdings of which are solely comprised of:
(i) Loans; (ii) contractual rights or assets directly arising from
those loans supporting the asset-backed securities; and (iii) a limited
amount of interest rate or foreign exchange derivatives that materially
relate to such loans and that are used for hedging purposes with
respect to the securitization structure.\58\ The authority contained in
this section of the proposed rule would therefore allow a banking
entity to acquire and retain an ownership interest in a loan
securitization vehicle (which would be a covered fund for purposes of
section 13(h)(2) of the BHC Act and the proposed rule) that the banking
entity organizes and offers, or acts as sponsor to, in excess of the
three percent limits specified in section 13(d)(4) of the BHC Act and
Sec. --.12 of the proposed rule.
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\56\ See 156 Cong. Rec. S5897 (daily ed. July 15, 2010)
(statement of Sen. Merkley).
\57\ See 12 U.S.C. 1851(g)(2).
\58\ See proposed rule Sec. --.13(d).
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Section --.14 of the proposed rule implements section 13(d)(1)(J)
of the BHC Act\59\ and permits a banking entity to engage in any
covered fund activity or investment that the Agencies determine
promotes and protects the safety and soundness of banking entities and
the financial stability of the United States.\60\ The Agencies have
proposed to permit three activities at this time under this authority.
These activities involve acquiring and retaining an ownership interest
in, or acting as sponsor to, certain bank owned life insurance
(``BOLI'') separate accounts, investments in and sponsoring of certain
asset-backed securitizations, and investments in and sponsoring of
certain entities that rely on the exclusion from the definition of
investment company in section 3(c)(1) and/or 3(c)(7) of the Investment
Company Act of 1940 (15 U.S.C. 80a-1 et seq.) (``Investment Company
Act'') but that are, in fact, common corporate organizational
vehicles.\61\ Additionally, the Agencies have proposed to permit a
banking entity to acquire and retain an ownership interest in, or act
as sponsor to, a covered fund, if such acquisition or retention is done
(i) in the ordinary course of collecting a debt previously contracted,
or (ii) pursuant to and in compliance with the conformance or extended
transition periods implemented under section 13(c)(6) of the BHC
Act.\62\
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\59\ Section 13(d)(1)(J) of the BHC Act provides the Agencies
discretion to determine that activities not specifically identified
by sections 13(d)(1)(A)-(I) of the BHC Act are also exempted from
the general prohibitions contained in section 13(a) of that Act, and
are thus permitted activities. In order to make such a
determination, the Agencies must find that such activity or
activities promote and protect the safety and soundness of banking
entities, as well as promote and protect the financial stability of
the United States. See 12 U.S.C. 1851(d)(1)(J).
\60\ See 12 U.S.C. 1851(d)(1)(J).
\61\ See proposed rule Sec. --.13(a)(1)-(2).
\62\ See proposed rule at Sec. --.14(b).
---------------------------------------------------------------------------
Section --.15 of the proposed rule, which implements section
13(e)(1) of the BHC Act,\63\ requires a banking entity engaged in
covered fund activities and investments to comply with (i) the internal
controls, reporting, and recordkeeping requirements required under
Sec. --.20 and Appendix C of the proposed rule, as applicable and (ii)
such other reporting and recordkeeping requirements as the relevant
supervisory Agency may deem necessary to appropriately evaluate the
banking entity's compliance with subpart C.\64\
---------------------------------------------------------------------------
\63\ Section 13(e)(1) of the BHC Act requires the Agencies to
issue regulations regarding internal controls and recordkeeping to
ensure compliance with section 13. See 12 U.S.C. 1851(e)(1).
\64\ See proposed rule Sec. --.15.
---------------------------------------------------------------------------
Section --.16 of the proposed rule implements section 13(f) of the
BHC Act and generally prohibits a banking entity from entering into
certain transactions with a covered fund that would be a covered
transaction as defined in section 23A of the FR Act.\65\ Section
--.16(a)(2) of the proposed rule clarifies that, for reasons explained
in part III.C.7 of this Supplementary Information, certain transactions
between a banking entity and a covered fund remain permissible. Section
--.16(b) of the proposed rule implements the statute's requirement that
any transaction permitted under section 13(f) of the BHC Act (including
a prime brokerage transaction) between the banking entity and a covered
fund is subject to section 23B of the FR Act,\66\ which, in general,
requires that the transaction be on market terms or on terms at least
as favorable to the banking entity as a comparable transaction by the
banking entity with an unaffiliated third party.
---------------------------------------------------------------------------
\65\ See proposed rule Sec. --.16.
\66\ 12 U.S.C. 371c-1.
---------------------------------------------------------------------------
Section --.17 of the proposed rule prohibits a banking entity from
relying on any exemption to the prohibition on acquiring and retaining
an ownership interest in, acting as sponsor to, or having certain
relationships with, a covered fund, if the permitted activity or
investment would involve or result in a material conflict of interest,
result in a material exposure to high-risk assets or high-risk trading
strategies, or pose a threat to the safety and soundness of the banking
entity or to the financial stability of the United States.\67\ This
section also defines material conflict of interest, high-risk asset,
and high-risk trading strategy for these purposes.
---------------------------------------------------------------------------
\67\ See proposed rule Sec. --.17.
---------------------------------------------------------------------------
D. Compliance Program Requirement
Subpart D of the proposed rule requires a banking entity engaged in
covered trading activities or covered fund activities to develop and
implement a program reasonably designed to ensure and monitor
compliance with the prohibitions and restrictions on covered trading
activities and covered fund activities and investments set forth in
section 13 of the BHC Act and the proposed rule.\68\ Section --.20(b)
of the proposed rule specifies six elements that each compliance
program established under subpart D must, at a minimum, include:
---------------------------------------------------------------------------
\68\ See proposed rule Sec. --.20. If a banking entity does not
engage in covered trading activities and/or covered fund activities
and investments, it need only ensure that its existing compliance
policies and procedures include measures that are designed to
prevent the banking entity from becoming engaged in such activities
and making such investments, and which require the banking entity to
develop and provide for the required compliance program prior to
engaging in such activities or making such investments.
---------------------------------------------------------------------------
Internal written policies and procedures reasonably
designed to document, describe, and monitor the covered trading
activities and covered fund activities and investments of the banking
entity to ensure that such activities comply with section 13 of the BHC
Act and the proposed rule;
A system of internal controls reasonably designed to
monitor and identify potential areas of noncompliance with section 13
of the BHC Act and the proposed rule in the banking entity's covered
trading and covered fund activities and to prevent the occurrence of
activities that are prohibited by section 13 of the BHC Act and the
proposed rule;
A management framework that clearly delineates
responsibility and accountability for compliance with section 13 of the
BHC Act and the proposed rule;
Independent testing for the effectiveness of the
compliance program, conducted by qualified banking entity personnel or
a qualified outside party;
Training for trading personnel and managers, as well as
other appropriate personnel, to effectively implement and enforce the
compliance program; and
Making and keeping records sufficient to demonstrate
compliance with section 13 of the BHC Act and the proposed rule, which
a banking entity must promptly provide to the relevant Agency upon
request and retain for a period of no less than 5 years.
[[Page 68854]]
For a banking entity with significant covered trading activities or
covered fund activities and investments, the compliance program must
also meet a number of minimum standards that are specified in Appendix
C of the proposed rule.\69\ The application of detailed minimum
standards for these types of banking entities is intended to reflect
the heightened compliance risks of large covered trading activities and
covered fund activities and investments and to provide clear, specific
guidance to such banking entities regarding the compliance measures
that would be required for purposes of the proposed rule. For banking
entities with smaller, less complex covered trading activities and
covered fund activities and investments, these detailed minimum
standards are not applicable, though the Agencies expect that such
smaller entities will consider these minimum standards as guidance in
designing an appropriate compliance program.
---------------------------------------------------------------------------
\69\ A banking entity must comply with the minimum standards
specified in Appendix C of the proposed rule (i) with respect to its
covered trading activities, if it engages in any covered trading
activities and has, together with its affiliates and subsidiaries,
trading assets and liabilities the average gross sum of which (on a
worldwide consolidated basis), as measured as of the last day of
each of the four prior calendar quarters, (X) is equal to or greater
than $1 billion or (Y) equals 10 percent or more of its total
assets; and (ii) with respect to its covered fund activities and
investment, if it engages in any covered fund activities and
investments and either (X) has, together with its affiliates and
subsidiaries, aggregate investments in covered funds the average
value of which is, as measured as of the last day of each of the
four prior calendar quarters, equal to or greater than $1 billion or
(Y) sponsors and advises, together with its affiliates and
subsidiaries, covered funds the average total assets of which are,
as measured as of the last day of each of the four prior calendar
quarters, equal to or greater than $1 billion.
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E. Conformance Provisions
Subpart E of the Board's proposed rule incorporates, with minor
technical and conforming edits, the final rule which the Board, after
soliciting and considering public comment, issued regarding the
conformance periods for entities engaged in prohibited proprietary
trading or covered fund activities and investments.\70\ That rule
implements the conformance period and extended transition period, as
applicable, during which a banking entity and nonbank financial company
supervised by the Board must bring its activities, investments and
relationships into compliance with the prohibitions and restrictions on
proprietary trading and acquiring an ownership interest in, or having
certain relationships with, a covered fund.
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\70\ See 76 FR 8265 (Feb. 14, 2011).
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F. Treatment of Smaller, Less-Complex Banking Entities
In formulating the proposed rule, the Agencies have carefully
considered and taken into account the potential impact of the proposed
rule on small banking entities and banking entities that engage in
little or no covered trading activities or covered fund activities and
investments, including the burden and cost that might be associated
with such banking entities' compliance with the proposed rule. In
particular, the Agencies have proposed to reduce the effect of the
proposed rule on such banking entities by limiting the application of
certain requirements, such as the reporting and recordkeeping
requirements of Sec. --.7 and Appendix A of the proposed rule and the
compliance program requirements contained in subpart D and Appendix C
of the proposed rule, to those banking entities that engage in little
or no covered trading activities or covered fund activities and
investments. The Agencies have also requested comment (i) throughout
this Supplementary Information on a number of questions related to the
costs and burdens associated with particular aspects of the proposal,
as well as (ii) in Part VII.B of this Supplementary Information on any
significant alternatives that would minimize the impact of the proposal
on small banking entities.
G. Application of Section 13 of the BHC Act to Securitization Vehicles
or Issuers of Asset-Backed Securities
Many issuers of asset-backed securities may be included within the
definition of covered fund since they would be an investment company
but for the exclusions contained in section 3(c)(1) or 3(c)(7) of the
Investment Company Act.\71\ If an issuer of asset-backed securities is
considered to be a covered fund, then a banking entity would not be
permitted to acquire or retain any ownership interest issued by such
issuer except as otherwise permitted under section 13 of the BHC Act
and the proposed rule.\72\ Separately, issuers of asset-backed
securities may be included within the definition of banking entity, as
noted in Part III.A.2 of this Supplementary information. Although the
proposed definition of banking entity would not include any entity that
is a covered fund, an issuer of asset-backed securities that is both
(i) an affiliate or subsidiary of a banking entity,\73\ and (ii) does
not rely on an exclusion contained in section 3(c)(1) of 3(c)(7) of the
Investment Company Act, would be a banking entity and thus subject to
the requirements of section 13 of the BHC Act and the proposed rule,
including: (i) The prohibition on proprietary trading; (ii) limitations
on investments in and relationships with a covered fund; (iii) the
establishment and implementation of a compliance program as required
under the proposed rule; and (iv) recordkeeping and reporting
requirements. Given the breadth of the definition of ``affiliate,''
these requirements may apply to a significant portion of the
outstanding securitization market, including issuers of asset-backed
securities that rely on rule 3a-7 or section 3(c)(5) of the Investment
Company Act.
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\71\ For purposes of the proposed rule, any securitization
entity that meets the requirements for an exclusion under Rule 3a-7
or section 3(c)(5) of the Investment Company Act, or any other
exclusion or exemption from the definition of ``investment company''
under the Investment Company Act (other than sections 3(c)(1) or
3(c)(7) of the Investment Company Act), would not be a covered fund
under the proposed definition. Additionally, an issuer of asset-
backed securities that is subject to legal documents mandating
compliance with the conditions of section 3(c)(1) of 3(c)(7) of the
Investment Company Act would not be a covered fund if such issuer
also can satisfy all the conditions of an alternative exclusion or
exemption for which it is eligible.
\72\ For example, under the proposed rule, a banking entity
would be able to acquire or retain an interest or security of an
issuer of asset-backed securities that is a covered fund if: (i) The
interest or security of the issuer does not qualify as an
``ownership interest'' under Sec. --.10(b)(3) of the proposed rule;
(ii) the issuer of asset-backed securities is comprised solely of
loans, contractual rights or assets directly arising from those
loans, and certain specified interest rate or foreign exchange
derivatives used for hedging purposes, as permitted under Sec.
--.13(d) or --.14(a)(2)(v) of the proposed rule; (iii) the banking
entity is a ``securitizer'' or ``originator'' and acquires and
retains such interest in compliance with the minimum requirements of
section 15G of the Exchange Act and any implementing regulations
issued thereunder, as provided under Sec. --.14(a)(2)(iii) of the
proposed rule; or (v) the banking entity organizes and offers the
issuer and the ownership interest is a permitted investment under
Sec. --.12 of the proposed rule. The circumstances where a banking
entity may acquire or retain an ownership interest in a covered fund
are discussed in detail in Part III.C of this Supplemental
Information.
\73\ The definitions of ``affiliate'' and ``subsidiary'' are
discussed in detail in Part III.A.2 of this Supplemental
Information.
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In recognition of these concerns, the Agencies have requested
comment throughout this Supplementary Information on the potential
effects of section 13 of the BHC Act and the proposed rule on the
securitization industry and issuers of asset-backed securities.
[[Page 68855]]
III. Section by Section Summary of Proposed Rule
A. Subpart A--Authority and Definitions
1. Section --.1: Authority, Purpose, Scope, and Relationship to Other
Authorities
a. Authority and Scope
Section --.1 of the proposed rule describes the authority under
which each Agency is issuing the proposed rule, the purpose of the
proposed rule, and the banking entities to which each Agency's rule
applies. In addition, Sec. --.1(d) of the proposed rule implements
section 13(g)(1) of the BHC Act, which provides that the prohibitions
and restrictions of section 13 apply to the activities of a banking
entity regardless of whether such activities are authorized for a
banking entity under other applicable provisions of law.\74\
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\74\ See proposed rule Sec. --.1(d).
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b. Effective Date
Section 13(c)(1) of the BHC Act provides that section 13 shall take
effect on the earlier of (i) 12 months after the date of issuance of
final rules implementing that section, or (ii) 2 years after the date
of enactment of section 13, which is July 21, 2012.\75\ Because the
Agencies did not issue final rules implementing section 13 of the BHC
Act by July 21, 2011, Sec. --.1 of the proposed rule specifies that
the effective date for its provisions will be July 21, 2012.
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\75\ See 12 U.S.C. 1851(c)(1).
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The Agencies note that the proposed effective date will impact not
only the date on which the proposed rule's prohibitions and
restrictions on proprietary trading and covered fund activities and
investments go into effect (subject to the conformance period or
extended transition period provided by section 13(c) of the BHC
Act),\76\ but also the date on which a banking entity must comply with
(i) the reporting and recordkeeping requirements of Sec. --.7 and
Appendix A of the proposed rule and (ii) the compliance program mandate
of Sec. --.20 and Appendix C of the proposed rule. As proposed, Sec.
--.1 would require a banking entity subject to either the reporting and
recordkeeping or compliance program requirements to begin complying
with these requirements as of July 21, 2012.\77\ With respect to the
compliance program requirement of the proposed rule, Sec. --.1 would
require a banking entity to have developed and implemented the required
program by the proposed effective date, though the Agencies note that
prohibited activities and investments may not be fully conformed by
that date. The Agencies expect a banking entity to fully conform all
investments and activities to the requirements of the proposed rule as
soon as practicable within the conformance periods provided in section
13 of the BHC Act and the Board's rules thereunder, which define the
conformance periods. With respect to the reporting and recordkeeping
requirements of the proposed rule, Sec. --.1 of the proposed rule
would require a banking entity to begin furnishing these reports for
all trading units or asset management units as of the effective date,
though the quantitative measurements furnished for proprietary trading
activities that are conducted in reliance on the authority provided by
the conformance period would not be used to identify prohibited
proprietary trading until such time as the relevant trading activities
must be conformed.
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\76\ See id. at 1851(c)(2)-(6).
\77\ See proposed rule Sec. --.1.
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The Agencies expect that a banking entity may need a period of time
to prepare for effectiveness of the proposed rule and, in particular,
to implement both the compliance program and the reporting and
recordkeeping requirements provided under the proposed rule.
Accordingly, in order to help assess the effects and impact of the
proposed effective date and any alternative compliance dates, the
Agencies request comment on the following questions:
Question 1. Does the proposed effective date provide banking
entities with sufficient time to prepare to comply with the
prohibitions and restrictions on proprietary trading and covered fund
activities and investments? If not, what other period of time is needed
and why?
Question 2. Does the proposed effective date provide banking
entities with sufficient time to implement the proposal's compliance
program requirement? If not, what are the impediments to implementing
specific elements of the compliance program and what would be a more
effective time period for implementing each element and why?
Question 3. Does the proposed effective date provide banking
entities sufficient time to implement the proposal's reporting and
recordkeeping requirements? If not, what are the impediments to
implementing specific elements of the proposed reporting and
recordkeeping requirements and what would be a more effective time
period for implementing each element and why?
Question 4. Should the Agencies use a gradual, phased in approach
to implement the statute rather than having the implementing rules
become effective at one time? If so, what prohibitions and restrictions
should be implemented first? Please explain.
2. Section --.2: Definitions
Section --.2 of the proposed rule defines a variety of terms used
throughout the proposed rule, including ``banking entity,'' which
defines the scope of entities to which the proposed rule applies.
Consistent with the statutory definition of that term, Sec. --.2(e) of
the proposed rule provides that a ``banking entity'' includes: (i) Any
insured depository institution; (ii) any company that controls an
insured depository institution; (iii) any company that is treated as a
bank holding company for purposes of section 8 of the International
Banking Act of 1978 (12 U.S.C. 3106); and (iv) any affiliate or
subsidiary of any of the foregoing.\78\ In addition, in order to avoid
application of section 13 of the BHC Act in a way that appears
unintended by the statute and would create internal inconsistencies in
the statutory scheme, the proposed rule also clarifies that the term
``banking entity'' does not include any affiliate or subsidiary of a
banking entity, if that affiliate or subsidiary is (i) a covered fund,
or (ii) any entity controlled by such a covered fund.\79\ This
clarification is proposed because the definition of ``affiliate'' and
``subsidiary'' under the BHC Act is broad, and could include a covered
fund that a banking entity has permissibly sponsored or made an
investment in because, for example, the banking entity acts as general
partner or managing member of the covered fund as part of its permitted
sponsorship activities.\80\ If
[[Page 68856]]
such a covered fund were considered a ``banking entity'' for purposes
of the proposed rule, the fund itself would become subject to all of
the restrictions and limitations of section 13 of the BHC Act and the
proposed rule, which would be inconsistent with the purpose and intent
of the statute. For example, such a covered fund would then generally
be prohibited from investing in other covered funds, notwithstanding
the fact that section 13(f)(3) of the BHC Act specifically contemplates
such investments. Accordingly, the proposed rule would exclude from the
definition of banking entity any fund that a banking entity may invest
in or sponsor as permitted by the proposed rule.
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\78\ See proposed rule Sec. --.2(e). Sections --.2(a) and (bb)
of the proposed rule clarify that the terms ``affiliate'' and
``subsidiary'' have the same meaning as in sections 2(d) and (k) of
the BHC Act (12 U.S.C. 1841(d) and (k)).
\79\ The Agencies note that since the proposed rule implements
section 13 of the BHC Act, it incorporates that Act's definition of
``affiliate'' and ``subsidiary.'' See proposed rule Sec. Sec.
--.2(a) and (bb). The terms affiliate and subsidiary are generally
defined in section 2 of the BHC Act according to whether such entity
controls or is controlled by another relevant entity. See 12 U.S.C.
1841(d), (k). The concept of control under the proposed rule, in
turn, is as defined in section 2 of the BHC Act and as implemented
by the Board. See 12 U.S.C. 1841(a)(2); 12 CFR 225.2(e).
\80\ Under section 2 of the BHC Act and the Board's Regulation Y
(12 CFR part 225), a banking entity acting as general partner or
managing member of another company would be deemed to control that
company and, as such, the company would be both an ``affiliate'' and
``subsidiary'' of the banking entity for purposes of the BHC Act.
See 12 U.S.C. 1841(d), (k).
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An entity such as a mutual fund would generally not be a subsidiary
or affiliate of a banking entity under this definition if the banking
entity only provides advisory or administrative services to, has
certain limited investments in, or organizes, sponsors, and manages a
mutual fund (which includes a registered investment company) in
accordance with BHC Act rules.\81\
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\81\ See, e.g., 12 U.S.C. 1483(c)(6), (c)(8), and (k); 12 CFR
225.28(b)(6), 225.86(b)(3).
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Section --.2(j) of the proposed rule defines the term ``covered
banking entity,'' which is used in each Agency's proposed rule to
describe the specific types of banking entities to which that Agency's
rule applies. In addition, a number of other definitions contained in
Sec. --.2 are discussed in further detail below in connection with the
separate sections of the proposed rule in which they are used.
The proposed rule also defines the terms ``buy and purchase'' and
``sell and sale,'' which are used throughout the proposed rule to
describe the scope of transactions that are subject to subparts B and C
of the proposed rule. These definitions are substantially similar to
the definitions of the same terms under the Exchange Act, except that
the proposed definitions provide additional clarity regarding the types
of transactions that would be considered the purchase or sale of a
commodity future or derivative or ownership interest in a covered
fund.\82\ These definitions are purposefully broad in scope, and are
intended to include a wide range of transaction types that would permit
a banking entity to gain or eliminate, or increase or reduce, exposure
to a covered financial position or ownership interest in a covered
fund.
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\82\ See proposed rule Sec. Sec. --.2(g), (v); 15 U.S.C.
78c(a)(13), (14).
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Request for Comment
The Agencies request comment on the proposed rule's definition of
``banking entity.'' In particular, the Agencies request comment on the
following questions:
Question 5. Is the proposed rule's definition of banking entity
effective? What alternative definitions might be more effective in
light of the language and purpose of the statute?
Question 6. Are there any entities that should not be included
within the definition of banking entity since their inclusion would not
be consistent with the language or purpose of the statute or could
otherwise produce unintended results? Should a registered investment
company be expressly excluded from the definition of banking entity?
Why or why not?
Question 7. Is the proposed rule's exclusion of a covered fund that
is organized, offered and held by a banking entity from the definition
of banking entity effective? Should the definition of banking entity be
modified to exclude any covered fund? Why or why not?
Question 8. Banking entities commonly structure their registered
investment company relationships and investments such that the
registered investment company is not considered an affiliate or
subsidiary of the banking entity. Should a registered investment
company be expressly excluded from the definition of banking entity?
Why or why not? Are there circumstances in which such companies should
be treated as banking entities subject to section 13 of the BHC Act?
How many such companies would be covered by the proposed definition?
Question 9. Under the proposed rule, would issuers of asset-backed
securities be captured by the proposed definition of ``banking
entity''? If so, are issuers of asset-backed securities within certain
asset classes particularly impacted? Are particular types of
securitization vehicles (trusts, LLCs, etc.) more likely than others to
be included in the definition of banking entity? Should issuers of
asset-backed securities be excluded from the proposed definition of
``banking entity,'' and if so, why? How would such an exclusion be
consistent with the language and purpose of the statute?
Question 10. What would be the potential impact of including
existing issuers of asset-backed securities \83\ in the proposed
definition of ``banking entity'' on existing issuers of asset-backed
securities and the securitization market generally? How many existing
issuers of asset-backed securities might be included in the proposed
definition of ``banking entity''? Are there ways in which the proposed
rule could be amended to mitigate or eliminate potential impact, if
any, on existing asset-backed securities \84\ without compromising the
intent of the statute?
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\83\ For purposes of this Supplemental Information, ``existing
issuers of asset-backed securities'' means issuers that issued
asset-backed securities prior to the effective date of the proposed
rule.
\84\ For purposes of this Supplemental Information, ``existing
asset-backed securities'' means asset-backed securities that were
issued prior to the effective date of the proposed rule.
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Question 11. What would be the legal and economic impact to an
issuer of asset-backed securities of being considered a ``banking
entity''? What additional costs would be incurred in the establishment
and implementation of a compliance program related to the provisions of
the proposed rule as required by Sec. --.20 of the proposed rule
(including Appendix C, where applicable)? Who would pay those
additional costs?
Question 12. If the ownership requirement under the proposed rule
for credit risk retention (section 15G of the Exchange Act) combined
with the control inherent in the position of servicer or investment
manager means that more securitization vehicles would be considered
affiliates of banking entities, would fewer banking entities be willing
to (i) serve as the servicer or investment manager of securitization
transactions and/or (ii) serve as the originator or securitizer (as
defined in section 15G of the Exchange Act) of securitization
transactions? What other impact might the potential interplay between
these rules have on future securitization transactions? Could there be
other potential unintended consequences?
Question 13. Are the proposed rule's definitions of buy and
purchase and sale and sell appropriate? If not, what alternative
definitions would be more appropriate? Should any other terms be
defined? If so, are there existing definitions in other rules or
regulations that could be used in this context? Why would the use of
such other definitions be appropriate?
B. Subpart B--Proprietary Trading Restrictions
1. Section --.3: Prohibition on Proprietary Trading
Section --.3 of the proposed rule describes the scope of the
prohibition on proprietary trading and defines a
[[Page 68857]]
number of terms related to proprietary trading. The Agencies note that
the definition of ``proprietary trading'' in the statute and under the
proposed rule is broad. This definition must be viewed in light of the
exemptions described later in the proposed rule, which reflect
statutory provisions permitting a number of activities.
a. Prohibition on Proprietary Trading
Section --.3(a) of the proposed rule implements section 13(a)(1)(A)
of the BHC Act and prohibits a banking entity from engaging in
proprietary trading unless otherwise permitted under Sec. Sec. --.4
through --.6 of the proposed rule. Section --.3(b)(1) of the proposed
rule defines proprietary trading in accordance with section 13(h)(4) of
the BHC Act.\85\ This definition is a key element of the proposal
because, unless an activity covered by the definition is specifically
permitted under one of the exemptions contained in Sec. Sec. --.4
through --.6 of the proposed rule, a banking entity is prohibited from
engaging in that activity. Specifically, the proposal largely restates
the statutory definition of proprietary trading, defining that term to
mean engaging in the purchase or sale of one or more covered financial
positions as principal for the trading account of the banking
entity.\86\ The terms ``trading account'' and ``covered financial
position'' are defined in Sec. Sec. --.3(b)(2) and --.3(b)(3) of the
proposed rule, respectively. The proposed definition of proprietary
trading also clarifies that proprietary trading does not include acting
as agent, broker, or custodian for an unaffiliated third party, because
acting in these types of capacities does not involve trading as
principal, which is one of the requisite aspects of the statutory
definition.
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\85\ See proposed rule Sec. --.3(b)(1).
\86\ See 12 U.S.C. 1851(h)(4); see also proposed rule Sec.
--.3(b)(1). Although the statutory definition refers to the
``purchase, sale, acquisition, or disposition of'' covered financial
positions, the proposed rule uses the simpler terms ``purchase'' and
``sale,'' which are defined broadly in Sec. Sec. --.2(g) and (v) of
the proposed rule.
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b. ``Trading Account''
i. Definition of ``Trading Account''
Section 13(h)(6) of the BHC Act defines the term ``trading
account'' as ``any account used for acquiring or taking positions in
securities [or other enumerated instruments] principally for the
purpose of selling in the near-term (or otherwise with the intent to
resell in order to profit from short-term price movements),'' as well
as any such other accounts that the Agencies by rule determine.\87\ As
an initial matter, the Agencies note that it is often difficult to
clearly identify the purpose for which a position is acquired or taken
and whether that purpose is short-term in nature, particularly since
identification of that purpose generally depends on the intent with
which the position is acquired or taken. Moreover, the statute does not
define the terms ``near-term'' or ``short-term'' for these purposes.
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\87\ See 12 U.S.C. 1851(h)(6).
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In implementing the statutory definition of trading account, the
proposed rule generally restates the statutory definition, with the
addition of certain details intended to provide banking entities with
greater clarity regarding the scope of positions that fall within the
definition of trading account.\88\ The proposed definition of trading
account has three prongs. First, under the proposed rule, a trading
account includes any account that is used by a banking entity to
acquire or take one or more covered financial positions for the purpose
of: (i) Short-term resale; (ii) benefitting from actual or expected
short-term price movements; (iii) realizing short-term arbitrage
profits; or (iv) hedging one or more such positions.\89\ Second, the
proposed definition of trading account also includes any account used
by a banking entity that is subject to the Market Risk Capital Rules to
acquire or take one or more covered financial positions that are
subject to those rules, other than certain foreign exchange and
commodity positions.\90\ Third, the proposed definition of trading
account also includes any account used by a banking entity that is a
securities dealer, swap dealer, or security-based swap dealer to
acquire or take positions in connection with its dealing
activities.\91\ To provide additional clarity and guidance regarding
the trading account definition, the proposed rule also includes a
rebuttable presumption that any account used to acquire or take a
covered financial position that is held for sixty days or less is a
trading account under the first prong, unless the banking entity can
demonstrate that the position was not acquired principally for short-
term trading purposes. The proposed definition also clarifies that no
account will be a trading account to the extent that it is used to
acquire or take certain positions under repurchase or reverse
repurchase arrangements or securities lending transactions, positions
for bona fide liquidity management purposes, or certain positions held
by derivatives clearing organizations or clearing agencies. Each of the
three definitional prongs is independent of the others--any one prong
would, if met, cause the relevant account to fall within the definition
of ``trading account.''
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\88\ The Agencies note that the structure of the proposed
definition, which defines a trading account by reference to the
positions that the account is used to acquire or take, is consistent
with the structure of the statutory language used in section
13(h)(6) of the BHC Act.
\89\ See proposed rule Sec. ----.3(b)(2)(i)(A).
\90\ See proposed rule Sec. --.3(b)(2)(i)(B).
\91\ See proposed rule Sec. --.3(b)(2)(i)(C).
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The Agencies have drawn on existing rules, in particular the Market
Risk Capital Rules and various securities and commodities laws, in
identifying trading accounts and defining related terms in the
proposal.
ii. Positions Acquired or Taken for Short-Term Trading Purposes
The first prong of the proposed trading account definition refers
to positions that a banking entity acquires or takes principally for
short-term purposes--that is, for one of the following enumerated
purposes described in Sec. Sec. --.3(b)(2)(i)(A)(1) through (4) of the
proposed rule:
Short-term resale;
Benefitting from actual or expected short-term price
movements;
Realizing short-term arbitrage profits; or
Hedging one or more such positions.
This prong reflects the statutory definition's reference to
positions acquired or taken ``principally for the purpose of selling in
the near-term (or otherwise with the intent to resell in order to
profit from short-term price movements).'' \92\
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\92\ See 12 U.S.C. 1851(h)(6); see also proposed rule Sec.
--.3(b)(2)(i).
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Section --.3(b)(2)(i)(A)(1) of the proposed rule's definition of
trading account includes covered financial positions acquired or taken
principally for the purpose of short-term resale.\93\ This part of the
trading account definition restates language contained in the statutory
definition of trading account and describes one class of positions that
are acquired or taken for short-term trading purposes.
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\93\ See proposed rule Sec. --.3(b)(2)(i)(A)(1).
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Section --.3(b)(2)(i)(A)(2) of the proposed rule includes covered
financial positions acquired or taken principally for the purpose of
benefitting from actual or expected short-term price movements.\94\
This part of the trading account definition does not require the resale
of the position; rather, it requires only an intent to engage in any
form of transaction on a short-term basis (including a transaction
[[Page 68858]]
separate from, but related to, the initial acquisition of the position)
for the purpose of benefitting from a short-term movement in the price
of the underlying position. This part of the proposed definition would,
for example, include a derivative or other position where the banking
entity enters into (or intends to enter into) a subsequent transaction
in the near-term to simply offset or ``close out,'' rather than sell,
all or a portion of the risks of the initial position, in order to
benefit from a price movement occurring between the acquisition of the
underlying position and the subsequent offsetting transaction.
Similarly, it would also include a derivative, commodity future, or
other position that, regardless of the term of that position, is
subject to the exchange of short-term variation margin through which
the banking entity intends to benefit from short-term price movements.
The proposed definition would also capture the acquisition of a debt
instrument where the banking entity intends to enter into a short-term
transaction to simply offset, rather than sell, the credit, interest
rate and/or other material risk elements of the initial position so as
to benefit from a price movement occurring between acquisition of the
underlying position and the subsequent offsetting transaction.
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\94\ See proposed rule Sec. --.3(b)(2)(i)(A)(2).
---------------------------------------------------------------------------
Section --.3(b)(2)(i)(A)(3) of the proposed rule's definition of
trading account includes covered financial positions acquired or taken
principally to lock in short-term arbitrage profits.\95\ Although
similar to the positions described in Sec. ----.3(b)(2)(i)(A)(2) of
the proposed definition (i.e., those acquired for the purpose of
benefitting from actual or expected short-term price movements), this
part of the definition focuses on short-term arbitrage profits more
generally, without regard to whether the transaction is predicated on
expected or actual movements in price. Rather, a position acquired to
lock in arbitrage profits would include positions acquired or taken
with the intent to benefit from differences in multiple market prices,
even in cases in which no movement in those prices is necessary to
realize the intended profit. Such arbitrage-based transactions might
involve profiting from the difference in the market price of multiple
related positions or assets, or might instead involve the difference in
market price for particular price or risk elements associated with
positions or assets. This would include, for example, arbitrage profits
resulting from the convergence or divergence in prices between
different positions held by a banking entity engaged in relative value
convergence arbitrage, which involves marrying a long and short
position to benefit from a convergence or divergence in price between
the two, or any similar strategy, because such convergence or
divergence could happen at any time (i.e., in one day, in sixty-one
days, or some other time period).
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\95\ See proposed rule Sec. --.3(b)(2)(i)(A)(3).
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Section --.3(b)(2)(i)(A)(4) of the proposed rule's definition of
trading account includes covered financial positions acquired or taken
for the purpose of hedging another position that is itself held in a
trading account.\96\ In particular, the Agencies assume that, with
respect to any position the purpose of which is to hedge another
covered financial position in the trading account, the banking entity
generally intends to hold the hedging position, whatever its nominal
duration, for only so long as the underlying position is held.
Accordingly, the proposed rule makes clear that such hedging positions
fall within the definition of trading account.
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\96\ See proposed rule Sec. --.3(b)(2)(i)(A)(4).
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iii. Overview of Current Market Risk Capital Rules Approach to Short-
Term Trading Positions
The first prong of the proposed trading account definition, which
references positions acquired principally for short-term trading
purposes, is, like the statutory definition it implements,
substantially similar to a key portion of the definition of a ``covered
position'' under the Market Risk Capital Rules.\97\ For the reasons
discussed below, the Agencies have taken this similarity into account
and propose to construe the first prong of the definition of trading
account under the proposed rule--and in particular its reference to
``short-term''--in a manner that is consistent with the Market Risk
Capital Rules' approach to identifying positions taken with short-term
trading intent.
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\97\ The Federal banking agencies' current Market Risk Capital
Rules are located at 12 CFR Part 3, Appendix B (OCC), 12 CFR Part
208, Appendix E and 12 CFR Part 225, Appendix E (Board), and 12 CFR
Part 325, Appendix C (FDIC), and apply on a consolidated basis to
banks and bank holding companies with trading activity (on a
worldwide consolidated basis) that equals 10 percent or more of the
institution's total assets, or $1 billion or more. On January 11,
2011, the Federal banking agencies proposed revisions to the Market
Risk Capital Rules that include, inter alia, changes to the
definition of covered position. Proposed revisions to the Market
Risk Capital Rules include (i) changes to portions of the covered
position definition not relevant to the statutory definition of
trading account in section 13 of the BHC Act and (ii) the addition
of a requirement that any position in a trading account also be a
``trading position'' in order to be considered a covered position.
See 76 FR 1890 (Jan. 11, 2011). The revised definition of ``trading
position'' that has been proposed for those purposes is generally
identical to this proposed rule's definition of trading account
(i.e., a position acquired or taken: (i) For the purpose of short-
term resale; (ii) with the intent of benefitting from actual or
expected short-term price movements; (iii) to lock in short-term
arbitrage profits; or (iv) to hedge another trading position). The
Agencies also note that the first prong of the proposed rule's
trading account definition is also substantially similar to the
Basel Committee's definition of ``trading book.'' See Basel
Committee on Banking Supervision, Amendment to the Capital Accord to
Incorporate Market Risks, available at http://bis.org/publ/bcbs119.pdf.
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The Market Risk Capital Rules define a covered position to include
all positions in a bank's ``trading account,'' as that term is defined,
in part, in the Report of Condition and Income that banks are required
to file periodically with respect to their financial condition (``Call
Report''). Under the Market Risk Capital Rules, a covered position is
one that is subject to a risk-based capital charge that is based, at
least in part, on the banking organization's internal risk management
models for purposes of calculating the banking organization's risk-
based capital requirement.\98\ In defining the term ``trading
account,'' the Call Report notes that trading activities typically
include, among other activities, ``acquiring or taking positions in
such items principally for the purpose of selling in the near-term or
otherwise with the intent to resell in order to profit from short-term
price movements.'' \99\ This language is substantially identical to the
statutory
[[Page 68859]]
definition of trading account in section 13 of the BHC Act in that it
refers to acquiring or taking positions (i) principally for the purpose
of selling in the near-term or (ii) otherwise with the intent to resell
in order to profit from short-term price movements.
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\98\ The Agencies note that the Market Risk Capital Rules, both
in their current and proposed form, also (i) include within the
definition of covered position other positions not captured by the
reference to positions acquired for the purpose of short-term resale
or with the intent of benefitting from actual or expected short-term
price movements (e.g., all commodity and foreign exchange positions,
regardless of the intended holding period) and (ii) exclude from
that definition certain positions otherwise acquired with short-term
trading intent for a variety of policy reasons. The Agencies have
not proposed to incorporate such inclusions or exclusions for
purposes of the proposed rule's definition of trading account;
rather, the Market Risk Capital Rules and related concepts have been
referred to only to the extent that they pertain to positions
acquired for the purpose of short-term resale or with the intent of
benefitting from actual or expected short-term price movements.
\99\ Report of Condition and Income at A78a (also including, in
the definition of ``trading account,'' ``regularly underwriting or
dealing in securities; interest rate, foreign exchange rate,
commodity, equity, and credit derivative contracts; other financial
instruments; and other assets for resale * * * and * * * acquiring
or taking positions in such items as an accommodation to customers
or for other trading purposes.''). Accordingly, given its broader
scope, the Call Report ``trading account'' includes trading
positions that fall outside the statutory ``trading account'' for
purposes of determining what is prohibited and permitted covered
trading activity under section 13 of the BHC Act.
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In providing guidance regarding the application of ``trading
account,'' the Call Report also states that trading account positions
include any position that is classified as ``trading securities'' under
relevant U.S. Generally Accepted Accounting Principles (``GAAP'')
standards for accounting.\100\ Under the referenced accounting
standards, trading securities are defined as those ``that are bought
and held principally for the purpose of selling them in the near-term''
and ``generally used with the objective of generating profits on short-
term differences in price.'' \101\ The Agencies note that the
definition of a trading security under the relevant U.S. GAAP
accounting standards is similar to both (i) the financial positions
described in the second prong of the Call Report's definition of
trading account and (ii) the financial positions described in the
statutory definition of trading account under section 13 of the BHC
Act.
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\100\ See Report of Condition and Income at A78a, referring to
ASC Topic 320, Investments--Debt and Equity Securities (formerly
FASB Statement of Financial Accounting Standards No. 115,
``Accounting for Certain Investments in Debt and Equity
Securities'').
\101\ See id. In formulating the proposed rule, the Agencies
carefully considered whether to define trading account for purposes
of the proposed rule in a manner that formally incorporated the
accounting standards governing trading securities. The Agencies have
not proposed this approach because: (i) The statutory proprietary
trading prohibition under section 13 of the BHC Act applies to
financial instruments, such as derivatives, to which the trading
security accounting standards may not apply; (ii) these accounting
standards permit companies to classify, at their discretion, assets
as trading securities even where the assets would not otherwise meet
the definition of trading security; and (iii) these accounting
standards could change in the future without consideration of the
potential impact on section 13 of the BHC Act.
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Although neither the Market Risk Capital Rules, the Call Report,
nor relevant accounting standards provide a precise definition of what
constitutes ``near-term'' or ``short-term'' for purposes of evaluating
whether a position is of the type held in a trading account or is a
trading security, guidance provided under relevant accounting standards
notes that ``near-term'' for purposes of classifying trading activities
is ``generally measured in hours and days rather than months or
years.'' \102\ The Agencies expect that the precise period of time that
may be considered near-term or short-term for purposes of evaluating
any particular covered financial position would depend on a variety of
factors, including the facts and circumstances of the covered financial
position's acquisition, the banking entity's trading and business
strategies, and the nature of the relevant markets. In considering the
purpose for which a covered financial position is acquired or taken and
evaluating whether such position is acquired or taken for short-term
purposes, the Agencies intend to rely on a variety of information,
including quantitative measurements of banking entities' covered
trading activities (as described below in Part II.B.5 of this
Supplementary Information), supervisory review of banking entities'
compliance practices and internal controls, and supervisory review of
individual transactions.
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\102\ See FASB ASC Master Glossary definition of ``trading.''
Although Sec. --.3(b)(2)(ii) of the proposed rule includes a
rebuttable presumption that an account used to acquire or take
certain covered financial positions that are held for 60 days or
less is a trading account, the Agencies note that U.S. GAAP does not
include a presumption that securities sold within 60 days of
acquisition were held for the purpose of selling them in the near
term.
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In order to better reinforce the general consistency between the
proposal's approach to defining a trading account and the ``trading
account'' concept embedded in the Market Risk Capital Rules, the second
prong of the proposed definition of trading account, contained in Sec.
--.3(b)(2)(i)(B) of the proposed rule, provides that a trading account
includes any account used to acquire or take one or more covered
financial positions, other than positions that are foreign exchange
derivatives, commodity derivatives, or contracts of sale of a commodity
for future delivery (unless the position is otherwise held with short-
term intent), that are also market risk capital rule covered positions,
if the banking entity, or any affiliate of the banking entity that is a
bank holding company, calculates risk-based capital ratios under the
Market Risk Capital Rules.\103\ For these purposes, a ``market risk
capital rule covered position'' is defined as any covered position as
that term is defined for purposes of (i) in the case of a banking
entity that is a bank holding company or insured depository
institution, the market risk capital rule that is applicable to the
banking entity, and (ii) in the case of a banking entity that is
affiliated with a bank holding company, other than a banking entity to
which a market risk capital rule is applicable, the market risk capital
rule that is applicable to the affiliated bank holding company.\104\ In
particular, for banking entities already subject to the Market Risk
Capital Rules, it appears that positions subject to trading account
treatment under those rules because they involve short-term trading
intent are generally the type of positions to which the proprietary
trading restrictions of section 13 of the BHC Act were intended to
apply. In addition, including all covered financial positions that
receive trading account treatment under the Market Risk Capital Rules
because they meet a nearly identical standard regarding short-term
trading intent would also eliminate the potential for inconsistency or
regulatory arbitrage in which a banking entity might characterize a
position as ``trading'' for capital purposes but not for purposes of
the proposed rule.
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\103\ The Agencies have excluded positions that are foreign
exchange derivatives, commodity derivatives, or contracts of sale of
a commodity for future delivery from this prong of the proposed
trading account definition because all foreign exchange and
commodity positions are considered ``covered positions'' under the
Market Risk Capital Rules regardless of whether they involve the
short-term trading intent required under the statutory definition of
trading account in section 13(h)(6) of the BHC Act.
\104\ See proposed rule Sec. --.3(c)(8). Accordingly, in the
context of a subsidiary of a bank holding company (other than a
subsidiary, such as a bank, to which a market risk capital rule is
already directly applicable), if that bank holding company is
subject to a market risk capital rule, any position of that
subsidiary that meets the definition of a ``covered position'' under
the market risk capital rule applicable to the bank holding company
would be subject to Sec. --.3(b)(2)(i)(B) of the proposed rule.
---------------------------------------------------------------------------
The Agencies emphasize that this second prong of the trading
account definition is being proposed in contemplation of the proposed
revisions to the Market Risk Capital Rules and, in particular, the
proposed definition of ``covered position'' under those proposed
revisions. To the extent that those proposed revisions with respect to
the definition of ``covered position'' are not adopted, or adopted in a
form other than as proposed, the Agencies would expect to take that
into account in determining whether or how to include the proposed
second prong of the trading account definition for purposes of the
final rule to implement section 13 of the BHC Act.\105\
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\105\ In particular, the Agencies note that under the proposed
revisions to the Market Risk Capital Rules, but not the existing
Market Risk Capital Rule, the term ``covered position'' expressly
includes, other than with respect to commodity and foreign exchange
positions, only positions taken with short-term trading intent. See
76 FR 1890 (Jan. 11, 2011). The Agencies do not intend to
incorporate ``covered positions'' under the Market Risk Capital
Rules in a way that includes positions lacking short-term trading
intent.
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iv. Positions Acquired or Taken by Securities Dealers, Swap Dealers,
and Security-Based Swap Dealers
The third prong of the proposed definition of trading account is
contained in Sec. --.3(b)(2)(i)(C) of the
[[Page 68860]]
proposed rule and provides that a trading account includes any account
used to acquire or take one or more covered financial positions by a
banking entity that is: (i) A SEC-registered securities or municipal
securities dealer; (ii) a government securities dealer that registered,
or that has filed notice, with an appropriate regulatory agency; \106\
(iii) a CFTC-registered swap dealer; or (iv) a SEC-registered security-
based swap dealer, in each case to the extent that the covered
financial position is acquired or taken in connection with the
activities that require the banking entity to be registered, or to file
notice, as such.\107\ Similarly included is any covered financial
position acquired or taken by a banking entity that is engaged in the
business of a dealer, swap dealer, or security-based swap dealer
outside of the United States, if such position is acquired or taken in
connection with the activities of such business.\108\ As a result of
this third prong, all covered financial positions acquired or taken by
a registered dealer, swap dealer or security-based swap dealer, a
government securities dealer that has filed notice with an appropriate
regulatory agency, or a banking entity engaged in the same type of
dealing activities outside the United States, are automatically
included within the scope of positions described in the trading account
definition, if they are acquired or taken in connection with the
activities that require the banking entity to be registered, or file
notice, as such (or, in the case of a banking entity engaged in the
business of a dealer, swap dealer, or security-based swap dealer
outside of the United States, in connection with the activities of such
business). As discussed below, the proposed rule contains exemptions
that permit a variety of covered trading activity in which these types
of entities typically engage, notwithstanding the inclusion of all
covered financial positions of such entities within the definition of
trading account.
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\106\ See 15 U.S.C. 78c(a)(42)(E); 15 U.S.C. 78o5(a)(1)(B); 17
CFR 400.5(b); 17 CFR 449.1. Section 15C(a)(1)(A) of the Exchange Act
requires any government securities dealer, other than a registered
broker-dealer or a financial institution, to register with the SEC
pursuant to section 15C(a)(2). Registered broker-dealers and
financial institutions are required to file written notice with
their appropriate regulatory agency, as defined in section 3(a)(34)
of the Exchange Act, prior to acting as a government securities
dealer. See 15 U.S.C. 78o-5(a)(1)(B). The proposed definition of
trading account would cover positions of all three forms of
government securities dealers: (i) those registered with the SEC;
(ii) registered broker-dealers; and (iii) financial institutions
that have filed notice with an appropriate regulatory agency.
\107\ See proposed rule Sec. --.3(b)(2)(i)(C)(1)-(4). The
Agencies emphasize that this provision applies only to positions
taken in connection with the activities that require the banking
entity to be registered as one of the listed categories of dealer,
not to all of the activities of that banking entity. For example, an
insured depository institution may be registered as a swap dealer,
but only the swap dealing activities that require it to be so
registered would be covered by the second prong of the trading
account definition. A position taken in connection with other
activities of the insured depository institution that do not trigger
registration as a swap dealer, such as lending, deposit-taking, the
hedging of business risks, or other end-user activity, would only be
included within the trading account if the position met one of the
other prongs of the trading account definition (i.e., Sec. Sec.
--.3(b)(2)(i)(A) or (B) of the proposed rule).
\108\ See proposed rule Sec. --.3(b)(2)(i)(C)(5).
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The Agencies have proposed this third prong of the trading account
definition because all assets or other positions held by firms that
register or file notice as securities or derivatives dealers as part of
their dealing activity are generally held for sale to customers upon
request or otherwise support the firm's trading activities (e.g., by
hedging its dealing positions), and so would appear to involve the
requisite short-term intent and be captured within the statutory
definition of trading account. To the extent that a covered financial
position is acquired or taken by such a banking entity outside the
scope of the dealing activities that require the banking entity to be
registered, or to file notice, as a dealer, swap dealer, or security-
based swap dealer, that position may still cause the relevant account
to be a trading account under the proposed rule if the account holding
such a position otherwise meets the terms of the first or second prong
of the trading account definition (i.e., positions acquired or taken
for short-term trading purposes or certain Market Risk Capital Rules
positions).
v. Rebuttable Presumption for Certain Positions
In order to provide greater clarity and guidance on the application
of the trading account definition, and in particular for those banking
entities with no experience in evaluating short-term trading intent or
that are not subject to the Market Risk Capital Rules, the proposed
rule also includes a rebuttable presumption regarding certain positions
that, by reason of their holding period, are presumed to be trading
account positions. In particular, Sec. --.3(b)(2)(ii) of the proposed
rule provides that an account would be presumed to be a trading account
if it is used to acquire or take a covered financial position, other
than dealing positions or certain Market Risk Capital Rules covered
positions that are automatically considered part of the trading
account, that the banking entity holds for a period of sixty days or
less. However, the presumption does not apply if the banking entity can
demonstrate, based on all the facts and circumstances, that the covered
financial position, either individually or as a category, was not
acquired or taken principally for the purpose of short-term resale,
benefitting from short-term price movements, realizing short-term
arbitrage profits, or hedging another trading account position.\109\
Because it appears likely that most positions held for sixty days or
less would have been acquired with short-term trading intent, the
proposal presumes such positions are trading account positions unless
the banking entity can demonstrate otherwise. The purpose of the
proposed rebuttable presumption is to simplify the process of
evaluating whether individual positions are included in the definition
of trading account. The proposal does not apply this rebuttable
presumption to positions described in Sec. --.3(b)(2)(i)(B) or (C) of
the proposed rule (i.e., certain Market Risk Capital Rules positions
and dealing positions), because these positions are automatically part
of the trading account, and cannot be rebutted.
---------------------------------------------------------------------------
\109\ See proposed rule Sec. --.3(b)(2)(ii).
---------------------------------------------------------------------------
However, the Agencies recognize that, for a variety of reasons, a
banking entity may acquire a covered financial position for purposes
other than short-term trading but nonetheless dispose of that position
within the sixty-day period covered by the presumption. Accordingly,
Sec. --.3(b)(2)(ii) is only a presumption, and may be rebutted by
reference to all the facts and circumstances surrounding the
acquisition of a particular position. For example, if a banking entity
acquired a covered financial position with the demonstrable intent of
holding it for investment or other non-trading purposes but, because of
developments not expected or anticipated at the time of acquisition
(e.g., increased customer demand, an unexpected increase in its
volatility or a need to liquidate the position to meet unexpected
liquidity demands), held it for less than sixty days, those facts and
circumstances would generally suggest that the position was not
acquired with short-term trading intent, notwithstanding the
presumption.\110\ The proposed rule also makes clear that this rebuttal
may be made not only with respect to a particular transaction, but also
with respect to a particular category of transactions, recognizing that
it may be possible to identify a category of similar
[[Page 68861]]
transactions that clearly do not involve short-term trading,
notwithstanding the typical holding period of the related positions.
---------------------------------------------------------------------------
\110\ In such cases, the documented intention for acquiring or
taking the position should be consistent with the intention
articulated for financial reporting and other purposes.
---------------------------------------------------------------------------
It is important to note that these presumptions are designed to
help determine whether a transaction is within the definition of
``proprietary trading,'' not whether a transaction is permissible under
section 13 of the BHC Act. A transaction may fall within the definition
of ``proprietary trading'' and yet be permissible if it meets one of
the exemptions provided in the proposed rule, such as the exemption for
market making-related activities.
vi. Request for Comment
The Agencies request comment on the proposed rule's approach to
defining trading account. In particular, the Agencies request comment
on the following questions:
Question 14. Is the proposed rule's definition of trading account
effective? Is it over- or under-inclusive in this context? What
alternative definition might be more effective in light of the language
and purpose of the statute? How would such definition better identify
the accounts that are intended to be covered by section 13 of the BHC
Act?
Question 15. Is the proposed rule's approach for determining when a
position falls within the definition of ``trading account'' for
purposes of the proposed rule from when it must be reported in the
``trading account'' for purpose of filing the Call Report effective?
What additional guidance could the Agencies provide on this
distinction? Are there alternative approaches that would be more
effective in light of the language and purpose of the statute? Is this
approach workable for affiliates of bank holding companies that are not
subject to the Federal banking agencies' market Risk Capital Rules
(e.g., affiliated investment advisers)? If not, why not? Are affiliates
of bank holding companies familiar with the concepts from the Market
Risk Capital Rules that are being incorporated into the proposed rule?
If not, what steps would an affiliate of a bank holding company have to
take to become familiar with these concepts and what would be the costs
and/or benefits of such actions? Is application of the trading account
concept from the Federal banking agencies' Market Risk Capital Rules to
affiliates of bank holding companies necessary to promote consistency
and prevent regulatory arbitrage? Please explain.
Question 16. Is the manner in which the Agencies intend to take
into account, and substantially adopt, the approach used in the Market
Risk Capital Rules and related concepts for determining whether a
position is acquired with short-term trading intent effective?
Question 17. Should the proposed rule's definition of trading
account, or its use of the term ``short-term,'' be clarified? Are there
particular transactions or positions to which its application would be
unclear? Should the proposed rule define ``short-term'' for these
purposes? What alternative approaches to construing the term ``short-
term'' should the Agencies consider and/or adopt?
Question 18. Are there particular transactions or positions to
which the application of the proposed definition of trading account is
unclear? Is additional regulatory language, guidance, or clarity
necessary?
Question 19. Is the exchange of variation margin as a potential
indicator of short-term trading in derivative or commodity future
transactions appropriate for the definition of trading account? How
would this impact such transactions or the manner by which banking
entities conduct such transactions? For instance, would banking
entities seek to avoid the use of variation margin to avoid this rule?
What are the costs and benefits of referring to the exchange of
variation margin to determine if positions should be included in a
banking entity's trading account? Please explain.
Question 20. Are there particular transactions or positions that
are included in the definition of trading account that should not be?
If so, what transactions or positions and why?
Question 21. Are there particular transactions or positions that
are not included in the definition of trading account that should be?
If so, what transactions or positions and why?
Question 22. Is the proposed rule of construction for positions
acquired or taken by dealers, swap dealers and security-based swap
dealers appropriate and consistent with the purpose and language of
section 13 of the BHC Act? Is its application to any particular type of
entity, such as an insured depository institution engaged in
derivatives dealing activities, sufficiently clear and effective? If
not, what alternative would be clearer and/or more effective?
Question 23. Is the rebuttable presumption included in the proposed
rule appropriate and effective? Are there more effective ways in which
to provide clarity regarding the determination of whether or not a
position is included within the definition of trading account? If so,
what are they?
Question 24. Are records currently created and retained that could
be used to demonstrate investment or other non-trading purposes in
connection with rebutting the presumption in the proposed rule? If yes,
please identify such records and explain when they are created and
whether they would be useful in connection with a single transaction or
a category of similar transactions. If no, we seek commenter input
regarding the manner in which banking entities might demonstrate
investment or other non-trading intent. Should the Agencies require
banking entities to make and keep records to demonstrate investment or
non-trading intent with respect to their covered financial positions?
Question 25. How should the proposed trading account definition
address arbitrage positions? Should all arbitrage positions be included
in the definition of trading account, unless the timing of such profits
is long-term and established at the time the arbitrage position is
acquired or taken? Please explain in detail, including a discussion of
different arbitrage trading strategies and whether subjecting such
strategies to the proposed rule would be consistent with the language
and purpose of section 13 of the BHC Act.
Question 26. Is the holding period referenced in the rebuttable
presumption appropriate? If not, what holding period would be more
appropriate, and why?
Question 27. Should the proposed rule include a rebuttable
presumption regarding positions that are presumed not to be within the
definition of trading account? If so, why, and what would the
presumption be?
Question 28. Should any additional accounts be included in the
proposed rule pursuant to the authority granted under section 13(h)(6)
of the BHC Act? If so, what accounts and why? For example, should
accounts used to acquire or take certain long-term positions be
included in the definition? If so, how would subjecting such accounts
to the proposed rule's prohibitions and restrictions be consistent with
the language and purpose of section 13 of the BHC Act?
Question 29. Do any of the activities currently engaged in by
issuers of asset-backed securities that would be considered a banking
entity constitute proprietary trading as defined by Sec. --.3(b) of
this rule proposal? Would any activities relating to investment of
funds in accounts held by issuers of asset-backed securities (e.g.,
reserve accounts, prefunding accounts, reinvestment accounts, etc.) or
the purchase and sale of securities as part
[[Page 68862]]
of the management of a collateralized debt obligation portfolio be
considered proprietary trading under the proposed rule? What would be
the potential impact of the prohibition on proprietary trading on the
use of such accounts in (i) existing securitization transactions and
(ii) future securitization transactions? Would any of the securities
typically acquired and retained using these accounts be considered an
ownership interest in a covered fund under the proposed rule? Does the
exclusion of trading in certain government obligations in Sec. --.6(a)
of the proposed rule mitigate the impact of the proposed rule on such
issuers of asset-backed securities and their activities? Why or why
not?
c. Excluded Positions
i. Excluded Positions Under Certain Repurchase and Reverse Repurchase
Arrangements
Section --.3(b)(2)(iii)(A) of the proposed rule's definition of
trading account provides that an account will not be a trading account
to the extent that such account is used to acquire or take one or more
covered financial positions that arise under a repurchase or reverse
repurchase agreement pursuant to which the banking entity has
simultaneously agreed, in writing at the start of the transaction, to
both purchase and sell a stated asset, at stated prices, and on stated
dates or on demand with the same counterparty.\111\ This clarifying
exclusion is proposed because positions held under a repurchase or
reverse repurchase agreement operate in economic substance as a secured
loan, and are not based on expected or anticipated movements in asset
prices. Accordingly, these types of asset purchases and sales do not
appear to be the type of transaction intended to be covered by the
statutory definition of trading account.
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\111\ See proposed rule Sec. --.3(b)(2)(iii)(A).
---------------------------------------------------------------------------
ii. Excluded Positions Under Securities Lending Transactions
Section --.3(b)(2)(iii)(B) of the proposed rule's definition of
trading account provides that an account will not be a trading account
to the extent that such account is used to acquire or take one or more
covered financial positions that arise under a transaction in which the
banking entity lends or borrows a security temporarily to or from
another party pursuant to a written securities lending agreement under
which the lender retains the economic interests of an owner of such
security, and has the right to terminate the transaction and to recall
the loaned security on terms agreed to by the parties.\112\ This
clarifying exclusion is proposed because a position held under a
securities lending arrangement can be used, for example, to operate in
economic substance and function, as a means to facilitate settlement of
securities transactions, and is not based on expected or anticipated
movements in asset prices. Accordingly, securities lending transactions
do not appear to be the type of transaction intended to be covered by
the statutory definition of trading account.
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\112\ See proposed rule Sec. ----.3(b)(2)(iii)(B). The language
describing securities lending transactions in the proposed rule
generally mirrors that contained in Rule 3a5-3 under the Exchange
Act. See 17 CFR 240.3a5-3.
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iii. Excluded Positions Acquired or Taken for Liquidity Management
Purposes
Section ----.3(b)(2)(iii)(C) of the proposed definition of trading
account provides that an account will not be a trading account to the
extent that such account is used to acquire or take a position for the
purpose of bona fide liquidity management, so long as important
criteria are met.\113\
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\113\ See proposed rule Sec. ----.3(b)(2)(iii)(C).
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This proposed clarifying exclusion is intended to make clear that,
where the purpose for which a banking acquires or takes a position is
to ensure that it has sufficient liquid assets to meet its short-term
cash demands, and the related position is held as part of the banking
entity's liquidity management process, that transaction falls outside
of the types of transactions described in the proposed rule's
definition of trading account. Maintaining liquidity management
positions is a critical aspect of the safe and sound operation of
certain banking entities, and does not involve the requisite short-term
trading intent that forms the basis of the statutory definition of
``trading account.'' In the context of bona fide liquidity management
activity that would qualify for the clarifying exclusion, a banking
entity's purpose for acquiring or taking these types of positions is
not to benefit from short-term profit or short-term price movements,
but rather to ensure that it has sufficient, readily-marketable assets
available to meet its expected short-term liquidity needs.
However, the Agencies are concerned with the potential for abuse of
this clarifying exclusion--specifically, that a banking entity might
attempt to improperly mischaracterize positions acquired or taken for
prohibited proprietary trading purposes as positions acquired or taken
for liquidity management purposes. To address this, the proposed rule
requires that the transaction be conducted in accordance with a
documented liquidity management plan that meets five criteria. First,
the plan would be required to specifically contemplate and authorize
any particular instrument used for liquidity management purposes, its
profile with respect to market, credit and other risks, and the
liquidity circumstances in which the position may or must be used.
Second, the plan would have to require that any transaction
contemplated and authorized by the plan be principally for the purpose
of managing the liquidity of the banking entity, and not for the
purpose of short-term resale, benefitting from actual or expected
short-term price movements, realizing short-term arbitrage profits, or
hedging a position acquired or taken for such short-term purposes.
Third, the plan would have to require that any positions acquired or
taken for liquidity management purposes be highly liquid and limited to
financial instruments the market, credit and other risks of which are
not expected to give rise to appreciable profits or losses as a result
of short-term price movements.\114\ Fourth, the plan would be required
to limit any position acquired or taken for liquidity management
purposes, together with any other positions acquired or taken for such
purposes, to an amount that is consistent with the banking entity's
near-term funding needs, including deviations from normal operations,
as estimated and documented pursuant to methods specified in the plan.
Fifth, the plan would be required to be consistent with the relevant
Agency's supervisory requirements, guidance and expectations regarding
liquidity management. The Agencies would review these liquidity plans
and transactions effected in accordance with these plans through
supervisory and examination processes to ensure that the applicable
criteria are met and that any position acquired or taken in reliance on
the clarifying exclusion for liquidity management transactions is fully
consistent with such plans.
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\114\ Any instance in which positions characterized as taken for
liquidity purposes do give rise to appreciable profits or losses as
a result of short-term price movements will be subject to
significant Agency scrutiny and, absent compelling explanatory facts
and circumstances, would be viewed as prohibited proprietary trading
under the proposal.
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[[Page 68863]]
iv. Excluded Positions of Derivatives Clearing Organizations and
Clearing Agencies
Section --.3(b)(2)(iii)(D) of the proposed rule's definition of
trading account provides that an account will not be a trading account
to the extent that such account is used to acquire or take one or more
covered financial positions that are acquired or taken by a banking
entity that is a derivatives clearing organization registered under
section 5b of the Commodity Exchange Act (7 U.S.C. 7a-1) or a clearing
agency registered with the SEC under section 17A of the Exchange Act
(15 U.S.C. 78q-1) in connection with clearing derivatives or securities
transactions.\115\ This clarifying exclusion is proposed because, in
the case of a banking entity that acts as a registered, central
counterparty in the securities or derivatives markets, these types of
transactions do not appear to be the type of transaction intended to be
covered by the statutory definition of trading account, as the purpose
of such transactions is to provide a clearing service to third parties
and not to profit from short-term resale or short-term price movements.
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\115\ See proposed rule Sec. ----.3(b)(2)(iii)(D).
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v. Request for Comment
The Agencies request comment regarding the proposed clarifying
exclusions and whether any other types of activity or transactions
should be excluded from the proposed definition of trading account for
clarity. In particular, the Agencies request comment on the following
questions:
Question 30. Are the proposed clarifying exclusions for positions
under certain repurchase and reverse repurchase arrangements and
securities lending transactions over- or under-inclusive and could they
have unintended consequences? Is there an alternative approach to these
clarifying exclusions that would be more effective? Are the proposed
clarifying exclusions broad enough to include bona fide arrangements
that operate in economic substance as secured loans and are not based
on expected or anticipated movements in asset prices? Are there other
types of arrangements, such as open dated repurchase arrangements, that
should be excluded for clarity and, if so, how should the proposed rule
be revised? Alternatively, are the proposed clarifying exclusions
narrow enough to not inadvertently exclude from coverage any similar
arrangements or transactions that do not have these characteristics?
Question 31. Are repurchase and reverse repurchase arrangements and
securities lending transactions sufficiently similar that they should
be treated in the same way for purposes of the proposed rule? Are there
aspects of repurchase and reverse repurchase arrangements or securities
lending transactions that should be highlighted in considering the
application of the proposed rule? Do repurchase and reverse repurchase
arrangements or securities lending transactions raise any additional or
heightened concerns regarding risk? Please identify and explain how
these concerns should be reflected in the proposed rule.
Question 32. Are the proposed exclusions for repurchase and reverse
repurchase arrangements and securities lending transactions appropriate
or are there conditions that commenters believe would be appropriate as
a pre-requisite to relying on these exclusions? Please identify such
conditions and explain. Alternatively, we seek commenter input
regarding why repurchase and reverse repurchase arrangements and
securities lending transactions do not present the potential for abuse,
namely, that a banking entity might attempt to improperly
mischaracterize prohibited proprietary trading as activity that
qualifies for the proposed exclusions.
Question 33. Is the proposed clarifying exclusion for liquidity
management transactions effective and appropriate? If not, what
alternative would be more effective and appropriate, and why? Is the
proposed exclusion under- or over-inclusive? Does the proposed
clarifying exclusion place sufficient limitations on liquidity
management transactions to prevent abuse of the clarifying exclusion?
If not, what additional limitations should be specified? Are any of the
limitations contained in the proposed rule inappropriate or
unnecessary? If so, how could such limitations be eliminated or altered
in way that does not permit abuse of the clarifying exclusion?
Question 34: Is the proposed exclusion for liquidity management
positions necessary? If not excluded, would such activity otherwise
qualify for an exemption contained in the proposed rule (e.g., the
exemptions contains in Sec. Sec. ----.5 and ----.6(a) of the proposed
rule)? What types of banking entities are likely to engage in the
liquidity management activities described in the proposed exclusion?
Question 35: What types of instruments do particular types of
banking entities currently use in connection with liquidity management
activities (e.g., Treasuries)? Why are such instruments chosen for
liquidity management purposes? Would such instruments meet the proposed
requirement that the position be highly liquid and limited to financial
instruments the market, credit and other risk of which are not expected
to give rise to appreciable profits or losses as a result of short-term
price movements? Why or why not?
Question 36: What methodologies do banking entities currently use
for estimating deviations from normal operations in connection with
liquidity management programs?
Question 37: Which unit or units within a banking entity are
typically responsible for liquidity management? What is the typical
reporting line structure used to control and supervise that unit or
units? Are the responsibilities of personnel in the unit limited to
liquidity management or do they perform other functions in addition to
liquidity management? How is compensation determined for personnel in
the unit of the banking entity responsible for liquidity management?
Question 38: Would current liquidity management programs meet the
five proposed criteria for liquidity management programs? If not which
criteria would not be met, and why? What effect would the proposed
liquidity management exclusions have on current liquidity management
programs and banking entities in general?
Question 39: Are liquidity management programs used for purposes
other than ensuring the banking entity has sufficient assets available
to it that are readily marketable to meet expected short-term liquidity
needs? If so, for what purposes, and why?
Question 40: What costs or other burdens would arise if the
proposal did not contain an exclusion for positions acquired or taken
for liquidity management purpose? Please explain and quantify these
costs or other burdens in detail.
Question 41: Is the proposed liquidity management exclusion
sufficiently clear? If not, why is the exclusion unclear and how should
the Agencies clarify the terms of this exclusion?
Question 42. Is the proposed clarifying exclusion for certain
positions taken by derivatives clearing organizations and clearing
agencies effective and appropriate? If not, what alternative would be
more effective and appropriate, and why?
Question 43. Are any additional clarifying exclusions warranted? If
so, what clarifying exclusion, and why?
[[Page 68864]]
Question 44. Should the proposed definition exclude any position
the market risk of which cannot be hedged by the banking entity in a
two-way market?\116\ If so, what would be the basis for concluding that
such positions are clearly not within the statutory definition of
trading account?
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\116\ The Agencies also note that such an exclusion would be
similar to the express exclusion of similar positions under the
Federal banking agencies' most recent proposed revisions to the
Market Risk Capital Rules. See 76 FR 1890, 1912 (Jan. 11, 2011)
(excluding from the definition of a covered position any position
the material risk elements of which the holder is unable to hedge in
a two-way market).
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Question 45. Should the proposed definition include a clarifying
exclusion for any position in illiquid assets? If so, what would be the
basis for concluding that such positions are clearly not within the
statutory definition of trading account? How should ``illiquid assets''
be defined for these purposes? Should the definition be consistent with
the definition given that term in the Board's Conformance Rule under
section 13 of the BHC Act (12 CFR 225.180 et seq.)? \117\
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\117\ See 76 FR 8265 (Feb. 14, 2011). The Board's conformance
rule defines ``illiquid asset'' as ``any real property, security
obligation, or other asset that (i) is not a liquid asset; (ii)
because of statutory or regulatory restrictions applicable to the
hedge fund, private equity fund or asset, cannot be offered, sold,
or otherwise transferred by the hedge fund or private equity fund to
a person that is unaffiliated with the relevant banking entity; or
(iii) because of contractual restrictions applicable to the hedge
fund, private equity fund or asset, cannot be offered, sold, or
otherwise transferred by the hedge fund or private equity fund for a
period of 3 years or more to a person that is unaffiliated with the
relevant banking entity.'' 12 CFR 225.180(g). A ``liquid asset'' is
defined in paragraph (h) of the conformance rule. See 12 CFR
225.180(h).
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d. Covered Financial Position
i. Definition of ``Covered Financial Position''
Section --.3(b)(3)(i) of the proposed rule defines a covered
financial position as any long, short, synthetic or other position\118\
in: (i) A security, including an option on a security; (ii) a
derivative, including an option on a derivative; or (iii) a contract of
sale of a commodity for future delivery, or an option on such a
contract. The types of financial instruments described in the proposed
definition are consistent with those referenced in section 13(h)(4) of
the BHC Act as part of the statutory definition of proprietary
trading.\119\
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\118\ The proposed definition's reference to any ``long, short,
synthetic or other position'' is intended to make clear that a
position in an identified category of financial instrument qualifies
as a covered financial position regardless of whether the position
is (i) an asset or liability or (ii) is acquired through acquisition
or sale of the financial instrument or synthetically through a
derivative or other transaction.
\119\ Section 13(h)(4) of the BHC Act also permits the Agencies
to extend the scope of the proprietary trading restrictions to other
financial instruments. The Agencies have not proposed to do so at
this time.
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To provide additional clarity, Sec. ----.3(b)(3)(ii) of the
proposed rule provides that, consistent with the statute, the term
covered financial position does not include any position that is itself
a loan, a commodity, or foreign exchange or currency.\120\ The
exclusion of these types of positions is intended to eliminate
potential confusion by making clear that the purchase and sale of
loans, commodities and foreign exchange--none of which are referred to
in section 13(h)(4) of the BHC Act--are outside the scope of
transactions to which the proprietary trading restrictions apply. The
reference in Sec. ----.3(b)(3)(ii) to a position that is, rather than
a position that is in, a loan, a commodity, or foreign exchange or
currency is intended to capture only the purchase and sale of these
instruments themselves. This reflects the fact that, consistent with
section 13(h)(4) of the BHC Act and the proposed rule, although a
position that is a foreign exchange derivative or commodity derivative
is included in the definition of covered financial position and
therefore subject to the prohibition on proprietary trading, a position
that is a commodity or foreign currency is not.\121\ For example, the
spot purchase of a commodity would meet the terms of the exclusion, but
the acquisition of a futures position in the same commodity would not.
The Agencies request comment on the proposed rule's definition of
covered financial position. In particular, the Agencies request comment
on the following questions:
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\120\ See proposed rule Sec. ----.3(b)(ii).
\121\ The types of commodity- and foreign exchange-related
derivatives that are included within the definition of
``derivative'' under the proposed rule are discussed in detail below
in Part III.B.2.d.ii of this Supplementary Information.
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Question 46. Is the proposed rule's definition of covered financial
position effective? Is the definition over- or under-inclusive? What
alternative approaches might be more effective in light of the language
and purpose of section 13 of the BHC Act, and why?
Question 47. Are there definitions in other rules or regulations
that might inform the proposed definition of covered financial
position? If so, what rule or regulation? How should that approach be
incorporated into the proposed definition? Why would that approach be
more appropriate?
Question 48. Are there particular transactions or positions to
which the application of the proposed definition of covered financial
position is unclear? Is additional regulatory language, guidance, or
clarity necessary?
Question 49. The proposal would apply to long, short, synthetic, or
other positions in one of the listed categories of financial
instruments. Does this language adequately describe the type of
positions that are intended to fall within the proposed definition of
covered financial position? If not, why not? Are there different or
additional concepts that should be specified in this context? Please
explain.
Question 50. Should the Agencies expand the scope of covered
financial positions to include other transactions, such as spot
commodities or foreign exchange or currency, or certain subsets of
transaction (e.g., spot commodities or foreign exchange or currency
traded on a high-frequency basis)? If so, which instruments and why?
Question 51. What factors should the Agencies consider in deciding
whether to extend the scope of the proprietary trading restriction to
other financial instruments under the authority granted in section
13(h)(4) of the BHC Act? Please explain.
Question 52. Is the proposed exclusion of any position that is a
loan, a commodity, or foreign exchange or currency effective? If not,
what alternative approaches might be more effective in light of the
language and purpose of section 13 of the BHC Act? Should additional
positions be excluded? If so, why and under what authority?
ii. Other Terms Used in the Definition of Covered Financial Position
The proposal also defines a number of terms used in the proposed
definition of covered financial position. The term ``security'' is
defined by reference to that same term under the Exchange Act.\122\ The
terms ``commodity'' and ``contract of sale of a commodity for future
delivery'' are defined by reference to those same terms under the
Commodity Exchange Act.\123\ The Agencies have proposed to reference
these existing definitions from the securities and commodities laws
because these existing definitions are generally well-understood by
market participants and have been subject to extensive interpretation
in the context of securities and commodities trading activities.
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\122\ See proposed rule Sec. ----.2(w).
\123\ See proposed rule Sec. Sec. ----.3(c)(1), (2).
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The proposed rule also defines the term ``derivative.'' \124\ In
particular, the
[[Page 68865]]
definition of ``derivative'' under the proposed rule includes any
``swap'' (as that term is defined in the Commodity Exchange Act) and
any ``security-based swap'' (as that term is defined in the Exchange
Act), in each case as further defined by the CFTC and SEC by joint
regulation, interpretation, guidance, or other action, in consultation
with the Board pursuant to section 712(d) of the Dodd-Frank Act. The
Agencies have proposed to incorporate these definitions of ``swap'' and
``security-based swap'' under the Federal securities and commodities
laws because those definitions: (i) Govern the primary Federal
regulatory scheme applicable to exchange-traded and over-the-counter
derivatives; (ii) will be frequently evaluated and applied by banking
entities in the course of their trading activities; and (iii) capture
agreements and contracts that are or function as derivatives.\125\ The
proposed rule also includes within the definition of derivative certain
other transactions that, although not included within the definition of
``swap'' or ``security-based swap,'' also appear to be, or operate in
economic substance as, derivatives, and which if not included could
permit banking entities to engage in proprietary trading that is
inconsistent with the spirit of section 13 of the BHC Act.
Specifically, the proposed definition of derivative also includes: (i)
Any purchase or sale of a nonfinancial commodity for deferred shipment
or delivery that is intended to be physically settled; (ii) any foreign
exchange forward or foreign exchange swap (as those terms are defined
in the Commodity Exchange Act); \126\ (iii) any agreement, contract, or
transaction in foreign currency described in section 2(c)(2)(C)(i) of
the Commodity Exchange Act (7 U.S.C. 2(c)(2)(C)(i)); \127\ (iv) any
agreement, contract, or transactions in a commodity other than foreign
currency described in section 2(c)(2)(D)(i) of the Commodity Exchange
Act (7 U.S.C. 2(c)(2)(D)(i)); and (v) any transaction authorized under
section 19 of the Commodity Exchange Act (7 U.S.C. 23(a) or (b)). The
Agencies are requesting comment on whether including these five types
of transactions within the proposed definition of derivative is
appropriate.
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\124\ See proposed rule Sec. ----.2(l).
\125\ The Agencies note that they have not included a variety of
security-related derivatives within the proposed definition of
derivative, as such transactions are ``securities'' for purposes of
both the Exchange Act and the proposed rule and, as a result,
already included in the broader definition of ``covered financial
position'' to which the prohibition on proprietary trading applies.
\126\ The Agencies note that foreign exchange swaps and foreign
exchange forwards are considered swaps for purposes of the Commodity
Exchange Act definition of that term unless the Secretary of the
Treasury determines, pursuant to section 1a(47)(E) of that Act (7
U.S.C. 1a(47)(E)), that foreign exchange swaps and forwards should
not be regulated as swaps under the Commodity Exchange Act and are
not structured to evade certain provisions of the Dodd-Frank Act. On
May 5, 2011, the Treasury Secretary proposed to exercise that
authority to exclude foreign exchange forwards and foreign exchange
swaps from the definition of ``swap.'' See Determination of Foreign
Exchange Swaps and Foreign Exchange Forwards Under the Commodity
Exchange Act, 76 FR 25774 (May 5, 2011). If the Secretary of the
Treasury issues a final determination, as proposed, a ``foreign
exchange swap'' and ``foreign exchange forward'' would be excluded
from the definition of ``swap'' under the Commodity Exchange Act
and, therefore, would fall outside of the proposed rule's definition
of ``derivative.'' Accordingly, the Agencies have proposed to
expressly include such transactions in the proposed definition of
derivative, but have requested comment on a variety of questions
related to whether foreign exchange swaps and forwards should be
included or excluded from the definition of derivative. The Agencies
note that, aside from foreign exchange swaps and forwards, the
Commodity Exchange Act's definition of ``swap'' (and therefore the
proposed definition of ``derivative'') also includes other types of
foreign exchange derivatives, including non-deliverable foreign
exchange forwards (NDFs), foreign exchange options, and currency
options, which fall outside of the Secretary of the Treasury's
authority to issue a determination to exclude certain transactions
from the ``swap'' definition.
\127\ Section 2(c)(2)(C)(i) was added to the Commodity Exchange
Act in 2008 to address retail foreign exchange transactions that
were documented as automatically renewing spot contracts (so-called
rolling spot transactions) and therefore not futures contracts
subject to the Commodity Exchange Act, but which were functionally
and economically similar to futures. See Retail Foreign Exchange
Transactions, 76 FR 41375, 47376-77 (July 15, 2011). However,
section 2(c)(2)(C)(i) of the Commodity Exchange Act does not apply
to transactions entered into by U.S. financial institutions,
including insured depository institutions, brokers, dealers, and
certain retail foreign exchange dealers. See 7 U.S.C.
2(c)(2)(C)(i)(I)(aa). To apply this definitional prong to such
banking entities, the definition of derivative includes a
transaction ``described in'' section 2(c)(2)(C)(i) of the Commodity
Exchange Act. In other words, the use of this phrase is intended to
capture any transaction described in section 2(c)(2)(C)(i) without
regard to the identity of the counterparty.
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To provide additional clarity, the proposed definition of
derivative also clarifies two types of transactions that are outside
the scope of the definition. First, the proposed definition of
derivative would not include any consumer, commercial, or other
agreement, contract, or transaction that the CFTC and SEC have further
defined by joint regulation, interpretation, guidance, or other action
as not within the definition of swap, as that term is defined in the
Commodity Exchange Act, or security-based swap, as that term is defined
in the Exchange Act. The SEC and CFTC have, in proposing rules further
defining the terms ``swap'' and ``security-based swap,'' proposed to
not include a variety of agreements, contracts, and transactions within
those definitions by joint regulation or interpretation, and the
Agencies have proposed to expressly reflect such exclusions in the
proposed rule's definition in order to avoid the potential application
of its restrictions to transactions that are not commonly thought to be
derivatives.\128\ Second, the proposed definition of derivative also
does not include any identified banking product, as defined in section
402(b) of the Legal Certainty for Bank Products Act of 2000 (7 U.S.C.
27(b)), that is subject to section 403(a) of that Act (7 U.S.C.
27a(a)). This provision is proposed to clearly exclude identified
banking products that are expressly excluded (i) from the definition of
``security-based swap'' and (ii) from Commodity Exchange Act and CFTC
jurisdiction pursuant to section 403(a) of the Legal Certainty for Bank
Products Act of 2000.\129\
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\128\ See 76 FR 29818 (May 23, 2011). For example, the SEC and
CFTC have proposed to not include (i) certain insurance products
within the definitions of ``swap'' and ``security-based swap'' by
regulation and (ii) certain consumer agreements (e.g., agreements to
acquire or lease real property or purchase products at a capped
price) and commercial agreements (e.g., employment contracts or the
purchase of real property, intellectual property, equipment or
inventory) by joint interpretation. See id. at 29832-34. The
Agencies have proposed to define ``derivative'' in the proposed rule
by reference to the definition of ''swap'' and ``security-based
swap'' under the Federal securities and commodities laws in
contemplation of the SEC and CFTC's proposed regulatory and
interpretative exclusions; to the extent that such exclusions are
not included in any final action taken by the SEC and CFTC, the
Agencies will consider whether to state such exclusions expressly
within the proposed rule's definition of derivative.
\129\ Examples of excluded identified banking products are
deposit accounts, savings accounts, certificates of deposit, or
other deposit instruments issued by a bank.
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The proposed rule defines a ``loan'' as any loan, lease, extension
of credit, or secured or unsecured receivable.\130\ The Agencies note
that the proposed definition of loan is expansive, and includes a broad
array of loans and similar credit transactions, but does not include
any asset-backed security that is issued in connection with a loan
securitization or otherwise backed by loans.
---------------------------------------------------------------------------
\130\ See proposed rule Sec. ----.2(q).
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The Agencies request comment on the proposed rule's definition of
terms used in the definition of covered financial position. In
particular, the Agencies request comment on the following questions:
Question 53. Are the proposed rule's definitions of commodity and
contract of sale of a commodity for future delivery appropriate? If
not, what
[[Page 68866]]
alternative definitions would be more appropriate?
Question 54. Is the proposed definition of derivative effective? If
not, what alternative definition would be more effective? Should the
proposed rule expressly incorporate the definition of ``swap'' and
security-based swap'' under the Federal commodities and securities
laws? If not, what alternative approach should be taken? Are there
transactions included in those incorporated definitions that should not
be included in the proposed rule's definition? If so, what transactions
and why? Are there transactions excluded from those incorporated
definitions that should be included within the proposed rule's
definition? If so, what transactions and why?
Question 55. Is the proposed inclusion of foreign exchange forwards
and swaps in the definition of derivative effective? If not, why not?
On what basis would the Agencies conclude that such transactions are
not derivatives? Are these transactions economically or functionally
more similar to secured loans or repurchase arrangements than to
commodity forwards and swaps? Would there be any unintended
consequences to banking entities if such transactions are included in
the proposal's definition of derivative? What effect is including
foreign exchange swaps and forwards in the definition of derivative
likely to have on banking entities, participants in the foreign
exchange markets, and the liquidity and efficiency of foreign exchange
markets generally? If included within the definition of derivative,
should transactions in foreign exchange swaps and forwards be permitted
under section 13(d)(1)(J) of the BHC Act? If so, why and on what basis?
Please quantify your responses, to the extent feasible.
Question 56. Is the proposed inclusion of any purchase or sale of a
nonfinancial commodity for deferred shipment or delivery that is
intended to be physically settled in the definition of derivative
effective? If not, why not? Would there be any unintended consequences
to banking entities if such transactions are included in the proposal's
definition of derivative?
Question 57. Is the proposed inclusion of foreign currency
transactions described in section 2(c)(2)(C)(i) of the Commodity
Exchange Act in the definition of derivative effective? If not, why
not? Would there be any unintended consequences to banking entities if
such transactions are included in the proposal's definition of
derivative?
Question 58. Is the proposed inclusion of commodity transactions
described in section 2(c)(2)(D)(i) of the Commodity Exchange Act in the
definition of derivative effective? If not, why not? Would there be any
unintended consequences to banking entities if such transactions are
included in the proposal's definition of derivative?
Question 59. Is the proposed inclusion of any transaction
authorized under section 19 of the Commodity Exchange Act (7 U.S.C.
23(a) or (b)) in the definition of derivative effective? If not, why
not? Would there be any unintended consequences to banking entities if
such transactions are included in the proposal's definition of
derivative?
Question 60. Is the manner in which the proposed definition of
derivative excludes any transaction that the CFTC or SEC exclude by
joint regulation, interpretation, guidance, or other action from the
definition of ``swap'' or ``security-based swap'' effective? If not,
what alternative approach would be more appropriate? Should such
exclusions be restated in the proposed rule's definition? If so, why?
Question 61. Is the proposed rule's definition of loan appropriate?
If not, what alternative definition would be more appropriate? Should
the definition of ``loan'' exclude a security? Should other types of
traditional banking products be included in the definition of ``loan''?
If so, why?
iii. Definition of Other Terms Related to Proprietary Trading
Section --.3(d) of the proposed rule defines a variety of other
terms used throughout subpart B of the proposed rule. These definitions
are discussed in further detail below in the relevant summary of the
separate sections of the proposed rule in which they are used.
The Agencies request comment on the proposed rule's definition of
other terms used in subpart B of the proposed rule. In particular, the
Agencies request comment on the following questions:
Question 62. Are the proposed rule's definitions of other terms in
Sec. --.3(d) appropriate? If not, what alternative definitions would
be more appropriate?
Question 63. Is the definition of additional terms for purposes of
subpart B of the proposed rule necessary? If so, what terms should be
defined? How should those terms be defined?
2. Section --.4: Permitted Underwriting and Market Making-Related
Activities
Section --.4 of the proposed rule implements section 13(d)(1)(B) of
the BHC Act, which permits banking entities to engage in certain
underwriting and market making-related activities, notwithstanding the
prohibition on proprietary trading.\131\ Section --.4(a) addresses
permitted underwriting activities, and Sec. --.4(b) addresses
permitted market making-related activities.
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\131\ See 12 U.S.C. 1851(d)(1)(B).
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a. Permitted Underwriting Activities
Section --.4(a) of the proposed rule permits a banking entity to
purchase or sell a covered financial position in connection with the
banking entity's underwriting activities to the extent that such
activities are designed not to exceed the reasonably expected near-term
demands of clients, customers, or counterparties (the ``underwriting
exemption''). In order to rely on this exemption, a banking entity's
underwriting activities must meet all seven of the criteria listed in
Sec. --.4(a)(2). These seven criteria are intended to ensure that any
banking entity relying on the underwriting exemption is engaged in bona
fide underwriting activities, and conducts those activities in a way
that is not susceptible to abuse through the taking of speculative,
proprietary positions as a part of, or mischaracterized as,
underwriting activity.
First, the banking entity must have established the internal
compliance program required by subpart D of the proposed rule, as
further described below in Part III.D of this SUPPLEMENTARY
INFORMATION. This requirement is intended to ensure that any banking
entity relying on the underwriting exemption has reasonably designed
written policies and procedures, internal controls, and independent
testing in place to support its compliance with the terms of the
exemption.
Second, the covered financial position that is being purchased or
sold must be a security. This requirement reflects the common usage and
understanding of the term ``underwriting.'' \132\
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\132\ The Agencies note, however, that a derivative or commodity
future transaction may be otherwise permitted under another
exemption (e.g., the exemptions for market making-related or risk-
mitigating hedging activities).
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Third, the transaction must be effected solely in connection with a
distribution of securities for which the banking entity is acting as an
underwriter. This prong is intended to give effect to the essential
element of the underwriting exemption--i.e., that the transaction be in
connection with underwriting activity. For these purposes, the proposed
rule defines both (i) a distribution of securities and (ii) an
underwriter. The definitions of these terms are generally identical to
the
[[Page 68867]]
definitions provided for the same terms in the SEC's Regulation M,\133\
which governs the activities of underwriters, issuers, selling security
holders, and others in connection with offerings of securities under
the Exchange Act.\134\ The Agencies have proposed to use similar
definitions because the meanings of these terms under Regulation M are
generally well-understood by market participants and define the scope
of underwriting activities in which banking entities typically engage,
including underwriting of SEC-registered offerings, underwriting of
unregistered distributions, and acting as a placement agent in private
placements.
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\133\ 17 CFR 242.100 et seq.
\134\ See proposed rule Sec. Sec. --.4(a)(3), (4); 17 CFR
242.100(b).
---------------------------------------------------------------------------
With respect to the definition of distribution, the Agencies note
that Regulation M defines a distribution of securities as ``an offering
of securities, whether or not subject to registration under the
Securities Act that are distinguished from ordinary trading
transactions by the magnitude of the offering and the presence of
special selling efforts.'' \135\ The manner in which this Regulation M
definition distinguishes a distribution of securities from other
transactions appears to be relevant in the context of the underwriting
exemption and useful to address potential evasion of the general
prohibition on proprietary trading, while permitting bona fide
underwriting activities. Accordingly, in order to qualify as a
distribution for purposes of the proposal, as with Regulation M, the
offering must meet the two elements--``magnitude'' and ``special
selling efforts and selling methods.'' The Agencies have not defined
the terms ``magnitude'' and ``special selling efforts and selling
methods'' in the proposed rule, but would expect to rely on the same
factors considered under Regulation M in assessing these elements. For
example, the number of shares to be sold, the percentage of the
outstanding shares, public float, and trading volume that those shares
represent are all relevant to an assessment of magnitude.\136\ In
addition, delivering a sales document, such as a prospectus, and
conducting road shows are generally indicative of special selling
efforts and selling methods.\137\ Another indicator of special selling
efforts and selling methods is compensation that is greater than that
for secondary trades but consistent with underwriting compensation for
an offering. Similar to the approach taken under Regulation M, the
Agencies note that ``magnitude'' does not imply that a distribution
must be large; instead, this factor is a means to distinguish a
distribution from ordinary trading, and therefore does not preclude
small offerings or private placements from qualifying for the
underwriting exemption.
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\135\ 17 CFR 242.100.
\136\ See Review of Antimanipulation Regulation of Securities
Offering, Exchange Act Release No. 33924 (Apr. 19, 1994), 59 FR
21681, 21684 (Apr. 26, 1994) (``Regulation M Concept Release'').
\137\ See Regulation M Concept Release, 59 FR at 21684-85.
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The definition of ``underwriter'' in the proposed rule is generally
similar to that under the SEC's Regulation M, except that the proposed
rule's definition would also include, within that definition, a person
who has an agreement with another underwriter to engage in a
distribution of securities for or on behalf of an issuer or selling
security holder.\138\ Consistent with current practices and the Council
study, the Agencies propose to take into consideration the extent to
which the banking entity is engaged in the following activities when
determining whether a banking entity is acting as an underwriter as
part of a distribution of securities:
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\138\ See proposed rule Sec. --.4(a)(4)(ii).
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Assisting an issuer in capital raising;
Performing due diligence;
Advising the issuer on market conditions and assisting in
the preparation of a registration statement or other offering
documents;
Purchasing securities from an issuer, a selling security
holder, or an underwriter for resale to the public;
Participating in or organizing a syndicate of investment
banks;
Marketing securities; and
Transacting to provide a post-issuance secondary market
and to facilitate price discovery.
The Agencies note that the precise activities performed by an
underwriter may vary depending on the liquidity of the securities being
underwritten and the type of distribution being conducted. For example,
each factor need not be present in a private placement.
There may be circumstances in which an underwriter would hold
securities that it could not sell in the distribution for investment
purposes. If the acquisition of such unsold securities were in
connection with the underwriting pursuant to the permitted underwriting
activities exemption, the underwriter would also be able to dispose of
such securities at a later time.\139\
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\139\ The Agencies note, however, that such sale would have to
be made in compliance with other applicable provisions of the
Federal securities laws and regulations.
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Fourth, to the extent that the transaction involves a security for
which a person must generally be a registered securities dealer,
municipal securities dealer or government securities dealer in order to
underwrite the security, the banking entity must have the appropriate
dealer registration (or in the case of a financial institution that is
a government securities dealer, has filed notice of that status as
required by section 15C(a)(1)(B) of the Exchange Act) or otherwise be
exempt from registration or excluded from regulation as a dealer.\140\
Similarly, if the banking entity is engaged in the business of a dealer
outside the United States in a manner for which no U.S. registration is
required, the banking entity must be subject to substantive regulation
of its dealing business in the jurisdiction in which the business is
located. This requirement is intended to ensure that (i) any
underwriting activity conducted in reliance on the exemption is subject
to appropriate regulation and (ii) banking entities are not
simultaneously characterizing the transaction as underwriting for
purposes of the exemption while characterizing it in a different manner
for purposes of applicable securities laws.
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\140\ See proposed rule Sec. --.4(a)(2)(iv). For example, if a
banking entity is a bank engaged in underwriting asset-backed
securities for which it would be required to register as a
securities dealer but for the exclusion contained in section
3(a)(5)(C)(iii) of the Exchange Act, the proposed rule would not
require that banking entity be a registered securities dealer in
order to rely on the underwriting exemption for that transaction.
The proposed rule does not apply the dealer registration/notice
requirement to the underwriting of exempted securities, security-
based swaps, commercial paper, bankers acceptances or commercial
bills because the underwriting of such instruments does not require
registration as a securities dealer under the Exchange Act.
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Fifth, the underwriting activities of the banking entity with
respect to the covered financial position must be designed not to
exceed the reasonably expected near-term demands of clients, customers
and counterparties.\141\ This requirement restates the statutory
limitation on the underwriting exemption.
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\141\ See proposed rule Sec. --.4(a)(2)(v).
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Sixth, the underwriting activities of the banking entity must be
designed to generate revenues primarily from fees, commissions,
underwriting spreads or other income, and not from appreciation in the
value of covered financial positions it holds related to such
activities or the hedging of such covered financial position.\142\ This
requirement
[[Page 68868]]
is intended to ensure that activities conducted in reliance on the
underwriting exemption demonstrate patterns of revenue generation and
profitability consistent with, and related to, the services an
underwriter provides to its customers in bringing securities to market,
rather than changes in the market value of the securities underwritten.
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\142\ For these purposes, underwriting spreads would include any
``gross spread'' (i.e., the difference between the price an
underwriter sells securities to the public and the price it
purchases them from the issuer) designed to compensate the
underwriter for its services.
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Seventh, the compensation arrangements of persons performing
underwriting activities at the banking entity must be designed not to
encourage proprietary risk-taking. Activities for which a banking
entity has established a compensation incentive structure that rewards
speculation in, and appreciation of, the market value of securities
underwritten, rather than success in bringing securities to market for
a client, are inconsistent with permitted underwriting activities under
the proposed rule. Although a banking entity relying on the
underwriting exemption may appropriately take into account revenues
resulting from movements in the price of securities that the banking
entity underwrites to the extent that such revenues reflect the
effectiveness with which personnel have managed underwriting risk, the
banking entity should provide compensation incentives that primarily
reward client revenues and effective client service, not proprietary
risk-taking.
The Agencies request comment on the proposed rule's implementation
of the underwriting exemption. In particular, the Agencies request
comment on the following questions:
Question 64. Is the proposed rule's implementation of the
underwriting exemption effective? If not, what alternative approach
would be more effective? For example, should the exemption include
other transactions that do not involve a distribution of securities for
which the banking entity is acting as underwriter?
Question 65. Are the seven requirements included in the
underwriting exemption effective? Is the application of each
requirement to potential transactions sufficiently clear? Should any of
the requirements be changed or eliminated? Should other requirements be
added in order to better provide an exemption that is not susceptible
to abuse through the taking of speculative, proprietary positions in
the context of, or mischaracterized as, underwriting? Alternatively,
are any of the proposed requirements inappropriately restrictive in
that they would be inconsistent with the statutory exemption for
certain underwriting activities? If so, how?
Question 66. Do underwriters currently have processes in place that
would prevent or reduce the likelihood of taking speculative,
proprietary positions in the context of, or mischaracterized as,
underwriting? If so, what are those processes?
Question 67. Would any of the proposed requirements cause
unintended consequences? Would the proposed requirements alter current
underwriting practices in any way? Would any of the proposed
requirements trigger an unwillingness to engage in underwriting? What
impact, if any, would the proposed exemption have on capital raising?
Please explain.
Question 68. What increased costs, if any, would underwriters incur
to satisfy the seven proposed requirements of the underwriting
exemption? Would underwriters pass the increased costs onto issuers,
selling security holders, or their customers in connection with
qualifying for the proposed exemption?
Question 69. In addition to the specific activities highlighted
above for purposes of evaluating whether a banking entity is acting as
an underwriter as part of distribution of securities (e.g., assisting
an issuer in capital raising, performing due diligence, etc), are there
other or alternative activities that should be considered? Please
explain.
Question 70. Should the requirement that a covered financial
position be a security be expanded to include other financial
instruments? If so, why? How are such other instruments underwritten
within the meaning of section 13(d)(1)(B) of the BHC Act?
Question 71. Is the proposed definition of a ``distribution'' of
securities appropriate, or over- or under-inclusive in this context? Is
there any category of underwriting activity that would not be captured
by the proposed definition? If so, what are the mechanics of that
underwriting activity? Should it be permitted under the proposed rule,
and, if so, why? Would an alternative definition better identify
offerings intended to be covered by the proposed definition? If so,
what alternative definition, and why?
Question 72. Is the proposed definition of ``underwriter''
appropriate, or over- or under-inclusive in this context? Would an
alternative definition, such as the statutory definition of
``underwriter'' under the Securities Act, better identify persons
intended to be covered by the proposed definition? If so, why?
Question 73. How accurately can a banking entity engaging in
underwriting predict the near-term demands of clients, customers, and
counterparties with respect to an offering? How can principal risk that
is retained in connection with underwriting activities to support near-
term client demand be distinguished from positions taken for
speculative purposes?
Question 74. Is the requirement that the underwriting activities of
a banking entity relying on the underwriting exemption be designed to
generate revenues primarily from fees, commissions, underwriting
spreads or similar income effective? If not, how should the requirement
be changed? Does the requirement appropriately capture the type and
nature of revenues typically generated by underwriting activities? Is
any further clarification or additional guidance necessary?
Question 75. Is the requirement that the compensation arrangements
of persons performing underwriting activities at a banking entity be
designed not to reward proprietary risk-taking effective? If not, how
should the requirement be changed? Are there other types of
compensation incentives that should be clearly referenced as
consistent, or inconsistent, with permitted underwriting activity? Are
there specific and identifiable characteristics of compensation
arrangements that clearly incentivize prohibited proprietary trading?
Question 76. Are there other types of underwriting activities that
should also be included within the scope of the underwriting exemption?
If so, what additional activities and why? How would an exemption for
such additional activities be consistent with the language and purpose
of section 13 of the BHC Act? What criteria, requirements, or
restrictions would be appropriate to include with respect to such
additional activities to prevent misuse or evasion of the prohibition
on proprietary trading?
Question 77. Does the proposed underwriting exemption appropriately
accommodate private placements? If not, what changes are necessary to
do so?
Question 78. The creation, offer and sale of certain structured
securities such as trust preferred securities or tender option bonds,
among others, may involve the purchase of another security and
repackaging of that security through an intermediate entity. Should the
sale of the security by a banking entity to an intermediate entity as
part of the creation of the structured security be
[[Page 68869]]
permitted under one of the exemptions to the prohibition on proprietary
trading currently included in the proposed rule (e.g., underwriting or
market making)? Why or why not? For purposes of determining whether an
exemption is available under these circumstances, should gain on sale
resulting from the sale of the purchased security to the intermediate
entity as part of the creation of the structured security be considered
a relevant factor? Why or why not? What other factors should be
considered in connection with the creation of the structured securities
and why? Would the analysis be different if the banking entity acquired
and retained the security to be sold to the intermediate entity as part
of the creation of the structured securities as part of its
underwriting of the underlying security? Why or why not?
Question 79. We seek comment on the application of the proposed
exemption to a banking entity retaining a portion of an underwriting.
Please discuss whether or not firms frequently retain securities in
connection with a distribution in which the firm is acting as
underwriter. Please identify the types of offerings in which this may
be done (e.g., fixed income offerings, securitized products, etc.).
Please identify and discuss any circumstances which can contribute to
the decision regarding whether or not to retain a portion of an
offering. Please describe the treatment of retained securities (e.g.,
the time period of retention, the type of account in which securities
are retained, the potential disposition of the securities). Please
discuss whether or not the retention is documented and, if so, how.
Should the Agencies require disclosure of securities retained in
connection with underwritings? Should the Agencies require specific
documentation to demonstrate that the retained portion is connected to
an underwriting pursuant to the proposed rule? If so, what kind of
documentation should be required? Please discuss how you believe
retention should be addressed under the proposal.
b. Permitted Market Making-Related Activities
Section --.4(b) of the proposed rule permits a banking entity to
purchase or sell a covered financial position in connection with the
banking entity's market making-related activities (the ``market-making
exemption'').
i. Approach to Implementing the Exemption for Market Making-Related
Activities.
As the Council study noted, implementing the statutory exception
for permitted market making-related activities requires a regulatory
regime that differentiates permitted market making-related activity,
and in particular the taking of principal positions in the course of
making a market in particular financial instruments, from prohibited
proprietary trading. Although the purpose and function of these two
activities are markedly different--market making-related activities
provide intermediation and liquidity services to customers, while
proprietary trading involves the generation of profit through
speculative risk-taking--clearly distinguishing these activities may be
difficult in practice. Market making-related activities, like
prohibited proprietary trading, sometimes require the taking of
positions as principal, and the amount of principal risk that must be
assumed by a market maker varies considerably by asset class and
differing market conditions.\143\ It may be difficult to distinguish
principal positions that appropriately support market making-related
activities from positions taken for short-term, speculative purposes.
In particular, it may be difficult to determine whether principal risk
has been retained because (i) the retention of such risk is necessary
to provide intermediation and liquidity services for a relevant
financial instrument or (ii) the position is part of a speculative
trading strategy designed to realize profits from price movements in
retained principal risk.\144\
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\143\ With respect to certain kinds of market making-related
activities, such as market making in securities, these principal
positions are often referred to as ``inventory'' or ``inventory
positions.'' However, since certain types of market making-related
activities, such as market making in derivatives, involve the
retention of principal positions arising out of multiple derivatives
transactions in particular risks (e.g., retained principal interest
rate risk), rather than retention of actual financial instruments,
the broader term ``principal positions'' is used in this discussion.
\144\ The Council study contains a detailed discussion of the
challenges involved in delineating prohibited proprietary trading
from permitted market making-related activities. See Council study
at 15-18.
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In order to address these complexities, the Agencies have proposed
a multi-faceted approach that draws on several key elements. First,
similar to the underwriting exemption, the proposed rule includes a
number of criteria that a banking entity's activities must meet in
order to rely on the exemption for market making-related activities.
These criteria are intended to ensure that the banking entity is
engaged in bona fide market making. As described in greater detail in
Part III.D of the Supplementary Information, among these criteria is
the requirement that the banking entity have in place a programmatic
compliance regime to guide its compliance with section 13 of the BHC
Act and the proposed rule. This compliance regime includes requirements
that a banking entity have effective policies, procedures, and internal
controls that are designed to ensure that prohibited proprietary
trading positions are not taken under the guise of permitted market
making-related activity. Second, as described in greater detail in Part
III.B.5 of this Supplementary Information, Appendix B of the proposed
rule contains a detailed commentary regarding how the Agencies propose
to identify permitted market making-related activities. This commentary
includes six principles the Agencies propose to use as a guide to help
distinguish market-making related activities from prohibited
proprietary trading. Third, also as described in greater detail in Part
III.B.5 of this Supplementary Information, Sec. --.7 and Appendix A of
the proposed rule require a banking entity with significant covered
trading activities to report certain quantitative measurements for each
of its trading units.\145\ These quantitative measurements are intended
to assist both banking entities and the Agencies in assessing whether
the quantitative profile of a trading unit (e.g., the types of revenues
it generates and the risks it retains) is consistent with permitted
market making-related activities under the proposed rule.
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\145\ The definition of ``trading unit'' for this purpose is
discussed in detail in Part III.B.5 of this Supplementary
Information.
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The proposal's multi-faceted approach is intended, through the
incorporation of multiple regulatory and supervisory tools, to strike
an appropriate balance in implementing the market-making exemption in a
way that articulates the scope of permitted activities and meaningfully
addresses the potential for misuse of the exemption, while not unduly
constraining the important liquidity and intermediation services that
market makers provide to their customers and to the capital markets at
large.
The Agencies request comment on the proposed rule's approach to
implementing the exemption for permitted market making-related
activities. In particular, the Agencies request comment on the
following questions:
Question 80. Is the proposed rule's approach to implementing the
exemption for permitted market making-related activities (i)
appropriate and (ii) likely to be effective? If not, what
[[Page 68870]]
alternative approach would be more appropriate or effective?
Question 81. Does the proposed multi-faceted approach appropriately
take into account and address the challenges associated with
differentiating prohibited proprietary trading from permitted market
making-related activities? Should the approach include other elements?
If so, what elements and why? Should any of the proposed elements be
revised or eliminated? If so, why and how?
Question 82. Does the proposed multi-faceted approach provide
banking entities and market participants with sufficient clarity
regarding what constitutes permitted market making-related activities?
If not, how could greater clarity be provided?
Question 83. What impact will the proposed multi-faceted approach
have on the market making-related services that a banking entity
provides to its customers? How will the proposed approach impact market
participants who use the services of market makers? How will the
approach impact the capital markets at large, and in particular the
liquidity, efficiency and price transparency of capital markets? If any
of these impacts are positive, how can they be amplified? If any of
these impacts are negative, how can they be mitigated? Would the
proposed rule's prohibition on proprietary trading and exemption for
market making-related activity reduce incentives or opportunities for
banking entities to trade against customers, as opposed to trading on
behalf of customers? If so, please discuss the benefits arising from
such reduced incentives or opportunities.
Question 84. What burden will the proposed multi-faceted approach
have on banking entities, their customers, and other market
participants? How can any burden be minimized or eliminated in a manner
consistent with the language and purpose of the statute?
Question 85. Are there particular asset classes that raise special
concerns in the context of market making-related activity that should
be considered in connection with the proposed market-making exemption?
If so, what asset class(es) and concern(s), and how should the concerns
be addressed in the proposed exemption?
Question 86. Are there other market making-related activities that
the rule text should more clearly permit? Why or why not?
ii. Required Criteria for Permitted Market Making-Related Activities
As part of the proposal's multi-faceted approach to implementing
the exemption for permitted market making-related activities, Sec.
--.4(b)(2) of the proposed rule specifies seven criteria that a banking
entity's market making-related activities must meet in order to rely on
the exemption, each of which are described in detail below. These
criteria are designed to ensure that any banking entity relying on the
exemption is engaged in bona fide market making-related activities and
conducts those activities in a way that is not susceptible to abuse
through the taking of speculative, proprietary positions as a part of,
or mischaracterized as, market making-related activity.
First Criterion--Establishment of Internal Compliance Program
Section --.4(b)(2)(i) of the proposed rule requires a banking
entity to establish a comprehensive compliance program to monitor and
control its market making-related activities. Subpart D of the proposed
rule further describes the appropriate elements of an effective
compliance program. This criterion is intended to ensure that any
banking entity relying on the market-making exemption has reasonably
designed written policies and procedures, internal controls, and
independent testing in place to support its compliance with the terms
of the exemption.
Second Criterion--Bona Fide Market Making
Section --.4(b)(2)(ii) of the proposed rule articulates the core
element of the statutory exemption, which is that the activity must be
market making-related. In order to give effect to this requirement,
Sec. ----.4(b)(2)(ii) of the proposed rule requires the trading desk
or other organizational unit that purchases or sells a particular
covered financial position to hold itself out as being willing to buy
and sell, or otherwise enter into long and short positions in, the
covered financial position for its own account on a regular or
continuous basis. Notably, this criterion requires that a banking
entity relying on the exemption with respect to a particular
transaction must actually make a market in the covered financial
position involved; simply because a banking entity makes a market in
one type of covered financial position does not permit it to rely on
the market-making exemption for another type of covered financial
position.\146\ Similarly, the particular trading desk or other
organizational unit of the banking entity that is relying on the
exemption for a particular type of covered financial position must also
be the trading desk or other organizational unit that is actually
making the market in that covered financial position; market making in
a particular covered financial position by one trading desk of a
banking entity does not permit another trading desk of the banking
entity to rely on the market-making exemption for that type of covered
financial position.
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\146\ The Agencies note that a market maker may often make a
market in one type of covered financial positions and hedge its
activities using different covered financial positions in which it
does not make a market. Such hedging transactions would meet the
terms of the market-making exemption if the hedging transaction met
the requirements of Sec. --.4(b)(3) of the proposed rule.
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The language used in Sec. --.4(b)(2)(ii) of the proposed rule to
describe bona fide market making-related activity is similar to the
definition of ``market maker'' under section 3(a)(38) of the Exchange
Act.\147\ The Agencies have proposed to use similar language because
the Exchange Act definition is generally well-understood by market
participants and is consistent with the scope of bona fide market
making-related activities in which banking entities typically engage.
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\147\ Section 3(a)(38) of the Exchange Act defines ``market
maker'' as ``any specialist permitted to act as a dealer, any dealer
acting in the capacity of block positioner, and any dealer who, with
respect to a security, holds himself out (by entering quotations in
an inter-dealer quotation communications system or otherwise) as
being willing to buy and sell such security for his own account on a
regular or continuous basis.'' 15 U.S.C. 78c(a)(38).
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In assessing whether a particular trading desk or other
organizational unit holds itself out as being willing to buy and sell,
or otherwise enter into long and short positions in, a covered
financial position for its own account on a regular or continuous basis
in liquid markets, the Agencies expect to take an approach similar to
that used by the SEC in the context of assessing whether a person is
engaging in bona fide market making. The precise nature of a market
maker's activities often varies depending on the liquidity, trade size,
market infrastructure, trading volumes and frequency, and geographic
location of the market for any particular covered financial position.
In the context of relatively liquid positions, such as equity
securities or other exchange-traded instruments, a trading desk or
other organizational unit's market making-related activity should
generally include:
Making continuous, two sided quotes and holding oneself
out as willing to buy and sell on a continuous basis;
A pattern of trading that includes both purchases and
sales in roughly comparable amounts to provide liquidity;
[[Page 68871]]
Making continuous quotations that are at or near the
market on both sides; and
Providing widely accessible and broadly disseminated
quotes.\148\
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\148\ The Agencies note that these indicia are generally
consistent with the indicia of bona fide market making in equity
markets articulated by the SEC for purposes of describing the
exception to the locate requirement of the SEC's Regulation SHO for
market makers engaged in bona fide market-making activities. See
Exchange Act Release No. 58775 (October 14, 2008), 73 FR 61690,
61698-61699 (Oct. 17, 2008); see also 17 CFR 242.203(b)(2)(iii).
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In less liquid markets, such as over-the-counter markets for debt
and equity securities or derivatives, the appropriate indicia of market
making-related activities will vary, but should generally include:
Holding oneself out as willing and available to provide
liquidity by providing quotes on a regular (but not necessarily
continuous) basis; \149\
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\149\ The frequency of such regular quotations will itself vary;
less illiquid markets may involve quotations on a daily or more
frequent basis, while highly illiquid markets may trade only by
appointment.
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With respect to securities, regularly purchasing covered
financial positions from, or selling the positions to, clients,
customers, or counterparties in the secondary market; and
Transaction volumes and risk proportionate to historical
customer liquidity and investments needs.\150\
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\150\ The Agencies also note that the CFTC and SEC have
identified, in a proposed rule further defining the terms ``swap
dealer'' and ``security-based swap dealer'' under the Commodity
Exchange Act and Exchange Act, a variety of distinguishing
characteristics of swap dealers and security-based swap dealers in
the context of derivatives, including that: (i) Dealers tend to
accommodate demand for swaps and security-based swaps from other
parties; (ii) dealers are generally available to enter into swaps or
security-based swaps to facilitate other parties' interest in
entering into those instruments; (iii) dealers tend not to request
that other parties propose the terms of swaps or security-based
swaps, but instead tend to enter into those instruments on their own
standard terms or on terms they arrange in response to other
parties' interest; and (iv) dealers tend to be able to arrange
customized terms for swaps or security-based swaps upon request, or
to create new types of swaps or security-based swaps at the dealer's
own initiative. See 75 FR 80174, 80176 (Dec. 21, 2010).
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The Agencies would apply these indicia when evaluating when a
banking entity is eligible for the market making-related activities
exemption, but also recognize that these indicia cannot be applied at
all times and under all circumstances because some may be inapplicable
to the specific asset class or market in which the market making
activity is conducted.
The bona fide market making-related activity described in Sec.
--.4(b)(2)(ii) of the proposed rule would include block positioning if
undertaken by a trading desk or other organizational unit of a banking
entity for the purpose of intermediating customer trading.\151\ In
addition, bona fide market making-related activity may include taking
positions in securities in anticipation of customer demand, so long as
any anticipatory buying or selling activity is reasonable and related
to clear, demonstrable trading interest of clients, customers, or
counterparties.
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\151\ The definition of ``market maker'' in the Exchange Act
includes a dealer acting in the capacity of a block positioner.
Although the term ``block positioner'' is not defined in the
proposed rule, the Agencies note that the SEC has adopted a
definition of ``qualified block positioner'' in the SEC's Rule 3b-
8(c) (17 CFR 240.3b-8(c)), which may serve as guidance in
determining whether a block positioner engaged in block positioning
is engaged in bona fide market making-related activities for
purposes of Sec. --.4(b)(2)(ii) of the proposed rule. Under the
SEC's Rule 3b-8(c), among other things, a qualified block positioner
must meet all of the following conditions: (i) Engages in the
activity of purchasing long or selling short, from time to time,
from or to a customer (other than a partner or a joint venture or
other entity in which a partner, the dealer, or a person associated
with such dealer participates) a block of stock with a current
market value of $200,000 or more in a single transaction, or in
several transactions at approximately the same time, from a single
source to facilitate a sale or purchase by such customer; (ii) has
determined in the exercise of reasonable diligence that the block
could not be sold to or purchased from others on equivalent or
better terms; and (iii) sells the shares comprising the block as
rapidly as possible commensurate with the circumstances. The
Agencies note that the rule establishes a minimum dollar value
threshold for a block. The size of a block will vary among different
asset classes.
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Third Criterion--Reasonably Expected Near-Term Demands of Clients,
Customers, and Counterparties
Under Sec. --.4(b)(2)(iii) of the proposed rule, the market
making-related activities of the trading desk or other organization
unit that conducts a transaction in reliance on the market-making
exemption must be designed not to exceed the reasonably expected near-
term demands of clients, customers, and counterparties. This criterion
implements the language in section 13(d)(1)(B) of the BHC Act and is
intended to prevent a trading desk relying on the market-making
exemption from taking a speculative proprietary position unrelated to
customer needs as part of its purported market making-related
activities. As described in further detail in Parts III.B.5 and III.D
of the Supplementary Information, the proposed rule also includes a
programmatic compliance requirement and requires reporting of
quantitative measurements for certain banking entities, both of which
are designed, in part, to meaningfully circumscribe the principal
positions taken as part of market making-related activities to those
which are necessary to meet the reasonably expected near-term demands
of clients, customers, and counterparties. The Agencies expect that the
programmatic compliance requirement and required reporting of
quantitative measurements will play an important role in assessing a
banking entity's compliance with Sec. --.4(b)(2)(iii)'s requirement.
In addition, as described in Part II.B.5 of the Supplementary
Information, Appendix B of the proposed rule provides additional,
detailed commentary regarding how the Agencies expect a firm relying on
the market-making exemption to manage principal positions and how the
Agencies propose to assess whether such positions are consistent with
market making-related activities under the proposed rule.
In order for a banking entity's expectations regarding near-term
customer demand to be considered reasonable, such expectations should
be based on more than a simple expectation of future price appreciation
and the generic increase in marketplace demand that such price
appreciation reflects. Rather, a banking entity's expectation should
generally be based on the unique customer base of the banking entity's
specific market-making business lines and the near-term demands of
those customers based on particular factors beyond a general
expectation of price appreciation. To the extent that a trading desk or
other organizational unit of a banking entity is engaged wholly or
principally in trading that is not in response to, or driven by,
customer demands, the Agencies would not expect those activities to
qualify under Sec. --.4(b) of the proposed rule, regardless of whether
those activities promote price transparency or liquidity. For example,
a trading desk or other organizational unit of a banking entity that is
engaged wholly or principally in arbitrage trading with non-customers
would not meet the terms of the proposed rule's market making
exemption. In the case of a market maker engaging in market making in a
security that is executed on an organized trading facility or exchange,
that market maker's activities are generally consistent with reasonably
expected near-term customer demand when such activities involve
passively providing liquidity by submitting resting orders that
interact with the orders of others in a non-directional or market-
neutral trading strategy and the market maker is registered, if the
exchange or organized trading facility
[[Page 68872]]
registers market makers.\152\ However, activities by such a person that
primarily takes liquidity on an organized trading facility or exchange,
rather than provides liquidity, would not qualify for the market-making
exemption under the proposed rule, even if those activities were
conducted by a registered market maker.
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\152\ The Agencies emphasize that the status of being a
registered market maker is not, on its own, a sufficient basis for
relying on the exemption for market making-related activity
contained in Sec. --.4(b). however, being a registered market maker
is required under these circumstances if the applicable exchange or
organized trading facility registers market makers. Registration as
a market maker generally involves filing a prescribed form with an
exchange or organized trading facility, in accordance with its rules
and procedures, and complying with the applicable requirements for
market makers set forth in the rules of that exchange or organized
trading facility. See, e.g., Nasdaq Rule 4612, New York Stock
Exchange Rule 104, CBOE Futures Exchange Rule 515, BATS Exchange
Rule 11.5.
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Fourth Criterion--Registration Under Securities or Commodities Laws
Under Sec. --.4(b)(2)(iv) of the proposed rule, a banking entity
relying on the market-making exemption with respect to trading in
securities or certain derivatives must be appropriately registered as a
dealer, or exempt from registration or excluded from regulation as a
dealer, under applicable securities or commodities laws. With respect
to a market-making transaction in one or more covered financial
positions that are securities, other than exempted securities,
security-based swaps, commercial paper, bankers acceptances or
commercial bills, for which a person must be a registered securities
dealer, municipal securities dealer or government securities dealer in
order to deal in the security, the banking entity must have the
appropriate dealer registration (or in the case of a financial
institution that is a government securities dealer, has filed notice of
that status as required by section 15C(a)(1)(B) of the Exchange Act) or
otherwise be exempt from registration or excluded from regulation as a
dealer.\153\ Similarly, with respect to a market-making transaction
involving a swap or security-based swap for which a person must
generally be a registered swap dealer or security-based swap dealer,
respectively, the banking entity must be appropriately registered or
otherwise be exempt from registration or excluded from regulation as a
swap dealer or security-based swap dealer.\154\ If the banking entity
is engaged in the business of a securities dealer, swap dealer or
security-based swap dealer outside the United States in a manner for
which no U.S. registration is required, the banking entity must be
subject to substantive regulation of its dealing business in the
jurisdiction in which the business is located. This requirement is
intended to ensure that (i) any market making-related activity
conducted in reliance on the exemption is subject to appropriate
regulation and (ii) a banking entity does not simultaneously
characterize the transaction as market making-related for purposes of
the exemption while characterizing it in a different manner for
purposes of applicable securities or commodities laws.
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\153\ See proposed rule Sec. Sec. --.4(b)(2)(iv)(A), (D), (E).
For example, if a banking entity is a bank engaged in market-making
in qualified Canadian government obligations for which it would be
required to register as a securities dealer but for the exclusion
contained in section 3(a)(5)(C)(i)(I) of the Exchange Act, the
proposed rule would not require that banking entity to be a
registered securities dealer in order to rely on the market-making
exemption for that market-making transaction. Such a bank would,
however, be required to file notice that it is a government
securities dealer and comply with rules applicable to financial
institutions that are government securities dealers. See 15 U.S.C.
78c(a)(42)(E); 15 U.S.C. 78o-5(a)(1)(B); 17 CFR 400.5(b); 17 CFR
449.1. Similar to the underwriting exemption, the proposed rule does
not apply the dealer registration requirement to market making in
securities that are exempted securities, commercial paper, bankers
acceptances or commercial bills because dealing in such securities
does not require registration as securities dealer under the
Exchange Act; however, registering as a municipal securities dealer
or government securities dealer is required, if applicable.
\154\ See proposed rule Sec. Sec. --.4(b)(2)(iv)(B), (C). A
banking entity may be required to be a registered securities dealer
if it engages in market-making transactions involving security-based
swaps with persons that are not eligible contract participants. See
15 U.S.C. 78c(a)(5) (the definition of ``dealer'' in section 3(a)(5)
of the Exchange Act, 15 U.S.C. 78c(a)(5), generally includes ``any
person engaged in the business of buying and selling securities (not
including security-based swaps, other than security-based swaps with
or for persons that are not eligible contract participants), for
such person's own account.'').
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Fifth Criterion--Revenues From Fees, Commissions, Bid/Ask Spreads or
Other Similar Income
Under Sec. --.4(b)(2)(v) of the proposed rule, the market making-
related activities of the banking entity must be designed to generate
revenues primarily from fees, commissions, bid/ask spreads or other
income not attributable to appreciation in the value of covered
financial positions it holds in trading accounts or the hedging of such
positions. This criterion is intended to ensure that activities
conducted in reliance on the market-making exemption demonstrate
patterns of revenue generation and profitability consistent with, and
related to, the intermediation and liquidity services a market maker
provides to its customers, rather than changes in the market value of
the positions or risks held in inventory. Similar to the requirement
that a firm relying on the market-making exemption design its
activities not to exceed reasonably expected near-term client,
customer, or counterparty demands, the Agencies expect that the
programmatic compliance requirement and required reporting of
quantitative measurements will play an important role in assessing a
banking entity's compliance with Sec. --.4(b)(2)(v)'s requirement. In
addition, as described in Part III.B.5 of this Supplementary
Information, Appendix B of the proposed rule provides additional,
detailed commentary regarding how the Agencies propose to assess
whether the types of revenues generated by a banking entity relying on
the market-making exemption are consistent with market making-related
activities.
Sixth Criterion--Compensation Incentives
Under Sec. --.4(b)(2)(vii) of the proposed rule, the compensation
arrangements of persons performing market making-related activities at
the banking entity must be designed not to encourage or reward
proprietary risk-taking. Activities for which a banking entity has
established a compensation incentive structure that rewards speculation
in, and appreciation of, the market value of a covered financial
position held in inventory, rather than success in providing effective
and timely intermediation and liquidity services to customers, are
inconsistent with permitted market making-related activities. Although
a banking entity relying on the market-making exemption may
appropriately take into account revenues resulting from movements in
the price of principal positions to the extent that such revenues
reflect the effectiveness with which personnel have managed principal
risk retained, a banking entity relying on the market-making exemption
should provide compensation incentives that primarily reward customer
revenues and effective customer service, not proprietary risk-taking.
In addition, as described in Part III.B.5 of this Supplementary
Information, Appendix B of the proposed rule provides further
commentary regarding how the Agencies propose to assess whether the
compensation incentives provided to trading personnel performing
trading activities in reliance on the market-making exemption are
consistent with market making-related activities.
[[Page 68873]]
Seventh Criterion--Consistency With Appendix B Commentary
Under Sec. --.4(b)(2)(vi) of the proposed rule, the market making-
related activities of the trading desk or other organizational unit
that conducts the purchase or sale are required to be consistent with
the commentary provided in Appendix B, which provides guidance that the
Agencies propose to apply to help distinguish permitted market making-
related activities from prohibited proprietary trading. Appendix B's
proposed commentary, which is described in detail below in Part III.B.5
of this Supplementary Information, discusses various factors by which
the Agencies propose to distinguish prohibited proprietary trading from
permitted market making-related activities (e.g., how and to what
extent a market maker hedges the risk of its market-making
transactions, including (i) further detail related directly to other
criteria in Sec. --.4(b)(2) (e.g., the types of revenues generated by
market makers), and (ii) expectations regarding other factors not
expressly included in Sec. --.4(b)(2)).
B. Market Making-Related Hedging
Section --.4(b)(3) of the proposed rule provides that certain
hedging transactions related to market-making positions and holdings
will also be deemed to be made in connection with a banking entity's
market making-related activities for purposes of the market-making
exemption. In particular, Sec. --.4(b)(3) provides that the purchase
or sale of a covered financial position for hedging purposes will
qualify for the market-making exemption if it meets two requirements.
First, the purchase or sale must be conducted in order to reduce the
specific risks to the banking entity in connection with and related to
individual or aggregated positions, contracts, or other holdings
acquired pursuant to the market-making exemption. Where the purpose of
a transaction is to hedge a market making-related position, it would
appear to be market making-related activity of the type described in
section 13(d)(1)(B) of the BHC Act. Second, the hedging transaction
must also meet the criteria specified in the general exemption for
risk-mitigating hedging activity for purposes of the proprietary
trading prohibition, which is contained in Sec. Sec. --.5(b) and (c)
of the proposed rule and described in detail in Part III.B.3 of this
Supplementary Information. Those criteria are intended to clearly
define the scope of appropriate risk-mitigating hedging activities, to
foreclose reliance on the exemption for prohibited proprietary trading
that is conducted in the context of, or mischaracterized as, hedging
activity, and to require documentation regarding the hedging purpose of
certain transactions that are established at a level of organization
that is different than the level of organization establishing or
responsible for the underlying risk or risks that are being hedged,
which in the context of the market making-related activity would
generally be the trading desk.
iii. Request for Comment
The Agencies request comment on the proposed criteria that must be
met in order to rely on the market-making exemption. In particular, the
Agencies request comment on the following questions (as well as related
questions in Part III.B.5 of this Supplementary Information):
Question 87. Are the seven criteria included in the market-making
exemption effective? Is the application of each criterion to potential
transactions sufficiently clear? Should any of the criteria be changed
or eliminated? Should other criteria be added?
Question 88. Is incorporation of concepts from the definition of
``market maker'' under the Exchange Act useful for purposes of section
13 of the BHC Act and consistent with its purposes? If not, what
alternative definition would be more useful or more consistent?
Question 89. Is the proposed exemption overly broad or narrow? For
example, would it encompass activity that should be considered
prohibited proprietary trading under the proposed rule? Alternatively,
would it prohibit forms of market making or market making-related
activities that are permitted under other rules or regulations?
Question 90. We seek commenter input on the types of banking
entities and forms of activities that would not qualify for the
proposed market-making exemption but that commenters consider to
otherwise be market making. Please discuss the impact of not permitting
such activities under the proposed exemption (e.g., the impact on
liquidity).
Question 91. Is the requirement that a trading desk or other
organizational unit relying on the market-making exemption hold itself
out as being willing to buy and sell, or otherwise enter into long and
short positions in, the relevant covered financial position for its own
account on a regular or continuous basis effective? If not, what
alternative would be more effective? Does the proposed requirement
appropriately differentiate between market making-related activities in
different markets and asset classes? If not, how could such differences
be better reflected? Should the requirement be modified to include
certain arbitrage trading activities engaged in by market makers that
promote liquidity or price transparency, but do not serve customer,
client or counterparty demands, within the scope of market making-
related activity? If so why? How could such liquidity- or price
transparency-promoting activities be meaningfully identified and
distinguished from prohibited proprietary trading practices that also
may incidentally promote liquidity or price transparency? Do particular
markets or instruments, such as the market for exchange-traded funds,
raise particular issues that are not adequately or appropriately
addressed in the proposal? If so, how could the proposal better address
those instruments, markets or market features?
Question 92. Do the proposed indicia of market making in liquid
markets accurately reflect the factors that should generally be used to
analyze whether a banking entity is engaged in market making-related
activities for purposes of section 13 of the BHC Act and the proposed
rule? If not, why not? Should any of the proposed factors be eliminated
or modified? Should any additional factors be included? Is reliance on
the SEC's indicia of bona fide market making for purposes of Regulation
SHO under the Exchange Act and the equity securities market appropriate
in the context of section 13 of the BHC Act and the proposed rule with
respect to liquid markets? If not, why not?
Question 93. Do the proposed indicia of market making in illiquid
markets accurately reflect the factors that should generally be used to
analyze whether a banking entity is engaged in market making-related
activities for purposes of section 13 of the BHC Act and the proposed
rule? If not, why not? Should any of the proposed factors be eliminated
or modified? Should any additional factors be included?
Question 94. How accurately can a banking entity predict the near-
term demands of clients, customers, and counterparties? Are there
measures that can distinguish the amount of principal risk that should
be retained to support such near-term client, customer, or counterparty
demand from positions taken for speculative purposes? How is client,
customer, or counterparty demand anticipated in connection with market
making-related activities, and how does such approach vary by asset
class?
[[Page 68874]]
Question 95. Is the requirement that a banking entity relying on
the market-making exemption be registered as a dealer (or in the case
of a financial institution that is a government securities dealer, has
filed notice of that status as required by section 15C(a)(1)(B) of the
Exchange Act), or exempt from registration or excluded from regulation
as a dealer under relevant securities or commodities laws effective? If
not, how should the requirement be changed? Does the requirement
appropriately take into account the particular registration
requirements applicable to dealing in different types of financial
instruments? If not, how could it better do so? Does the requirement
appropriately take into account the various registration exemptions and
exclusions available to certain entities, such as banks, under the
securities and commodities laws? If not, how could it better do so?
Question 96. Is the requirement that a trading desk or other
organizational unit of a banking entity relying on the market-making
exemption be designed to generate revenues primarily from fees,
commissions, bid/ask spreads or similar income effective? If not, how
should the requirement be changed? Does the requirement appropriately
capture the type and nature of revenues typically generated by market
making-related activities? Is any further clarification or additional
guidance necessary? Can revenues primarily from fees, commissions, bid/
ask spreads or similar income be meaningfully separated from other
types of revenues?
Question 97. Is the requirement that the compensation arrangements
of persons performing market making-related activities at a banking
entity not be designed to encourage proprietary risk-taking effective?
If not, how should the requirement be changed? Are there other types of
compensation incentives that should be clearly referenced as
consistent, or inconsistent, with permitted market making-related
activity? Are their specific and identifiable characteristics of
compensation arrangements that clearly incentivize prohibited
proprietary trading?
Question 98. Is the inclusion of market making-related hedging
transactions within the market-making exemption effective and
appropriate? Are the proposed requirements that certain hedging
transactions must meet in order to be considered to have been made in
connection with market making-related activity effective and
sufficiently clear? If not, what alternative requirements would be more
effective and/or clearer? Should any of the proposed requirements be
eliminated? If so, which ones, and why?
Question 99. Should the terms ``client,'' ``customer,'' or
``counterparty'' be defined for purposes of the market-making
exemption? If so, how should these terms be defined? For example, would
an appropriate definition of ``customer'' be: (i) A continuing
relationship in which the banking entity provides one or more financial
products or services prior to the time of the transaction; (ii) a
direct and substantive relationship between the banking entity and a
prospective customer prior to the transaction; (iii) a relationship
initiated by the banking entity to a prospective customer to induce
transactions; or (iv) a relationship initiated by the prospective
customer with a view to engaging in transactions?
Question 100. Are there other types of market making-related
activities that should also be included within the scope of the market-
making exemption? If so, what additional activities and why? How would
an exemption for such additional activities be consistent with the
language and intent of section 13 of the BHC Act? What criteria,
requirements, or restrictions would be appropriate to include with
respect to such additional activities? How would such criteria,
requirements, or restrictions prevent circumvention or evasion of the
prohibition on proprietary trading?
Question 101. Do banking entities currently have processes in place
that would prevent or reduce the likelihood of taking speculative,
proprietary positions in the context of, or mischaracterized as, market
making-related activities? If so, what processes?
3. Section --.5: Permitted Risk-Mitigating Hedging Activities
Section --.5 of the proposed rule permits a banking entity to
purchase or sell a covered financial position if the transaction is
made in connection with, and related to, individual or aggregated
positions, contracts, or other holdings of a banking entity and is
designed to reduce the specific risks to the banking entity in
connection with and related to such positions, contracts, or other
holdings (the ``hedging exemption''). This section of the proposed rule
implements, in relevant part, section 13(d)(1)(C) of the BHC Act, which
provides an exemption from the prohibition on proprietary trading for
certain risk-mitigating hedging activities.
a. Approach to Implementing the Hedging Exemption
Like market making-related activities, risk-mitigating hedging
activities present certain implementation challenges because of the
potential that prohibited proprietary trading could be conducted in the
context of, or mischaracterized as, a hedging transaction. This is
because it may often be difficult to identify in retrospect whether a
banking entity engaged in a particular transaction to manage or
eliminate risks arising from related positions, on the one hand, or to
profit from price movements related to the hedge position itself, on
the other. The intent with which a purported hedge position is acquired
may often be difficult to discern in practice.
In light of these complexities, the Agencies have again proposed a
multi-faceted approach to implementation. As with the underwriting and
market-making exemptions, the Agencies have proposed a set of criteria
that must be met in order for a banking entity to rely on the hedging
exemption. The proposed criteria are intended to define the scope of
permitted risk-mitigating hedging activities and to foreclose reliance
on the exemption for prohibited proprietary trading that is conducted
in the context of, or mischaracterized as, permitted hedging activity.
This includes implementation of the programmatic compliance regime
required under subpart D of the proposed rule and, in particular,
requires that a banking entity with significant trading activities
implement robust, detailed hedging policies and procedures and related
internal controls that are designed to prevent prohibited proprietary
trading in the context of permitted hedging activity.\155\ In
particular, a banking entity's compliance regime must include written
hedging policies at the trading unit level and clearly articulated
trader mandates for each trader to ensure that the decision of when and
how to put on a hedge is consistent with such policies and mandates,
and not fully left to a trader's discretion.\156\ In addition, to
address potential supervisory concerns raised by certain types of
hedging transactions, Sec. --.5 of the proposed rule also requires a
banking entity to document certain hedging transactions at the time the
hedge is established. This multi-faceted approach is intended to
articulate the Agencies' expectations regarding the scope of permitted
risk-
[[Page 68875]]
mitigating hedging activities in a manner that limits potential abuse
of the hedging exemption while not unduly constraining the important
risk management function that is served by a banking entity's hedging
activities.
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\155\ These aspects of the compliance program requirement are
described in further detail in Part III.D of this Supplementary
Information.
\156\ See, e.g., proposed rule Appendix C.II.a.
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b. Required Criteria for Permitted Risk-Mitigating Hedging Activitiesm
Section --.5(b) of the proposed rule describes the seven criteria
that a banking entity must meet in order to rely on the hedging
exemption. First, Sec. --.5(b)(1) of the proposed rule requires the
banking entity to have established an internal compliance program,
consistent with the requirements of subpart D, that is designed to
ensure the banking entity's compliance with the requirements of this
paragraph, including reasonably-designed written policies and
procedures, internal controls, and independent testing. This criterion
is intended to ensure that any banking entity relying on the exemption
has appropriate internal control processes in place to support its
compliance with the terms of the exemption.
Second, Sec. --.5(b)(2)(i) of the proposed rule requires that a
transaction for which a banking entity is relying on the hedging
exemption have been made in accordance with written policies,
procedures and internal controls established by the banking entity
pursuant to subpart D. This criterion would preclude reliance on the
hedging exemption if the transaction was inconsistent with a banking
entity's own hedging policies and procedures, as such inconsistency
would appear to be indicative of prohibited proprietary trading.
Third, Sec. --.5(b)(2)(ii) of the proposed rule requires that the
transaction hedge or otherwise mitigate one or more specific risks,
including market risk, counterparty or other credit risk, currency or
foreign exchange risk, interest rate risk, basis risk, or similar
risks, arising in connection with and related to individual or
aggregated positions, contracts, or other holdings of a banking entity.
This criterion implements the essential element of the hedging
exemption--i.e., that the transaction be risk-mitigating. Notably, and
consistent with the statutory reference to mitigating risks of
individual or aggregated positions, this criterion would include the
hedging of risks on a portfolio basis. For example, it would include
the hedging of one or more specific risks arising from a portfolio of
diverse holdings, such as the hedging of the aggregate risk of one or
more trading desks. However, in each case, the Agencies would expect
that the transaction or series of transactions being used to hedge is,
in the aggregate, demonstrably risk-reducing with respect to the
positions, contracts, or other holdings that are being hedged. A
banking entity relying on the exemption should be prepared to identify
the specific position or portfolio of positions that is being hedged
and demonstrate that the hedging transaction is risk-reducing in the
aggregate, as measured by appropriate risk management tools.
In addition, this criterion would include a series of hedging
transactions designed to hedge movements in the price of a portfolio of
positions. For example, a banking entity may need to engage in dynamic
hedging, which involves rebalancing its current hedge position(s) based
on a change in the portfolio resulting from permissible activities or
from a change in the price, or other characteristic, of the individual
or aggregated positions, contracts, or other holdings. The Agencies
recognize that, in such dynamic hedging, material changes in risk may
require a corresponding modification to the banking entity's current
hedge positions.\157\
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\157\ This corresponding modification to the hedge should also
be reasonably correlated to the material changes in risk that are
intended to be hedged or otherwise mitigated, as required by
proposed rule Sec. --.5(b)(2)(iii).
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The Agencies also expect that a banking entity relying on the
exemption would be able to demonstrate that the banking entity is
already exposed to the specific risks being hedged; generally, the
purported hedging of risks to which the banking entity is not actually
exposed would not meet the terms of the exemption. However, the hedging
exemption would be available in certain cases where the hedge is
established slightly before the banking entity becomes exposed to the
underlying risk if such anticipatory hedging activity: (i) Is
consistent with appropriate risk management practices; (ii) otherwise
meets the terms of the hedging exemption; and (iii) does not involve
the potential for speculative profit. For example, if a banking entity
was contractually obligated, or otherwise highly likely, to become
exposed to a particular risk and there was a sound risk management
rationale for hedging that risk slightly in advance of actual exposure,
the hedging transaction would generally be consistent with the
requirement described in Sec. --.5(b)(2)(ii) of the proposed rule.
Fourth, Sec. --.5(b)(2)(iii) of the proposed rule requires that
the transaction be reasonably correlated, based upon the facts and
circumstances of the underlying and hedging positions and the risks and
liquidity of those positions, to the risk or risks the transaction is
intended to hedge or otherwise mitigate. A transaction that is only
tangentially related to the risks that it purportedly mitigates would
appear to be indicative of prohibited proprietary trading. Importantly,
the Agencies have not proposed that a transaction relying on the
hedging exemption be fully correlated; instead, only reasonable
correlation is required.\158\ The degree of correlation that may be
reasonable will vary depending on the underlying risks and the
availability of alternative hedging options--risks that can be easily
and cost-effectively hedged with extremely high or near-perfect
correlation would typically be expected to be so hedged, whereas other
risks may be difficult or impossible to hedge with anything greater
than partial correlation. Moreover, it is important to consider the
fact that trading positions are often subject to a number of different
risks, and some risks may be hedged easily and at low cost but may only
account for a small proportion of the total risk in the position.\159\
More generally, potential correlation levels between asset classes can
differ significantly, and analysis of the reasonableness of correlation
would depend on the facts and circumstances of the initial position(s),
risk(s) created, liquidity of the instrument, and the legitimacy of the
hedge. Regardless of the precise degree of correlation, if the
predicted performance of a hedge position during the period that the
hedge position and the related position are held would result in a
banking entity earning appreciably more profits on the hedge position
than it stood to lose on the related position, the hedge would appear
likely to be a proprietary trade designed to result in profit rather
than an exempt hedge position.
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\158\ Although certain accounting standards, such as FASB ASC
Topic 815 hedge accounting, address circumstances in which a
transaction may be considered a hedge of another transaction, the
proposed rule does not refer to or rely on these accounting
standards, because such standards (i) are designed for financial
statement purposes, not to identify proprietary trading and (ii)
change often and are likely to change in the future without
consideration of the potential impact on section 13 of the BHC Act.
\159\ Interest rate risk in an equity derivative transaction is
one example--the hedging of interest rate risk in an equity
derivative position may only result in a small reduction in overall
risk and interest rates may only exhibit a small correlation with
the value of the equity derivative, but the lack of perfect or
significant correlation would not impair reliance on the hedging
exemption.
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Fifth, Sec. --.5(b)(2)(iv) of the proposed rule requires that the
hedging transaction not give rise, at the
[[Page 68876]]
inception of the hedge, to significant exposures that are not
themselves hedged in a contemporaneous transaction. A transaction that
creates significant new risk exposure that is not itself hedged at the
same time would appear to be indicative of prohibited proprietary
trading. For example, over-hedging, correlation trading, or pairs
trading strategies that generate profits through speculative,
proprietary risk-taking would fail to meet this criterion. Similarly, a
transaction involving a pair of positions that hedge each other with
respect to one type of risk exposure, but create or contain a residual
risk exposure would, taken together, constitute prohibited proprietary
trading and not risk-mitigating hedging if those positions were taken
collectively for the purpose of profiting from short-term movements in
the effective price of the residual risk exposure. However, the
proposal also recognizes that any hedging transaction will inevitably
give rise to certain types of new risk, such as counterparty credit
risk or basis risk reflecting the differences between the hedge
position and the related position; the proposed criterion only
prohibits the introduction of additional significant exposures through
the hedging transaction. In addition, proposed Sec. --.5(b)(2)(iv)
only requires that no new and significant exposures be introduced at
the inception of the hedge, and not during the entire period that the
hedge is maintained, reflecting the fact that new, unanticipated risks
can and sometimes do arise out of hedging positions after the hedge is
established. The Agencies have proposed to address the appropriate
management of risks that arise out of a hedge position after inception
through Sec. --.5(b)(2)(v) of the proposed rule.
Sixth, Sec. --.5(b)(2)(v) of the proposed rule requires that any
transaction conducted in reliance on the hedging exemption be subject
to continuing review, monitoring and management after the hedge
position is established. Such review, monitoring, and management must:
(i) Be consistent with the banking entity's written hedging policies
and procedures; (ii) maintain a reasonable level of correlation, based
upon the facts and circumstances of the underlying and hedging
positions and the risks and liquidity of those positions, to the risk
or risks the purchase or sale is intended to hedge or otherwise
mitigate; and (iii) mitigate any significant exposure arising out of
the hedge after inception. In accordance with a banking entity's
written internal hedging policies, procedures, and internal controls, a
banking entity should actively review and manage its hedging positions
and the risks that may arise out of those positions over time. A
banking entity's internal hedging policies should be designed to ensure
that hedges remain effective as correlations or other factors change.
In particular, a risk-mitigating hedge position typically should be
unwound as exposure to the underlying risk is reduced or increased as
underlying risk increases, as selective hedging activity would appear
to be indicative of prohibited proprietary trading.\160\ A banking
entity's written internal hedging policies, procedures, and internal
controls for monitoring and managing its hedges also should be
reasonably designed to prevent the occurrence of such prohibited
proprietary trading activity and be reasonably specific about the level
of hedging that is expected to be maintained regardless of
opportunities for profit associated with over- or under-hedging.
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\160\ The Agencies note that in some cases, it may be
appropriate for a banking entity to unwind a hedge, even if the
underlying risk remains, if the cost of that hedge become
uneconomic, better hedging options become available, or the overall
risk profile of the banking entity has changed such that no longer
hedging the risk is consistent with appropriate risk management
practices.
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Seventh, Sec. --.5(b)(2)(vi) of the proposed rule requires that
the compensation arrangements of persons performing the risk-mitigating
hedging activities are designed not to reward proprietary risk-taking.
Hedging activities for which a banking entity has established a
compensation incentive structure that rewards speculation in, and
appreciation of, the market value of a covered financial position,
rather than success in reducing risk, are inconsistent with permitted
risk-mitigating hedging activities.
c. Documentation Requirement
Section --.5(c) of the proposed rule imposes a documentation
requirement on certain types of hedging transactions. Specifically, for
any transaction that a banking entity conducts in reliance on the
hedging exemption that involves a hedge established at a level of
organization that is different than the level of organization
establishing the positions, contracts, or other holdings the risks of
which the hedging transaction is designed to reduce, the banking entity
must, at a minimum, document the risk-mitigating purpose of the
transaction and identify the risks of the individual or aggregated
positions, contracts, or other holdings of a banking entity that the
transaction is designed to reduce.\161\ Such documentation must be
established at the time the hedging transaction is effected, not after
the fact. The Agencies are concerned that hedging transactions
established at a different level of organization than the positions
being hedged may present or reflect heightened potential for prohibited
proprietary trading, as a banking entity may be able, after the fact,
to point to a particular, offsetting exposure within its organization
after a position is established and characterize that position as a
hedge even when, at the time the position was established, it was
intended to generate speculative proprietary gains, not mitigate risk.
To address this concern, the Agencies have proposed to require a
banking entity, when establishing a hedge at a different level of
organization than that establishing or responsible for the underlying
positions or risks being hedged, to document the hedging purpose of the
transaction and risks being hedged so as to establish a
contemporaneous, documentary record that will assist the Agencies in
assessing the actual reasons for which the position was established.
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\161\ For example, a hedge would be established at a different
level of organization of the banking entity if multiple market
making desks were exposed to similar risks and, to hedge such risks,
a portfolio hedge was established at the direction of a supervisor
or risk manager responsible for more than one desk rather than at
each of the market making desks that established the initial
positions, contracts, or other holdings.
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d. Request for Comment
The Agencies request comment on the proposed implementation of the
risk-mitigating hedging exemption with respect to proprietary trading.
In particular, the Agencies request comment on the following questions:
Question 102. Is the proposed rule's approach to implementing the
hedging exemption effective? If not, what alternative approach would be
more effective?
Question 103. Does the proposed multi-faceted approach
appropriately take into account and address the challenges associated
with differentiating prohibited proprietary trading from permitted
hedging activities? Should the approach include other elements? If so,
what elements and why? Should any of the proposed elements be revised
or eliminated? If so, why and how?
Question 104. Does the proposed approach to implementing the
hedging exemption provide banking entities and market participants with
sufficient clarity regarding what constitutes permitted hedging
activities? If not, how could greater clarity be provided?
[[Page 68877]]
Question 105. What impact will the proposed approach to
implementing the hedging exemption have on the hedging and risk
management activities of a banking entity and the services it provide
to its clients? If any of these impacts are positive, how can they be
amplified? If any of these impacts are negative, how can they be
mitigated?
Question 106. What burden will the proposed approach to
implementing the hedging exemption have on banking entities? How can
any burden be minimized or eliminated in a manner consistent with the
language and purpose of the statute?
Question 107. Are the criteria included in the hedging exemption
effective? Is the application of each criterion to potential
transactions sufficiently clear? Should any of the criteria be changed
or eliminated? Should other requirements be added?
Question 108. Is the requirement that a transaction hedge or
otherwise mitigate one or more specific risks, including market risk,
counterparty or other credit risk, currency or foreign exchange risk,
interest rate risk, basis risk, or similar risks, arising in connection
with and related to individual or aggregated positions, contracts, or
other holdings of a banking entity effective? If not, what requirement
would be more effective? Does the proposed approach sufficiently
articulate the types of risks that a banking entity typically hedges?
Does the proposal sufficiently address application of the hedging
exemption to portfolio hedging strategies? If not, how should the
proposal be changed?
Question 109. Does the manner in which section --.5 of the proposal
would implement the risk-mitigating hedging exemption effectively
address transactions that hedge or otherwise mitigate specific risks
arising in connection with and related to aggregated positions,
contracts, or other holdings of a banking entity? Do certain hedging
strategies or techniques that involve hedging the risks of aggregated
positions (e.g., portfolio hedging) (i) create the potential for abuse
of the hedging exemption or (ii) give rise to challenges in determining
whether a banking entity is engaged in exempt, risk-mitigating hedging
activity or prohibited proprietary trading? If so, what hedging
strategies and techniques, and how? Should additional restrictions,
conditions, or requirements be placed on the use of the hedging
exemption with respect to aggregated positions so as to limit potential
abuse of the exemption, assist banking entities and the Agencies in
determining compliance with the exemption, or otherwise improve the
effectiveness of the rule? If so, what additional restrictions,
conditions, or requirements, and why?
Question 110. Is the requirement that the transaction be reasonably
correlated to the risk or risks the transaction is intended to hedge or
otherwise mitigate effective? If not, how should the requirement be
changed? Should some specific level of correlation and/or hedge
effectiveness be required? Should the proposal specify in greater
detail how correlation should be measured? Should the proposal require
hedges to be effective in periods of financial stress? Does the
proposal sufficiently reflect differences in levels of correlation
among asset classes? If not, how could it better do so?
Question 111. Is the requirement that the transaction not give
rise, at the inception of the hedge, to significant exposures that are
not themselves hedged in a contemporaneous transaction effective? Does
the requirement establish an appropriate range for legitimate hedging
while constraining impermissible proprietary trading? Is this
requirement sufficiently clear? If not, what alternative would be more
effective and/or clearer? Are there types of risk-mitigating hedging
activities that may give rise to new and significant exposures that
should be permitted under the hedging exemption? If so, what
activities? Should the requirement that no significant exposure be
introduced be extended for the duration of the hedging position? If so,
why?
Question 112. Is the requirement that any transaction conducted in
reliance on the hedging exemption be subject to continuing review,
monitoring and management after the transaction is established
effective? If not, what alternative would be more effective?
Question 113. Is the requirement that the compensation arrangements
of persons performing risk-mitigating hedging activities at a banking
entity be designed not to reward proprietary risk-taking effective? If
not, how should the requirement be changed? Are there other types of
compensation incentives that should be clearly referenced as
consistent, or inconsistent, with permitted risk-mitigating hedging
activity? Are there specific and identifiable characteristics of
compensation arrangements that clearly incentivize prohibited
proprietary trading?
Question 114. Is the proposed documentation requirement effective?
If not, what alternative would be more effective? Are there certain
additional types of hedging transactions that should be subject to the
documentation requirement? If so, what transactions and why? Should all
types of hedging transactions be subject to the documentation
requirement? If so, why? Should banking entities be required to
document more aspects of a particular transactions (e.g., all of the
criteria applicable to Sec. --.5(b) of the proposed rule)? If so, what
aspects and why? What burden would the proposed documentation
requirement place on banking entities? How might such burden be reduced
or eliminated in a manner consistent with the language and purpose of
the statute?
Question 115. Aside from the required documentation, do the
substantive requirements of the proposed risk-mitigating hedging
exemption suggest that additional documentation would be required to
achieve compliance with the proposed rule? If so, what burden would
this additional documentation requirement place on banking entities?
How might such burden be reduced or eliminated in a manner consistent
with the language and purpose of the statute?
4. Section --.6: Other Permitted Trading Activities
Section --.6 of the proposed rule permits a banking entity to
engage in certain other trading activities described in section
13(d)(1) of the BHC Act. These permitted activities include trading in
certain government obligations, trading on behalf of customers, trading
by insurance companies, and trading outside of the United States by
certain foreign banking entities. Section --.6 of the proposed rule
does not contain all of the statutory exemptions contained in section
13(d)(1) of the BHC Act. Several of these exemptions appear, either by
plain language or by implication, to be intended to apply only to
covered fund activities and investments, and so the Agencies have not
proposed to include them in the proposed rule's proprietary trading
provisions.\162\ Those exemptions are referenced in other portions of
the proposed rule pertaining to covered funds.
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\162\ In particular, the proposed rule does not apply (i) the
exemption in section 13(d)(1)(E) of the BHC Act for SBICs and
certain public welfare or qualified rehabilitation investments, or
(ii) the exemptions in sections 13(d)(1)(G) and 13(d)(1)(I) of the
BHC Act for certain covered funds activities and investments, to the
proprietary trading provisions of subpart B.
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The Agencies request comment on the proposed rule's approach to
implementing the exemptions contained in section 13(d)(1) of the BHC
Act to the proposed rule's proprietary trading provisions. In
particular, the Agencies
[[Page 68878]]
request comment on the following questions:
Question 116. Is the proposed rule's approach of identifying which
of the statutory exemptions contained in section 13(d)(1) of the BHC
Act apply to the proposed rule's proprietary trading provisions
effective and/or consistent with the language and purpose of the
statute? If not, what alternative would be more effective and/or
consistent with the language and purpose of the statute?
Question 117. Are there statutory exemptions that should apply to
the proposed rule's proprietary trading provisions that were not
included? If so, what exemptions and why?
Question 118. Are there statutory exemptions that were included in
the proposed rule's proprietary trading provisions that should not have
been included? If so, what exemptions and why?
a. Permitted Trading in Government Obligations
Section --.6(a) of the proposed rule, which implements section
13(d)(1)(A) of the BHC Act,\163\ permits the purchase or sale of a
covered financial position that is: (i) An obligation of the United
States or any agency thereof; \164\ (ii) an obligation, participation,
or other instrument of or issued by the Government National Mortgage
Association, the Federal National Mortgage Association, the Federal
Home Loan Mortgage Corporation, a Federal Home Loan Bank, the Federal
Agricultural Mortgage Corporation or a Farm Credit System institution
chartered under and subject to the provisions of the Farm Credit Act of
1971 (12 U.S.C. 2001 et seq.); or (iii) an obligation issued by any
State or any political subdivision thereof.\165\ The proposed rule also
clarifies that these obligations include limited as well as general
obligations of the relevant government entity. The Agencies note that,
consistent with the statutory language, the types of instruments
described with respect to the enumerated government-sponsored entities
include not only obligations of such entities, but also participations
and other instruments of or issued by such entity. This would include,
for example, pass-through or participation certificates that are issued
and guaranteed by one of these government-sponsored entities (e.g., the
Federal National Mortgage Association and the Federal Home Loan
Mortgage Corporation) in connection with their securitization
activities.
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\163\ Section 13(d)(1)(A) of the BHC Act permits a banking
entity to purchase, sell, acquire or dispose securities and other
instruments described in section 13(h)(4) of the BHC Act if those
securities or other instruments are specified types of government
obligations, notwithstanding the prohibition on proprietary trading.
See 12 U.S.C. 1851(d)(1)(A).
\164\ The Agencies propose that United States ``agencies'' for
this purpose will include those agencies described in section
201.108(b) of the Board's Regulation A. See 12 CFR 201.108(b). The
Agencies also note that the terms of the exemption would encompass
the purchase or sale of enumerated government obligations on a
forward basis (e.g., in a to-be-announced market).
\165\ Consistent with the statutory language, the proposed rule
does not extend the government obligations exemption to transactions
in obligations of an agency of any State or political subdivision
thereof.
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The Agencies request comment on the proposed rule's approach to
implementing the government obligation exemption. In particular, the
Agencies request comment on the following questions:
Question 119. Is the proposed rule's application to trading in
government obligations sufficiently clear? Should such obligations
expressly include, for example, instruments issued by third parties but
insured or guaranteed by an enumerated government entity or otherwise
backed by its full faith and credit?
Question 120. Should the Agencies adopt an additional exemption for
proprietary trading in State or municipal agency obligations under
section 13(d)(1)(J) of the BHC Act? If so, how would such an exemption
promote and protect the safety and soundness of banking entities and
the financial stability of the United States?
Question 121. Should the Agencies adopt an additional exemption for
proprietary trading in options or other derivatives referencing an
enumerated government obligation under section 13(d)(1)(J) of the BHC
Act? For example, should the Agencies provide an exemption for options
or other derivatives with respect to U.S. government debt obligations?
If so, how would such an exemption promote and protect the safety and
soundness of banking entities and the financial stability of the United
States?
Question 122. Should the Agencies adopt an additional exemption for
proprietary trading in the obligations of foreign governments and/or
international and multinational development banks under section
13(d)(1)(J) of the BHC Act? If so, what types of obligations should be
exempt? How would such an exemption promote and protect the safety and
soundness of banking entities and the financial stability of the United
States?
Question 123. Should the Agencies adopt an additional exemption for
proprietary trading in any other type of government obligations under
section 13(d)(1)(J) of the BHC Act? If so, how would such an exemption
promote and protect the safety and soundness of banking entities and
the financial stability of the United States?
Question 124. Are the definitions of ``government security'' and
``municipal security'' in sections 3(a)(42) and 3(a)(29) of the
Exchange Act helpful in determining the proper scope of this exemption?
If so, please explain their utility and how incorporating such
definitions into the exemption would be consistent with the language
and purpose of section 13 of the BHC Act.
b. Permitted Trading on Behalf of Customers
Section 13(d)(1)(D) of the BHC Act permits a banking entity to
purchase or sell a covered financial position on behalf of customers,
notwithstanding the prohibition on proprietary trading. Section --.6(b)
of the proposed rule implements this section. Because the statute does
not specifically define when a transaction would be conducted ``on
behalf of customers,'' the proposed rule identifies three categories of
transactions that, while they may involve a banking entity acting as
principal for certain purposes, appear to be on behalf of customers
within the purpose and meaning of the statute. As proposed, only
transactions meeting the terms of these three categories would be
considered on behalf of customers for purposes of the exemption.
Section --.6(b)(i) of the proposed rule provides that a purchase or
sale of a covered financial position is on behalf of customers if the
transaction (i) is conducted by a banking entity acting as investment
adviser, commodity trading advisor, trustee, or in a similar fiduciary
capacity for a customer and for the account of that customer, and (ii)
involves solely covered financial positions of which the banking
entity's customer, and not the banking entity or any subsidiary or
affiliate of the banking entity, is beneficial owner (including as a
result of having long or short exposure under the relevant covered
financial position). This category is intended to capture a wide range
of trading activity conducted in the context of customer-driven
investment or commodity advisory, trust, or fiduciary services, so long
as that activity is structured in a way that the customer, and not the
banking entity providing those services, benefits from any gains and
suffers from any losses on such covered financial positions.\166\ A
transaction that is
[[Page 68879]]
structured so as to involve a listed form of relationship but
nonetheless allows gains or losses from trading activity to inure to
the benefit or detriment of the banking entity would fall outside the
scope of this category.
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\166\ For example, in the case of a banking entity acting as
investment adviser to a registered mutual fund, any trading by the
banking entity in its capacity of investment adviser and on behalf
of that fund would be permitted pursuant to Sec. --.6(b)(i) of the
proposed rule, so long as the relevant criteria were met.
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Section --.6(b)(ii) of the proposed rule provides that a
transaction is on behalf of customers if the banking entity is acting
as riskless principal. These type of transactions are similarly
customer-driven and do not expose the banking entity to gains or losses
on the value of the traded positions, notwithstanding the fact that the
banking entity technically acts as principal. The Agencies note that
the proposed language describing riskless principal transactions
generally mirrors that used in the Board's Regulation Y, OCC
interpretive letters, and the SEC's Rule 3a5-1 under the Exchange
Act.\167\
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\167\ See 12 CFR 225.28(b)(7)(ii); 17 CFR 240.3a5-1(b); OCC
Interpretive Letter 626 (July 7, 1993).
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Section --.6(b)(iii) of the proposed rule addresses trading for the
separate account of insurance policyholders by a banking entity that is
an insurance company. In particular, this part of the proposed rule
provides that a purchase or sale of a covered financial position is on
behalf of customers if:
The banking entity is an insurance company engaging in the
transaction for a separate account;
The banking entity is directly engaged in the business of
insurance and subject to regulation by a State insurance regulator or
foreign insurance regulator; \168\
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\168\ The proposed rule provides definitions of the terms
``State insurance regulator'' and ``foreign insurance regulator.''
See proposed rule Sec. Sec. --.3(c)(4), (13).
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The banking entity purchases or sells the covered
financial position solely for a separate account established by the
insurance company in connection with one or more insurance policies
issued by that insurance company;
All profits and losses arising from the purchase or sale
of the covered financial position are allocated to the separate account
and inure to the benefit or detriment of the owners of the insurance
policies supported by the separate account, and not the banking entity;
and
The purchase or sale is conducted in compliance with, and
subject to, the insurance company investment and other laws,
regulations, and written guidance of the State or jurisdiction in which
such insurance company is domiciled.
This category is included within the exemption for transactions on
behalf of customers because such insurance-related transactions are
generally customer-driven and do not expose the banking entity to gains
or losses on the value of separate account assets, even though the
banking entity may be treated as the owner of those assets for certain
purposes. However, to limit the potential for abuse of the exemption,
the proposed rule also includes related requirements designed to ensure
that the separate account trading activity is subject to appropriate
regulation and supervision under insurance laws and not structured so
as to allow gains or losses from trading activity to inure to the
benefit or detriment of the banking entity.\169\ The proposed rule
defines a ``separate account'' as an account established or maintained
by a regulated insurance company subject to regulation by a State
insurance regulator or foreign insurance regulator under which income,
gains, and losses, whether or not realized, from assets allocated to
such account, are, in accordance with the applicable contract, credited
to or charged against such account without regard to other income,
gains, or losses of the insurance company.\170\
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\169\ The Agencies would not consider profits to inure to the
benefit of the banking entity if the banking entity were solely to
receive payment, out of separate account profits, of fees unrelated
to the investment performance of the separate account.
\170\ See proposed rule Sec. --.2(z).
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The Agencies request comment on the proposed rule's approach to
implementing the exemption for trading on behalf of customers. In
particular, the Agencies request comment on the following questions:
Question 125. Is the proposed rule's articulation of three
categories of transactions on behalf of customers effective and
sufficiently clear? If not, what alternative would be more effective
and/or clearer? Should any of the categories be eliminated? Should any
additional categories be added? Please explain.
Question 126. Is the proposed rule's exemption of certain
investment adviser, commodity trading advisor, trustee or similar
fiduciary transactions effective? What other types of relationships are
or should be captured by the proposed rule's reference to ``similar
fiduciary relationships,'' and why? Is application of this part of the
exemption to particular transactions sufficiently clear? Should any
other specific types of fiduciary or other relationships be specified
in the rule? If so, what types and why? What impact will the proposed
rule's implementation of the exemption have on the investment adviser,
commodity trading advisor, trustee or similar fiduciary activities of
banking entities? If such impacts are negative, how could they be
mitigated or eliminated in a manner consistent with the purpose and
language of the statute?
Question 127. Is the proposed rule's exemption of riskless
principal transactions effective? If not, what alternative would be
more appropriate? Is the description of qualifying riskless principal
activity sufficiently clear? If not, how should it be clarified? Should
the riskless principal transaction exemption include a requirement that
the banking entity must purchase (or sell) the covered financial
position as principal at the same price to satisfy the customer buy (or
sell) order, exclusive of any explicitly disclosed markup or markdown,
commission equivalent, or other fee? Why or why not? Should the
riskless principal exemption include a requirement with respect to the
timeframe in which the principal transaction must be allocated to a
riskless principal or customer account? Why or why not?
Question 128. Is the proposed rule's exemption of trading for
separate accounts by insurance companies effective? If not, what
alternative would be more appropriate? Does the proposed exemption
sufficiently address the variety of customer-driven separate account
structures typically used? If not, how should it address such
structures? Does the proposed exemption sufficiently address the
variety of regulatory or supervisory regimes to which insurance
companies may be subject?
Question 129. What impact will the proposed rule's implementation
of the exemption have on the insurance activities of insurance
companies affiliated with banking entities? If such impacts are
negative, how could they be mitigated or eliminated in a manner
consistent with the purpose and language of the statute?
Question 130. Should the term ``customer'' be defined for purposes
of the exemption for transactions on behalf of customers? If so, how
should it be defined? For example, would an appropriate definition be
(i) a continuing relationship in which the banking entity provides one
or more financial products or services prior to the time of the
transaction, (ii) a direct and substantive relationship between the
banking entity and a prospective customer prior to the transaction, or
(iii) a relationship initiated by the banking entity to a prospective
customer for purposes of the transaction?
[[Page 68880]]
Question 131. Is the exemption for trading on behalf of customers
in the proposed rule over- or under-inclusive? If it is under-
inclusive, please discuss any additional activities that should qualify
as trading on behalf of customers under the rule. What are the
mechanics of the particular trading activity and how does it qualify as
being on behalf of customers? Are there certain requirements or
restrictions that should be placed on the activity, if permitted by the
rule, to prevent evasion of the prohibition on proprietary trading? How
would permitting the activity be consistent with the purpose and
language of section 13 of the BHC Act? If the proposed exemption is
over-inclusive, please explain what aspect of the proposed exemption
does not involve trading on behalf of customers within the language and
purpose of the statute.
c. Permitted Trading by a Regulated Insurance Company
Section --.6(c) of the proposed rule implements section 13(d)(1)(F)
of the BHC Act,\171\ which permits a banking entity to purchase or sell
a covered financial position if the banking entity is a regulated
insurance company acting for its general account or an affiliate of an
insurance company acting for the insurance company's general account,
subject to certain conditions. Section --.6(d) of the proposed rule
generally restates the statutory requirements of the exemption, which
provide that:
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\171\ See 12 U.S.C. 1851(d)(1)(F).
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The insurance company must directly engage in the business
of insurance and be subject to regulation by a State insurance
regulator or foreign insurance regulator;
The insurance company or its affiliate must purchase or
sell the covered financial position solely for the general account of
the insurance company;
The purchase or sale must be conducted in compliance with,
and subject to, the insurance company investment laws, regulations, and
written guidance of the State or jurisdiction in which such insurance
company is domiciled; and
The appropriate Federal banking agencies, after
consultation with the Council and the relevant insurance commissioners
of the States, must not have jointly determined, after notice and
comment, that a particular law, regulation, or written guidance
described above is insufficient to protect the safety and soundness of
the banking entity or of the financial stability of the United
States.\172\
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\172\ The Federal banking agencies have not proposed at this
time to determine, as part of the proposed rule, that the insurance
company investment laws, regulations, and written guidance of any
particular State or jurisdiction are insufficient to protect the
safety and soundness of the banking entity, or of the financial
stability of the United States. The Federal banking agencies expect
to monitor, in conjunction with the Federal Insurance Office
established under section 502 of the Dodd-Frank Act, the insurance
company investment laws, regulations, and written guidance of States
or jurisdictions to which exempt transactions are subject and make
such determinations in the future, where appropriate.
The proposed rule defines a ``general account'' as all of the assets of
the insurance company that are not legally segregated and allocated to
separate accounts under applicable State law.\173\
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\173\ See proposed rule Sec. --.3(c)(6).
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The Agencies request comment on the proposed rule's approach to
implementing the exemption for general account trading by insurance
companies. In particular, the Agencies request comment on the following
questions:
Question 132. Should any of the statutory requirements for the
exemption be further clarified in the proposed rule? If so, how? Should
any additional requirements be added? If so, what requirements and why?
Question 133. Does the proposed rule appropriately and clearly
define a general account for these purposes? If not, what alternative
definition would be more appropriate?
Question 134. For purposes of the exemption, are the insurance
company investment laws, regulations, and written guidance of any
particular State or jurisdiction insufficient to protect the safety and
soundness of the banking entity, or of the financial stability of the
United States? If so, why?
Question 135. What impact will the proposed rule's implementation
of the exemption have on the insurance activities of insurance
companies affiliated with banking entities? If such impacts are
negative, how could they be mitigated or eliminated in a manner
consistent with the purpose and language of the statute?
d. Permitted Trading Outside of the United States
Section --.6(d) of the proposed rule implements section 13(d)(1)(H)
of the BHC Act,\174\ which permits certain foreign banking entities to
engage in proprietary trading that occurs solely outside of the United
States.\175\ This statutory exemption limits the extraterritorial
application of the prohibition on proprietary trading to the foreign
activities of foreign firms, while preserving national treatment and
competitive equality among U.S. and foreign firms within the United
States. Consistent with the statute, the proposed rule defines both the
type of foreign banking entities that are eligible for the exemption
and the circumstances in which proprietary trading by such an entity
will be considered to have occurred solely outside of the United
States.
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\174\ Section 13(d)(1)(H) of the BHC Act permits a banking
entity to engage in proprietary trading, notwithstanding the
prohibition on proprietary trading, if it is conducted by a banking
entity pursuant to paragraph (9) or (13) of section 4(c) of the BHC
Act and the trading occurs solely outside of the United States and
the banking entity is not directly or indirectly controlled by a
banking entity that is organized under the laws of the United States
or of one or more States. See 12 U.S.C. 1851(d)(1)(H).
\175\ This section's discussion of the concept ``solely outside
of the United States'' is provided solely for purposes of the
proposed rule's implementation of section 13(d)(1)(H) of the BHC
Act, and does not affect a banking entity's obligation to comply
with additional or different requirements under applicable
securities, banking, or other laws.
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i. Foreign Banking Entities Eligible for the Exemption
Section --.6(d)(1)(i) of the proposed rule provides that, in order
to be eligible for the foreign trading exemption, the banking entity
must not be directly or indirectly controlled by a banking entity that
is organized under the laws of the United States or of one or more
States. This requirement limits the scope of the exemption to banking
entities that are organized under foreign law and controlled only by
entities organized under foreign law. Consistent with the statutory
language, a banking entity organized under the laws of the United
States or any State and the subsidiaries and branches of such banking
entity (wherever organized or licensed) may not rely on the
exemption.\176\ Similarly, a U.S. subsidiary or branch of a foreign
banking entity would not qualify for the exemption.
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\176\ Under the proposal, a ``State'' means any State, territory
or possession of the United States, and the District of Columbia.
See proposed rule Sec. --.2(aa).
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Section --.6(d)(1)(ii) of the proposed rule incorporates the
statutory requirement that the banking entity must also conduct the
transaction pursuant to sections 4(c)(9) or 4(c)(13) of the BHC Act.
Section --.6(d)(2) clarifies when a banking entity would meet that
requirement, the criteria for which vary depending on whether or not
the banking entity is a foreign banking organization.\177\
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\177\ Section --.6(d)(2) only addresses when a transaction will
be considered to have been conducted pursuant to section 4(c)(9) of
the BHC Act. Although the statute also references section 4(c)(13)
of the BHC Act, the Board has applied the authority contained in
that section solely to the foreign activities of U.S. banking
organizations which, by the express terms of section 13(d)(1)(H) of
the BHC Act, are unable to rely on the foreign trading exemption.
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[[Page 68881]]
Section 4(c)(9) of the BHC Act provides that the restrictions on
interests in nonbanking organizations contained in that statute do not
apply to the ownership of shares held or activities conducted by any
company organized under the laws of a foreign country the greater part
of whose business is conducted outside the United States, if the Board
by regulation or order determines that, under the circumstances and
subject to the conditions set forth in the regulation or order, the
exemption would not be substantially at variance with the purposes of
the BHC Act and would be in the public interest.\178\ The Board has
implemented section 4(c)(9) as part of subpart B of the Board's
Regulation K,\179\ which specifies a number of conditions and
requirements that a foreign banking organization must meet in order to
use such authority. Such conditions and requirements include, for
example, a qualifying foreign banking organization test that requires
the foreign banking organization to demonstrate that more than half of
its worldwide business is banking and that more than half of its
banking business is outside the United States. The proposed rule makes
clear that if a banking entity is a foreign banking organization, it
will qualify for the foreign trading exemption if the entity is a
qualifying foreign banking organization that conducts the transaction
in compliance with subpart B of the Board's Regulation K, and the
transaction occurs solely outside of the United States.
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\178\ See 12 U.S.C. 1843(c)(9).
\179\ See 12 CFR 211.20 et seq.
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Section 13 of the BHC Act also applies to foreign companies that
control a U.S. insured depository institution but are not currently
subject to the BHC Act generally or to the Board's Regulation K--for
example, because the foreign company controls a savings association or
an FDIC-insured industrial loan company. Accordingly, the proposed rule
also clarifies when this type of foreign banking entity would be
considered to have conducted a transaction ``pursuant to section
4(c)(9)'' for purposes of the foreign trading exemption.\180\ In
particular, the draft rule proposes that to qualify for the foreign
trading exemption, such firms must meet at least two of three
requirements that evaluate the extent to which the foreign entity's
business is conducted outside the United States, as measured by assets,
revenues, and income. This test largely mirrors the qualifying foreign
banking organization test that is made applicable under section 4(c)(9)
of the BHC Act and Sec. 211.23(a) of the Board's Regulation K, except
that the test does not also require such a foreign entity to
demonstrate that more than half of its banking business is outside the
United States.\181\
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\180\ The Board emphasizes that this clarification would be
applicable solely in the context of section 13(d)(1) of the BHC Act.
The application of section 4(c)(9) to foreign companies in other
contexts is likely to involve different legal and policy issues and
may therefore merit different approaches.
\181\ See 12 U.S.C. 1843(c)(9); 12 CFR 211.23(a); proposed rule
Sec. --.6(d)(2). This difference reflects the fact that foreign
entities subject to section 13 of the BHC Act, but not the BHC Act
generally, are likely to be, in many cases, predominantly commercial
firms. A requirement that such firms also demonstrate that more than
half of their banking business is outside the United States would
likely make the exemption unavailable to such firms and subject
their global activities to the prohibition on proprietary trading, a
result that the statute does not appear to have intended.
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ii. Trading Solely Outside of the United States
The proposed rule also clarifies when a transaction will be
considered to have occurred solely outside of the United States for
purposes of the exemption. In interpreting this aspect of the statutory
language, the proposal focuses on the extent to which material elements
of the transaction occur within, or are conducted by personnel within,
the United States. This focus seeks to avoid extraterritorial
application of the prohibition of proprietary trading outside the
United States while preserving competitive parity within U.S. markets.
The proposed rule does not evaluate solely whether the risk of the
transaction or management or decision-making with respect to the
transaction rests outside the United States, as such an approach would
appear to permit foreign banking entities to structure transactions so
as to be ``outside of the United States'' for risk and booking purposes
while engaging in transactions within U.S. markets that are prohibited
for U.S. banking entities.
In particular, Sec. --.6(d)(3) of the proposed rule provides that
a transaction will be considered to have occurred solely outside of the
United States only if four conditions are met:
The transaction is conducted by a banking entity that is
not organized under the laws of the United States or of one or more
States;
No party to the transaction is a resident of the United
States;
No personnel of the banking entity that is directly
involved in the transaction is physically located in the United States;
\182\ and
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\182\ Personnel directly involved in the transaction would
generally not include persons performing purely administrative,
clerical, or ministerial functions.
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The transaction is executed wholly outside the United
States.
These four criteria are intended to ensure that a transaction executed
in reliance on the exemption does not involve U.S. counterparties, U.S.
trading personnel, U.S. execution facilities, or risks retained in the
United States. The presence of any of these factors would appear to
constitute a sufficient locus of activity in the U.S. marketplace so as
to preclude availability of the exemption.
A resident of the United States is defined in Sec. --.2(t) of the
proposed rule, and includes: (i) Any natural person resident in the
United States; (ii) any partnership, corporation or other business
entity organized or incorporated under the laws of the United States or
any State; (iii) any estate of which any executor or administrator is a
resident of the United States; (iv) any trust of which any trustee,
beneficiary or, if the trust is revocable, settlor is a resident of the
United States; (v) any agency or branch of a foreign entity located in
the United States; (vi) any discretionary or non-discretionary account
or similar account (other than an estate or trust) held by a dealer or
fiduciary for the benefit or account of a resident of the United
States; (vii) any discretionary account or similar account (other than
an estate or trust) held by a dealer or fiduciary organized or
incorporated in the United States, or (if an individual) a resident of
the United States; or (viii) any partnership or corporation organized
or incorporated under the laws of any foreign jurisdiction formed by or
for a resident of the United States principally for the purpose of
engaging in one or more transactions described in Sec. --.6(d)(1) or
Sec. --.13(c)(1) of the proposed rule.\183\ The proposed definition is
designed to capture the scope of U.S. counterparties, decision-makers
and personnel that, if involved in the transaction, would preclude that
transaction from being considered to have occurred solely outside the
United States. The Agencies note that the proposed definition is
similar but not identical to the definition of ``U.S. person'' for
purposes of the SEC's Regulation S, which governs securities offerings
and sales outside of the United
[[Page 68882]]
States that are not registered under the Securities Act.\184\
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\183\ See proposed rule Sec. --.2(t).
\184\ See 17 CFR 230.902(k).
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iii. Request for Comment
The Agencies request comment on the proposed rule's approach to
implementing the foreign trading exemption. In particular, the Agencies
request comment on the following questions:
Question 136. Is the proposed rule's implementation of the foreign
trading exemption effectively delineated? If not, what alternative
would be more effective and/or clearer?
Question 137. Are the proposed rule's provisions regarding when an
activity will be considered to have been conducted pursuant to section
4(c)(9) of the BHC Act effective and sufficiently clear? If not, what
alternative would be more effective and/or clearer? Do those provisions
effectively address the application of the foreign trading exemption to
foreign banking entities not subject to the BHC Act generally? If not,
how should the proposed rule apply the exemption?
Question 138. Are the proposed rule's provisions regarding when an
activity will be considered to have occurred solely outside the United
States effective and sufficiently clear? If not, what alternative would
be more effective and/or clearer? Should any requirements be modified
or removed? If so, which requirements and why? Should additional
requirements be added? If so, what requirements and why?
Question 139. Is the proposed rule's definition of ``resident of
the United States'' effective and sufficiently clear? If not, what
alternative would be more effective and/or clearer? Is the definition
over- or under-inclusive? If so, why? Should the definition more
closely track, or incorporate by reference, the definition of ``U.S.
person'' under the SEC's Regulation S under the Securities Act? If so,
why?
Question 140. Does the proposed rule effectively define a resident
of the United States for these purposes? If not, how should the
definition be altered?
Question 141. Should the Agencies use the authority provided in
section 13(d)(1)(J) of the BHC Act to allow U.S.-controlled banking
entities to engage in proprietary trading pursuant to section 4(c)(13)
of the BHC Act outside of the United States under certain
circumstances? If so, under what circumstances should this be permitted
and how would such activity promote and protect the safety and
soundness of banking entities and the financial stability of the United
States?
e. Discretionary Exemptions for Proprietary Trading Under Section
13(d)(1)(J) of the BHC Act
Section 13(d)(1)(J) of the BHC Act permits the Agencies to grant,
by rule, other exemptions from the prohibition on proprietary trading
if the Agencies determine that the exemption would promote and protect
the safety and soundness of the banking entity and the financial
stability of the United States.\185\ The Agencies have not, at this
time, proposed any such discretionary exemptions with respect to the
prohibition on proprietary trading. The Agencies request comment as
follows:
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\185\ See 12 U.S.C. 1851(d)(1)(J). In addition to permitting the
Agencies to provide additional exemptions from the prohibition on
proprietary trading, section 13(d)(1)(J) also states that the
Agencies may provide additional exemptions from the prohibition on
investing in or sponsoring a covered fund, as discussed in Part
III.C.5 of this Supplementary Information.
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Question 142. Should the Agencies adopt any exemption from the
prohibition on proprietary trading under section 13(d)(1)(J) of the BHC
Act? If so, what exemption and why? How would such an exemption promote
and protect the safety and soundness of banking entities and the
financial stability of the United States?
5. Section --.7: Reporting and Recordkeeping Requirements Applicable to
Trading Activities
Section --.7 of the proposed rule, which implements in part section
13(e)(1) of the BHC Act,\186\ requires certain banking entities to
comply with the reporting and recordkeeping requirements specified in
Appendix A of the proposed rule. In addition, Sec. --.7 requires
banking entities to comply with the recordkeeping requirements in Sec.
--.20 of the proposed rule, related to the banking entity's compliance
program,\187\ as well as any other reporting or recordkeeping
requirements that the relevant Agency may impose to evaluate the
banking entity's compliance with the proposed rule.\188\ Proposed
Appendix A requires a banking entity with significant trading
activities to furnish periodic reports to the relevant Agency regarding
various quantitative measurements of its trading activities and create
and retain records documenting the preparation and content of these
reports. The measurements vary depending on the scope, type, and size
of trading activities. In addition, proposed Appendix B contains a
detailed commentary regarding the characteristics of permitted market
making-related activities and how such activities may be distinguished
from trading activities that, even if conducted in the context of a
banking entity's market-making operations, would constitute prohibited
proprietary trading.
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\186\ Section 13(e)(1) of the BHC Act requires the Agencies to
issue regulations regarding internal controls and recordkeeping to
ensure compliance with section 13. See 12 U.S.C. 1851(e)(1). Section
--.20 and Appendix C of the proposed rule also implement section
13(e)(1) of the BHC Act.
\187\ See Supplementary Information, Part III.D.
\188\ See proposed rule Sec. --.7.
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A banking entity must comply with proposed Appendix A's reporting
and recordkeeping requirements only if it has, together with its
affiliates and subsidiaries, trading assets and liabilities the average
gross sum of which (on a worldwide consolidated basis) is, as measured
as of the last day of each of the four prior calendar quarters, equal
to or greater than $1 billion.\189\ The Agencies have not proposed to
extend the reporting and recordkeeping requirements to banking entities
with smaller amounts of trading activity, as it appears that the more
limited benefits of applying these requirements to such banking
entities, whose trading activities are typically small, less complex,
and easier to supervise, would not justify the burden associated with
complying with the reporting and recordkeeping requirements.
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\189\ See proposed rule Sec. --.7(a). The Agencies note that
this $1 billion trading asset and liability threshold is the same
standard that is used in the Market Risk Capital Rules for
determining which bank holding companies and insured depository
institutions must calculate their risk-based capital requirements
for trading positions under those rules. These banking entities
maintain large and complex portfolios of trading assets and are
therefore the most likely to be engaged in the types of trading
activities that will require significant oversight of compliance
with the restrictions on proprietary trading.
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a. General Approach to Reporting and Recordkeeping Requirements
The reporting and recordkeeping requirements of Sec. --.7 and
Appendix A of the proposed rule are an important part of the proposed
rule's multi-faceted approach to implementing the prohibition on
proprietary trading. These requirements are intended, in particular, to
address some of the difficulties associated with (i) identifying
permitted market making-related activities and distinguishing such
activities from prohibited proprietary trading and (ii) identifying
certain trading activities resulting in material exposure to high-risk
assets or high-risk trading strategies. To do so, the proposed rule
requires certain
[[Page 68883]]
banking entities to calculate and report detailed quantitative
measurements of their trading activity, by trading unit. These
measurements will help banking entities and the Agencies in assessing
whether such trading activity is consistent with permitted trading
activities in scope, type and profile. The quantitative measurements
that must be reported under the proposed rule are generally designed to
reflect, and to provide meaningful information regarding, certain
characteristics of trading activities that appear to be particularly
useful in differentiating permitted market making-related activities
from prohibited proprietary trading. For example, the proposed
quantitative measurements measure the size and type of revenues
generated, and the types of risks taken, by a trading unit. Each of
these measurements appears to be useful in assessing whether a trading
unit is (i) engaged in permitted market making-related activity or (ii)
materially exposed to high-risk assets or high-risk trading strategies.
Similarly, the proposed quantitative measurements also measure how much
revenue is generated per such unit of risk, the volatility of a trading
unit's profitability, and the extent to which a trading unit trades
with customers. Each of those characteristics appears to be useful in
assessing whether a trading unit is engaged in permitted market making-
related activity.
However, the Agencies recognize that no single quantitative
measurement or combination of measurements can accurately identify
prohibited proprietary trading without further analysis of the context,
facts, and circumstances of the trading activity. In addition, certain
quantitative measurements may be useful for assessing one type of
trading activity, but not helpful in assessing another type of trading
activity. As a result, the Agencies propose to use a variety of
quantitative measurements to help identify transactions or activities
that warrant more in-depth analysis or review.
To be effective, this approach requires identification of useful
quantitative measurements as well as judgment regarding the type of
measurement results that suggest a further review of the trading unit's
activity is warranted. The Agencies intend to take a heuristic approach
to implementation in this area that recognizes that quantitative
measurements can only be usefully identified and employed after a
process of substantial public comment, practical experience, and
revision. In particular, the Agencies note that, although a variety of
quantitative measurements have traditionally been used by market
participants and others to manage the risks associated with trading
activities, these quantitative tools have not been developed, nor have
they previously been utilized, for the explicit purpose of identifying
trading activity that warrants additional scrutiny in differentiating
prohibited proprietary trading from permitted market making-related
activities. Additional study and analysis will be required before
quantitative measurements may be effectively designed and employed for
that purpose.
Consistent with this heuristic approach, the proposed rule includes
a large number of potential quantitative measurements on which public
comment is sought, many of which overlap to some degree in terms of
their informational value. Not all of these quantitative measurements
may ultimately be adopted, depending on their relative strengths,
weaknesses, costs, and benefits. The Agencies note that some of the
proposed quantitative measurements may not be relevant to all types of
trading activities or may provide only limited benefits, relative to
cost, when applied to certain types of trading activities. In addition,
certain quantitative measurements may be difficult or impracticable to
calculate for a specific covered trading activity due to differences
between asset classes, market structure, or other factors. The Agencies
have therefore requested comment on a large number of issues related to
the relevance, practicability, costs, and benefits of the quantitative
measurements proposed. The Agencies also seek comment on whether the
quantitative measurements described in the proposal may be appropriate
to use in assessing compliance with section 13 of the BHC Act.
In addition to the proposed quantitative measurements, a banking
entity may itself develop and implement other quantitative measurements
in order to effectively monitor its covered trading activities for
compliance with section 13 of the BHC Act and the proposed rule and to
establish, maintain, and enforce an effective compliance program, as
required by Sec. --.20 of the proposed rule and Appendix C. The
Agencies note that the proposed quantitative measurements in Appendix A
are intended to assist banking entities and Agencies in monitoring
compliance with the proprietary trading restrictions and, thus, are
related to the compliance program requirements in Sec. --.20 of the
proposed rule and proposed Appendix C. Nevertheless, implementation of
the proposed quantitative measurements under Appendix A would not
necessarily provide all the data necessary for the banking entity to
establish an effective compliance program, and a banking entity may
need to develop and implement additional quantitative measurements. The
Agencies recognize that appropriate and effective quantitative
measurements may differ based on the profile of the banking entity's
businesses in general and, more specifically, of the particular trading
unit, including types of instruments traded, trading activities and
strategies, and history and experience (e.g., whether the trading desk
is an established, successful market maker or a new entrant to a
competitive market). In all cases, banking entities must ensure that
they have robust measures in place to identify and monitor the risks
taken in their trading activities, to ensure the activities are within
risk tolerances established by the banking entity, and to monitor for
compliance with the proprietary trading restrictions in the proposed
rule.
To the extent that data regarding measurements, as set forth in the
proposed rule, are collected, the Agencies propose to utilize the
automatic two-year conformance period provided in section 13 of the BHC
Act to carefully review that data, further study the design and utility
of these measurements, and if necessary, propose changes to the
reporting requirements as the Agencies believe are needed to ensure
that these measurements are as effective as possible.\190\ This
heuristic, gradual approach to implementing reporting requirements for
quantitative measurements would be intended to ensure that the
requirements are formulated in a manner that maximizes their utility
for identifying trading activity that warrants additional scrutiny in
assessing compliance with the prohibition on proprietary trading, while
limiting the risk that the use of quantitative measurements could
inadvertently curtail permissible market making-related activities that
provide an important service to market participants and the capital
markets at large.
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\190\ Section 13(c)(2) of the BHC Act provides banking entities
two years from the date that the proposed rule becomes effective
(with the possibility of up to three, one-year extensions) to bring
their activities, investments, and relationships into compliance
with section 13, including the prohibition on proprietary trading.
See 12 U.S.C. 1851(c)(2).
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In addition, the Agencies request comment on the use of numerical
thresholds for certain quantitative
[[Page 68884]]
measurements that, if reported by a banking entity, would require the
banking entity to review its trading activities for compliance and
summarize that review to the relevant Agency. The Agencies have not
proposed specific numerical thresholds in the proposal because
substantial public comment and analysis would be beneficial prior to
formulating and proposing specific numerical thresholds. Instead, the
Agencies intend to carefully consider public comments that are provided
on this issue and to separately determine whether it would be
appropriate to propose, subsequent to finalizing the current proposal,
such numerical thresholds.
The Agencies request comment on the proposed approach to
implementing reporting requirements for proprietary trading. In
particular, the Agencies request comment on the following questions:
Question 143. Is the use of the proposed reporting requirements as
part of the multi-faceted approach to implementing the prohibition on
proprietary trading appropriate? Why or why not?
Question 144. Is the proposed gradual approach to implementing
reporting requirements effective? If not, what approach would be more
effective? For example, should the Agencies defer reporting of
quantitative measurements until banking entities have developed and
refined their compliance programs through the supervision and
examination process? What would be the costs and benefits of such an
approach?
Question 145. What role, if any, could or should the Office of
Financial Research (``OFR'') play in receiving and analyzing banking
entities' reported quantitative measurements? Should reporting to the
OFR be required instead of reporting to the relevant Agency, and would
such reporting be consistent with the composition and purpose of OFR?
In the alternative, should reporting to either (i) only the relevant
Agency (or Agencies) or (ii) both the relevant Agency (or Agencies) and
OFR be required? If so, why? What are the potential costs and benefits
of reporting quantitative measurements to the OFR? Please explain.
Question 146. Is there an alternative manner in which the Agencies
should develop and propose the reporting requirements for quantitative
measurements? If so, how should they do so?
Question 147. Does the proposed approach provide sufficient time
for the development and implementation of effective reporting
requirements? If not, what alternative approach would be preferable?
Question 148. Should a trading unit be permitted not to furnish a
quantitative measurement otherwise required under Appendix A if it can
demonstrate that the measurement is not, as applied to that unit,
calculable or useful in achieving the purposes of the Appendix with
respect to the trading unit's covered trading activities? How might a
banking entity make such a demonstration?
Question 149. Is the manner in which the Agencies propose to
utilize the conformance period for review of collected data and
refinement of the reporting requirements effective? If not, what
process would be more effective?
Question 150. Is the proposed $1 billion trading asset and
liability threshold, which is also currently used in the Market Risk
Capital Rules for purposes of identifying which banks and bank holdings
companies must comply with those rules, an appropriate standard for
triggering the reporting and recordkeeping requirements of the proposed
rule? Why or why not? If not, what alternative standard would be a
better benchmark for triggering the reporting and recordkeeping
requirements?
Question 151. What are the typical trading activities (e.g., market
making-related activities) of a banking entity with less than $1
billion in gross trading assets and liabilities? How complex are those
trading activities?
Question 152. Should the proposed $1 billion trading and asset
liability threshold used for triggering the reporting and recordkeeping
requirements adjust each time the thresholds for complying with the
Market Risk Capital Rules adjust, or otherwise be adjusted over time?
If not, how and when should the numerical threshold be adjusted?
Question 153. Should all banking entities be required to comply
with the reporting and recordkeeping requirements set forth in Appendix
A in order to better protect against prohibited proprietary trading,
rather than only those banking entities that meet the proposed $1
billion trading asset and liability threshold? Why or why not?
Question 154. Should banking entities that fall under the proposed
$1 billion trading asset and liability threshold be required to comply
with the reporting and recordkeeping provisions for a pilot period in
order to help inform judgment regarding the levels of quantitative
measurements at such entities and the appropriate frequency and scope
of examination by the relevant Agency for such banking entities? Why or
why not?
b. Proposed Appendix A--Purpose and Definitions
Section I of proposed Appendix A describes the purpose of the
appendix, which is to specify reporting requirements that are intended
to assist banking entities that are engaged in significant trading
activities and the Agencies in identifying trading activities that
warrant further review or examination to verify compliance with the
proprietary trading restrictions, including whether an otherwise-
permitted activity under Sec. Sec. --.4 through --.6(a) of the
proposed rule is consistent with the requirement that such activity not
result, directly or indirectly, in a material exposure by the banking
entity to high-risk assets and high-risk trading strategies. In
particular, section I provides that the purpose of the appendix is to
assist the relevant Agency and banking entities in:
Better understanding and evaluating the scope, type, and
profile of the banking entity's covered trading activities;
Monitoring the banking entity's covered trading
activities;
Identifying covered trading activities that warrant
further review or examination by the banking entity to verify
compliance with the proprietary trading restrictions;
Evaluating whether the trading activities of trading units
engaged in market making-related activities under Sec. --.4(b) of the
proposed rule are consistent with the requirements governing permitted
market making-related activities;
Evaluating whether the trading activities of trading units
that are engaged in permitted trading activity under Sec. Sec. --.4,
--.5, or --.6(a) of the proposed rule (e.g., permitted underwriting,
market making-related activity, risk-mitigating hedging, or trading in
certain government obligations) are consistent with the requirement
that such activity not result, directly or indirectly, in a material
exposure by the banking entity to high-risk assets and high-risk
trading strategies;
Identifying the profile of particular trading activities
of the banking entity, and the individual trading units of the banking
entity, to help establish the appropriate frequency and scope of
examination by the relevant Agency of such activities; and
Assessing and addressing the risks associated with the
banking entity's trading activities.
The types of trading and market making-related activities in which
banking entities engage is often highly
[[Page 68885]]
complex, and any quantitative measurement is capable of producing both
``false negatives'' and ``false positives'' that suggest that
prohibited proprietary trading is occurring when it is not, or vice
versa. Recognizing this, section I of proposed Appendix A makes clear
that the quantitative measurements that may be required to be reported
would not be intended to serve as a dispositive tool for identifying
permissible or impermissible activities.
Section II of proposed Appendix A defines relevant terms used in
the appendix. These include certain definitions that clarify how and
when certain calculations must be made, as well as a definition of
``trading unit'' that governs the level of organization at which a
banking entity must calculate quantitative measurements. The proposed
definition of ``trading unit'' covers multiple organizational levels of
a banking entity, including:
Each discrete unit engaged in the coordinated
implementation of a revenue generation strategy that participates in
the execution of any covered trading activity; \191\
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\191\ As noted in Appendix A, the Agencies expect that this
would generally be the smallest unit of organization used by the
banking entity to structure and control its risk-taking activities
and employees, and would include each unit generally understood to
be a single ``trading desk.'' For example, if a banking entity has
one set of employees engaged in market making-related activities in
the equities of U.S. non-financial corporations, and another set of
employees engaged in market making-related activities in the
equities of U.S. financial corporations, the two sets of employees
would appear to be part of a single trading unit if both sets of
employees structure and control their trading activities together,
making and executing highly coordinated decisions about required
risk levels, inventory levels, sources of revenue growth and similar
features. On the other hand, if the risk decisions and revenue
strategies are considered and executed separately by the two sets of
employees, with only loose coordination, they would appear to be two
distinct trading units. In determining whether a set of employees
constitute a single trading unit, important factors would likely
include whether compensation is strongly linked to the group's
performance, whether risk levels and trading limits are managed and
set jointly or separately, and whether trades are booked together or
separately.
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Each organizational unit used to structure and control the
aggregate risk-taking activities and employees of one or more trading
units described above;
All trading operations, collectively; and
Any other unit of organization specified by the relevant
Agency with respect to a particular banking entity.\192\
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\192\ This latter prong of the definition has been included to
ensure that the Agencies have the ability to require banking
entities to report quantitative measurements in other ways to
prevent a banking entity from organizing its trading operations so
as to undermine the effectiveness of the reporting requirement.
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The definition of ``trading unit'' is intended to capture multiple
layers of a banking entity's organization structure, including
individual trading desks, intermediate divisions that oversee a variety
of trading desks, and all trading operations in the aggregate. As
described below, under the proposal, the quantitative measurements
specified in section IV of proposed Appendix A must be calculated and
reported for each such ``trading unit.'' Accordingly, the definition of
trading unit is purposefully broad and captures multiple levels of
organization so as to ensure that quantitative measurements provide
meaningful information, at both a granular and aggregate level, to help
banking entities and the Agencies evaluate the quantitative profile of
trading operations in a variety of contexts.
The Agencies expect that the scope and nature of trading units to
which the quantitative measurements are applied would have an important
impact on the informational content and utility of the resulting
measurements. Applying a quantitative measurement to a trading unit at
a level that aggregates a variety of distinct trading activities may
obscure or ``smooth'' differences between distinct lines of business,
asset categories and risk management processes in a way that renders
the measurement relatively uninformative, because it does not
adequately reflect the specific characteristics of the trading
activities being conducted. Similarly, applying a quantitative
measurement to a trading unit at a highly granular level could, if it
captured only a narrow portion of activity that is conducted as part of
a broader business strategy, introduce meaningless ``noise'' into the
measure or result in a measurement that is idiosyncratic in nature.
This highly granular application could render the measurement
relatively uninformative because it would not accurately reflect the
entirety of the trading activities being conducted. In order to address
the potential weaknesses of applying the quantitative measurements at
an aggregate and a granular level, respectively, the proposal requires
reporting at both levels. The informational inputs required to
calculate any particular quantitative measurement at either level are
the same. Consequently, it is expected that, depending on the nature of
the systems of a particular institution, there may be little, if any,
incremental burden associated with calculating and reporting
quantitative measurements at multiple levels.
The Agencies request comment on the proposed reporting requirements
in Appendix A. In particular, the Agencies request comment on the
following questions:
Question 155. Are the ways in which the proposed rule would make
use of reported quantitative measurements effective? If not, what uses
would be more effective? Should the proposed rule instead use
quantitative measurements as a dispositive tool for identifying
prohibited proprietary trading? If so, what types of quantitative
measurements should be employed, what numerical amount would indicate
impermissible proprietary trading activity, and why? Should the
quantitative measurements play a less prominent role than proposed in
identifying prohibited proprietary trading and why?
Question 156. Are the proposed definitions of terms provided in
Appendix A effective? If not, how should the definitions be amended?
Question 157. Is the proposed definition of ``trading unit''
effective? Is it sufficiently clear? If not, what alternative
definition would be more effective and/or clearer? Should the
definition include more or less granular levels of activity? If so,
what specific criteria should be used to determine the appropriate
level of granularity?
Question 158. If you are a banking entity, how would your trading
activity be categorized, in terms of quantity and type, under the
proposed definition of trading unit in Appendix A? For each trading
unit type, what categories of quantitative measurements (e.g., risk-
management measurements) or specific quantitative measurements (e.g.,
Stressed Value-at-Risk (``Stress VaR'')) are best suited to assist in
distinguishing prohibited proprietary trading from permitted trading
activity?
Question 159. Is the proposed rule's requirement that quantitative
measurements be reported at multiple levels of organization, including
for quantitative measurements historically reported on an aggregate
basis (e.g., Value-at-Risk (``VaR'') or Stress VaR) appropriate? If
not, what alternative would be more effective? What burdens are
associated with such a requirement? How might those burdens be reduced
or limited? Please quantify your answers, to the extent feasible.
c. Proposed Appendix A--Scope of Required Reporting
Part III of proposed Appendix A defines the scope of the reporting
requirements. The proposed rule adopts a tiered approach that requires
banking entities with the most extensive trading activities to report
the largest number of quantitative measurements, while
[[Page 68886]]
banking entities with smaller trading activities have fewer or no
reporting requirements. This tiered approach is intended to reflect the
heightened compliance risks of banking entities with extensive trading
activities and limit the regulatory burden imposed on banking entities
with relatively small or no trading activities, which appear to pose
significantly less compliance risk.
Banking Entities With Gross Trading Assets and Liabilities of $5
Billion or More
For any banking entity that has, together with its affiliates and
subsidiaries, trading assets and liabilities the average gross sum of
which (on a worldwide consolidated basis), as measured as of the last
day of each of the four prior calendar quarters, equals or exceeds $5
billion, the proposal would require the banking entity to furnish
quantitative measurements for all trading units of the banking entity
engaged in trading activity subject to Sec. Sec. --.4, --.5, or
--.6(a) of the proposed rule (i.e., permitted underwriting and market
making-related activity, risk-mitigated hedging, and trading in certain
government obligations). The scope of data to be furnished depends on
the activity in which the trading unit is engaged. First, for the
trading units of such a banking entity that are engaged in market
making-related activity pursuant to Sec. --.4(b) of the proposed rule,
proposed Appendix A requires that a banking entity furnish seventeen
quantitative measurements.\193\ Second, all trading units of such a
banking entity engaged in trading activity subject to Sec. Sec.
--.4(a), --.5, or --.6(a) of the proposed rule would be required to
report five quantitative measurements designed to measure the general
risk and profitability of the trading unit.\194\ The Agencies expect
that each of these general types of measurements will be useful in
assessing the extent to which any permitted trading activity involves
exposure to high-risk assets or high-risk trading strategies. These
requirements would apply to all type of trading units engaged in
underwriting and market making-related activity, risk-mitigated
hedging, and trading in certain government obligations. These
additional measurements are designed to help evaluate the extent to
which the quantitative profile of a trading unit's activities is
consistent with permissible market making-related activities.
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\193\ See proposed rule Appendix A.III.A. These seventeen
quantitative measurements are discussed further below.
\194\ See proposed rule Appendix A.III.A. These five
quantitative measurements are: (i) Comprehensive Profit and Loss;
(ii) Comprehensive Profit and Loss Attribution; (iii) VaR and Stress
VaR; (iv) Risk Factor Sensitivities; and (v) Risk and Position
Limits. Each of these and other quantitative measurements discussed
in proposed Appendix A are discussed in detail below.
---------------------------------------------------------------------------
Banking Entities With Gross Trading Assets and Liabilities Between $1
Billion and $5 Billion
For any banking entity that has, together with its affiliates and
subsidiaries, trading assets and liabilities the average gross sum of
which (on a worldwide consolidated basis), as measured as of the last
day of each of the four prior calendar quarters, equals or exceeds $1
billion but is less than $5 billion, the proposal would require
quantitative measurements to be furnished for trading units that are
engaged in market making-related activity subject to Sec. --.4(b) of
the proposed rule. Trading units of such banking entities that are
engaged in market making-related activities must report eight
quantitative measurements that are designed to help evaluate the extent
to which the quantitative profile of a trading unit's activities is
consistent with permissible market making-related activities.\195\ The
proposal applies a smaller number of measurements to a smaller universe
of trading units for this class of banking entities because they are
likely to pose lesser compliance risk and fewer supervisory and
examination challenges. A less burdensome reporting regime, coupled
with other elements of the proposal (e.g., the compliance program
requirement), is likely to be equally as effective in ensuring
compliance with section 13 of the BHC Act and the proposed rule for
banking entities with smaller trading operations.
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\195\ See proposed rule Appendix A.III.A. These eight
quantitative measurements are (i) Comprehensive Profit and Loss;
(ii) Comprehensive Profit and Loss Attribution; (iii) Portfolio
Profit and Loss; (iv) Fee Income and Expense; (v) Spread Profit and
Loss; (vi) VaR; (vii) Volatility of Comprehensive Profit and Loss
and Volatility of Portfolio Profit and Loss; and (viii)
Comprehensive Profit and Loss to Volatility Ratio and Portfolio
Profit and Loss to Volatility Ratio.
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Frequency of Calculation and Reporting
Section III.B of proposed Appendix A specifies the frequency of
required calculation and reporting of quantitative measurements. Under
the proposed rule, each required quantitative measurement must be
calculated for each trading day. Required quantitative measurements
must be reported to the relevant Agency on a monthly basis, within 30
days of the end of the relevant calendar month, or on such other
reporting schedule as the relevant Agency may require. Section III.C of
proposed Appendix A requires a banking entity to create and retain
records documenting the preparation and content of any quantitative
measurement furnished by the banking entity, as well as such
information as is necessary to permit the relevant Agency to verify the
accuracy of such measurements, for a period of 5 years. This would
include records for each trade and position.
Question 160. Is the proposed tiered approach to identifying which
banking entities and trading units must comply with the reporting
requirements effective? If not, what alternative would be more
effective? Does the proposal strike the appropriate balance between the
potential benefits of the reporting requirements for monitoring and
assuring compliance and the potential costs of those reporting
requirements? If not, how could that balance be improved? Should the
relevant gross trading assets and liabilities threshold for any
category be increased or reduced? If so, why?
Question 161. Should the $1 billion and $5 billion gross trading
assets and liabilities thresholds used to identify the extent to which
a banking entity is required to furnish quantitative measurements be
increased or reduced? If so, why? Should the thresholds be indexed in
some way to account for fluctuations in capital markets activity over
time? If so, what would be an appropriate method of indexation?
Question 162. Is the proposed $5 billion trading asset and
liability threshold an appropriate standard for triggering enhanced
reporting requirements under the proposed rule? Why or why not? If not,
what alternative standard would be a better benchmark for triggering
enhanced reporting requirements?
Question 163. Should the proposed $5 billion trading and asset
liability threshold used for triggering enhanced reporting requirements
under the proposed rule be subject to adjustment over time? If so, how
and when should the numerical threshold be adjusted?
Question 164. Is there a different criterion other than gross
trading assets and liabilities that would be more appropriate for
identifying banking entities that must furnish quantitative
measurements? If so, what is the alternative criterion, and why would
it be more appropriate? Are worldwide gross trading assets and
liabilities the appropriate criterion for foreign-based banking
entities? If not, what alternative criterion would be more appropriate,
and why?
Question 165. Are the quantitative measurements specified for the
various types of banking entities and trading
[[Page 68887]]
units effective? If not, what alternative set of measurements would be
more effective? For each type of trading unit, does the proposal strike
the appropriate balance between the potential benefits of the reporting
requirements for monitoring and assuring compliance and the potential
costs of those reporting requirements? If not, how could that balance
be improved?
Question 166. Should banking entities with gross trading assets and
liabilities between $1 billion and $5 billion also be required to
calculate and report some of the quantitative measurements proposed for
banking entities meeting the $5 billion threshold for purposes of
assessing whether the banking entity's underwriting, market making,
risk-mitigating hedging, and trading in certain government obligations
activities involve a material exposure to high-risk assets or high-risk
trading strategies? If so, which quantitative measurements and why? If
not, why not?
Question 167. Is the proposed frequency of reporting effective? If
not, what frequency would be more effective? Should the quantitative
measurements be required to be reported quarterly, annually, or upon
the request of the applicable Agency and why?
d. Proposed Appendix A--Quantitative Measurements
Section IV of proposed Appendix A describes, in detail, the
individual quantitative measurements that must be furnished. These
measurements are grouped into the following five broad categories, each
of which is described in more detail below:
Risk-management measurements--VaR, Stress VaR, VaR
Exceedance, Risk Factor Sensitivities, and Risk and Position Limits;
Source-of-revenue measurements--Comprehensive Profit and
Loss, Portfolio Profit and Loss, Fee Income and Expense, Spread Profit
and Loss, and Comprehensive Profit and Loss Attribution;
Revenues-relative-to-risk measurements--Volatility of
Comprehensive Profit and Loss, Volatility of Portfolio Profit and Loss,
Comprehensive Profit and Loss to Volatility Ratio, Portfolio Profit and
Loss to Volatility Ratio, Unprofitable Trading Days based on
Comprehensive Profit and Loss, Unprofitable Trading Days based on
Portfolio Profit and Loss, Skewness of Portfolio Profit and Loss, and
Kurtosis of Portfolio Profit and Loss;
Customer-facing activity measurements--Inventory Turnover,
Inventory Aging, and Customer-facing Trade Ratio; and
Payment of fees, commissions, and spreads measurements--
Pay-to-Receive Spread Ratio.
The Agencies have proposed these quantitative measurements because,
taken together, these measurements appear useful for understanding the
context in which trading activities occur and identifying activities
that may warrant additional scrutiny to determine whether these
activities involve prohibited proprietary trading because the trading
activity either is inconsistent with permitted market making-related
activities or presents a material exposure to high-risk assets or high-
risk trading strategies. As described below, different quantitative
measurements are proposed to identify different aspects and
characteristics of trading activity for the purpose of helping to
identify prohibited proprietary trading, and the Agencies expect that
the quantitative measurements will be most useful for this purpose when
implemented and reviewed collectively, rather than in isolation. The
Agencies believe that, in the aggregate, many banking entities already
collect and review many of these measurements as part of their risk
management activities, and expect that many of the quantitative
measurements proposed would be readily computed and monitored at the
multiple levels of organization that are included in proposed Appendix
A's definition of ``trading unit,'' to which they would apply.
The first set of quantitative measurements relates to risk
management, and includes VaR, Stress VaR, VaR Exceedance, Risk Factor
Sensitivities, and Risk and Position Limits. These measurements are
widely used by banking entities to measure and manage trading risks and
activities. In the case of VaR, Stress VaR, VaR Exceedance, and Risk
Factor Sensitivities, these measures provide internal, model-based
assessments of overall risk, stated in terms of large but plausible
losses that may occur or changes in revenue that would be expected to
result from movements in underlying risk factors. In the case of Risk
and Position Limits, the measure provides an explicit assessment of
management's expectation of how much risk is required to perform
permitted market-making and hedging activities. With the exception of
Stress VaR, each of these measurements are routinely used to manage and
control risk taking activities, and are also used by some banking
entities for purposes of calculating regulatory capital and allocating
capital internally. In the context of permitted market making-related
activities, these risk management measures are useful in assessing
whether the actual risk taken is consistent with the level of principal
risk that a banking entity must retain in order to service the near-
term demands of customers. Significant, abrupt or inconsistent changes
to key risk management measures, such as VaR, that are inconsistent
with prior experience, the experience of similarly situated trading
units and management's stated expectations for such measures may
indicate impermissible proprietary trading. In addition, indicators of
unanticipated or unusual levels of risk taken, such as a significant
number of VaR Exceedance or breaches of internal Risk and Position
Limits, may suggest behavior that is inconsistent with appropriate
levels of risk and may warrant further scrutiny.
The second set of quantitative measurements relates to the source
of revenues, and includes Comprehensive Profit and Loss, Portfolio
Profit and Loss, Fee Income, Spread Profit and Loss, and Comprehensive
Profit and Loss Attribution. These measurements are intended to capture
the extent, scope, and type of profits and losses generated by trading
activities and provide important context for understanding how revenue
is generated by trading activities. Because permitted market making-
related activities seek to generate profits by providing customers with
intermediation and related services while maintaining, and to the
extent practicable minimizing, the risks associated with any asset or
risk inventory required to meet customer demands, these revenue
measurements would appear to provide helpful information to banking
entities and the Agencies regarding whether actual revenues are
consistent with these expectations. The Agencies note that although
banking entities already routinely calculate and analyze the extent and
source of revenues derived from their trading activities, calculating
the proposed source of revenue measurements according to the
specifications described in proposed Appendix A may require banking
entities to implement new processes to calculate and furnish the
required data.
The third set of measurements relates to realized risks and revenue
relative to realized risks, and includes Volatility of Profit and Loss,
Comprehensive Profit and Loss to Volatility Ratio and Portfolio Profit
and Loss to Volatility Ratio, Unprofitable Trading Days based on
Comprehensive Profit and Loss and Unprofitable Trading Days based on
[[Page 68888]]
Portfolio Profit and Loss, and Skewness of Portfolio Profit and Loss
and Kurtosis of Portfolio Profit and Loss. These measurements are
intended to provide banking entities and the Agencies with ex post,
data-based assessments of risk, as a supplement to internal, model-
based assessments of risk, and give further context around the
riskiness of underlying trading activities and the profitability of
these activities relative to the risks taken. Some of these
measurements, such as the skewness and kurtosis measurements, are
proposed in order to capture asymmetric, ``fat tail'' risks that (i)
are not well captured by simple volatility measures, (ii) may not be
well captured by internal risk measurement metrics, such as VaR, and
(iii) can be associated with proprietary trading strategies that seek
to earn short-term profits by taking exposures to these types of risks.
The Agencies expect that these realized-risk and revenue-relative-to-
realized-risk measurements would provide information useful in
assessing whether trading activities are producing revenues that are
consistent, in terms of the degree of risk that is being assumed, with
typical market making-related activities. Market making and related
activities seek to generate profitability primarily by generating fees,
commissions, spreads and other forms of customer revenue that are
relatively, though not completely, insensitive to market fluctuations
and generally result in a high level of revenue relative to risk over
an appropriate time frame. In contrast, proprietary trading strategies
seek to generate revenue primarily through favorable changes in asset
valuations. The Agencies note that each of the proposed measurements
relating to realized risks and revenues relative to realized risks are
generally consistent with existing revenue, risk, and volatility data
routinely collected by banking entities with large trading operations
or are simple, standardized functions of such data.
The fourth set of quantitative measurements relates to customer-
facing activity measurements, and includes Inventory Risk Turnover,
Inventory Aging, and Customer-facing Trade Ratio. These measurements
are intended to provide banking entities and Agencies with meaningful
information regarding the extent to which trading activities are
directed at servicing the demands of customers. Quantitative
measurements such as Inventory Risk Turnover and Inventory Aging assess
the extent to which size and volume of trading activity is aimed at
servicing customer needs, while the Customer-facing Trade Ratio
provides directionally useful information regarding the extent to which
trading transactions are conducted with customers. The Agencies expect
that these measurements will be useful in assessing whether permitted
market making-related activities are focused on servicing customer
demands. Although the Agencies understand that banking entities
typically measure inventory aging and turnover in the context of cash
instruments (e.g., equity and debt securities), they note that applying
these measurements, as well as the Customer-facing Trade Ratio
generally, would require banking entities to implement new processes to
calculate and furnish the related data.
The fifth set of quantitative measurements relates to the payment
of fees, commissions, and spreads, and includes the Pay-to-Receive
Spread Ratio. This measurement is intended to measure the extent to
which trading activities generate revenues for providing intermediation
services, rather than generate expenses paid to other intermediaries
for such services. Because market making-related activities ultimately
focus on servicing customer demands, they typically generate
substantially more fees, spreads and other sources of customer revenue
than must be paid to other intermediaries to support customer
transactions. Proprietary trading activities, however, that generate
almost no customer facing revenue will typically pay a significant
amount of fees, spreads and commissions in the execution of trading
strategies that are expected to benefit from short-term price
movements. Accordingly, the Agencies expect that the proposed Pay-to-
Receive Spread Ratio measurement will be useful in assessing whether
permitted market making-related activities are primarily generating,
rather than paying, fees, spreads and other transactional revenues or
expenses. A level of fees, commissions, and spreads paid that is
inconsistent with prior experience, the experience of similarly
situated trading units and management's stated expectations for such
measures could indicate impermissible proprietary trading.
For each individual quantitative measurement, proposed Appendix A
describes the measurement, provides general guidance regarding how the
measurement should be calculated (where needed) and specifies the
period over which each calculation should be made. The proposed
quantitative measurements attempt to incorporate, wherever possible,
measurements already used by banking entities to manage risks
associated with their trading activities. Of the measurements proposed,
the Agencies expect that a large majority of measurements proposed are
either (i) already routinely calculated by banking entities or (ii)
based solely on underlying data that are already routinely calculated
by banking entities. However, calculating these measurements according
to the specifications described in proposed Appendix A and at the
various levels of organization mandated may require banking entities to
implement new processes to calculate and furnish the required data.
The extent of the burden associated with calculating and reporting
quantitative measurements will likely vary depending on the particular
measurements and differences in the sophistication of management
information systems at different banking entities. As noted, the
proposal tailors these data collections to the size and type of
activity conducted by each banking entity in an effort to minimize the
burden in particular on firms that engage in few or no trading
activities subject to the proposed rule.
The Agencies have also attempted to provide, to the extent
possible, a standardized description and general method of calculating
each quantitative measurement that, while taking into account the
potential variation among trading practices and asset classes, would
facilitate reporting of sufficiently uniform information across
different banking entities so as to permit horizontal reviews and
comparisons of the quantitative profile of trading units across firms.
The Agencies request comment on the proposed quantitative
measurements. In particular, the Agencies request comment on the
following questions:
Question 168. Are the proposed quantitative measurements
appropriate in general? If not, what alternative(s) would be more
appropriate, and why? Should certain quantitative measurements be
eliminated, and if so, why? Should additional quantitative measurements
be added? If so, which measurements and why? How would those additional
measurements be described and calculated?
Question 169. How many of the proposed quantitative measurements do
banking entities currently utilize? What are the current benefits and
costs associated with calculating such quantitative measurements? Would
the reporting and recordkeeping requirements proposed in Appendix A for
such quantitative measurements impose any significant, additional
benefits or costs?
[[Page 68889]]
Question 170. Which of the proposed quantitative measurements do
banking entities currently not utilize? What are the potential benefits
and costs to calculating these quantitative measurements and complying
with the proposed reporting and recordkeeping requirements? Please
quantify your answers, to the extent feasible.
Question 171. Is the scope and frequency of required reporting
appropriate? If not, what alternatives would be more appropriate? What
burdens would be associated with reporting quantitative measurements on
that basis, and how could those burdens be reduced or eliminated in a
manner consistent with the purpose and language of the statute? Please
quantify your answers, to the extent feasible.
Question 172. For each of the categories of quantitative
measurements (e.g., quantitative measurements relating to risk
management), what factors should be considered in order to further
refine the proposed category of quantitative measurements to better
distinguish prohibited proprietary trading from permitted trading
activity? For example, should the timing of a calculation be considered
significant in certain contexts (e.g., should specific quantitative
measurements be calculated during the middle of a trading day instead
of the end of the day)? Please quantify your answers, to the extent
feasible.
Question 173. In light of the size, scope, complexity, and risk of
covered trading activities, do commenters anticipate the need to hire
new staff with particular expertise in order to calculate the required
quantitative measurements (e.g., collect data and make computations)?
Do commenters anticipate the need to develop additional infrastructure
to obtain and retain data necessary to compute the proposed
quantitative measurements? Please explain and quantify your answers, to
the extent feasible.
Question 174. For each individual quantitative measurement that is
proposed:
Is the use of the quantitative measurement to help
distinguish between permitted and prohibited trading activities
effective? If not, what alternative would be more effective? Does the
quantitative measurement provide any additional information of value
relative to other quantitative measurements proposed?
Is the use of the quantitative measurement to help
determine whether an otherwise-permitted trading activity is consistent
with the requirement that such activity must not result, directly or
indirectly, in a material exposure by the banking entity to high-risk
assets and high-risk trading strategies effective? If not, what
alternative would be more effective?
What factors should be considered in order to further
refine the proposed quantitative measurement to better distinguish
prohibited proprietary trading from permitted trading activity? For
example, should the timing of a calculation be considered significant
in certain contexts (e.g., should specific quantitative measurements be
calculated during the middle of a trading day instead of at the end of
the day)?
If the quantitative measurement is proposed to be applied
to a trading unit that is engaged in activity pursuant to Sec. Sec.
--.4(a), --.5, or --.6(a) of the proposed rule, is the quantitative
measurement calculable in relation to such activity? Is the
quantitative measurement useful for determining whether underwriting,
risk-mitigating hedging, or trading in certain government obligations
is resulting, directly or indirectly, in a material exposure by the
banking entity to high-risk assets or high-risk trading strategies?
Is the description of the quantitative measurement
sufficiently clear? What alternative would be more appropriate or
clearer? Is the description of the quantitative measurement
appropriate, or is it overly broad or narrow? If it is overly broad,
what additional clarification is needed? Should the Agencies provide
this additional clarification in the appendix's description of the
quantitative measurement? If the description is overly narrow, how
should it be modified to appropriately describe the quantitative
measurement, and why?
Is the general calculation guidance effective and
sufficiently clear? If not, what alternative would be more effective or
clearer? Is more or less specific calculation guidance necessary? If
so, what level of specificity is needed to calculate the quantitative
measurement? What are the different calculation options and
methodologies that could be used to reach the desired level of
specificity? What are the costs and benefits of these different
options? If the proposed calculation guidance is not sufficiently
specific, how should the calculation guidance be modified to reach the
appropriate level of specificity? For example, rather than provide this
level of specificity in proposed Appendix A, should the Agencies
instead make each banking entity responsible for determining the best
method of calculating the quantitative measurement at this level of
specificity, based on the banking entity's business and profile, which
would then be subject to supervision, review, or examination by the
relevant Agency? If the proposed calculation guidance is overly
specific, why is it too specific and how should the guidance be
modified to reach the appropriate level of specificity?
Is the general calculation guidance for the measurement
consistent with how banking entities currently calculate the
quantitative measurement, if they do so? If not, how does the proposed
guidance differ from methodology currently used by banking entities?
What is the purpose of the current calculation methodology used by
banking entities?
What operational or logistical challenges might be
associated with performing the calculation of the quantitative
measurement and obtaining any necessary informational inputs?
Is the quantitative measurement not calculable for any
specific type of trading unit? If so, what type of trading unit, and
why is the quantitative measurement not calculable for that type of
trading unit? Is there an alternative quantitative measurement that
would reflect the same trading activity but not pose the same
calculation difficulty? Are there particular challenges to documenting
that a specific quantitative measurement is not calculable?
Is the quantitative measurement substantially likely to
frequently produce false negatives or false positives that suggest that
prohibited proprietary trading is occurring when it is not, or vice
versa? If so, why? If so, what alternative quantitative measurement
would better help identify prohibited proprietary trading?
Should the quantitative measurement better account for
distinctions among trading activities, trading strategies, and asset
classes? If so, how? For example, should the quantitative measurements
better account for distinctions between trading activities in cash and
derivatives markets? If so, how? Are there any other distinctions for
which the quantitative measurements may need to account? If so, what
distinctions, and why?
Does the quantitative measurement provide useful
information as applied to all types of trading activities, or only a
certain subset of trading activities? If it only provides useful
information for a subset of trading activities, how should this issue
be addressed? How beneficial is the information that the quantitative
measurement provides for this subset of trading activities? Do any of
the other quantitative measurements provide the
[[Page 68890]]
same level of beneficial information for this subset of trading
activities? Should the quantitative measurement be required to be
reported for all trading activities, only a relevant subset of trading
activities, or not at all?
Does the quantitative measurement provide useful
information as applied to all asset classes, or only a certain subset
of asset classes? If it only provides useful information for a subset
of asset classes, how should this issue be addressed? How beneficial is
the information the quantitative measurement provides for this subset
of asset classes? Do any of the other quantitative measurements provide
the same level of beneficial information for this subset of asset
classes? Should the quantitative measurement be required to be reported
for all asset classes, only a relevant subset of asset classes, or not
at all?
Is the calculation period effective and sufficiently
clear? If not, what alternative would be more effective or clearer?
How burdensome and costly would it be to calculate the
measurement at the specified calculation frequency and calculation
period? Are there any difficulties or costs associated with calculating
the measurement for particular trading units? How significant are those
potential costs relative to the potential benefits of the measurement
in monitoring for impermissible proprietary trading? Are there
potential modifications that could be made to the measurement that
would reduce the burden or cost? If so, what are those modifications?
Please quantify your answers, to the extent feasible.
Question 175. In light of the size, scope, complexity, and risk of
covered trading activities, are there certain types of quantitative
measurements that will not be appropriate for some types of banking
entities, desks, or levels? If so, would it be appropriate to require
only certain quantitative measurements for such banking entities,
desks, or levels?
Question 176. How might the number of quantitative measurements
impact behavior of banking entities? Is there a cost of requiring more
quantitative measurements, such as the cost of increased uncertainty
regarding the combined results of such quantitative measurements? To
what extent and in what ways might uncertainty as to how the
quantitative measurements are applied and evaluated impact behavior?
Proposed Appendix B--Commentary Regarding Identification of Permitted
Market Making-Related Activities
Proposed Appendix B provides commentary that is intended to assist
a banking entity in distinguishing permitted market making-related
activities from trading activities that, even if conducted in the
context of a banking entity's market making operations, would
constitute prohibited proprietary trading. As noted in Part I of
proposed Appendix B, the commentary applies to all banking entities
that are engaged in market making-related activities in reliance on
Sec. --.4(b) of the proposed rule. Part II of proposed Appendix B
clarifies that all defined terms used in Appendix B have the meaning
given those terms in Sec. Sec. --.2 and --.3 of the proposed rule and
Appendix A.
The commentary regarding identification of permitted market making-
related activities, which is contained in Part III of proposed Appendix
B, includes three principal components. The first component provides an
overview of market making-related activities and describes, in detail,
typical practices in which market makers engage and typical
characteristics of market making-related activities, articulating the
general framework within which the Agencies view market making-related
activities.\196\ For example, the commentary provides that market
making-related activities, in the context of a banking entity acting as
principal, generally involve either (i) in the case of market making in
a security that is executed on an organized trading facility or
exchange, passively providing liquidity by submitting resting orders
that interact with the orders of others on an organized trading
facility or exchange and acting as a registered market maker, where
such exchange or organized trading facility provides the ability to
register as a market maker, or (ii) in other cases, providing an
intermediation service to its customers by assuming the role of a
counterparty that stands ready to buy or sell a position that the
customer wishes to sell or buy. The second component of the commentary
provides an overview of prohibited proprietary trading activities,
which describes the general framework within which the Agencies view
prohibited proprietary trading and contrasts that activity to the
practices and characteristics of market making-related activities.\197\
The third component describes certain challenges that arise in
distinguishing permitted market making-related activities and
prohibited proprietary trading, particularly in cases in which both of
these activities occur within the context of a market making
operation,\198\ and proposes guidance that the Agencies would apply in
distinguishing permitted market making-related activities from
prohibited proprietary trading. This guidance includes six factors that
would cause a banking entity to be considered, absent explanatory
circumstances, to be engaged in prohibited proprietary trading, and not
permitted market making-related activity. The six factors are:
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\196\ See proposed rule Appendix B, Sec. III.A. The practices
and characteristics that are described generally reinforce and
augment the specific requirements that a banking entity must meet in
order to rely on the market-making exemption under Sec. ----.4(b)
of the proposed rule.
\197\ See proposed rule Appendix B, Sec. III.B.
\198\ See proposed rule Appendix B, Sec. III.C. Proposed
Appendix B notes, for example, that it may be difficult to
distinguish (i) inventory positions that appropriately support
market making-related activities from (ii) positions taken for
proprietary purposes. See id.
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Trading activity in which a trading unit retains risk in
excess of the size and type required to provide intermediation services
to customers; \199\
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\199\ For simplicity and ease of reading, the Agencies have used
the term ``customer'' throughout the discussion of market making-
related activity. However, as discussed in proposed Appendix B, a
market maker's ``customers'' generally vary depending on the asset
class and market in which the market maker is providing
intermediation services. In the context of market making in a
security that is executed on an organized trading facility or an
exchange, a ``customer'' is any person on behalf of whom a buy or
sell order has been submitted by a broker-dealer or any other market
participant. In the context of market making in a covered financial
position in an over-the-counter market, a ``customer'' generally
would be a market participant that makes use of the market maker's
intermediation services, either by requesting such services or
entering into a continuing relationship with the market maker with
respect to such services. In certain cases, depending on the
conventions of the relevant market (e.g., the over-the-counter
derivatives market), such a ``customer'' may consider itself or
refer to itself more generally as a ``counterparty.''
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Trading activity in which a trading unit primarily
generates revenues from price movements of retained principal positions
and risks, rather than customer revenues;
Trading activity in which a trading unit: (i) Generates
only very small or very large amounts of revenue per unit of risk
taken; (ii) does not demonstrate consistent profitability; or (iii)
demonstrates high earnings volatility;
Trading activity in which a trading unit either (i) does
not transact through a trading system that interacts with orders of
others or primarily with customers of the banking entity's market
making desk to provide liquidity services, or (ii) holds principal
positions in excess of reasonably expected near term customer demands;
Trading activity in which a trading unit routinely pays
rather than earns fees, commissions, or spreads; and
[[Page 68891]]
The use of compensation incentives for employees of a
particular trading activity that primarily reward proprietary risk-
taking.\200\
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\200\ See proposed rule Appendix B, Sec. III.C.1-6. The
Agencies note that each of these six criteria is directly related to
the overview of market making-related activities provided in section
III.A. of proposed Appendix B.
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The proposed commentary makes clear that the enumerated factors are
subject to certain facts and circumstances that may explain why a
trading activity may meet one or more factors but does not involve
prohibited proprietary trading, and provides a range of examples of
such explanatory facts and circumstances.\201\ The Agencies emphasize
that these examples are not meant to be exhaustive, as a variety of
other circumstances may exist to explain why a particular trading
activity, even if meeting one of the factors, may nonetheless be a
permitted market making-related activity.\202\
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\201\ The proposed commentary does not contemplate explanatory
facts and circumstances for the compensation incentives factor,
given that the choice of compensation incentives provided to trading
personnel is under the full control of the banking entity.
\202\ The Agencies also note that, although a particular trading
activity may not meet the requirements applicable to permitted
market making-related activities, it may still be exempt under
another available exemption.
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In addition, for each of these six factors, the proposed rule
provides general guidance as to (i) the types of facts and
circumstances on which the relevant Agency may base any determination
that a banking entity's trading activity met the relevant factor and
(ii) which quantitative measurements, if furnished by a banking entity
pursuant to Appendix A, the relevant Agency would use to help assess
the extent to which a banking entity's activities met the relevant
factor.
The Agencies request comment on the proposed commentary regarding
identification of permitted market making-related activities. In
particular, the Agencies request comment on the following questions:
Question 177. Is the overview of permitted market making-related
activities and prohibited proprietary trading proposed in Appendix B
accurate? If not, what alternative overview would be more accurate?
Does the overview appropriately account for differences in market
making-related activities across different asset classes? If not, which
type of market making-related activity does the overview not
sufficiently describe or account for?
Question 178. Is the requirement that a market maker engaged in
market making that is executed on an exchange or an organized trading
facility must be a registered market maker, provided the relevant
exchange or organized trading facility provides the ability to
register, appropriate, or is it over- or under-inclusive? Please
discuss and provide detailed examples of any such markets where
registering as a market maker is not feasible or should not be required
for purposes of this rule, and unregistered market makers provide
similar services or perform similar functions.
Question 179. With respect to market making that is executed on an
exchange or an organized trading facility, what potential impact or
unintended consequences might result from limiting the market making
exemption to registered market makers when the relevant exchange or
organized trading facility registers market makers? Would such a
requirement result in any potential decrease in the passive provision
of liquidity by the submission of resting orders? Do you anticipate
that any such decrease would be exacerbated in times of market stress?
If yes, please describe the impact on liquidity and the marketplace in
general. Please discuss whether and how any potential decrease in
liquidity could be mitigated. In addition, would such a requirement
result in additional costs that would be borne by market participants
purchasing and selling on an exchange or organized trading facility?
Please identify and discuss any other additional costs. Please discuss
whether and how any such consequences can be mitigated.
Question 180. In addition to benefits discussed in the
Supplementary Information, are there other benefits that would be
achieved by requiring that a market maker be registered with respect to
market making on an exchange or an organized trading facility? Is there
a way to amplify these benefits? Could these benefits be realized
through alternative means? If so, how?
Question 181. In addition to registered market makers on exchanges
or organized trading facilities, what other classes of liquidity
providers exist? Are their obligations and activities similar to, or
different than those of registered market makers? If so, how? Are the
compensated in a different manner?
Question 182. How much liquidity is provided by registered market
makers versus other liquidity providers by asset class (e.g., equities,
etc.) with respect to trading on an exchange or an organized trading
facility? The Agencies encourage commenters to provide data in support
of comments.
Question 183. Is there any specific element of market making-
related activity that the overview does not take into account in its
description of market making? If so, how should the overview account
for this element? Are there any descriptions of market making-related
activity in the overview that should not be considered to be market
making-related activity? If so, why? Is there any specific element of
prohibited proprietary trading activity that the overview does not take
into account in its description of prohibited proprietary trading? If
so, how should the overview account for this element? Are there any
descriptions of prohibited proprietary trading activity in the overview
that should not be considered to be prohibited proprietary trading? If
so, why?
Question 184. Are each of the six factors specified for helping to
distinguish permitted market making-related activity from prohibited
proprietary trading appropriate? If not, how should they be changed,
and why? Should any factors be eliminated or added? If so, which ones
and why? Could any of the proposed factors occur as a result of the
banking entity engaging in one of the other permitted activities (e.g.,
underwriting, trading on behalf of customers)? If so, would the facts
and circumstances that the Agencies propose to consider be sufficient
to determine and verify that the banking entity is not engaged in
prohibited proprietary trading? If not, how should this issue be
addressed?
Question 185. Are the facts and circumstances that would be used to
determine whether a banking entity's activities satisfy a certain
factor appropriate? If not, how should they be changed, and why? Should
any be eliminated or added? If so, which ones, and why?
Question 186. Are the identified quantitative measurements that the
Agencies would use to help assess a particular factor appropriate? If
not, how should they be changed, and why? Should any be eliminated or
added? If so, which ones, and why?
f. Incorporation of Numerical Thresholds in the Commentary Regarding
Identification of Permitted Market Making-Related Activities
As noted above, the Agencies are currently requesting comment on
whether to incorporate, as part of the proposed rule, numerical
thresholds for certain quantitative measurements, and if so, how to do
so. For example, the proposed rule could include one or more numerical
thresholds that, if met by a banking entity, would require the banking
entity to review its trading
[[Page 68892]]
activities for compliance and summarize that review to the relevant
Agency.
The primary purpose of using some form of threshold would be to
provide banking entities with a clear standard regarding trading
activity that presented a quantitative profile sufficiently
questionable to warrant further review and explanation to the relevant
Agency. Such clarity would appear to provide significant benefits both
to banking entities in conducting their trading activities in
conformance with the proposed rule and to Agencies in monitoring
trading activities and obtaining additional, more detailed information
in circumstances warranting closer scrutiny. In addition to the
benefits of transparency, thresholds would also encourage consistent
review by banking entities and the Agencies of transactions, both
within a banking entity and across all banking entities. The purpose of
such thresholds would not be to serve as bounds of permitted conduct or
as a comprehensive, dispositive tool for determining whether prohibited
proprietary trading has occurred.
Numerical thresholds have not been included in the proposed rule
because the Agencies believe that public comment and further review is
warranted before numerical thresholds and specific numerical amounts
may be proposed. Instead, the Agencies request comment on whether such
thresholds would be desirable and, if so, what particular form such
thresholds should take and what specific numerical thresholds would be
appropriate. To facilitate the comment process, this request for
comment includes a number of illustrative examples of numerical
thresholds on which specific comment is sought.
In particular, the Agencies request comment on the following
questions:
Question 187. What are the potential benefits and costs of
incorporating into the proposed rule one or more numerical thresholds
for certain quantitative measurements that, if reported by a banking
entity, would require the banking entity to review its trading
activities for compliance and summarize that review to the relevant
Agency? Would such thresholds provide useful clarity to banking
entities and/or market participants regarding the types of trading
activities that merit additional scrutiny? Should numerical thresholds
be used for any purposes other than highlighting trading activities
that should be reviewed, the results of which would be reported to the
relevant Agency? If so, for what purpose, and how and why?
Question 188. For which of the relevant quantitative measurements
might it be appropriate and effective to include a numerical threshold
that would trigger banking entity review and explanation? How should a
numerical threshold be formulated, and why? Should a numerical
threshold for a single quantitative measurement be applied
individually, or should the threshold instead be triggered by exceeding
some combination of numerical thresholds for different measurements?
For any particular threshold, what numerical amount should be used, and
why? How would such numerical amount be consistent with a level at
which further review and explanation is warranted? Should the amount
vary by asset class or other characteristic? If so, how?
Question 189. For each of the following illustrative examples of
potential thresholds, is the threshold formulated effectively? If not,
what alternative formulation would be more effective? Should the
threshold formulation vary by asset class or other characteristic? If
so, how and why? If the threshold was utilized, what actual numerical
amount should be specified, and why? How would such numerical amount be
consistent with a level at which further review and explanation is
warranted? Should the numerical amount vary by asset class or other
characteristic? If so, how and why?
``If a trading unit reports an increase in VaR, Stress
VaR, or Risk Factor Sensitivities greater than [--] over a period of
[--] months, or such other threshold as [Agency] may require, the
banking entity must (i) promptly review and investigate the trading
unit's activities to verify whether the trading unit is operating in
compliance with the proprietary trading restrictions and (ii) report to
[Agency] a summary of such review, including any explanatory
circumstances.''
``If a trading unit reports an average Comprehensive
Profit and Loss that is less than [--] times greater than the Portfolio
Profit and Loss, exclusive of Spread Profit and Loss, for [--]
consecutive months, or such other threshold as [Agency] may require,
the banking entity must (i) promptly review and investigate the trading
unit's activities to verify whether the trading unit is operating in
compliance with the proprietary trading restrictions and (ii) report to
[Agency] a summary of such review, including any explanatory
circumstances.''
``If a trading unit reports a Comprehensive Profit and
Loss to Volatility Ratio that is less than [--] times greater than that
trading desk's Portfolio Profit and Loss to Volatility Ratio over a
period of [--] months, or such other threshold as [Agency] may require,
the banking entity must (i) promptly review and investigate the trading
unit's activities to verify whether the trading unit is operating in
compliance with the proprietary trading restrictions and (ii) report to
[Agency] a summary of such review, including any explanatory
circumstances.''
``If a trading unit reports a number of Unprofitable
Trading Days Based on Portfolio Profit and Loss that is less than [--]
greater than the number of Unprofitable Trading Days Based on
Comprehensive Profit and Loss for [--] consecutive months, or such
other threshold as [Agency] may require, the banking entity must (i)
promptly review and investigate the trading unit's activities to verify
whether the trading unit is operating in compliance with the
proprietary trading restrictions and (ii) report to [Agency] a summary
of such review, including any explanatory circumstances.''
``If a trading unit reports a Pay-to-Receive Spread Ratio
that is less than [--] over a period of [--] months, or such other
threshold as [Agency] may require, the banking entity must (i) promptly
review and investigate the trading unit's activities to verify whether
the trading unit is operating in compliance with the proprietary
trading restrictions and (ii) report to [Agency] a summary of such
review, including any explanatory circumstances.''
6. Section --.8: Limitations on Permitted Trading Activities
Section --.8 of the proposed rule implements section 13(d)(2) of
the BHC Act, which places certain limitations on the permitted trading
activities (e.g., permitted market making-related activities, risk-
mitigating hedging, etc.) in which a banking entity may engage.\203\
Consistent with the statute, Sec. --.8(a) of the proposed rule
provides that no transaction, class of transactions, or activity is
permissible under Sec. Sec. --.4 through --.6 of the proposed rule if
the transaction, class of transactions, or activity would:
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\203\ See 12 U.S.C. 1851(d)(2).
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Involve or result in a material conflict of interest
between the banking entity and its clients, customers, or
counterparties;
Result, directly or indirectly, in a material exposure by
the banking entity to a high-risk asset or a high-risk trading
strategy; or
Pose a threat to the safety and soundness of the banking
entity or U.S. financial stability.
[[Page 68893]]
The proposed rule further defines ``material conflict of
interest,'' ``high-risk asset,'' and ``high-risk trading strategy'' for
these purposes.
a. Scope of ``Material Conflict of Interest''
Section --.8(b) of the proposed rule defines the scope of material
conflicts of interest which, if arising in connection with a permitted
trading activity, are prohibited under the proposal.\204\ Conflicts of
interest may arise in a variety of circumstances related to permitted
trading activities. For example, a banking entity may acquire
substantial amounts of nonpublic information about the financial
condition of a particular company or issuer through its lending,
underwriting, investment advisory or other activities which, if
improperly transmitted to and used in trading operations, would permit
the banking entity to use such information to its customers', clients'
or counterparties' disadvantage. Similarly, a banking entity may
conduct a transaction that places the banking entity's own interests
ahead of its obligations to its customers, clients or counterparties,
or it may seek to gain by treating one customer involved in a
transaction more favorably than another customer involved in that
transaction. Concerns regarding conflicts of interest are likely to be
elevated when a transaction is complex, highly structured or opaque,
involves illiquid or hard-to-value instruments or assets, requires the
coordination of multiple internal groups (such as multiple trading
desks or affiliated entities), or involves a significant asymmetry of
information or transactional data among participants.\205\ In all
cases, the existence of a material conflict of interest depends on the
specific facts and circumstances.
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\204\ Section --.17(b) of the proposed rule defines the scope of
material conflicts of interest which, if arising in connection with
permitted covered fund activities, are prohibited.
\205\ See, e.g., U.S. Senate Permanent Subcommittee on
Investigations, Wall Street and the Financial Crisis: Anatomy of a
Financial Collapse (Apr. 13, 2011), available at http://hsgac.senate.gov/public/_files/Financial_Crisis/FinancialCrisisReport.pdf.
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To address these types of material conflicts of interest, Sec.
--.8(b) of the proposed rule specifies that a material conflict of
interest between a banking entity and its clients, customers, or
counterparties exists if the banking entity engages in any transaction,
class of transactions, or activity that would involve or result in the
banking entity's interests being materially adverse to the interests of
its client, customer, or counterparty with respect to such transaction,
class of transactions, or activity, unless the banking entity has
appropriately addressed and mitigated the conflict of interest, where
possible, and subject to specific requirements provided in the
proposal, through either (i) timely and effective disclosure, or (ii)
informational barriers.\206\ Unless the conflict of interest is
addressed and mitigated in one of the two ways specified in the
proposal, the related transaction, class of transactions or activity
would be prohibited under the proposed rule, notwithstanding the fact
that it may be otherwise permitted under Sec. Sec. --.4 through --.6
of the proposed rule.\207\
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\206\ See proposed rule Sec. --.8(b)(1).
\207\ The Agencies note that a banking entity subject to
Appendix C must implement a compliance program that includes, among
other things, policies and procedures that explain how the banking
entity monitors and prohibits conflicts of interest with clients,
customers, and counterparties. Further, as noted in the discussion
of the definition of ``material conflict of interest'' in Part
III.B.6 of this Supplemental Information, the discussion of that
definition is provided solely for purposes of the proposed rule's
definition of material conflict of interest, and does not affect the
scope of that term in other contexts or a banking entity's
obligation to comply with additional or different requirements with
respect to a conflict under applicable securities, banking, or other
laws (e.g., section 27B of the Securities Act, which governs
conflicts of interest relating to certain securitizations; section
206 of the Investment Advisers Act of 1940, which applies to
conflicts of interest between investment advisers and their clients;
or 12 CFR 9.12, which applies to conflicts of interest in the
context of a national bank's fiduciary activities).
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However, while these conflicts may be material for purposes of the
proposed rule, the mere fact that the buyer and seller are on opposite
sides of a transaction and have differing economic interests would not
be deemed a ``material'' conflict of interest with respect to
transactions related to bona fide underwriting, market making, risk-
mitigating hedging or other permitted activities, assuming the
activities are conducted in a manner that is consistent with the
proposed rule and securities and banking laws and regulations.
Section --.8(b)(1) of the proposed rule describes the two
requirements that must be met in cases where a banking entity addresses
and mitigates a material conflict of interest through timely and
effective disclosure. First, Sec. --.8(b)(1)(i) of the proposed rule
requires that the banking entity, prior to effecting the specific
transaction or class or type of transactions, or engaging in the
specific activity, for which a conflict may arise, make clear, timely,
and effective disclosure of the conflict or potential conflict of
interest, together with any other necessary information.\208\ This
would also require such disclosure to be provided in reasonable detail
and in a manner sufficient to permit a reasonable client, customer, or
counterparty to meaningfully understand the conflict of interest.\209\
Disclosure that is only general or generic, rather than specific to the
individual, class, or type of transaction or activity, or that omits
details or other information that would be necessary to a reasonable
client's, customer's, or counterparty's understanding of the conflict
of interest, would not meet this standard. Second, Sec. --.8(b)(1)(ii)
of the proposed rule requires that the disclosure be made explicitly
and effectively, and in a manner that provides the client, customer, or
counterparty the opportunity to negate, or substantially mitigate, any
materially adverse effect on the client, customer, or counterparty that
was created or would be created by the conflict or potential
conflict.\210\
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\208\ See proposed rule Sec. --.8(b)(1)(A).
\209\ See id.
\210\ See proposed rule Sec. --.8(b)(1)(B).
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The Agencies note that, in order to provide the requisite
opportunity for the client, customer or counterparty to negate or
substantially mitigate the disadvantage created by the conflict, the
disclosure would need to be provided sufficiently close in time to the
client's, customer's, or counterparty's decision to engage in the
transaction or activity to give the client, customer, or counterparty
an opportunity to meaningfully evaluate and, if necessary, take steps
that would negate or substantially mitigate the conflict. Disclosure
provided far in advance of the individual, class, or type of
transaction, such that the client, customer, or counterparty is
unlikely to take that disclosure into account when evaluating a
transaction, would not suffice. Conversely, disclosure provided without
a sufficient period of time for the client, customer, or counterparty
to evaluate and act on the information it receives, or disclosure
provided after the fact, would also not suffice under the proposal. The
Agencies note that the proposed definition would not prevent or require
disclosure with respect to transactions or activities that align the
interests of the banking entity with its clients, customers, or
counterparties or that otherwise do not involve ``material'' conflicts
of interest as discussed above.
The proposed disclosure standard reflects the fact that some types
of conflicts may be appropriately resolved through the disclosure of
clear and meaningful information to the client, customer, or
counterparty that provides such party with an informed opportunity to
consider and negate or substantially mitigate the conflict.
[[Page 68894]]
However, in the case of a conflict in which a client, customer, or
counterparty does not have sufficient information and opportunity to
negate or mitigate the materially adverse effect on the client,
customer, or counterparty created by the conflict, the existence of
that conflict of interest would prevent the banking entity from
availing itself of any exemption (e.g., the underwriting or market-
making exemptions) with respect to the relevant transaction, class of
transactions, or activity. The Agencies note that the proposed
disclosure provisions are provided solely for purposes of the proposed
rule's definition of material conflict of interest, and do not affect a
banking entity's obligation to comply with additional or different
disclosure or other requirements with respect to a conflict under
applicable securities, banking, or other laws (e.g., section 27B of the
Securities Act, which governs conflicts of interest relating to certain
securitizations; section 206 of the Investment Advisers Act of 1940,
which governs conflicts of interest between investment advisers and
their clients; or 12 CFR 9.12, which applies to conflicts of interest
in the context of a national bank's fiduciary activities).
Section --.8(b)(2) of the proposed rule describes the requirements
that must be met in cases where a banking entity uses information
barriers that are reasonably designed to prevent a material conflict of
interest from having a materially adverse effect on a client, customer
or counterparty. Information barriers can be used to restrict the
dissemination of information within a complex organization and to
prevent material conflicts by limiting knowledge and coordination of
specific business activities among units of the entity. Examples of
information barriers include, but are not limited to, restrictions on
information sharing, limits on types of trading, and greater separation
between various functions of the firm. Information barriers may also
require that banking entity units or affiliates have no common officers
or employees. Such information barriers have been recognized in Federal
securities laws and rules as a means to address or mitigate potential
conflicts of interest or other inappropriate activities.\211\
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\211\ For example, information barriers have been used in
complying with the requirement in section 15(g) of the Exchange Act
that registered brokers and dealers establish, maintain and enforce
written policies and procedures reasonably designed, taking into
consideration the nature of such broker's or dealer's business, to
prevent the misuse of material, nonpublic information by such broker
or dealer or any person associated with such broker or dealer.
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In order to address and mitigate a conflict of interest through the
use of the information barriers pursuant to Sec. --.8(b)(2) of the
proposed rule, a banking entity would be required to establish,
maintain, and enforce information barriers that are memorialized in
written policies and procedures, including physical separation of
personnel, functions, or limitations on types of activity, that are
reasonably designed, taking into consideration the nature of the
banking entity's business, to prevent the conflict of interest from
involving or resulting in a materially adverse effect on a client,
customer or counterparty.\212\ Importantly, the proposed rule also
provides that, notwithstanding a banking entity's establishment of such
information barriers, if the banking entity knows or should reasonably
know that a material conflict of interest arising out of a specific
transaction, class or type of transactions, or activity may involve or
result in a materially adverse effect on a client, customer, or
counterparty, the banking entity may not rely on those information
barriers to address and mitigate any conflict of interest. In such
cases, the transaction or activity would be prohibited, unless the
banking entity otherwise complies with the requirements of Sec.
--.8(b)(1).\213\ This aspect of the proposal is intended to make clear
that, in specific cases in which a banking entity has established an
information barrier but knows or should reasonably know that it has
failed or will fail to prevent a conflict of interest arising from a
specific transactions or activity that disadvantages a client,
customer, or counterparty, the information barrier is insufficient to
address that conflict and the transaction would be prohibited, unless
the banking entity is otherwise able to address and mitigate the
conflict through timely and effective disclosure under the
proposal.\214\
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\212\ See proposed rule Sec. --.8(b)(2). As part of maintaining
and enforcing information barriers, a banking entity should have
processes to review, test, and modify information barriers on a
continuing basis. In addition, banking entities should have ongoing
monitoring to maintain and to enforce information barriers, for
example by identifying whether such barriers have not prevented
unauthorized information sharing and addressing instances in which
the barriers were not effective. This may require both remediating
any identified breach as well as updating the information barriers
to prevent further breaches, as necessary. Periodic assessment of
the effectiveness of information barriers and periodic review of the
written policies and procedures are also important to the
maintenance and enforcement of effective information barriers and
reasonably designed policies and procedures. Such assessments can be
done either (i) internally by a qualified employee or (ii)
externally by a qualified independent party.
\213\ See proposed rule Sec. --.8(b)(2).
\214\ In addition, if a conflict occurs to the detriment of a
client, customer, or counterparty despite an information barrier,
the Agencies would also expect the banking entity to review the
effectiveness of its information barrier and make adjustments, as
necessary, to avoid future occurrences, or review whether such
information barrier is appropriate for that type of conflict.
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The Agencies note that the proposed definition of material conflict
of interest does not address instances in which a banking entity has
made a material misrepresentation to its client, customer, or
counterparty in connection with a transaction, class of transactions,
or activity, as such transactions or activity appears to involve fraud
rather than a conflict of interest. However, the Agencies note that
such misrepresentations are generally illegal under a variety of
Federal and State regulatory schemes (e.g., the Federal securities
laws). In addition, the Agencies note that any activity involving a
material misrepresentation to, or other fraudulent conduct with respect
to, a client, customer, or counterparty would not be permitted under
the proposed rule in the first instance. For example, a trading
activity involving a material misrepresentation to a client, customer,
or counterparty would fail, on its face, to satisfy the proposed terms
of the underwriting or market-making exemption.
b. Definition of ``High-Risk Asset'' and ``High-Risk Trading Strategy''
Section --.8(c) of the proposed rule defines ``high-risk asset''
and ``high-risk trading strategy'' for proposes of Sec. --.8's
proposed limitations on permitted trading activities. Section
--.8(c)(1) defines a ``high-risk asset'' as an asset or group of assets
that would, if held by the banking entity, significantly increase the
likelihood that the banking entity would incur a substantial financial
loss or would fail. Section --.8(c)(2) defines a ``high-risk trading
strategy'' as a trading strategy that would, if engaged in by the
banking entity, significantly increase the likelihood that the banking
entity would incur a substantial financial loss or would fail.\215\
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\215\ The Agencies note that a banking entity subject to
proposed Appendix C must implement a compliance program that
includes, among other things, policies and procedures that explain
how the banking entity monitors and prohibits exposure to high-risk
assets and high-risk trading strategies, and identifies a variety of
assets and strategies (e.g., assets or strategies with significant
embedded leverage).
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c. Request for Comment
The Agencies request comment on the proposed limitations on
permitted trading activities. In particular, the
[[Page 68895]]
Agencies request comment on the following questions:
Question 190. Is the manner in which the proposed rule implements
the limitations of section 13(d)(2) of the BHC Act effective and
sufficiently clear? If not, what alternative would be more effective
and/or clearer?
Question 191. Is the proposed rule's definition of material
conflict of interest effective and sufficiently clear? If not, what
alternative would be more effective and/or clearer?
Question 192. Is the proposed definition of material conflict of
interest over-or under-inclusive? If so, how should the definition be
broader or narrower? Is there an alternative definition that would be
appropriate? If so, what definition? Why would that alternative
definition better define material conflict of interest for purposes of
implementing section 13 of the BHC Act?
Question 193. Would the proposed definition of material conflict of
interest have any unintended chilling effect on underwriting, market
making, risk-mitigating hedging or other permitted activities? If so,
what alternatives might limit such an effect?
Question 194. Would the proposed definition of material conflict of
interest lead to unintended consequences? If so, what unintended
consequences and why? Please suggest modifications to the proposed
definition that would mitigate those consequences.
Question 195. Is it likely that the proposed definition of material
conflict of interest would anticipate all future material conflicts of
interest, particularly as the financial markets evolve and change? If
not, what alternative definition would better anticipate future
material conflicts of interest?
Question 196. Does the proposed rule provide sufficient guidance
for determining when a material conflict of interest exists? If not,
what additional detail should be provided? Should the Agencies adopt an
approach similar to that under the securities laws, in which a material
conflict of interest is not specifically defined?
Question 197. Are there transactions, classes or types of
transactions, or activities inherent in underwriting, market-making,
risk-mitigating hedging or other permitted activities that should not
be prohibited but may be captured by the proposed definition of
material conflict of interest? If so, what transactions and activities?
Should they be permitted under the proposed rule? If so, why and under
what conditions, if any? Conversely, are there transactions or
activities that would be permitted under the proposed rule that should
be prohibited? If so, what transactions and activities? Why should they
be prohibited under the proposed rule?
Question 198. Please discuss the inherent conflicts of interest
that arise from bona fide underwriting, market making-related activity,
risk-mitigating hedging, or any other permitted activity, and provide
specific examples of such inherent conflicts. Do you believe that such
conflicts ever result in a materially adverse interest between a
banking entity and a client, customer, or counterparty? How should the
proposal address inherent conflicts that result from otherwise-
permitted activities?
Question 199. Is the manner in which the proposed rule permits the
use of disclosure in certain cases to address and mitigate conflicts of
interest appropriate? Why or why not? Should additional or alternative
requirements be placed on the use of disclosure to address and mitigate
conflicts? If so, what additional and alternative requirements, and
why? Is the level of detail and specificity required by the proposed
rule with respect to disclosure appropriate? If not, what alternative
level of detail and specificity would be more appropriate?
Question 200. Should the proposed rule require written disclosure
to a client, customer, or counterparty regarding a material conflict of
interest? If so, please explain why written disclosure should be
required. Are there certain circumstances where written disclosure
should be required, but others where oral disclosure should be
sufficient? For example, should oral disclosure be permitted for
transactions in certain fast-moving markets or transactions with
sophisticated clients, customers, or counterparties? If oral disclosure
is permitted under certain circumstances, should subsequent written
disclosure be required? Please explain.
Question 201. Should the proposed rule provide further detail
regarding the types of conflicts of interest that cannot be addressed
and mitigated through disclosure? If so, what type of additional detail
would be helpful, and why? Should the proposed rule enumerate an
exhaustive or non-exhaustive list of conflicts that cannot be addressed
and mitigated through disclosure? If so, what conflicts should that
list include, and why?
Question 202. Should the proposed rule provide further detail
regarding the frequency at which disclosure must be made? Should
general disclosure be permitted for certain types of transactions,
classes of transactions, or activities? For example, should a banking
entity be permitted to make a one-time, written disclosure to a client,
customer, or counterparty prior to engaging in a certain type of
transaction or activity? Should general disclosure be permitted for
certain types of clients, customers, or counterparties (e.g., highly
sophisticated parties)? Please explain why specific disclosure (i.e.,
prior to each transaction, class of transaction, or activity) would not
be necessary under the identified circumstances. Are there any clients,
customers, or counterparties that should be able to waive a material
conflict of interest under certain circumstances? If so, under what
circumstances would a waiver approach be appropriate and consistent
with the statute? Please explain.
Question 203. Should the proposed definition of material conflict
of interest deem certain potential conflicts of interest to not be
material conflicts of interest if a banking entity establishes,
maintains, and enforces policies and procedures (other than information
barriers) reasonably designed to prevent transactions, classes of
transactions, or activities that would involve or result in a material
conflict of interest? If so, for what types of potential conflicts?
What policies and procedures would be appropriate? How would this
approach be consistent with the purpose and language of the statute?
Should such policies and procedures only be considered effective if
they prevent the banking entity from receiving an advantage to the
disadvantage of the client, customer, or counterparty?
Question 204. Are there any particular types of clients, customers,
or counterparties for whom disclosure of a material conflict of
interest should not be required under the proposal, consistent with the
statute? Please identify the types of clients, customers, or
counterparties for whom disclosure might not be necessary and explain.
Why might disclosures be useful for some clients, customers, or
counterparties, but not others? Please explain. What characteristics
should a firm use in determining whether or not a client, customer, or
counterparty needs a particular disclosure?
Question 205. Are there additional steps that a banking entity that
seeks to manage conflicts of interest through the use of disclosure
should be required to take with regard to disclosure? If so, what
steps?
Question 206. Are there circumstances in which disclosure might be
impracticable or ineffective? If so, what circumstances, and why?
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Question 207. Is the manner in which the proposed rule permits the
use of information barriers to address and mitigate conflicts of
interest appropriate? Why or why not? Should additional or alternative
requirements be placed on the use of information barriers to address
and mitigate conflicts? If so, what additional and alternative
requirements, and why?
Question 208. Should the proposed rule mandate the use of other
means of managing potential conflicts of interest? If so, what specific
means should be considered? How effective are any such methods as
currently used? Can such methods be circumvented? If so, in what ways?
Question 209. What burdens or costs might be associated with the
disclosure-related or information barrier-related requirements
contained in the proposed definition of material conflict of interest?
How might these burdens or costs be eliminated or reduced in a manner
consistent with the purpose and language of section 13 of the BHC Act?
Question 210. Are there specific transactions, classes of
transactions or activities that should be managed through consent? If
so, what transactions or activities, and why? What form of consent
should be required? What level of detail should any such consent
include? Should consent only apply to certain conflicts and not others?
If so, which conflicts? Are there circumstances in which obtaining
consent might be impracticable or ineffective? Should consent be
limited to certain types of clients, customers, or counterparties? If
so, which clients, customers, or counterparties? Are there certain
types of clients, customers, or counterparties for whom consent would
never be sufficient? Are there additional steps that a banking entity
that seeks to manage conflicts of interest through the use of consent
should be required to take? Please specify such steps.
Question 211. What is the potential relationship between, and
interplay of, the proposed rule and Section 621 of the Dodd-Frank Act
regarding conflicts of interest relating to certain securitizations
which contains a prohibition on material conflicts of interest?
Question 212. Should the proposed rule provide for specific types
of procedures that would be more effective in managing and mitigating
conflicts of interest than others? Do banking entities currently use
certain procedures that effectively manage and mitigate material
conflicts of interest? If so, please describe such procedures and
explain why such procedures are effective. Is the proposed rule
consistent with such procedures? Why or why not? What are the costs and
benefits of modifying your current procedures in response to the
proposed rule?
Question 213. Is the proposed rule's definition of a high-risk
asset effective and sufficiently clear? If not, what alternative would
be more effective and/or clearer? Should the proposed rule specify
particular assets that are deemed high-risk per se? If so, what assets
and why?
Question 214. Is the proposed rule's definition of a high-risk
trading strategy effective and sufficiently clear? If not, what
alternative would be more effective and/or clearer? Should the proposed
rule specify particular trading strategies that are deemed high-risk
per se? If so, what trading strategies and why?
C. Subpart C--Covered Fund Activities and Investments
As noted above, except as otherwise permitted, section 13(a)(1)(B)
of the BHC Act prohibits a banking entity from acquiring or retaining
any ownership in, or acting as sponsor to, a covered fund.\216\ Subpart
C of the proposed rule applies those portions of section 13 of the BHC
Act that operate as a prohibition or restriction on a banking entity's
ability, as principal, directly or indirectly, to acquire or retain an
ownership interest in, act as sponsor to, or have certain relationships
with, a covered fund. Subpart C also implements the permitted activity
and investment authorities provided for under section 13(d)(1) of the
BHC Act related to covered fund activities and investments, as well as
the rule of construction related to the sale and securitization of
loans under section 13(g)(2) of that Act. Additionally, subpart C
contains a discussion of the internal controls, reporting and
recordkeeping requirements applicable to covered fund activities and
investments, and incorporates by reference the minimum compliance
standards for banking entities contained in subpart D of the proposed
rule, as well as Appendix C, to the extent applicable.
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\216\ See 12 U.S.C. 1851(a)(1)(B).
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1. Section --.10: Prohibition of Acquisition or Retention of Ownership
Interests in, and Certain Relationships With, a Covered Fund
Section --.10 of the proposed rule defines the scope of the
prohibition on acquisition or retention of ownership interests in, and
certain relationships with, a covered fund, as well as defines a number
of key terms related to such prohibition.
a. Prohibition Regarding Covered Fund Activities and Investments
Section --.10(a) of the proposed rule implements section
13(a)(1)(B) of the BHC Act and prohibits a banking entity from, as
principal, directly or indirectly, acquiring or retaining an equity,
partnership, or other ownership interest in, or acting as sponsor to, a
covered fund, unless otherwise permitted under subpart C of the
proposed rule.\217\ This prohibition reflects the statute's purpose and
effect of limiting a banking entity's ability to invest in or have
exposure to a covered fund.
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\217\ See proposed rule Sec. --.10(a).
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The Agencies note that the general prohibition in Sec. --.10(a) of
the proposed rule applies solely to a banking entity's acquisition or
retention of an ownership interest in or acting as sponsor to a covered
fund ``as principal, directly or indirectly.'' \218\ As such, the
proposed rule would not prohibit the acquisition or retention of an
ownership interest (including a general partner or membership interest)
in a covered fund: (i) By a banking entity in good faith in a fiduciary
capacity, except where such ownership interest is held under a trust
that constitutes a company as defined in section (2)(b) of the BHC Act;
(ii) by a banking entity in good faith in its capacity as a custodian,
broker, or agent for an unaffiliated third party; (iii) by a
``qualified plan,'' as that term is defined in section 401 of the
Internal Revenue Code of 1956 (26 U.S.C. 401), if the ownership
interest would be attributed to a banking entity solely by operation of
section 2(g)(2) of the BHC Act; or (iv) by a director or employee of a
banking entity who acquires the interest in his or her personal
capacity and who is directly engaged in providing advisory or other
services to the covered fund, unless the banking entity, directly or
indirectly, extended credit for the purpose of enabling the director or
employee to acquire the ownership interest in the fund and the credit
was used to acquire such ownership interest in the fund.
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\218\ The Agencies note that this language is intended to
prevent a banking entity from evading the restrictions contained in
section 13(a)(1)(B) of the BHC Act on acquiring or retaining an
ownership interest in a covered fund.
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Among other things, Sec. --.10(b) of the proposed rule defines the
term ``covered fund.'' \219\ This definition explains the universe of
entities to which the
[[Page 68897]]
prohibition contained in Sec. --.10(a) applies unless the activity is
specifically permitted under an available exemption contained in
subpart C of the proposed rule. Other related terms, including
``ownership interest,'' ``prime brokerage transaction,'' ``sponsor,''
and ``trustee,'' are in turn defined in Sec. Sec. --.10(b)(2) through
--.10(b)(6) of the proposed rule.
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\219\ See proposed rule Sec. --.10(b)(1). The term banking
entity, which is discussed above in Part III.A.2 of this
Supplementary Information, is defined in Sec. --.2(e).
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b. ``Covered Fund'' and Related Definitions
i. Definition of ``Covered Fund''
Section 13(h)(2) of the BHC Act defines the terms ``hedge fund''
and ``private equity fund'' to mean ``any issuer that would be an
investment company, as defined in the [Investment Company Act], but for
section 3(c)(1) or 3(c)(7) of that Act,'' or such similar funds as the
Agencies may by rule determine.\220\ Given that the statute defines a
``hedge fund'' and ``private equity fund'' synonymously, the proposed
rule implements this statutory definition by combining the terms into
the definition of a ``covered fund.'' \221\
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\220\ 12 U.S.C. 1851(h)(2). Sections 3(c)(1) and 3(c)(7) of the
Investment Company Act, in relevant part, provide two exclusions
from the definition of ``investment company'' for, as appropriate,
(1) any issuer whose outstanding securities are beneficially owned
by not more than one hundred persons and which is not making and
does not presently propose to make a public offering of its
securities (other than short-term paper), or (2) any issuer, the
outstanding securities of which are owned exclusively by persons
who, at the time of acquisition of such securities, are qualified
purchasers, and which is not making and does not at that time
proposes to make a public offering of such securities. See 15 U.S.C.
80a-3(c)(1) and (c)(7).
\221\ See proposed rule Sec. --.10(b)(1).
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Sections 3(c)(1) and 3(c)(7) of the Investment Company Act are
exclusions from the definition of ``investment company'' in that Act
and are commonly relied on by a wide variety of entities that would
otherwise be covered by the broad definition of ``investment company''
contained in that Act. As a result, the statutory definition in section
13(h)(2) of the BHC Act could potentially include within its scope many
entities and corporate structures that would not usually be thought of
as a ``hedge fund'' or ``private equity fund.'' For instance, joint
ventures, acquisition vehicles, certain wholly-owned subsidiaries, and
other widely-utilized corporate structures typically rely on the
exclusion contained in section 3(c)(1) or 3(c)(7) of the Investment
Company Act. These types of entities are generally not used to engage
in investment or trading activities. Additionally, as noted in Part
II.G of this Supplementary Information, certain securitization vehicles
may be included in this definition.
The proposed rule follows the scope of the statutory definition by
covering an issuer only if it would be an investment company, as
defined in the Investment Company Act, but for section 3(c)(1) or
3(c)(7) of that Act.\222\ Additionally, the proposed rule incorporates
the statutory application of the rule to ``such similar funds as the
Agencies may determine by rule as provided in section 13(b)(2) of the
BHC Act.'' \223\ The Agencies have proposed to include as ``similar
funds'' a commodity pool,\224\ as well as the foreign equivalent of any
entity identified as a ``covered fund.'' \225\ These entities have been
included in the proposed rule as ``similar funds'' given that they are
generally managed and structured similar to a covered fund, except that
they are not generally subject to the Federal securities laws due to
the instruments in which they invest or the fact that they are not
organized in the United States or one or more States.
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\222\ See proposed rule Sec. --.10(b)(1)(i). Under the proposed
rule, if an issuer (including an issuer of asset-backed securities)
may rely on another exclusion or exemption from the definition of
``investment company'' under the Investment Company Act other than
the exclusions contained in section 3(c)(1) or 3(c)(7) of that Act,
it would not be considered a covered fund, as long as it can satisfy
all of the conditions of an alternative exclusion or exemption for
which it is eligible.
\223\ 12 U.S.C. 1851(b)(2).
\224\ ``Commodity pool'' is defined in the Commodity Exchange
Act to mean any investment trust, syndicate, or similar form of
enterprise operated for the purpose of trading in commodity
interests, including any: (i) Commodity for future delivery,
security futures product, or swap; (ii) agreement, contract, or
transaction described in section 2(c)(2)(C)(i) or 2(c)(2)(D)(i) of
the Commodity Exchange Act; (iii) commodity option authorized under
section 4c of the Commodity Exchange Act; or (iv) leverage
transaction authorized under section 23 of the Commodity Exchange
Act. See 7 U.S.C. 1a(10).
\225\ See proposed rule Sec. --.10(b)(1)(iii). The proposed
rule makes clear that any issuer, as defined in section 2(a)(22) of
the Investment Company Act, (15 U.S.C. 80a-2(a)(22)), that is
organized or offered outside of the United States, would qualify as
a covered fund if, were it organized or offered under the laws, or
offered for sale or sold to a resident, of the United States or of
one or more States, it would be either: (i) An investment company,
as defined in the Investment Company Act, but for section 3(c)(1) or
3(c)(7) of that Act; (ii) a commodity pool; or (iii) any such
similar fund as the appropriate Federal banking agencies, the SEC,
and the CFTC may determine, by rule, as provided in section 13(b)(2)
of the BHC Act.
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ii. Definition of ``Ownership Interest''
The proposed rule defines ``ownership interest'' in order to make
clear the scope of section 13(a)(1)(B) of the BHC Act and Sec.
--.10(a)'s prohibition on a banking entity acquiring or retaining any
equity, partnership, or other ownership interest in a covered fund. The
definition of ownership interest includes a description of what
interests constitute an ownership interest, as well as an exclusion
from the definition of ownership interest for carried interest.\226\
The proposed rule defines ownership interest to mean, with respect to a
covered fund, any equity, partnership, or other similar interest
(including, without limitation, a share, equity security, warrant,
option, general partnership interest, limited partnership interest,
membership interest, trust certificate, or other similar interest) in a
covered fund, whether voting or nonvoting, as well as any derivative of
such interest. This definition focuses on the attributes of the
interest and whether it provides a banking entity with economic
exposure to the profits and losses of the covered fund, rather than its
form. To the extent that a debt security or other interest of a covered
fund exhibits substantially the same characteristics as an equity or
other ownership interest (e.g., provides the holder with voting rights,
the right or ability to share in the covered fund's profits or losses,
or the ability, directly or pursuant to a contract or synthetic
interest, to earn a return based on the performance of the fund's
underlying holdings or investments), the Agencies could consider such
instrument an ownership interest as an ``other similar instrument.''
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\226\ See proposed rule Sec. --.10(b)(3).
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Many banking entities that serve as investment adviser or commodity
trading advisor to a covered fund are compensated for services they
provide to the fund through receipt of so-called ``carried interest.''
In recognition of the manner in which such compensation is
traditionally provided, the proposed rule also clarifies that an
ownership interest with respect to a covered fund does not include an
interest held by a banking entity (or an affiliate, subsidiary or
employee thereof) in a covered fund for which the banking entity (or an
affiliate, subsidiary or employee thereof) serves as investment
manager, investment adviser or commodity trading advisor, so long as:
(i) The sole purpose and effect of the interest is to allow the banking
entity (or the affiliate, subsidiary or employee thereof) to share in
the profits of the covered fund as performance compensation for
services provided to the covered fund by the banking entity (or the
affiliate, subsidiary or employee thereof), provided that the banking
entity (or the affiliate, subsidiary or employee thereof) may be
obligated under the terms of such interest to return profits previously
received; (ii) all such profit, once allocated, is distributed to the
banking entity (or the affiliate, subsidiary or
[[Page 68898]]
employee thereof) promptly after being earned or, if not so
distributed, the reinvested profit of the banking entity (or the
affiliate, subsidiary or employee thereof) does not share in the
subsequent profits and losses of the covered fund; (iii) the banking
entity (or the affiliate, subsidiary or employee thereof) does not
provide funds to the covered fund in connection with acquiring or
retaining this carried interest; and (iv) the interest is not
transferable by the banking entity (or the affiliate, subsidiary or
employee thereof) except to an affiliate or subsidiary.\227\ The
proposed rule therefore permits a banking entity to receive an interest
as performance compensation for services provided by it or one of its
affiliates, subsidiaries, or employees to a covered fund, but only if
the enumerated conditions are met.
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\227\ See proposed rule Sec. --.10(b)(3)(ii).
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iii. Definition of ``Prime Brokerage Transaction''
Section 13(f)(3) of the BHC Act permits a banking entity to enter
into a prime brokerage transaction with a covered fund in which a
covered fund managed, organized, or sponsored by such banking entity
(or an affiliate or subsidiary thereof) has taken an ownership
interest.\228\ However, section 13 of the BHC Act does not define what
qualifies as a prime brokerage transaction. In order to provide clarity
regarding the types of services and relationships that are permitted as
a prime brokerage transaction, the proposed rule defines a ``prime
brokerage transaction'' to mean one or more products or services
provided by a banking entity to a covered fund, such as custody,
clearance, securities borrowing or lending services, trade execution,
or financing, data, operational, and portfolio management support.\229\
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\228\ See 12 U.S.C. 1851(f)(3).
\229\ See proposed rule Sec. --.10(b)(4).
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iv. Definition of ``Sponsor'' and ``Trustee''
The proposed rule defines ``sponsor'' in the same manner as section
13(h)(5) of the BHC Act.\230\ Section --.10(b)(5) of the proposed rule
defines the term ``sponsor'' as an entity that: (i) Serves as a general
partner, managing member, trustee, or commodity pool operator of a
covered fund; (ii) in any manner selects or controls (or has employees,
officers, or directors, or agents who constitute) a majority of the
directors, trustees, or management of a covered fund; or (iii) shares
with a covered fund, for the corporate, marketing, promotional, or
other purposes, the same name or a variation of the same name.\231\
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\230\ See 12 U.S.C. 1851(h)(5).
\231\ See proposed rule Sec. --.10(b)(5).
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The definition of ``sponsor'' contained in section 13(h)(5) of the
BHC Act focuses on the ability to control the decision-making and
operational functions of the fund. In keeping with this focus, the
proposed rule defines the term ``trustee'' (which is a part of the
definition of ``sponsor'') to exclude trustee that does not exercise
investment discretion with respect to a covered fund, including a
directed trustee, as that term is used in section 403(a)(1) of the
Employee's Retirement Income Security Act (29 U.S.C. 1103(a)(1)). The
proposed rule provides that a ``trustee'' includes any banking entity
that directs a directed trustee, or any person who possesses authority
and discretion to manage and control the assets of the covered
fund.\232\
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\232\ See proposed rule Sec. --.10(b)(6)(ii).
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v. Request for Comment
The Agencies request comment on the proposed rule's approach to
defining the terms covered fund, ownership interest, and other related
terms. In particular, the Agencies request comment on the following
questions:
Question 215. Is the proposed rule's approach to applying section
13 of the BHC Act's restrictions related to covered fund activities and
investments to those instances where a banking entity acts ``as
principal or beneficial owner'' effective? If not, why? What
alternative approach might be more effective in light of the language
and purpose of the statute?
Question 216. Does the proposed rule effectively address the
circumstances under which an investment by a director or employee of a
banking entity in a covered fund would be attributed to a banking
entity? If not, why? What alternative might be more effective?
Question 217. Does the proposed rule's definition of ``covered
fund'' effectively implement the statute? What alternative definitions
might be more effective in light of the language and purpose of the
statute?
Question 218. Is specific inclusion of commodity pools within the
definition of ``covered fund'' effective and consistent with the
language and purpose of the statute? Why or why not?
Question 219. The proposed definition of ``sponsor'' focuses on
``the ability to control the decision-making and operational functions
of the fund.'' In the securitization context, is this an appropriate
manner to determine the identity of the sponsor? If not, what factors
should be used to determine the identity of the sponsor in the
securitization context for purposes of the proposed rule and why? Is
the definition of ``sponsor'' set forth in the SEC's Regulation AB
\233\ an appropriate party to treat as sponsor for purposes of the
proposed rule? Is additional guidance necessary with respect to how the
proposed definition of ``sponsor'' should be applied to a
securitization transaction?
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\233\ See 17 CFR 229.1101(l).
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Question 220. Should the application of the proposed definition of
``sponsor'' mean that the servicer or investment manager in a
securitization transaction would be considered the sponsor for purposes
of the proposed rule? What impact would this interpretation of the
proposed definition have on existing securitizations?
Question 221. Should the definition of ``covered fund'' focus on
the characteristics of an entity rather than whether it would be an
investment company but for section 3(c)(1) or 3(c)(7) of the Investment
Company Act? If so, what characteristics should be considered and why?
Would a definition focusing on an entity's characteristics rather than
its form be consistent with the language and purpose of the statute?
Question 222. Instead of adopting a unified definition of ``covered
fund'' for those entities included under section 13(h)(2) of the BHC
Act, should the Agencies consider having separate definitions for
``hedge fund'' and ``private equity fund''? If so, which definitions
and why?
Question 223. Should the Agencies consider using the authority
provided under section 13(d)(1)(J) of the BHC Act to exempt the
acquisition or retention of an ownership interest in a covered fund
with certain attributes or characteristics, including, for example: (i)
A performance fee or allocation to an investment manager's equity
account calculated by taking into account income and realized and
unrealized gains; (ii) borrowing an amount in excess of one-half of its
total capital commitments or has gross notional exposure in excess of
twice its total capital commitments; (iii) sells securities or other
assets short; (iv) has restricted or limited investor redemption
rights; (v) invests in public and non-public companies through
privately negotiated transactions resulting in private ownership of the
business; (vi) acquires the unregistered equity or equity-like
securities of such companies that are illiquid as there is
[[Page 68899]]
no public market and third party valuations are not readily available;
(vii) requires holding those investments long-term; (viii) has a
limited duration of ten years or less; or (ix) returns on such
investments are realized and the proceeds of the investments are
distributed to investors before the anticipated expiration of the
fund's duration? Which, if any, of these characteristics are
appropriate to describe a hedge fund or private equity fund that should
be considered a covered fund for purposes of this rule? Are there any
other characteristics that would be more appropriate to describe a
covered fund? If so, which characteristics and why?
Question 224. Is specific inclusion of certain non-U.S. entities as
a ``covered fund'' under Sec. --.10(b)(1)(iii) of the proposed rule
necessary, or would such entities already be considered to be a
``covered fund'' under Sec. --.10(b)(1)(i) of the proposed rule? If
so, why? Does the proposed rule's language on non-U.S. entities
correctly describe those non-U.S. entities, if any, that should be
included in the definition of ``covered fund''? Why or why not? What
alternative language would be more effective? Should we define non-U.S.
funds by reference to the following structural characteristics: whether
they are limited in the number or type of investors; whether they
operate without regard to statutory or regulatory requirements relating
to the types of instruments in which they may invest or the degree of
leverage they may incur? Why or why not?
Question 225. Are there any entities that are captured by the
proposed rule's definition of ``covered fund,'' the inclusion of which
does not appear to be consistent with the language and purpose of the
statute? If so, which entities and why?
Question 226. Are there any entities that are not captured by the
proposed rule's definition of ``covered fund,'' the exclusion of which
does not appear to be consistent with the language and purpose of the
statute? If so, which entities and why?
Question 227. Do the proposed rule's definitions of ``covered
fund'' and/or ``ownership interest'' pose unique concerns or challenges
to issuers of asset-backed securities and/or securitization vehicles?
If so, why? Do certain types of securitization vehicles (trusts, LLCs,
etc.) typically issue asset-backed securities which would be included
in the proposed definition of ownership interest? What would be the
impact of the application of the proposed rules to these securitization
vehicles? Are certain asset classes (collateralized debt obligations,
future flows, corporate debt repackages, etc.) more likely to be
impacted by the proposed definition of ``covered fund'' because the
issuer cannot rely on an exemption other than 3(c)(1) or 3(c)(7) of the
Investment Company Act?
Question 228. How many existing issuers of asset-backed securities
would be included in the proposed definition of ``covered fund?'' What
would be the legal and economic impact of the proposed rule on holders
of asset-backed securities issued by existing securitization vehicles
that would be included in the proposed definition of covered fund?
Question 229. Are there entities that issue asset-backed securities
(as defined in Section 3(a) of the Exchange Act) that should be
exempted from the requirements of the proposed rule? How would such an
exemption promote and protect the safety and soundness of the banking
entity and the financial stability of the United States as required by
section 13(d)(1)(J) of the BHC Act?
Question 230. Since certain existing asset-backed securities may
have a term that exceeds the conformance or extended transition periods
provided for under section 13(c) of the BHC Act, should the Agencies
consider using the authority contained in section 13(d)(1)(J) of that
Act to exclude those existing asset-backed securities from the proposed
definition of ``ownership interest'' and/or should the rule permit a
banking entity to acquire or retain an ownership interest in existing
asset-backed issuers? If so, how would either approach be consistent
with the language and purpose of the statute?
Question 231. Many issuers of asset-backed securities have features
and structures that resemble some of the features of hedge funds and
private equity funds (e.g., CDOs are managed by an investment adviser
that has the discretion to choose investments, including investments in
securities). If the proposed definition of ``covered fund'' were to
exempt any entity issuing asset-backed securities, would this allow for
interests in hedge funds or private equity funds to be structured as
asset-backed securities and circumvent the proposed rule? If this
approach is taken, how should the proposal address this concern?
Question 232. Are the structural similarities between an entity
that issues asset-backed securities and hedge funds and private equity
funds of sufficient concern that the Agencies should not exclude any
entity that issues asset-backed securities from the definition of
covered fund?
Question 233. Should entities that rely on a separate exclusion
from the definition of investment company other than sections 3(c)(1)
or 3(c)(7) of the Investment Company Act be included in the definition
of ``covered fund''? Why or why not?
Question 234. Do the proposed rule's definitions of ``ownership
interest'' and ``carried interest'' effectively implement the statute?
What alternative definitions might be more appropriate in light of the
language and purpose of the statute? Are there other types of
instruments that should be included or excluded from the definition of
``ownership interest''? Does the proposed definition of ownership
interest capture most interests that are typically viewed as ownership
interests? Is the proposed rule's exemption of carried interest from
the definition of ownership interest with respect to a covered fund
appropriate? Does the exemption adequately address existing
compensation arrangements and the way in which a banking entity becomes
entitled to carried interest? Is it consistent with the current tax
treatment of these arrangements?
Question 235. In the context of asset-backed securities, the
distinction between debt and equity may be complicated (e.g., trust
certificates issued in a residential mortgage backed security
transaction) and the legal, accounting and tax treatment may differ for
the same instrument. Is guidance necessary with respect to the
application of the definition of ownership interest for asset-backed
securitization transactions?
Question 236. In many securitization transactions, the residual
interest represents the ``equity'' in the transaction. As this often
constitutes the portion of the securitization transaction with the most
risk, because it may absorb any losses experienced by the underlying
assets before any other interests issued by the securitization vehicle,
should the Agencies instead use their authority under section
13(d)(1)(J) of the BHC Act to exempt the buying and selling of any
ownership interest in a securitization vehicle that is a covered fund
other than the residual interest?
Question 237. For purposes of limiting either an exclusion for
issuers of asset-backed securities from the proposed definition of
``covered fund'' and/or an exclusion of asset-backed securities from
the proposed definition of ``ownership interest,'' what definition of
asset-backed security most effectively implements the language of
section 13 of the BHC Act? Section 3(a)(77) of the Exchange Act and the
SEC's Regulation
[[Page 68900]]
AB \234\ provide two possible definitions. Is either of these
definitions sufficient, and if so why? If one of the definitions is too
narrow, what additional entities/securities should be included and why?
If one of the definitions is too broad, what entities/securities should
be excluded and why? Would some other definition of asset-backed
security be more consistent with the language and purpose of section 13
of the BHC Act?
---------------------------------------------------------------------------
\234\ See 17 CFR 229.1101(c).
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Question 238. Are there special concerns raised by not including as
an ownership interest the residual interests in a securitization
vehicle? Should the Agencies instead exempt the buying and selling of
any ownership interest in a securitization vehicle that is a covered
fund other than the residual interest?
Question 239. Should the legal form of a beneficial interest be a
determining factor for deciding whether a beneficial interest is an
``ownership interest''? For example, should pass-through trust
certificates issued as part of a securitization transaction be excluded
from the definition of ``ownership interest''? Should the definition of
ownership interest explicitly include debt instruments with equity
features (e.g., voting rights, profit participations, etc.)?
Question 240. How should the proposed rule address those instances
in which both debt and equity interests are issued, and the debt
interests receive all of the economic benefits and all of the control
rights? Should the debt interests (other than the residual interest) be
counted as ownership interests even though they are not legally
ownership and do not receive any profit participation? Should the
equity interests be counted as ownership interests even though the
holder does not receive economic benefits or have any control rights?
Should the residual interest be considered the only ``ownership
interest'' for purposes of the proposed rule? Should mezzanine
interests that lack both control rights and profit participation be
considered an ownership interest? If the mezzanine interests obtain
control rights (because more senior classes have been repaid), should
they become ``ownership interests'' at that time for purposes of the
proposed rule? If both debt and equity interests are counted as
ownership interests, how should percentages of ownership interests be
calculated when the units of measurement do not match (e.g., a single
trust certificate, a single residual certificate with no face value and
multiple classes of currency-denominated notes)?
Question 241. Does the proposed rule's definition of ``prime
brokerage transaction'' effectively implement the statute? What other
types of transactions or services, if any, should be included in the
definition? Should any types of transactions or services be excluded
from the definition? Would an alternative definition be more effective,
and if so, why?
Question 242. Do the proposed rule's definitions of ``sponsor'' and
``trustee'' effectively implement the statute? Is the exclusion of
``directed trustee'' from the definition of ``trustee'' appropriate?
Question 243. Do the proposed rule's other definitions in Sec.
--.10(b) effectively implement the statute? What alternative
definitions might be more effective in light of the language and
purpose of the statute? Are additional definitions needed, and if so,
what definition(s)?
2. Section --.11: Permitted Organizing and Offering of a Covered Fund
Section --.11 of the proposed rule implements section 13(d)(1)(G)
of the BHC Act and permits a banking entity to organize and offer a
covered fund, including acting as sponsor of the fund, if certain
criteria are met.\235\ This exemption is designed to permit a banking
entity to be able to engage in certain traditional asset management and
advisory businesses in compliance with section 13 of the BHC Act.\236\
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\235\ See proposed rule Sec. --.11.
\236\ 156 Cong. Rec. S5889 (daily ed. July 15, 2010) (statement
of Sen. Hagan).
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a. Required Criteria for Permitted Organizing and Offering of Covered
Funds
Section --.11 of the proposed rule provides for and describes the
conditions that must be met in order to enable a banking entity to
qualify for the exemption to organize and offer a covered fund.\237\
These conditions include: (i) The banking entity must provide bona fide
trust, fiduciary, investment advisory, or commodity trading advisory
services;\238\ (ii) the covered fund must be organized and offered only
in connection with the provision of bona fide trust, fiduciary,
investment advisory, or commodity trading advisory services and only to
persons that are customers of such services of the banking entity;
(iii) the banking entity may not acquire or retain an ownership
interest in the covered fund except as permitted under subpart C of the
proposed rule; (iv) the banking entity must comply with the
restrictions governing relationships with covered funds under Sec.
--.16 of the proposed rule; (v) the banking entity may not, directly or
indirectly, guarantee, assume, or otherwise insure the obligations or
performance of the covered fund or of any covered fund in which such
covered fund invests; (vi) the covered fund, for corporate, marketing,
promotional, or other purposes, (A) may not share the same name or a
variation of the same name with the banking entity(or an affiliate or
subsidiary thereof), and (B) may not use the word ``bank'' in its name;
(vii) no director or employee of the banking entity may take or retain
an ownership interest in the covered fund, except for any director or
employee of the banking entity who is directly engaged in providing
investment advisory or other services to the covered fund; and (viii)
the banking entity must (A) clearly and conspicuously disclose, in
writing, to any prospective and actual investor in the covered fund
(such as through disclosure in the covered fund's offering documents)
the enumerated disclosures contained in Sec. --.11(h) of the proposed
rule, and (B) comply with any additional rules of the appropriate
Agency or Agencies, designed to ensure that losses in such covered fund
are borne solely by investors in the covered fund and not by the
banking entity.\239\ These requirements are explained in detail below.
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\237\ See proposed rule Sec. Sec. --.11(a)-(h).
\238\ While section 13(d)(1)(G) of the BHC Act does not
explicitly mention ``commodity trading advisory services,'' the
Agencies have proposed to include commodity pools within the
definition of ``covered fund'' and commodity trading advisory
services in the same way as investment advisory services because
commodity trading advisory services are the functional equivalent of
investment advisory services to commodity pools.
\239\ See id. at Sec. --.11(a)-(h). The Agencies are not
proposing any such additional rules at this time, although they may
do so in the future.
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i. Bona Fide Services
Section --.11(a) of the proposed rule requires that, in order to
qualify for the exemption related to organizing and offering a covered
fund, a banking entity provide bona fide trust, fiduciary, investment
advisory, or commodity trading advisory services.\240\ Banking entities
provide a wide range of customer-oriented services which may qualify as
bona fide trust, fiduciary, investment advisory, or commodity trading
advisory services.\241\ Additionally, depending on the type of banking
entity that conducts the activity or provides the service, variations
in the
[[Page 68901]]
precise services involved may occur. For example, a national bank and
an SEC-registered investment adviser may provide substantially similar
investment advisory services to clients, but be subject to different
statutory and regulatory requirements. In recognition of potential
variations in services and functional regulation, the proposed rule
does not specify what services would qualify as ``bona fide trust,
fiduciary, investment advisory, or commodity trading advisory
services'' under Sec. --.11(a) of the proposed rule. Instead, the
proposed rule largely mirrors the statutory language of section
13(d)(1)(G)(i) of the BHC Act and reflects the intention that so long
as a banking entity provides trust, fiduciary, investment advisory, or
commodity trading advisory services in compliance with relevant
statutory and regulatory requirements, the requirement contained in
Sec. --.11(a) of the proposed rule would generally be deemed to be
satisfied.
---------------------------------------------------------------------------
\240\ See 12 U.S.C. 1851(d)(1)(G)(i); proposed rule Sec.
--.11(a).
\241\ See, e.g., 12 U.S.C. 1843(c)(4), (c)(8), (k),12 CFR
225.28(b)(5) and (6), 12 CFR 225.86, 12 CFR 225.125 (with respect to
a bank holding company); 12 U.S.C. 24 (Seventh), 92a, 12 CFR Part 9
(with respect to a national bank); 12 U.S.C. 1831a, 12 CFR Part 362
(with respect to a state nonmember bank).
---------------------------------------------------------------------------
ii. ``Customers of Such Services'' Requirement
Section 13(d)(1)(G)(ii) of the BHC Act requires that a banking
entity organize and offer a covered fund ``only in connection with''
the provision of qualified services to persons that are customers of
such services of the banking entity.\242\ Section --.11(b) of the
proposed rule implements the statute and reflects the statutory
requirement that there are two independent conditions contained in
section 13(d)(1)(G)(ii) of the BHC Act: (i) A covered fund must be
organized and offered in connection with bona fide trust, fiduciary,
investment advisory, or commodity trading advisory services, and (ii)
the banking entity providing those services may offer the covered fund
only to persons that are customers of those services of the banking
entity.\243\ Requiring a customer relationship in connection with
organizing and offering a covered fund helps to ensure that a banking
entity is engaging in the covered fund activity for others and not on
the banking entity's own behalf.\244\
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\242\ See 12 U.S.C. 1851(d)(1)(G)(ii).
\243\ See proposed rule Sec. --.11(b).
\244\ See 156 Cong. Rec. at S5897 (daily ed. July 15, 2010)
(statement of Sen. Merkley).
---------------------------------------------------------------------------
Section 13(d)(1)(G)(ii) of the BHC Act does not explicitly require
that the customer relationship be pre-existing. Accordingly, the
proposed rule provides that it may be established through or in
connection with the banking entity's organization and offering of a
covered fund, so long as that fund is a manifestation of the provision
by the banking entity of bona fide trust, fiduciary, investment
advisory or commodity trading advisory services to the customer. This
application of the customer requirements is consistent with the manner
in which trust, fiduciary, investment advisory, and commodity trading
advisory services are provided by banking entities. Historically,
banking entities have raised capital commitments for covered funds from
existing customers as well as individuals or entities that have no pre-
existing relationship with the banking entity.
Banking entities commonly organize and offer funds to customers of
the banking entity's trust, fiduciary, and investment advisory or
commodity trading advisory services as a way of ensuring the efficient
and consistent provision of these services. For example, a person often
obtains the investment advisory services of the banking entity by
acquiring an interest in a fund organized and offered by the banking
entity. This is distinguished from a fund organized and offered by a
banking entity for the purpose of itself investing as principal,
indirectly through its investment in the fund, in assets held by the
fund. Under the proposed rule, a banking entity could, consistent with
past practice, provide a covered fund to persons that are customers of
such services for purposes of the exemption so long as the fund is
organized and offered as a means of providing bona fide trust,
fiduciary, investment advisory, or commodity trading advisory services
to customers. The banking entity may not organize and offer a covered
fund as a means of itself investing in the fund or assets held in the
fund.\245\
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\245\ The proposed rule does not change any requirement imposed
by separate statute, regulation, or other law, if applicable. For
instance, a banking entity that conducts a private placement of a
covered fund pursuant to the SEC's Regulation D pertaining to
private offerings would still be expected to comply with the
relevant requirements related to such offering, including the
limitations related to the manner in which and types of persons to
whom it may offer or sell interests in such fund. See 12 CFR 230.501
et seq.
---------------------------------------------------------------------------
The Agencies note that a banking entity could, through organizing
and offering a covered fund pursuant to the authority contained in
Sec. --.11 of the proposed rule that itself makes investments or
engages in trading activity, seek to evade the restrictions contained
in section 13 of the BHC Act and the proposed rule. In order to address
these concerns, the proposed rule provides that a banking entity
relying on the authority contained in Sec. --.11 must organize and
offer a covered fund pursuant to a credible plan or similar
documentation outlining how the banking entity intends to provide
advisory or similar services to its customers through organizing and
offering such fund.
iii. Compliance With Investment Limitations
Section 13(d)(1)(G)(iii) of the BHC Act limits the ability of a
banking entity that organizes and offers a covered fund to acquire or
retain an ownership interest in that covered fund.\246\ Separately,
other provisions of section 13 of the BHC Act provide independent
exemptions which permit a banking entity to acquire or retain an
ownership interest in a covered fund.\247\ Section --.11(c) of the
proposed rule incorporates these statutory provisions by prohibiting a
banking entity from acquiring or retaining an ownership interest in a
covered fund that it organizes and offers except as permitted under
subpart C of the proposed rule.\248\ The limits on a banking entity's
ability to invest in a covered fund that it organizes and offers are
described in Sec. --.12 of the proposal.
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\246\ See 12 U.S.C. 1851(d)(1)(G)(iii).
\247\ See, e.g., id. at 1851(d)(1)(C).
\248\ See proposed rule Sec. --.11(c).
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iv. Compliance With Section 13(f) of the BHC Act
Section --.11(d) of the proposed rule requires that the banking
entity comply with the limitations on certain relationships with
covered funds.\249\ These limitations apply in several contexts, and
are contained in Sec. --.16 of the proposed rule, discussed in detail
below. In general, Sec. --.16 of the proposed rule prohibits certain
transactions or relationships that would be covered by section 23A of
the FR Act, and provides that any permitted transaction is subject to
section 23B of the FR Act, in each instance as if such banking entity
were a member bank and such covered fund were an affiliate
thereof.\250\
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\249\ 12 U.S.C. 1851(d)(1)(G)(iv); proposed rule Sec. --.11(d).
\250\ See Supplementary Information, Part III.C.7.
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v. No Guarantees or Insurance of Fund Performance
Section --.11(e) of the proposed rule prohibits the banking entity
from, directly or indirectly, guaranteeing, assuming or otherwise
insuring the obligations or performance of the covered fund or any
covered fund in which such covered fund invests.\251\
[[Page 68902]]
This prong implements section 13(d)(1)(G)(iv) of the BHC Act and is
intended to prevent a banking entity from engaging in bailouts of a
covered fund in which it has an interest.\252\
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\251\ 12 U.S.C. 1851(d)(1)(G)(v); proposed rule Sec. --.11(e).
\252\ See 156 Cong. Rec. S5897 (daily ed. July 15, 2010)
(statement of Sen. Merkley).
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vi. Limitation on Name Sharing With a Covered Fund
Section --.11(f) of the proposed rule prohibits the covered fund
from sharing the same name or a variation of the same name with the
banking entity, for corporate, marketing, promotional, or other
purposes.\253\ This section implements section 13(d)(1)(G)(v) of the
BHC Act and addresses the concern that name-sharing could undermine
market discipline and encourage a banking entity to bail out a covered
fund it organizes and offers in order to preserve the entity's
reputation.\254\ Thus, under Sec. --.11(f) of the proposed rule, a
covered fund would be prohibited from sharing the same name or
variation of the same name with a banking entity that organizes and
offers or serves as sponsor to that fund (or an affiliate or subsidiary
of such banking entity). A covered fund would also be prohibited under
the proposed rule from using the word ``bank'' in its name.\255\
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\253\ 12 U.S.C. 1851(d)(1)(G)(vi); proposed rule Sec. --.11(f).
\254\ 156 Cong. Rec. S5897 (daily ed. July 15, 2010) (statement
of Sen. Merkley).
\255\ Similar restrictions on a fund sharing the same name, or
variation of the same name, with an insured depository institution
or company that controls an insured depository institution or having
the word ``bank'' in its name, have been used previously in order to
prevent customer confusion regarding the relationship between such
companies and a fund. See, e.g., Bank of Ireland, 82 Fed. Res. Bull.
1129 (1996).
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vii. Limitation on Ownership by Directors and Employees
Section --.11(g) of the proposed rule implements section
13(d)(1)(G)(vii) of the BHC Act. The provision prohibits any director
or employee of the banking entity from acquiring or retaining an
ownership interest in the covered fund, except for any director or
employee of the banking entity who is directly engaged in providing
investment advisory or other services to the covered fund.\256\ This
allows an individual acting as fund manager or adviser and employed by
a banking entity to acquire or retain an ownership interest in a
covered fund that aligns the manager or adviser's incentives with those
of its customers by allowing the individual to have ``skin in the
game'' with respect to a covered fund for which that individual
provides management or advisory services (which customers or clients
often request).\257\
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\256\ See 12 U.S.C. 1851(d)(1)(G)(vii); proposed rule Sec.
--.11(g).
\257\ See 156 Cong. Rec. S5897 (daily ed. July 15, 2010)
(statement of Sen. Merkley).
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The Agencies recognize that director or employee investments in a
covered fund may provide an opportunity for a banking entity to evade
the limitations regarding the amount or value of ownership interests a
banking entity may acquire or retain in a covered fund or funds
contained in section 13(d)(4) of the BHC Act and Sec. --.12 of the
proposed rule. In order to address this concern, the proposed rule
would generally attribute an ownership interest in a covered fund
acquired or retained by a director or employee to such person's
employing banking entity, if the banking entity either extends credit
for the purpose of allowing the director or employee to acquire such
ownership interest, guarantees the director or employee's purchase, or
guarantees the director or employee against loss on the investment.
viii. Disclosure Requirements
Section --.11(h) of the proposed rule requires that, in connection
with organizing and offering a covered fund, the banking entity (i)
clearly and conspicuously disclose, in writing, to prospective and
actual investors in the covered fund (such as through disclosure in the
covered fund's offering documents) that ``any losses in [such covered
fund] will be borne solely by investors in [the covered fund] and not
by [the banking entity and its affiliates or subsidiaries]; therefore,
[the banking entity's and its affiliates' or subsidiaries'] losses in
[such covered fund] will be limited to losses attributable to the
ownership interests in the covered fund held by [the banking entity and
its affiliates or subsidiaries] in their capacity as investors in [the
covered fund],'' and (ii) comply with any additional rules of the
appropriate Agency as provided in section 13(b)(2) of the BHC Act
designed to ensure that losses in any such covered fund are borne
solely by the investors in the covered fund and not by the banking
entity.\258\ The proposed rule also provides, as an additional
disclosure requirement related to organizing and offering a covered
fund, that a banking entity clearly and conspicuously disclose, in
writing, to any prospective and actual investor (such as through
disclosure in the covered fund's offering documents): (i) That such
investor should read the fund offering documents before investing in
the covered fund; (ii) that the ``ownership interests in the covered
fund are not insured by the FDIC, and are not deposits, obligations of,
or endorsed or guaranteed in any way, by any banking entity'' (unless
that happens to be the case); and (iii) the role of the banking entity
and its affiliates, subsidiaries, and employees in sponsoring or
providing any services to the covered fund. As noted above, the
proposed rule clarifies that a banking entity may satisfy the
requirements of this prong with respect to a covered fund by making the
required disclosures, in writing, in the covered fund's offering
documents.\259\
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\258\ 12 U.S.C. 1851(d)(1)(G)(viii); proposed rule Sec.
--.11(h).
\259\ As contemplated in Sec. --.11(a)(8)(ii) of the proposed
rule, to the extent that any additional rules are issued to ensure
that losses in a covered fund are borne solely by the investors in
the covered fund and not by the banking entity, a banking entity
would be required to comply with those as well in order to satisfy
the requirements of section 13(d)(1)(G)(viii) of the BHC Act.
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ix. Request for Comment
The Agencies request comment on the proposed rule's approach with
respect to implementing the exemption permitting banking entities to
organize and offer a covered fund. In particular, the Agencies request
comment on the following questions:
Question 244. Is the proposed rule's approach to implementing the
exemption for organizing and offering a covered fund effective? If not,
what alternative approach would be more effective and why?
Question 245. Should the approach include other elements? If so,
what elements and why? Should any of the proposed elements be revised
or eliminated? If so, why and how?
Question 246. Is the proposed rule's approach to implementing the
scope of bona fide trust, fiduciary, investment advisory and commodity
trading advisory services consistent with the statute? If not, what
alternative approach would be more effective? Should the scope of such
services be broader or, in the alternative, more limited? Are there
specific services which should be included but which are not currently
under the proposed rule?
Question 247. Does the proposed rule effectively implement the
``customers of such services'' requirement? If not, what alternative
approach would be more effective and why? Is the proposed rule's
approach consistent with the statute? Why or why not? How do banking
entities currently sell or provide interests in covered funds? Do
banking entities rely on a concept of ``customer'' by reference to
other laws or
[[Page 68903]]
regulations, and if so, what laws or regulations?
Question 248. Does the proposed rule effectively and clearly
recognize the manner in which banking entities provide trust,
fiduciary, investment advisory, or commodity trading advisory services
to customers? If not, how should the proposed rule be modified to be
more effective or clearer?
Question 249. Should the Agencies consider adopting a definition of
``customer of such services'' for purposes of implementing the
exemption related to organizing and offering a covered fund? If so,
what criteria should be included in such definition? For example,
should the customer requirement specify that the relationship be pre-
existing? Should the Agencies consider adopting an existing definition
related to ``customer'' and if so, what definitions (for instance, the
SEC's ``pre-existing, substantive relationship'' concept applicable to
private offerings under its Regulation D) would provide for effective
implementation of the customer requirement in section 13(d)(1)(G) of
the BHC Act? If so, why and how? How should the customer requirement be
applied in the context of non-U.S. covered funds? Is there an
equivalent concept used for such non-U.S. covered fund offerings?
Question 250. Should the Agencies distinguish between direct and
indirect customer relationships for purposes of implementing section
13(d)(1)(G) of the BHC Act? Should the rule differentiate between a
customer relationship established by a customer as opposed to a banking
entity? If so, why?
Question 251. Does the proposed rule effectively implement the
prohibition on a banking entity guaranteeing or insuring the
obligations or performance of certain covered funds? If not, what
alternative approach would be more effective, and why?
Question 252. Does the proposed rule effectively implement the
requirement that a banking entity comply with the limitation on certain
relationships with a covered fund contained in Sec. --.16 of the
proposed rule? If not, what alternative approach would be more
effective, and why?
Question 253. Does the proposed rule effectively implement the
prohibition on a covered fund sharing the same name or variation of the
same name with a banking entity? If not, what alternative approach
would be more effective and why? Should the prohibition on a covered
fund sharing the same name be limited to specific types of banking
entities (e.g., insured depository institutions and bank holding
companies) or only to the banking entity that organizes and offers the
fund, and if so why?
Question 254. Does the proposed rule effectively implement the
limitation on director or employee investments in a covered fund
organized and offered by a banking entity? If not, what alternative
approach would be more effective and why? Should the agencies provide
additional guidance on what ``other services'' should be included for
purposes of satisfying Sec. --.11(g)? Why or why not?
Question 255. Are the disclosure requirements related to organizing
and offering a covered fund appropriate? If not, what alternative
disclosure requirement(s) should the proposed rule include? Should the
Agencies consider adoption of a model disclosure form related to this
requirement? Does the timing of the proposed disclosure requirement
adequately address disclosure to secondary market purchasers?
3. Section --.12: Permitted Investment in a Covered Fund
Section --.12 of the proposed rule describes the limited
circumstances under which a banking entity may acquire or retain, as an
investment, an ownership interest in a covered fund that the banking
entity or one of its subsidiaries or affiliates organizes and offers.
This section implements section 13(d)(4) of the BHC Act and related
provisions, and describes the statutory limits on both (i) the amount
and value of an investment by a banking entity in a covered fund, and
(ii) the aggregate value of all investments in all covered funds made
by the banking entity.
As described below, a banking entity that makes or retains an
investment in a covered fund under Sec. --.12 of the proposed rule is
generally subject to three principal limitations related to such
investment. First, the banking entity's investment in a covered fund
may not represent more than 3 percent of the total outstanding
ownership interests of such fund (after the expiration of any seeding
period provided under the rule). Second, the banking entity's
investment in a covered fund may not result in more than 3 percent of
the losses of the covered fund being allocable to the banking entity's
investment. Third, a banking entity may invest no more than 3 percent
of its tier 1 capital in covered funds.\260\
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\260\ See, e.g., proposed rule Sec. Sec. --.12(b)(2), (c).
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a. Authority and Limitations on Permitted Investments
Section 13(d)(4) of the BHC Act permits a banking entity to acquire
and retain an ownership interest in a covered fund that the banking
entity organizes and offers pursuant to section 13(d)(1)(G), for the
purposes of (i) establishing the covered fund and providing the fund
with sufficient initial equity for investment to permit the fund to
attract unaffiliated investors, or (ii) making a de minimis investment
in the covered fund in compliance with applicable requirements.\261\
Section --.12 of the proposed rule implements this authority and
related limitations.
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\261\ See 12 U.S.C. 1851(d)(4).
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Consistent with this statutory provision, the proposed rule
requires a banking entity to (i) actively seek unaffiliated investors
to ensure that the banking entity's investment conforms with the limits
of Sec. --.12, and (ii) reduce through redemption, sale, dilution, or
other methods the aggregate amount and value of all ownership interests
of the banking entity in a single fund held under Sec. --.12 to an
amount that does not exceed 3 percent of the total outstanding
ownership interests of the fund not later than 1 year after the date of
establishment of the fund (or such longer period as may be provided by
the Board pursuant to Sec. --.12(e) of the proposed rule) (the ``per-
fund limitation''). Additionally, Sec. --.12 of the proposed rule
implements the statutory requirement that the aggregate value of all
ownership interests of the banking entity in all covered funds held as
an investment not exceed 3 percent of the tier 1 capital of the banking
entity (the ``aggregate funds limitation'').\262\
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\262\ See proposed rule at Sec. --.12(a)(2)(ii). The process
and manner in which a banking entity's 3 percent tier 1 capital
limit is determined for purposes of the proposed rule is discussed
in detail below in Part III.C.3 of this Supplementary Information.
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b. Permitted Investment in a Single Covered Fund
Section --.12(b) of the proposed rule describes the limitations and
restrictions on a banking entity's ability to make or retain an
investment in a single covered fund. This section implements the
requirements of section 13(d)(4) of the BHC Act.\263\
---------------------------------------------------------------------------
\263\ See 12 U.S.C. 1851(d)(4)(B).
---------------------------------------------------------------------------
Section --.12 of the proposed rule describes the manner in which
the limitations on the amount and value of ownership interests in a
covered fund must be calculated, in recognition of the fact that a
covered fund may have multiple classes of ownership interests which
possess different characteristics
[[Page 68904]]
or values that impact a person's ownership in that fund. A banking
entity must apply the limits to both the total value and amount of its
investment in a covered fund. For purposes of applying these limits,
the banking entity must calculate (without regard to committed funds
not yet called for investment): (i) The value of all investments or
capital contributions made with respect to any ownership interest by
the banking entity in a covered fund, divided by the value of all
investments or capital contributions made by all persons in that
covered fund, and (ii) the total number of ownership interests held as
an investment by the banking entity in a covered fund divided by the
total number of ownership interests held by all persons in that covered
fund.\264\ Therefore, under the proposed rule, such calculation would
include as the numerator the amount or value of a banking entity's
investment in a covered fund, and as the denominator the amount or
value (matched to the unit of measurement in the numerator) of all
classes of ownership interests held by all persons in that covered
fund. As noted above, the banking entity's investment in a covered fund
also may not result in more than 3 percent of the losses of the covered
fund being allocable to the banking entity's investment.\265\
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\264\ See proposed rule Sec. --.12(b)(2).
\265\ Under the proposed rule, a banking entity's investment in
a covered fund may not result in more than 3 percent of the losses
of the covered fund being allocable to the banking entity's
investment since the banking entity's permitted investment in a
covered fund may be no more than 3 percent of the value and amount
of such fund's total ownership interests, and the banking entity may
not, directly or indirectly, guarantee, assume, or otherwise insure
the obligations or performance of the covered fund. See 12 U.S.C.
1851(d)(1)(G)(v); proposed rule Sec. --.11(e).
---------------------------------------------------------------------------
In order to ensure that a banking entity calculates its investment
in a covered fund accurately and does not evade the per-fund investment
limitation, the proposed rule requires that the banking entity must
calculate its investment in the same manner and according to the same
standards utilized by the covered fund for determining the aggregate
value of the fund's assets and ownership interests in the covered
fund.\266\
---------------------------------------------------------------------------
\266\ See proposed rule Sec. --.12(b)(4).
---------------------------------------------------------------------------
Under the proposed rule, the amount and value of a banking entity's
investment in any single covered fund is (i) the total amount or value
held by the banking entity directly and through any entity that is
controlled, directly or indirectly, by the banking entity,\267\ plus
(ii) the pro rata amount or value of any covered fund held by any
entity (other than certain operating entities noted below) that is not
controlled, directly or indirectly, by the banking entity but in which
the banking entity owns, controls, or holds with the power to vote more
than 5 percent of the voting shares.\268\
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\267\ See proposed rule Sec. --.12(b)(1)(A).
\268\ See proposed rule Sec. --.12(b)(1)(B). As noted above,
whether or not an investment is controlled or noncontrolled will be
determined consistent with the BHC Act, as implemented by the Board.
See 12 U.S.C. 1841(a)(2); 12 CFR 225.2(e).
---------------------------------------------------------------------------
Additionally, the proposed rule provides that, to the extent that a
banking entity is contractually obligated to directly invest in, or is
found to be acting in concert through knowing participation in a joint
activity or parallel action toward a common goal of investing in, one
or more investments with a covered fund that is organized and offered
by the banking entity (whether or not pursuant to an express
agreement), such investment shall be included in the calculation of a
banking entity's per-fund limitation.\269\ In this way, the proposed
rule prevents a banking entity from evading the limitations under Sec.
--.12 of the proposed rule through committed co-investments.
---------------------------------------------------------------------------
\269\ See proposed rule Sec. --.12(b)(2)(B).
---------------------------------------------------------------------------
Section --.12(b)(3) of the proposed rule provides that the amount
and value of a banking entity's investment in a covered fund may at no
time exceed the 3 percent limits contained in Sec. --.12(b) of the
proposed rule after the conclusion of any conformance period, if
applicable.\270\ In cases where a fund calculates its value or stands
ready to issue or redeem interests frequently (e.g., daily), a banking
entity must calculate its per-fund limitation no less frequently than
the fund performs such calculation or issues or redeems interests. In
recognition of the fact that not every covered fund may calculate or
determine its valuation daily (for instance, if it does not allow
redemptions except infrequently or invests principally in illiquid
assets for which no market price is readily available), the proposed
rule would not require a daily calculation of value for such fund
(unless a daily calculation is determined by the fund).\271\ In such
cases, the calculation of the amount and value of a banking entity's
per-fund limitation must be made no less frequently than at the end of
every quarter.\272\ Additionally, since a banking entity must organize
and offer any covered fund in which it invests, the Agencies expect
that such banking entity would closely and regularly monitor not only
the value of such fund's interests, but also any changes in the fund's
investors' relative ownership percentages.\273\
---------------------------------------------------------------------------
\270\ See proposed rule Sec. --.12(b)(3).
\271\ With respect to an issuer of asset-backed securities,
depending on the transaction structure, such calculation may need to
be made each time a payment is made to any holder of the issuer's
asset-backed securities.
\272\ The Agencies note that while calculation of a banking
entity's ownership interest in a covered fund must be determined no
less frequently than at the end of every quarter, it is possible
that no change in a banking entity's ownership interest (e.g., no
redemptions or other changes in investor composition) may occur
during every quarter.
\273\ For instance, where a banking entity acts as sponsor to a
covered fund, in connection with the organizing and offering of that
fund it may include a requirement (such as a ``tag-along''
redemption right) in the fund's organizational documents in order to
assist the banking entity in complying with the per-fund investment
limitation.
---------------------------------------------------------------------------
c. Aggregate Permitted Investments in All Covered Funds and Calculation
of a Banking Entity's Tier 1 Capital
In addition to a limit on investments in a single covered fund,
section 13(d)(4) of the BHC Act requires the banking entity to comply
with the aggregate funds limitation on investments in all covered
funds.\274\ As required under section 13(d)(4)(B)(ii)(II) of the BHC
Act, the proposed rule provides that the aggregate of a banking
entity's ownership interests in all covered funds that are held under
Sec. --.12 of the proposed rule may not exceed 3 percent of the tier 1
capital of a banking entity.\275\ In order to maintain equality in
application of the aggregate funds limitation, the proposed rule
provides that, for purposes of determining compliance with Sec. --.12
of the proposed rule, the aggregate of all of a banking entity's
investments in all covered funds under Sec. --.12 of the proposed rule
must be valued pursuant to applicable accounting standards.\276\ This
value calculation is separate and in addition to the required
calculation of the value of a banking entity's investment in a covered
fund as part of determining compliance with the per-fund limitation.
---------------------------------------------------------------------------
\274\ As noted in the discussion regarding the per-fund
limitation, the proposed rule provides that, for purposes of
determining compliance with Sec. --.12, the banking entity's
permitted investment in a covered fund shall be calculated in the
same manner and according to the same standards utilized by the
covered fund for determining the aggregate value of the fund's
assets and ownership interests. However, the value of a banking
entity's aggregate permitted investments in all covered funds shall
be determined in accordance with applicable accounting standards.
See proposed rule Sec. --.12(c)(1).
\275\ See 12 U.S.C. 1851(d)(4)(B)(ii)(II); proposed rule Sec.
--.12(a)(2)(ii).
\276\ See proposed rule Sec. --.12(c)(1).
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Tier 1 capital is a banking law concept that, in the United States,
is
[[Page 68905]]
calculated and reported by certain depository institutions and bank
holding companies in order to determine their compliance with
regulatory capital standards. Accordingly, the proposed rule clarifies
that for purposes of the aggregate funds limitation in Sec. --.12, a
banking entity that is a bank, a bank holding company, a company that
controls an insured depository institution that reports tier 1 capital,
or uninsured trust company that reports tier 1 capital (each a
``reporting banking entity'') must apply the reporting banking entity's
tier 1 capital as of the last day of the most recent calendar quarter
that has ended, as reported to the relevant Federal banking
agency.\277\
---------------------------------------------------------------------------
\277\ See proposed rule Sec. --.12(c)(1)(A).
---------------------------------------------------------------------------
However, not all entities subject to section 13 of the BHC Act
calculate and report tier 1 capital. In order to provide a measure of
equality related to the aggregate funds limitation contained in section
13(d)(4)(B)(ii)(II) of the BHC Act and Sec. --.12(c) of the proposed
rule, the proposed rule clarifies how the aggregate funds limitation
shall be calculated for entities that are not required to calculate and
report tier 1 capital in order to determine compliance with regulatory
capital standards. Under the proposed rule, with respect to any banking
entity that is not affiliated with a reporting banking entity and not
itself required to report capital in accordance with the risk-based
capital rules of a Federal banking agency, the banking entity's tier 1
capital for purposes of the aggregate funds limitation shall be the
total amount of shareholders' equity of the top-tier entity within such
organization as of the last day of the most recent calendar quarter
that has ended, as determined under applicable accounting
standards.\278\ For a banking entity that is not itself required to
report tier 1 capital but is a subsidiary of a reporting banking entity
that is a depository institution (e.g., a subsidiary of a national
bank), the aggregate funds limitation shall be the amount of tier 1
capital reported by such depository institution.\279\ For a banking
entity that is not itself required to report tier 1 capital but is a
subsidiary of a reporting banking entity that is not a depository
institution (e.g., a nonbank subsidiary of a bank holding company), the
aggregate funds limitation shall be the amount of tier 1 capital
reported by the top-tier affiliate of such banking entity that holds
and reports tier 1 capital.\280\ Thus, for purposes of calculating the
aggregate funds limitation under Sec. --.12(c)(2) of the proposed
rule, the tier 1 capital for the different types of banking entities
would be as follows:
---------------------------------------------------------------------------
\278\ See proposed rule Sec. --.12(c)(2)(ii)(B)(2).
\279\ See proposed rule Sec. --.12(c)(2)(ii)(A).
\280\ See proposed rule Sec. --.12(c)(1)(B).
------------------------------------------------------------------------
Tier 1 capital for purposes of
Type of banking entity Sec. --.12
------------------------------------------------------------------------
Depository institution that is a Tier 1 capital of the
reporting banking entity (or a depository institution as of
subsidiary thereof). the last day of the most
recent calendar quarter that
has ended, as reported to the
relevant Federal banking
agency.
Bank holding company or a subsidiary Tier 1 capital of the bank
thereof (other than a reporting holding company as of the last
banking entity). day of the most recent
calendar quarter that has
ended, as reported to the
Board.
Company that controls an insured Tier 1 capital of the top tier
depository institution and that is a entity within such
reporting banking entity (or a organization as of the last
subsidiary thereof other than a day of the most recent
reporting banking entity). calendar quarter that has
ended, as reported to the
Board.
Other banking entity (including an Shareholders' equity of the top-
industrial loan company holding tier entity within such
company, thrift holding company, or a organization as of the last
subsidiary thereof). day of the most recent
calendar quarter that has
ended, under applicable
accounting standards.
------------------------------------------------------------------------
Additionally, in the case of a depository institution that is itself a
reporting banking entity and is also a subsidiary or affiliate of a
reporting banking entity, the aggregate of all investments in all
covered funds held by the depository institution (including investments
by its subsidiaries) may not exceed 3 percent of either the tier 1
capital of the depository institution or of the top-tier reporting
banking entity that controls such depository institution.\281\
---------------------------------------------------------------------------
\281\ If the aggregate value of all investments in all covered
funds attributable to such a depository institution is less than 3
percent of its tier 1 capital, then that amount of capital which is
greater than the amount supporting the depository institution's
investments (or those held by its subsidiaries) in a covered fund,
but less than 3 percent of the depository institution's tier 1
capital, may be used to support an investment in a covered fund by
an affiliated banking entity that is not itself a depository
institution that holds and reports tier 1 capital or controlled,
directly or indirectly, by such a depository institution.
---------------------------------------------------------------------------
d. Deduction of an Investment in a Covered Fund From Tier 1 Capital
Section 12(d) of the proposed rule also implements the provision
contained in section 13(d)(4)(b)(iii) of the BHC Act regarding the
deduction of a banking entity's aggregate investment in a covered fund
held under section 13(d)(4) of that Act from the assets and tangible
equity of the banking entity. The statute also provides that the amount
of the deduction must increase commensurate with the leverage of the
underlying fund.\282\
---------------------------------------------------------------------------
\282\ See 12 U.S.C. 1851(d)(4)(B)(iii).
---------------------------------------------------------------------------
Section --.12(d) of the proposal requires a banking entity to
deduct the aggregate value of its investments in covered funds from
tier 1 capital. Since Sec. --.12 of the proposed rule implements the
authorities contained in section 13(d)(4) of the BHC Act related to an
investment in a fund organized and offered by the banking entity (or an
affiliate or subsidiary thereof), the deduction contained in Sec.
--.12(d) applies only to those ownership interests held as an
investment by a banking entity pursuant to Sec. --.12 of the proposed
rule.\283\ For instance, a banking entity that acquires or retains an
ownership interest in a covered fund as a permitted risk-mitigating
hedge under Sec. --.13(b) of the proposed rule, or that acquires or
retains an ownership interest in the course of collecting a debt
previously contracted in good faith, would not be required to deduct
the value of such ownership interest from its tier 1 capital.\284\ The
deduction required under Sec. --.12(d) of the proposed rule must be
calculated consistent with other like deductions under the applicable
risk-based capital rules.\285\
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\283\ See proposed rule Sec. --.12(d).
\284\ The Agencies note that since this deduction from capital
implements Section 13(d)(4)(B)(iii) of the BHC Act, it is being
included in this proposed rule which deals with Section 13 of the
BHC Act. However, the Agencies may relocate this deduction as part
of any later revised capital rules if, in the future, it is
determined that inclusion in such rules is more appropriate.
\285\ See 12 CFR part 208, Appendices A, E, and F (for a state
member bank); 12 CFR part 225, Appendices A, E, and G (for a bank
holding company); 12 CFR part 3, Appendices A, B, and C (for a
national bank); 12 CFR part 325, Appendices A, C, and D (for a state
nonmember bank); and 12 CFR part 167, Appendix C (for a federal
thrift).
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[[Page 68906]]
e. Extension of Time To Divest an Ownership Interest in a Single
Covered Fund
Section 13(d)(4)(C) of the BHC Act permits the Board, upon
application by a banking entity, to extend for up to 2 additional years
the period of time within which a banking entity must reduce its
attributable ownership interests in a covered fund to no more than 3
percent of such fund's total ownership interests.\286\ The statute
provides the possibility of an extension only with respect to the per-
fund limitation, and not to the aggregate funds limitation.\287\
Section --.12(e) of the proposed rule implements this provision of the
statute. In order to grant any extension, the Board must determine that
the extension would be consistent with safety and soundness and would
not be detrimental to the public interest.\288\
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\286\ 12 U.S.C. 1851(d)(4)(C).
\287\ See id.
\288\ As noted in Part III.C.2.a.ii of this Supplementary
Information, the Agencies recognize the potential for evasion of the
restrictions contained in section 13 of the BHC Act through
organizing and offering a covered fund pursuant to the authority
contained in Sec. --.11 of the proposed rule. Therefore, in
addition to taking action against a banking entity that does not
actively seek unaffiliated investors to reduce or dilute the
investment of the banking entity as provided under Sec. --.12(a)(2)
of the proposed rule, the Agencies expect that if a banking entity
is habitually or routinely seeking an extension of the one-year
period provided under Sec. --.12(a)(2)(i)(B), this could be
evidence of seeking to evade the restrictions contained in the
proposed rule and, as appropriate, the Agencies may take action
against such banking entity.
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Section --.12(e) of the proposed rule requires any banking entity
that seeks an extension of this conformance period to submit a written
request to the Board. Under the proposal, any such request must: (i) Be
submitted in writing to the Board at least 90 days prior to the
expiration of the applicable time period; (ii) provide the reasons why
the banking entity believes the extension should be granted; and (iii)
provide a detailed explanation of the banking entity's plan for
reducing or conforming its investment(s).
In addition, the proposed rule provides that any extension request
by a banking entity must address each of the following matters (to the
extent they are relevant): (i) Whether the investment would--(A)
involve or result in material conflicts of interest between the banking
entity and its clients, customers or counterparties; (B) result,
directly or indirectly, in a material exposure by the banking entity to
high-risk assets or high-risk trading strategies; (C) pose a threat to
the safety and soundness of the banking entity; or (D) pose a threat to
the financial stability of the United States; (ii) market conditions;
(iii) the contractual terms governing the banking entity's interest in
the covered fund; (iv) the date on which the covered fund is expected
to have attracted sufficient investments from investors unaffiliated
with the banking entity to enable the banking entity to comply with the
limitations in section 12(a)(2)(i)(B) of the proposed rule; (v) the
total exposure of the banking entity to the investment and the risks
that disposing of, or maintaining, the investment in the covered fund
may pose to the banking entity or the financial stability of the United
States; (vi) the cost to the banking entity of divesting or disposing
of the investment within the applicable period; (vii) whether the
divestiture or conformance of the investment would involve or result in
a material conflict of interest between the banking entity and
unaffiliated clients, customers or counterparties to which it owes a
duty; (viii) the banking entity's prior efforts to divest or sell
interests in the covered fund, including activities related to the
marketing of interests in such covered fund; and (ix) any other factor
that the Board believes appropriate.\289\ Under the proposed rule, the
Board would consider requests for an extension in light of all relevant
facts and circumstances, including the factors described above.
---------------------------------------------------------------------------
\289\ See proposed rule Sec. --.12(e)(1)(ii).
---------------------------------------------------------------------------
Section --.12(e) of the proposed rule also would allow the Board to
impose conditions on any extension granted under the proposed rule if
the Board determines conditions are necessary or appropriate to protect
the safety and soundness of banking entities or the financial stability
of the United States, address material conflicts of interest or other
unsound practices, or otherwise further the purposes of section 13 of
the BHC Act and the proposed rule.\290\ In cases where the banking
entity is primarily supervised by another Agency, the Board would
consult with such Agency both in connection with its review of the
application and, if applicable, prior to imposing conditions in
connection with the approval of any request by the banking entity for
an extension of the conformance period under the proposed rule.\291\
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\290\ Nothing in section 13 of the BHC Act or the proposed rule
limits or otherwise affects the authority that the Board, the other
Federal banking agencies, the SEC, or the CFTC may have under other
provisions of law. In the case of the Board, these authorities
include, but are not limited to, section 8 of the Federal Deposit
Insurance Act and section 8 of the BHC Act. See 12 U.S.C. 1818,
1847.
\291\ See proposed rule Sec. Sec. --.12(e)(iii) and (iv).
---------------------------------------------------------------------------
f. Request for Comment
The Agencies request comment on the proposed rule's approach to
implementing the exemption which allows a banking entity to make or
retain a permitted investment in a covered fund that it organizes and
offers. In particular, the Agencies request comment on the following
questions:
Question 256. Is the proposed rule's approach to implementing the
exemption that allows a banking entity to make or retain a permitted
investment in a covered fund effective? If not, what alternative
approach would be more effective and why?
Question 257. Should the approach include other elements? If so,
what elements and why? Should any of the proposed elements be revised
or eliminated? If so, why and how?
Question 258. Should the proposed rule specify at what point a
covered fund will be considered to have been ``established'' for
purposes of commencing the period in which a banking entity may own
more than 3 percent of the total outstanding ownership interests in
such fund? If so, why and how?
Question 259. Does the proposed rule effectively implement the
requirement that a banking entity comply with the limitations on an
investment in a single covered fund? If not, what alternative approach
would be more effective and why?
Question 260. Does the proposed rule effectively implement the
requirement that a banking entity comply with the limitations on the
aggregate of all investments in all covered funds? If not, what
alternative approach would be more effective and why?
Question 261. Is the proposed rule's approach to calculating a
banking entity's investment in a covered fund effective? Should the
per-fund calculation be based on committed capital, rather than
invested capital? Why or why not? Is the timing of the calculation of a
banking entity's ownership interest in a single covered fund
appropriate? If not, why not, and what alternative approach would be
more effective and why? For example, should the per-fund calculation be
required on a less-frequent basis (e.g., monthly) for funds that
compute their value and allow purchases and redemptions on a daily
basis (e.g., daily)? Why or why not?
[[Page 68907]]
Question 262. Is the proposed rule's approach to parallel
investments effective? Why or why not? Should this provision require a
contractual obligation and/or knowing participation? Why or why not?
How else could the proposed rule define parallel investments? What
characteristics would more closely achieve the scope and intended
purposes of section 13 of the BHC Act?
Question 263. Is the proposed rule's treatment of investments in a
covered fund by employees and directors of a banking entity effective?
If not, what alternative approach would be more effective and why?
Question 264. Is the proposed rule's approach to differentiating
between controlled and noncontrolled investments in a covered fund
unduly complex or burdensome? If so, what alternative approach, if any,
would be more effective and why?
Question 265. Is the proposed rule's approach to valuing an
investment in a covered fund according to the same standards utilized
by the covered fund for determining the aggregate value of its assets
and ownership interests effective? If not, what alternative valuation
approach would be more effective and why? Should the rule specify one
methodology for valuing an investment in a covered fund?
Question 266. Is the proposed rule's approach regarding when to
require the calculation of a banking entity's aggregate investments in
all covered funds effective? What is the potential impact of
calculating a banking entity's aggregate investment limit under the
proposed rule on a quarterly basis as opposed to solely at the time an
investment in a covered fund is made? Would calculation of the
aggregate investment limit solely at the time an investment in a
covered fund is made be consistent with the language and purpose of the
statute? Does the proposed rule provide sufficient guidance for an
issuer of asset-backed securities about how and when to make such
calculation? Why or why not?
Question 267. Is the proposed rule's approach to determining and
calculating a banking entity's relevant tier 1 capital limit effective?
If not, what alternative approach would be more effective and why? With
respect to applying the aggregate funds limitation to a banking entity
that is not affiliated with an entity that is required to hold and
report tier 1 capital, is total shareholder equity on a consolidated
basis as of the last day of the most recent calendar quarter that has
ended an effective proxy for tier 1 capital? If not, what alternative
approach would be more effective and why?
Question 268. Should the proposed rule be modified to permit a
banking entity to bring its investments in covered funds into
compliance with the proposed rule within a reasonable period of time
if, for example, the banking entity's aggregate permitted investments
in covered funds exceeds 3 percent of its tier 1 capital for reasons
unrelated to additional investments (e.g., a banking entity's tier 1
capital decreases)? Why or why not?
Question 269. Does the proposed rule effectively and appropriately
implement the deduction from capital for an investment in a covered
fund contained in section 13(d)(4)(B)(iii) of the BHC Act? If not, what
alternative approach would be more effective or appropriate, given the
statutory language of the BHC Act and overall structure of section
13(d)(4), and why? What effect, if any, should the Agencies give to the
cross-reference in section 13(d)(4) to section 13(d)(3) of the BHC Act,
which provides Agencies with discretion to require additional capital,
if appropriate, to protect the safety and soundness of banking entities
engaged in activities permitted under section 13 of the BHC Act? How,
if at all, should a banking entity's deduction of its investment in a
covered fund be increased commensurate with the leverage of the covered
fund? Should the amount of the deduction be proportionate to the
leverage of the covered fund? For example, instead of a dollar-for-
dollar deduction, should the deduction be set equal to the banking
entity's investment in the covered fund times the difference between 1
and the covered fund's equity-to-assets ratio?
Question 270. Does the proposed rule effectively implement the
Board's statutory authority to grant an extension of the period of time
a banking entity may retain in excess of 3 percent of the ownership
interests in a single covered fund? Are the enumerated factors that the
Board may consider in connection with reviewing such an extension
appropriate (including factors related to the effect of an extension of
the covered fund), and if not, why not? Are there additional factors
that the Board should consider in reviewing such a request? Are there
specific additional conditions or limitations that the Board should, by
rule, impose in connection with granting such an extension? If so, what
conditions or limitations would be more effective?
Question 271. Given that the statute does not provide for an
extension of time for a banking entity to comply with the aggregate
funds limitation, within what period of time should a banking entity be
required to bring its investments into conformance with the aggregate
funds limit? Should the proposed rule expressly contain a grace period
for complying with these limits? Why or why not? If yes, what grace
period would be most effective and why?
Question 272. Does the proposed rule effectively implement the
prohibition on a banking entity guaranteeing or insuring the
obligations or performance of certain covered funds? If not, what
alternative approach would be more effective and why?
Question 273. In the context of securitization transactions,
control and ownership are often completely separated. Is additional
guidance necessary with respect to how control should be determined
with respect to issuers of asset-backed securities for purposes of
determining the calculation of the per-fund and aggregate ownership
limitations?
Question 274. In many securitization transactions, the voting
rights of investors are extremely limited and management may be
contractually delegated to a third party (because issuers of asset-
backed securities rarely have a board with any authority or any
employees). The servicer or manager has the ``ability to control the
decision-making and operational functions of the fund.'' When
calculating the per-fund and aggregate ownership limitations, to whom
should the proposed rule allocate ``control'' in this type of
situation? Which participants in a securitization transaction would
need to include the activities of an issuer of asset-backed securities
in their calculations of per-fund and aggregate ownership, and what is
the potential impact of such inclusion?
Question 275. For purposes of calculating the per-fund and
aggregate ownership limitations, how should the proposed rule address
those instances in which equity is issued, but the equity holder does
not receive economic benefits or have any control rights? For instance,
in order to enhance or achieve bankruptcy remoteness, a single purpose
trust without an owner (i.e, an orphan trust) may hold all of the
equity interests in a securitization vehicle. Such interests often do
not have any meaningful economic or control rights.
4. Section --.13: Other Permitted Covered Fund Activities and
Investments
Section 13 of the proposed rule implements the statutory exemptions
described in sections 13(d)(1)(C), (E), and (I) of the BHC Act that
permit a
[[Page 68908]]
banking entity: (i) To acquire an ownership interest in, or act as
sponsor to, one or more SBICs, a public welfare investment, or a
certain qualified rehabilitation expenditure; \292\ (ii) to acquire or
retain an ownership interest in a covered fund as a risk-mitigating
hedging position; and (iii) in the case of a non-U.S. banking entity,
to acquire or retain an ownership interest in or sponsor a foreign
covered fund. Additionally, Sec. --.13 of the proposed rule implements
in part the rule of construction related to the sale and securitization
of loans contained in section 13(g)(2) of the BHC Act. Similar to Sec.
--.6 of the proposed rule (which implements certain permitted
proprietary trading activities), Sec. --.13 contains only the
statutory exemptions contained in section 13(d)(1) of the BHC Act that
the Agencies have determined apply, either by plain language or by
implication, to investments in or relationships with a covered
fund.\293\
---------------------------------------------------------------------------
\292\ Section --.13(a) of the proposed rule also implements a
proposed determination by the Agencies under section 13(d)(1)(J) of
the BHC Act that a banking entity may not only invest in such
entities as provided under section 13(d)(1)(E) of the BHC Act, but
also may sponsor an entity described in that paragraph and that such
activity, since it generally would facilitate investment in small
businesses and support the public welfare, would promote and protect
the safety and soundness of banking entities and the financial
stability of the United States.
\293\ In particular, Sec. --.13 of the proposed rule does not
include: (i) The exemption in section 13(d)(1)(A) of the BHC Act for
trading in certain permitted government obligations; (ii) the
exemption in section 13(d)(1)(H) of the BHC Act for certain foreign
proprietary trading activities; and (iii) the exemption contained in
section 13(d)(1)(B) of the BHC Act related to underwriting and
market-making related activities. Each of these exemptions appear
relevant only to covered trading activities and not to covered fund
activities.
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a. Permitted Investments in SBICs and Related Funds
Section --.13(a) of the proposed rule implements sections
13(d)(1)(E) and (J) of the BHC Act \294\ and permits a banking entity
to acquire or retain any ownership interest in, or act as sponsor to:
(i) One or more SBICs, as defined in section 102 of the Small Business
Investment Act of 1958 (12 U.S.C. Sec. 662); (ii) an investment that
is designed primarily to promote the public welfare, of the type
permitted under paragraph (11) of section 5136 of the Revised Statutes
of the United States (12 U.S.C. Sec. 24), including the welfare of
low- and moderate-income communities or families (such as providing
housing, services, or jobs); and (iii) an investment that is a
qualified rehabilitation expenditure with respect to a qualified
rehabilitation building or certified historic structure, as such terms
are defined in section 47 of the Internal Revenue Code of 1986 or a
similar State historic tax credit program.\295\ Since section
13(d)(1)(E) of the BHC Act does not limit a banking entity's investment
to a limited partnership or other non-controlling investment, Sec.
--.13(a) of the proposed rule would permit a banking entity to be a
shareholder, general partner, managing member, or trustee of an SBIC
without regard to whether the interest is a controlling or non-
controlling interest.\296\
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\294\ Section 13(d)(1)(E) of the BHC Act permits a banking
entity to make investments in one or more SBICs, investments
designed primarily to promote the public welfare, investments of the
type permitted under 12 U.S.C. 24(eleventh), and investments that
are qualified rehabilitation expenditures with respect to a
qualified rehabilitated building or certified historic structure.
See 12 U.S.C. 1851(d)(1)(E).
\295\ See proposed rule Sec. --.13(a).
\296\ Pursuant to the exemption contained in Sec. --.13(a) of
the proposed rule, a banking entity may acquire an ownership
interest in, or act as sponsor to, a low income housing credit fund,
if such fund qualifies as an SBIC, public welfare investment or
qualified rehabilitation expenditure.
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In addition to the acquisition or retention of an ownership
interest, permitting a banking entity to act as sponsor to these types
of public interest investments will provide valuable expertise and
services to these types of entities, as well as help enable banking
entities to provide valuable funding and assistance to small business
and low- and moderate-income communities. Therefore, the Agencies
believe this exemption would be consistent with the safe and sound
operation of banking entities, and would also promote the financial
stability of the United States.
The Agencies request comment on the proposed rule's approach to
implementing the exemption for permitted investments in and
relationships with SBICs and certain related funds. In particular, the
Agencies request comment on the following questions:
Question 276. Is the proposed rule's approach to implementing the
SBIC, public welfare and qualified rehabilitation investment exemption
for acquiring or retaining an ownership interest in a covered fund
effective? If not, what alternative approach would be more effective?
Question 277. Should the approach include other elements? If so,
what elements and why? Should any of the proposed elements be revised
or eliminated? If so, why and how?
Question 278. Should the proposed rule permit a banking entity to
sponsor an SBIC and other identified public interest investments? Why
or why not? Does the Agencies' determination under section 13(d)(1)(J)
of the BHC Act regarding sponsoring of an SBIC, public welfare or
qualified rehabilitation investment effectively promote and protect the
safety and soundness of banking entities and the financial stability of
the United States? If not, why not?
Question 279. What would the effect of the proposed rule be on a
banking entity's ability to sponsor and syndicate funds supported by
public welfare investments or low income housing tax credits which are
utilized to assist banks and other insured depository institutions with
meeting their Community Reinvestment Act (``CRA'') obligations?
Question 280. Does the proposed rule unduly constrain a banking
entity's ability to meet the convenience and needs of the community
through CRA or other public welfare investments or services? If so, why
and how could the proposed rule be revised to address this concern?
b. Permitted Risk-Mitigating Hedging Activities
Section --.13(b) of the proposed rule permits a banking entity to
acquire and retain an ownership interest in a covered fund if the
transaction is made in connection with, and related to, certain
individual or aggregated positions, contracts, or other holdings of the
banking entity and is designed to reduce the specific risks to the
banking entity in connection with and related to such positions,
contracts, or other holdings. This section of the proposed rule
implements, in relevant part, section 13(d)(1)(C) of the BHC Act, which
provides an exemption from the prohibition on acquiring or retaining an
ownership interest in a covered fund for certain risk-mitigating
hedging activities.\297\
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\297\ See 12 U.S.C. 1851(d)(1)(C).
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Interests by a banking entity in a covered fund may not typically
be used as hedges for specific positions, contracts, or other holdings
of a banking entity. However, two situations where a banking entity may
potentially acquire or retain an ownership interest in a covered fund
as a hedge are (i) when acting as intermediary on behalf of a customer
that is not itself a banking entity to facilitate the exposure by the
customer to the profits and losses of the covered fund (similar to
acting as a ``riskless principal''),\298\ and (ii) to cover
[[Page 68909]]
a compensation arrangement with an employee of the banking entity that
directly provides investment advisory or other services to that fund.
Section --.13(b) of the proposed rule provides an exemption for banking
entity to acquire or retain an ownership interest in a covered fund in
these limited situations.\299\
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\298\ In order to prevent evasion of the general limitation that
a banking entity may not acquire or retain more than 3 percent of
the ownership interests in any single covered fund that such banking
entity organizes and offers, the proposed rule limits a banking
entity's ability to acquire or retain an ownership interest in a
covered fund as a permitted risk-mitigating hedge to those
situations where the customer of the banking entity is not itself a
banking entity. See proposed rule Sec. --.13(b)(1)(i)(A).
\299\ See proposed rule Sec. --.13(b).
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i. Approach for Hedges Using an Ownership Interest in a Covered Fund
As noted above in the discussion of Sec. --.5 of the proposed
rule, risk-mitigating hedging activities present certain implementation
challenges because of the potential that prohibited activities or
investments could be conducted in the context of, or mischaracterized
as, hedging transactions. In light of these complexities, the Agencies
have proposed a multi-faceted approach to implementation, which is
discussed in detail above in reference to Sec. --.5 of the proposed
rule.\300\ As with the hedging exemption provided under Sec. --.5,
this multi-faceted approach is intended to clearly articulate the
Agencies' expectations regarding the scope of permitted hedging
activities under Sec. --.13(b) in a manner that limits potential abuse
of the hedging exemption while not unduly constraining the important
risk management function that is served by a banking entity's hedging
activities. However, because of the possibility that using an ownership
interest in a covered fund as a hedging instrument may mask an intent
to evade the limitations on the amount and value of ownership interests
in a covered fund or funds under Sec. --.12, the proposed rule
contains several additional requirements related to a banking entity's
ability to use an ownership interest in a covered fund as a hedging
instrument.
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\300\ See Supplementary Information, Part III.B.3.
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ii. Required Criteria for Permitted Risk-Mitigating Hedging Activities
Involving a Covered Fund
Section --.13(b) of the proposed rule describes the criteria that a
banking entity must meet in order to rely on the hedging exemption with
respect to ownership interests of a covered fund. The majority of these
requirements are substantially similar to those discussed in detail
above in connection with the risk-mitigating hedging exemption
contained in Sec. --.5 of the proposed rule, and include the
requirements that: (i) The hedge is made in connection with and related
to individual or aggregated obligations or liabilities of the banking
entity that are: (A) taken by the banking entity when acting as
intermediary on behalf of a customer that is not itself a banking
entity to facilitate the exposure by the customer to the profits and
losses of the covered fund, or (B) directly connected to a compensation
arrangement with an employee that directly provides investment advisory
or other services to the covered fund; (ii) the banking entity has
established the internal compliance program required by subpart D
designed to ensure the banking entity's compliance with the
requirements of this paragraph, including reasonably designed written
policies and procedures regarding the instruments, techniques and
strategies that may be used for hedging, internal controls and
monitoring procedures, and independent testing; (iii) the transaction
is designed to reduce the specific risks to the banking entity in
connection with and related to such obligations or liabilities; (iv)
the acquisition or retention of an ownership interest in a covered
fund: (A) Is made in accordance with the written policies, procedures
and internal controls established by the banking entity pursuant to
subpart D; (B) hedges or otherwise mitigates an exposure to a covered
fund through a substantially similar offsetting exposure to the same
covered fund and in the same amount of ownership interest in that
covered fund that arises out of a transaction conducted solely to
accommodate a specific customer request with respect to, or directly
connected to its compensation arrangement with an employee that
directly provides investment advisory or other services to, that
covered fund; (C) does not give rise, at the inception of the hedge, to
significant exposures that were not already present in individual or
aggregated positions, contracts, or other holdings of a banking entity
and are not hedged contemporaneously; and (D) is subject to continuing
review, monitoring and management by the banking entity that: (1) Is
consistent with its written hedging policies and procedures; (2)
maintains a substantially similar offsetting exposure to the same
amount and type of ownership interest, based upon the facts and
circumstances of the underlying and hedging positions and the risks and
liquidity of those positions, to the risk or risks the purchase or sale
is intended to hedge or otherwise mitigate; and (3) mitigates any
significant exposure arising out of the hedge after inception; and (v)
the compensation arrangements of persons performing the risk-mitigating
hedging activities are designed not to reward proprietary risk-
taking.\301\
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\301\ See proposed rule Sec. --.13(b).
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These requirements, while substantially similar to those contained
in Sec. --.5 above, are different in several material aspects. First,
Sec. --.13(b)(1)(i) of the proposed rule provides that any banking
entity relying on this exemption may only hedge or otherwise mitigate
one or more specific risks arising in connection with and related to
the two situations enumerated in that section. These are risks taken by
the banking entity when acting as intermediary on behalf of a customer
that is not itself a banking entity to facilitate the exposure by the
customer to the profits and losses of the covered fund, or directly
connected to its compensation arrangement with an employee that
directly provides investment advisory or other services to the covered
fund.\302\ Second, Sec. --.13(b)(2)(ii)(B) of the proposed rule
requires that the acquisition or retention of an ownership interest in
a covered fund hedge or otherwise mitigate a substantially similar
offsetting exposure to the same covered fund and in the same amount of
ownership interest in that covered fund, which requires greater
equivalency between the reference asset and hedging instrument than the
correlation required under Sec. --.5. Third, Sec. --.13(b)(3) of the
proposed rule imposes a documentation requirement on all types of
hedging transactions where the banking entity uses ownership interests
in a covered fund as the hedging instrument. This requirement is
broader than that contained in Sec. --.5 and is reflective of the
limited scope of positions or exposures for which a banking entity may
acquire or retain an ownership interest in a covered fund as a hedge.
Specifically, for any transaction that a banking entity acquires or
retains an ownership interest in a covered fund in reliance of the
hedging exemption, the banking entity must document the risk-mitigating
purposes of the transaction and identify the risks of the individual or
aggregated positions, contracts, or other holding of the banking entity
that the transaction is designed to reduce. Such documentation must be
established at the time the hedging transaction is effected, not after
the fact. This documentation requirement establishes a contemporaneous
record that will assist the Agencies in assessing
[[Page 68910]]
the actual reasons for which the position was established.
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\302\ See proposed rule Sec. --.13(b)(1)(i).
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iv. Request for Comment
In addition to those questions raised in connection with the
proposed implementation of the risk-mitigating hedging exemption under
Sec. --.5 of the proposed rule, the Agencies request comment on the
proposed implementation of that same exemption with respect to covered
fund activities. In particular, the Agencies request comment on the
following questions:
Question 281. Is the proposed rule's approach to implementing the
hedging exemption for acquiring or retaining an ownership interest in a
covered fund effective? If not, what alternative approach would be more
effective?
Question 282. Should the approach include other elements? If so,
what elements and why? Should any of the proposed elements be revised
or eliminated? If so, why and how?
Question 283. What burden will the proposed approach to
implementing the hedging exemption have on banking entities? How can
any burden be minimized or eliminated in a manner consistent with the
language and purpose of the statute?
Question 284. Are the criteria included in Sec. --.13(b)'s hedging
exemption effective? Is the application of each criterion to potential
transactions sufficiently clear? Should any of the criteria be changed
or eliminated? Should other requirements be added?
Question 285. Is the requirement that an ownership interest in a
covered fund may only be used as a hedge (i) by the banking entity when
acting as intermediary on behalf of a customer that is not itself a
banking entity to facilitate the exposure by the customer to the
profits and losses of the covered fund, or (ii) to cover compensation
arrangements with an employee of the banking entity that directly
provides investment advisory or other services to that fund effective?
If not, what other requirements would be more effective?
Question 286. Does the proposed rule sufficiently articulate the
types of risks and positions that a banking entity typically would
utilize an ownership interest in a covered fund to hedge? If not, how
should the proposal be changed?
Question 287. Is the requirement that that the hedging transaction
involve a substantially similar offsetting exposure to the same covered
fund and in the same amount of ownership interest to the risk or risks
the transaction is intended to hedge or otherwise mitigate effective?
If not, how should the requirement be changed? Should some other level
of correlation be required? Should the proposal specify in greater
detail how correlation should be measured? If not, how could it better
do so?
Question 288. Is the requirement that the transaction not give
rise, at the inception of the hedge, to material risks that are not
themselves hedged in a contemporaneous transaction effective? Is the
proposed materiality qualifier appropriate and sufficiently clear? If
not, what alternative would be effective and/or clearer?
Question 289. Is the requirement that any transaction conducted in
reliance on the hedging exemption be subject to continuing review,
monitoring and management after the transaction is established
effective? If not, what alternative would be more effective?
Question 290. Is the proposed documentation requirement effective?
If not, what alternative would be more effective? What burden would the
proposed documentation requirement place on covered banking entities?
How might such burden be reduced or eliminated in a manner consistent
with the language and purpose of the statute?
c. Permitted Covered Fund Activities and Investments Outside of the
United States
Section --.13(c) of the proposed rule, which implements section
13(d)(1)(I) of the BHC Act,\303\ permits certain foreign banking
entities to acquire or retain an ownership interest in, or to act as
sponsor to, a covered fund so long as such activity occurs solely
outside of the United States and the entity meets the requirements of
sections 4(c)(9) or 4(c)(13) of the BHC Act. The purpose of this
statutory exemption appears to be to limit the extraterritorial
application of the statutory restrictions on covered fund activities to
foreign firms that, in the course of operating outside of the United
States, engage outside the United States in activities permitted under
relevant foreign law, while preserving national treatment and
competitive equality among U.S. and foreign firms within the United
States.\304\ Consistent with this purpose, the proposed rule defines
both the type of foreign banking entities that are eligible for the
exemption and the circumstances in which covered fund activities or
investments by such an entity will be considered to have occurred
solely outside of the United States (including clarifying when an
ownership interest will be deemed to have been offered for sale or sold
to a resident of the United States).
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\303\ Section 13(d)(1)(I) of the BHC Act permits a banking
entity to acquire or retain an ownership interest in, or have
certain relationships with, a covered fund notwithstanding the
prohibition on proprietary trading and restrictions on investments
in, and relationships with, a covered fund, if: (i) such activity or
investment is conducted by a banking entity pursuant to paragraph
(9) or (13) of section 4(c) of the BHC Act; (ii) the activity occurs
solely outside of the United States; (iii) no ownership interest in
such fund is offered for sale or sold to a resident of the United
States; and (iv) the banking entity is not directly or indirectly
controlled by a banking entity that is organized under the laws of
the United States or of one or more States. See 12 U.S.C.
1851(d)(1)(I).
\304\ See 156 Cong. Rec. S5897 (daily ed. July 15, 2010)
(statement of Sen. Merkley).
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i. Foreign Banking Entities Eligible for the Exemption
Section --.13(c)(1)(i) of the proposed rule incorporates the
statutory requirement that the banking entity not be, directly or
indirectly, controlled by a banking entity that is organized under the
laws of the United States or of one or more States. Consistent with the
statutory language, banking entities organized under the laws of the
United States or of one or more States, or the subsidiaries or branches
thereof (wherever organized or licensed), may not rely on the
exemption. Similarly, the U.S. subsidiaries or U.S. branches of foreign
banking entities would not qualify for the exemption.
Section --.13(c)(2) clarifies when a banking entity would be
considered to have met the statutory requirement that the banking
entity conduct the activity pursuant to paragraphs 4(c)(9) or 4(c)(13)
of the BHC Act \305\ Section 4(c)(9) of the BHC Act generally provides
that the restrictions on nonbanking activities contained in section
4(a) of that statute do not apply to the ownership of shares held or
activities conducted by any company organized under the laws of a
foreign country the greater part of whose business is conducted outside
the United States, if the Board by regulation or order determines that,
under the circumstances and subject to the conditions set forth in the
regulation or order, the exemption would not be substantially at
variance with the purposes of this Act and would be in
[[Page 68911]]
the public interest.\306\ The Board has, in part, implemented section
4(c)(9) through subpart B of the Board's Regulation K, which specifies
a number of conditions and requirements that a foreign banking
organization must meet in order to use such authority. Such conditions
and requirements include, for example, a qualifying foreign banking
organization test that requires the foreign banking organization to
demonstrate that more than half of its worldwide business is banking
and that more than half of its banking business is outside the United
States.
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\305\ Section --.13(c)(2) of the proposed rule only addresses
when a transaction or activity will be considered to have been
conducted pursuant to section 4(c)(9) of the BHC Act; although the
statute also references section 4(c)(13) of the BHC Act, the Board
has applied the authority contained in that section only to include
certain foreign activities of U.S. banking organizations. The
express language of section 13(d)(1)(I) of the BHC Act limits its
availability to foreign banking entities that are not controlled by
a banking entity organized under the laws of the United States or of
one or more states. A foreign banking entity may not rely on the
exemptive authority of section 4(c)(13) and, so, that section is not
addressed in the proposed rule.
\306\ See 12 U.S.C. 1843(c)(9).
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The proposed rule makes clear that a banking entity will qualify
for the foreign fund exemption if the entity is a foreign banking
organization subject to subpart B of the Board's Regulation K and the
transaction occurs solely outside the United States. Section 13 of the
BHC Act also applies to foreign companies that are banking entities
covered by Section 13 but are not currently subject either to the BHC
Act generally or the Board's Regulation K, for example, because the
foreign company controls a savings association or an FDIC-insured
industrial loan company but not a bank or branch in the United States.
Accordingly, the proposed rule clarifies when such a foreign banking
entity would be considered to have conducted a transaction or activity
``pursuant to section 4(c)(9)'' for purposes of the exemption at Sec.
--.13(c) of the proposed rule.\307\ In particular, the proposed rule
proposes that to qualify for the foreign banking entity exemption, such
firms must meet at least two of three requirements that evaluate the
extent to which the foreign entity's business is conducted outside the
United States, as measured by assets, revenues, and income. This test
largely mirrors the qualifying foreign banking organization test that
is made applicable under section 4(c)(9) and Sec. 211.23(a) of the
Board's Regulation K, except that the relevant test under Sec.
--.13(c)(2)(ii) of the proposed rule does not require such a foreign
entity to demonstrate that more than half of its business is banking
conducted outside the United States.\308\
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\307\ The Board emphasizes that this clarification would be
applicable solely in the context of sections 13(d)(1)(H) and (I) of
the BHC Act. The application of section 4(c)(9) to such foreign
companies in other contexts is likely to involve different legal and
policy issues and may therefore merit different approaches.
\308\ See 12 U.S.C. 1843(c)(9); 12 CFR 211.23(a); proposed rule
Sec. --.13(c)(2). This difference reflects the fact that foreign
entities subject to section 13 of the BHC Act but not the BHC Act
are, in many cases, predominantly commercial firms. A requirement
that a firm also demonstrate that more than half of its banking
business is outside the United States would likely make the
exemption unavailable to many such firms and subject their global
activities to the prohibition on acquiring or retaining an ownership
interest in, or acting as sponsor to, a covered fund, a result that
the statute does not appear to have intended.
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ii. Transactions and Activities Solely Outside of the United States
Section --.13(c) of the proposed rule also clarifies when a
transaction or activity will be considered to have occurred solely
outside of the Unites States for purposes of the exemption. In
interpreting this aspect of the statutory language, the proposal
focuses on the extent to which material elements of the transaction
occur within, or are effected by personnel within, the United States.
This aspect of the proposal reflects the apparent intent of the foreign
funds exemption to avoid extraterritorial application of the
restrictions on covered funds activities and investments outside the
United States while preserving competitive parity within U.S. market.
The proposed rule does not evaluate solely whether the risk of the
transaction or activity, or management or decision-making with respect
to such transaction or activity, rests outside the United States.
Rather, the proposal also provides that foreign banking entities may
not structure a transaction or activity so as to be ``outside of the
United States'' for risk and booking purposes while simultaneously
engaging in transactions within U.S. markets that are prohibited for
U.S. banking entities.
In particular, Sec. --.13(c)(3) of the proposed rule provides that
a transaction or activity will be considered to have occurred solely
outside of the United States only if all of the following three
conditions are satisfied:
The transaction or activity is conducted by a banking
entity that is not organized under the laws of the United States or of
one or more States;
No subsidiary, affiliate, or employee of the banking
entity that is involved in the offer or sale of an ownership interest
in the covered fund is incorporated or physically located in the United
States; and
No ownership interest in such covered fund is offered for
sale or sold to a resident of the United States.
These three criteria reflect statutory constraints and are intended
to ensure that a transaction or activity conducted in reliance on the
exemption does not involve either investors that are residents of the
United States or a relevant U.S. employee of the banking entity, as
such involvement would appear to constitute a sufficient locus of
activity in the U.S. marketplace so as to preclude the availability of
the exemption.
A resident of the United States is defined in Sec. --.2(t) of the
proposed rule, and is described in detail in Part III.B.4.d of this
Supplementary Information. The proposed rule applies this definition in
the context of the foreign covered funds exemption because it would
appear to appropriately capture the scope of counterparties (including
investors that are residents of the United States) or relevant U.S.
personnel of the banking entity, that, if involved in the transaction
or activity, would preclude such transaction or activity from being
considered to have occurred solely outside the United States. Under the
proposed rule, an employee or entity engaged in the offer or sale of an
ownership interest (or booking such transaction) must be outside of the
United States; however, an employee or entity with no customer
relationship and involved solely in providing administrative services
or so-called ``back office'' functions to the fund as incident to the
activity permitted under Sec. --.13(c) of the proposed rule (such as
clearing and settlement or maintaining and preserving records of the
fund with respect to a transaction where no ownership interest is
offered for sale or sold to a resident of the United States) would not
be subject to this requirement.
iii. Request for Comment
The Agencies request comment on the proposed rule's approach to
implementing the foreign covered funds activity and investment
exemption. In particular, the Agencies request comment on the following
questions:
Question 291. Is the proposed rule's implementation of the
``foreign funds'' exemption effective? If not, what alternative would
be more effective and/or clearer?
Question 292. Are the proposed rule's provisions regarding when an
activity will be considered to be conducted pursuant to section 4(c)(9)
of the BHC Act effective and sufficiently clear? If not, what
alternative would be more effective and/or clearer? Does it effectively
address application of the foreign funds exemption to foreign banking
entities not subject to the BHC Act generally? If not, how could it
better address application of the exemption?
Question 293. Are the proposed rule's provisions regarding when a
transaction or activity will be considered to have occurred solely
outside the United States effective and sufficiently clear? If not,
what alternative would be more
[[Page 68912]]
effective and/or clearer? Should additional requirements be added? If
so, what requirements and why? Should additional requirements be
modified or removed? If so, what requirements and why or how?
Question 294. Is the proposed exemption consistent with the purpose
of the statute? Is the proposed exemption consistent with respect to
national treatment for foreign banking organizations? Is the proposed
exemption consistent with the concept of competitive equity?
Question 295. Does the proposed rule effectively define a resident
of the United States for these purposes? If not, how should the
definition be altered? What definitions of resident of the United
States are currently used by banking entities? Would using any one of
these definitions reduce the burden of complying with section 13 of the
BHC Act? Why or why not?
d. Sale and Securitization of Loans
Section --.13(d) of the proposed rule permits a banking entity to
acquire and retain an ownership interest in a covered fund that is an
issuer of asset-backed securities, the assets or holdings of which are
solely comprised of: (i) Loans; (ii) contractual rights or assets
directly arising from those loans supporting the asset-backed
securities; and (iii) interest rate or foreign exchange derivatives
that (A) materially relate to the terms of such loans or contractual
rights or assets and (B) are used for hedging purposes with respect to
the securitization structure.\309\ The authority contained in this
section of the proposed rule would therefore allow a banking entity to
engage in the sale and securitization of loans by acquiring and
retaining an ownership interest in certain securitization vehicles
(which could qualify as a covered fund for purposes of section 13(h)(2)
of the BHC Act and the proposed rule) that the banking entity organizes
and offers, or acts as sponsor to, in excess of and without being
subject to the limitations contained in Sec. --.12 of the proposed
rule. Proposed Sec. --.13(d) is designed to assist in implementing
section 13(g)(2) of the BHC Act, which provides that nothing in section
13 of the BHC Act shall be construed to limit or restrict the ability
of a banking entity or nonbank financial company supervised by the
Board to sell or securitize loans in a manner otherwise permitted by
law.\310\
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\309\ See proposed rule Sec. --.13(d). The types of derivatives
permitted under Sec. --.13(d)(3) of the proposed rule are not meant
to include a synthetic securitization or a securitization of
derivatives, but rather to include those derivatives that are used
to hedge foreign exchange or interest rate risk resulting from loans
held by the issuer of asset-backed securities.
\310\ See 12 U.S.C. 1851(g)(2).
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The Agencies note that the phrase ``materially relate to terms of
such loans'' is intended to quantitatively limit the derivatives
permitted in a ``securitization of loans'' under Sec. --.13(d) of the
proposed rule to include only those derivatives where the notional
amount of the derivative is tied to the outstanding principal balance
of the loans supporting the asset-backed securities of such issuer,
either individually or in the aggregate. Additionally, such derivatives
must be used solely to hedge risks that result from a mismatch between
the loans and the related asset-backed securities (e.g., fixed rate
loans with floating rate asset-backed securities, loans tied to the
Prime Rate with LIBOR asset-backed securities, or Euro-denominated
loans with Dollar-denominated asset-backed securities). Therefore,
Sec. --.13(d)(3) of the proposed rule would not allow the use of a
credit default swap by an issuer of asset-backed securities.
The Agencies request comment on the proposed rule's approach to
implementing the rule of construction related to the sale and
securitization of loans. In particular, the Agencies request comment on
the following questions:
Question 296. Is the proposed rule's implementation of the
statute's ``sale and securitization of loans'' rule of construction
effective? If not, what alternative would be more effective and/or
clearer?
Question 297. Are there other entities or activities that should be
included in the proposed rule's implementation of the rule of
construction related to the sale and securitization of loans? If so,
what entity or activity and why?
Question 298. Is the proposed rule's application of the rule of
construction contained in section 13(g)(2) of the BHC Act appropriate?
Question 299. Are the proposed rule and this Supplementary
Information sufficiently clear regarding which derivatives would be
allowed in a ``securitization of loans'' under Sec. --.13(d)(3) of the
proposed rule? Is additional guidance necessary with respect to the
types of derivatives that would be included in or excluded from a
securitization of loans for purposes of interpreting the rule of
construction contained in section 13(g)(2) of the BHC Act? If so, what
topics should the additional guidance discuss and why?
Question 300. Should derivatives other than interest rate or
foreign exchange derivatives be allowed in a ``securitization of
loans'' for purposes of interpreting the rule of construction contained
in section 13(g)(2) of the BHC Act? Why or why not? What would be the
legal and economic impact of not allowing the use of derivatives other
than interest rate or foreign exchange derivatives in a
``securitization of loans'' under Sec. --.13(d)(3) of the proposed
rule for existing issuers of asset-backed securities and for future
issuers of asset-backed securities?
Question 301. Should the Agencies consider providing additional
guidance for when a transaction with intermediate steps constitutes one
or more securitization transactions that each would be subject to the
rule? For example, both auto lease securitizations and asset-backed
commercial paper conduits typically involve intermediate
securitizations. The asset-backed securities issued to investors in
such covered funds are technically supported by the intermediate asset-
backed securities. Should these kinds of securitizations be viewed as a
single transaction and included within a securitization of loans for
purposes of the proposed rule? Should each step be viewed as a separate
securitization?
5. Section --.14: Covered Fund Activities and Investments Determined To
Be Permissible
Section --.14 of the proposed rule, which implements section
13(d)(1)(J) of the BHC Act,\311\ permits a banking entity to engage in
any covered funds activity that the Agencies determine promotes and
protects the safety and soundness of a banking entity and the financial
stability of the United States.\312\ Any activity authorized under
Sec. --.14 of the proposed rule must still comply with the prohibition
and limitations governing relationships with covered funds contained in
section 13(f) of the BHC Act, as implemented by Sec. --.16 of this
proposal.\313\ Additionally,
[[Page 68913]]
like other activities permissible under section 13(d)(1) of the BHC Act
and as implemented by subpart C of the proposed rule, activities found
permissible under Sec. --.14 of the proposed rule and section
13(d)(1)(J) remain subject to other provisions of section 13 of the BHC
Act, including the sections limiting conflicts of interest and high-
risk assets or trading strategies, as well as the section designed to
prevent evasion of section 13 of the BHC Act.\314\
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\311\ Section 13(d)(1)(J) of the BHC Act provides the Agencies
discretion to determine that other activities not specifically
identified by sections 13(d)(1)(A)-(I) of the BHC Act are exempted
from the general prohibitions contained in section 13(a) of that
Act, and are thus permitted activities. In order to make such a
determination, the Agencies must find that such activity or
activities promote and protect the safety and soundness of a banking
entity, as well as promote and protect the financial stability of
the United States. See 12 U.S.C. 1851(d)(1)(J).
\312\ See 12 U.S.C. 1851(d)(1)(J).
\313\ Section 13(d)(1)(J) of the BHC Act only provides the
Agencies with the ability to provide additional exemptions from the
prohibitions contained in section 13(a)(1) of the BHC Act. Section
13(f) of the BHC Act, which deals with relationships and
transactions with a fund that is, directly or indirectly, organized
and offered or sponsored by a banking entity, operates as an
independent prohibition and set of limitations on the activities of
banking entities. As such, Sec. --.14 of the proposed rule cannot
and does not provide any exemptions from the prohibition on
relationships or transaction with a covered fund contained in
section 13(f) of the BHC Act or Sec. --.16 of the proposed rule.
\314\ See 12 U.S.C. 1851(d)(2), (e)(1).
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The Agencies have proposed to permit three activities at this time
under this authority. These activities involve acquiring or retaining
an ownership interest in and sponsoring of (i) certain BOLI separate
accounts; (ii) certain entities that, although within the definition of
covered fund are, in fact, common corporate organizational vehicles;
and (iii) a covered fund in the ordinary course of collecting a debt
previously contracted in good faith or pursuant to and in compliance
with the conformance or extended transition period provided for under
the Board's rules issued under section 13(c)(6) of the BHC Act.
a. Investments in Certain Bank Owned Life Insurance Separate Accounts
Banking entities have for many years invested in life insurance
policies that cover key employees, in accordance with supervisory
policies established by the Federal banking agencies.\315\ These BOLI
investments are typically structured as investments in separate
accounts that are excluded from the definition of ``investment
company'' under the Investment Company Act by virtue of section 3(c)(1)
or 3(c)(7) of that Act. By virtue of reliance on these exclusions,
these BOLI accounts would be covered by the definition of ``hedge
fund'' or ``private equity fund'' in section 13 of the BHC Act.\316\
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\315\ See, e.g., Bank Owned Life Insurance, Interagency
Statement on the Purchase and Risk Management of Life Insurance
(``Interagency BOLI Guidance'') (Dec. 7, 2004).
\316\ See 12 U.S.C. 1851(h)(2).
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However, when made in the normal course, these investments do not
involve the speculative risks intended to be addressed by section 13 of
the BHC Act. Moreover, applying the prohibitions in section 13 to these
investments would eliminate an investment that helps banking entities
to reduce their costs of providing employee benefits as well as other
costs.
Section --.14(a)(1) of the proposed rule permits a banking entity
to acquire and retain these BOLI investments, as well as act as sponsor
to a BOLI separate account.\317\ The proposal includes a number of
conditions designed to ensure that BOLI investments are not conducted
in a manner that raises the concerns that section 13 of the BHC Act is
intended to address. In particular, in order for a banking entity to
invest in or sponsor a BOLI separate account, the banking entity that
purchases the insurance policy: (i) May not control the investment
decisions regarding the underlying assets or holdings of the separate
account; and (ii) must hold its ownership interests in the separate
account in compliance with applicable supervisory guidance provided by
the appropriate Federal regulatory agency regarding BOLI.\318\
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\317\ The proposed rule defines ``separate account'' as ``an
account established and maintained by an insurance company subject
to regulation by a State insurance regulatory or a foreign insurance
regulator under which income, gains, and losses, whether or not
realized, from assets allocated to such account, are, in accordance
with the applicable contract, credited to or charged against such
account without regard to other income, gains, or losses of the
insurance company.'' See proposed rule Sec. --.2(z).
\318\ See proposed rule Sec. --.14(a)(1)(i)-(ii). While other
guidance or requirements may be imposed by the Agencies or an
individual Agency for a specific banking entity for which it serves
as the primary financial regulator, the Agencies note that, at a
minimum, investments under authority of this section must comply
with the Interagency BOLI Guidance. This guidance requires, among
other things, that a banking entity generally: (i) Not control the
investment decisions regarding the underlying assets or holdings of
the separate account; (ii) demonstrate to the satisfaction of the
relevant Agency that the potential returns from the investments in
such separate account are appropriately matched to the banking
entity's employee compensation or benefit plan obligations; and
(iii) not use such separate account to take speculative positions or
to support the general operations of the banking entity.
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The Agencies have structured this exemption in the proposed rule so
as to allow a banking entity to continue to manage and structure its
risks and obligations related to its employee compensation or benefit
plan obligations in a manner that promotes and protects the safety and
soundness of banking entities, which on an industry-wide level has the
concomitant effect of promoting and protecting the financial stability
of the United States.
b. Investments in Certain Other Covered Funds
As noted above, the definition of ``covered fund'' as contained in
Sec. --.10(b)(1) of the proposed rule potentially includes within its
scope many entities and corporate structures that would not usually be
thought of as a ``hedge fund'' or ``private equity fund.''
Additionally, the Dodd-Frank Act contains other provisions that permit
or require a banking entity to acquire or retain an ownership interest
in or act as sponsor to a covered fund in a manner not specifically
described under section 13 of the BHC Act.
Section --.14(a)(2) of the proposed rule permits a banking entity
to own certain specified entities that are often part of corporate
structures and that, by themselves and without other extenuating
circumstances or factors, do not raise the type of concerns which
section 13 of the BHC Act was intended to address but which
nevertheless may be captured by the definition of ``hedge fund'' or
``private equity fund'' in section 13(h)(2) of the BHC Act.
Specifically, Sec. --.14(a)(2) of the proposed rule permits a banking
entity to acquire or retain an ownership interest in or act as sponsor
to (i) a joint venture between the banking entity and any other person,
provided that the joint venture is an operating company and does not
engage in any activity or any investment not permitted under the
proposed rule; (ii) an acquisition vehicle, provided that the sole
purpose and effect of such entity is to effectuate a transaction
involving the acquisition or merger of one entity with or into the
banking entity or one of its affiliates; and (iii) a wholly-owned
subsidiary of the banking entity that is (A) engaged principally in
providing bona fide liquidity management services described under Sec.
--.3(b)(2)(iii)(C) of the proposed rule, and (B) carried on the balance
sheet of the banking entity.\319\
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\319\ See proposed rule Sec. --.14(a)(2).
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The Agencies note that these types of entities may meet the
definition of covered fund contained in Sec. --.10(b)(1) of the
proposed rule (and as contained in section 13(h)(2) of the BHC Act), to
the extent these entities rely solely on section 3(c)(1) or 3(c)(7) of
the Investment Company Act. However, these types of entities do not
engage in the type and scope of activities to which Congress intended
section 13 of the BHC Act to apply.\320\ Additionally, without this
exemption, many entities would be forced to alter their corporate
structure without achieving any reduction in risk. Permitting such
investments in these entities would thus appear to promote and protect
the safety and soundness of banking entities and promote and protect
the financial stability of the United States.
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\320\ See 156 Cong. Rec. H5226 (daily ed. June 30, 2010)
(statement of Reps. Himes and Frank).
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[[Page 68914]]
Section --.14(a)(2) of the proposed rule also permits a banking
entity to comply with section 15G of the Exchange Act (15 U.S.C. 78o-
11), added by section 941 of the Dodd-Frank Act, which requires a
banking entity to maintain a certain minimum interest in certain
sponsored or originated asset-backed securities.\321\ In order to give
effect to this separate requirement under the Dodd-Frank Act, Sec.
--.14(a)(2)(iii) of the proposed rule permits a banking entity to
acquire or retain an ownership interest in or act as sponsor to an
issuer of asset-backed securities, but only with respect to that amount
or value of economic interest in a portion of the credit risk for an
asset-backed security that is retained by a banking entity that is a
``securitizer'' or ``originator'' in compliance with the minimum
requirements of section 15G of the Exchange Act (15 U.S.C. 78o-11) and
any implementing regulations issued thereunder.\322\ The Agencies have
structured this exemption to recognize that Congress imposed other
requirements on firms that are banking entities under section 13 of the
BHC Act. Additionally, permitting a banking entity to retain the
minimum level of economic interest will incent banking entities to
engage in more careful and prudent underwriting and evaluation of the
risks and obligations that may accompany asset-backed securitizations,
which would promote and protect the safety and soundness of banking
entities and the financial stability of the United States.
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\321\ The relevant agencies issued a proposed rule to implement
the requirements of section 15G of the Exchange Act, as required
under section 941 of the Dodd-Frank Act. See Credit Risk Retention,
76 FR 24090 (Apr. 29, 2011).
\322\ See proposed rule Sec. --.14(a)(2)(iii).
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Section 14(a)(2) of the proposed rule permits a banking entity to
acquire and retain an ownership interest in a covered fund that is an
issuer of asset-backed securities described in Sec. 13(d) of the
proposed rule, the assets or holdings of which are solely comprised of:
(i) Loans; (ii) contractual rights or assets directly arising from
those loans supporting the asset-backed securities; and (iii) interest
rate or foreign exchange derivatives that (A) materially relate to the
terms of such loans or contractual rights or assets and (B) are used
for hedging purposes with respect to the securitization structure. This
exemption augments the authority regarding the sale and securitization
of loans available under Sec. --.13(d) of the proposed rule (which
partially implements the rule of construction under section 13(g)(2) of
the BHC Act) and permits a banking entity to engage in the purchase,
and not only the sale and securitization, of loans through authorizing
the acquisition or retention of an ownership interest in such
securitization vehicles that the banking entity does not organize and
offer, or for which it does not act as sponsor, provided that the
assets or holdings of such vehicles are solely comprised of the
instruments or obligations referenced above.\323\
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\323\ See id. at Sec. --.14(a)(2)(v).
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Permitting banking entities to acquire or retain an ownership
interest in these loan securitizations will provide a deeper and richer
pool of potential participants and a more liquid market for the sale of
such securitizations, which in turn should result in increased
availability of funds to individuals and small businesses, as well as
provide greater efficiency and diversification of risk. The Agencies
believe this exemption would promote and protect the safety and
soundness of a banking entity, and would also promote and protect the
financial stability of the United States.\324\
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\324\ The Agencies note that proposed exemption applies only to
the covered fund-related provisions of the proposed rule, and not to
its prohibition on proprietary trading.
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c. Acquiring or Retaining an Ownership Interest in or Acting a Sponsor
to a Covered Fund Under Certain Specified Authorities
Section --.14(b) of the proposed rule permits a banking entity to
acquire or retain an ownership interest in or act as sponsor to a
covered fund in those instances where the ownership interest is
acquired or retained by a banking entity (i) in the ordinary course of
collecting a debt previously contracted in good faith, if the banking
entity divests the ownership interest within applicable time periods
provided for by the applicable Agency, or (ii) pursuant to and in
compliance with the Conformance or Extended Transition Period
authorities provided for under the proposed rule.\325\
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\325\ See proposed rule Sec. --.14(b). The Conformance or
Extended Transition period authorities are substantially similar to
those proposed by the Board in its February 2011 final rule
governing such conformance periods under section 13 of the BHC Act.
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Allowing banking entities to rely on these authorities for
acquiring or retaining an ownership interest in or acting as sponsor to
a covered fund will enable banking entities to manage their risks and
structure their business in a manner consistent with their chosen
corporate form and in a manner that otherwise complies with applicable
laws. Thus, permitting such activities would promote and protect the
safety and soundness of a banking entity, and would also promote and
protect the financial stability of the United States.
d. Request for Comment
The Agencies request comment on the proposed rule's approach to
implementing the exemption related to activities specifically
determined to be permissible under section 13(d)(1)(J) of the BHC Act.
In particular, the Agencies request comment on the following questions:
Question 302. Is the proposed rule's implementation of exemptions
for covered fund activities and investments pursuant to section
13(d)(1)(J) of the BHC Act effective? If not, what alternative would be
more effective and/or clearer?
Question 303. Is the proposed rule's approach to utilizing section
13(d)(1)(J) of the BHC Act to permit a banking entity to acquire or
retain an ownership interest in, or act as sponsor to, certain entities
that would fall into the definition of covered fund effective? Why or
why not? If not, what alternative would be more effective and why? What
legal authority under the statute would permit such an alternative?
Question 304. Are the proposed rule's provisions regarding when a
covered fund activity will be deemed to be permitted under authority of
section 13(d)(1)(J) of the BHC Act effective and sufficiently clear? If
not, what alternative would be more effective and/or clearer?
Question 305. Do the exemptions provided for in Sec. --.14 of the
proposed rule effectively promote and protect the safety and soundness
of banking entities and the financial stability of the United States?
If not, why not?
Question 306. Are the proposed rule's provisions regarding what
qualifications must be satisfied in order to qualify for an exemption
under Sec. --.14 of the proposed rule effective and sufficiently
clear? If not, what alternative would be more effective and/or clearer?
Should additional requirements be added? If so, what requirements and
why? Should additional requirements be modified or removed? If so, what
requirements and why or how?
Question 307. Does the proposed rule effectively cover the scope of
covered funds activities which the Agencies should specifically
determine to be permissible under section 13(d)(1)(J) of the BHC Act?
If not, what activity or activities should be permitted? For additional
activities that should be permitted, on what grounds would these
activities promote and protect the safety and soundness of banking
entities and the financial stability of the United States?
[[Page 68915]]
Question 308. Does the proposed rule effectively address the
interplay between the restrictions on covered fund activities and
investments in section 13 of the BHC Act and the requirements imposed
on certain banking entities under section 15G of the Exchange Act? Why
or why not?
Question 309. Rather than permitting the acquisition or retentions
of an ownership interest in, or acting as sponsor to, specific covered
funds under section 13(d)(1)(J) of the BHC Act, should the Agencies use
the authority provided under section 13(d)(1)(J) to permit investments
in a covered fund that display certain characteristics? If so, what
characteristics should the Agencies consider? How would investments
with such characteristics promote and protect the safety and soundness
of the banking entity and promote the financial stability of the United
States?
Question 310. Should venture capital funds be excluded from the
definition of ``covered fund''? Why or why not? If so, should the
definition contained in rule 203(l)-1 under the Advisers Act be used?
Should any modification to that definition of venture capital fund be
made? How would permitting a banking entity to invest in such a fund
meet the standards contained in section 13(d)(1)(J) of the BHC Act?
Question 311. Should non-U.S. funds or entities be included in the
definition of ``covered fund''? Should any non-U.S. funds or entities
be excluded from this definition? Why or why not? How would permitting
a banking entity to invest in such a fund meet the standards contained
in section 13(d)(1)(J) of the BHC Act?
Question 312. Should so-called ``loan funds'' that invest
principally in loans and not equity be excluded from the definition of
``covered fund''? Why or why not? What characteristics would be most
effective in determining whether a fund invests principally in loans
and not equity? How would permitting a banking entity to invest in such
a fund meet the standards contained in section 13(d)(1)(J) of the BHC
Act?
Question 313. Are the proposed rule's proposed determinations that
the specified covered funds activities or investments promote and
protect the safety and soundness of banking entities and the financial
stability of the United States appropriate? If not, how should the
determinations be amended or altered?
6. Section --.15: Internal Controls, Reporting and Recordkeeping
Requirements Applicable to Covered Fund Activities and Investments
Section --.15 of the proposed rule, which implements section
13(e)(1) of the BHC Act,\326\ requires a banking entity engaged in
covered fund activities and investments to comply with (i) the internal
controls, reporting, and recordkeeping requirements required under
Sec. --.20 and Appendix C of the proposed rule, as applicable and (ii)
such other reporting and recordkeeping requirements as the relevant
supervisory Agency may deem necessary to appropriately evaluate the
banking entity's compliance with this subpart C.\327\ These
requirements are discussed in detail in Part III.D of this
Supplementary information.
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\326\ Section 13(e)(1) of the BHC Act requires the Agencies to
issue regulations regarding internal controls and recordkeeping to
ensure compliance with section 13. See 12 U.S.C. 1851(e)(1).
\327\ See proposed rule Sec. --.15.
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7. Section --.16: Limitations on Relationships With a Covered Fund
Section 13(f) of the BHC Act generally prohibits a banking entity
from entering into certain transactions with a covered fund that would
be a covered transaction as defined in section 23A of the FR Act.\328\
Section --.16 of the proposed rule implements this provision. Section
--.16(a)(2) of the proposed rule clarifies that, for reasons explained
in detail below, certain transactions between a banking entity and a
covered fund remain permissible. Section --.16(b) of the proposed rule
implements the statute's requirement that any transaction permitted
under section 13(f) of the BHC Act (including a prime brokerage
transaction) between the banking entity and covered fund is subject to
section 23B of the FR Act,\329\ which, in general, requires that the
transaction be on market terms or on terms at least as favorable to the
banking entity as a comparable transaction by the banking entity with
an unaffiliated third party.
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\328\ 12 U.S.C. 371c.
\329\ 12 U.S.C. 371c-1.
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a. General Prohibition on Certain Transactions and Relationships
Section 13(f)(1) of the BHC Act generally prohibits a banking
entity that, directly or indirectly, serves as investment manager,
investment adviser, commodity trading adviser, or sponsor to a covered
fund (or that organizes and offers a covered fund pursuant to section
13(d)(1)(G) of the BHC Act) from engaging in any transaction with the
covered fund, or with any covered fund that is controlled by such fund,
if the transaction would be a ``covered transaction'' as defined in
section 23A of the FR Act, as if the banking entity and any affiliate
thereof were a member bank and the covered fund were an affiliate
thereof.\330\ Section --.16(a)(1) of the proposed rule includes this
prohibition.
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\330\ As noted above, the proposed rule implements the
definition of ``banking entity'' in a manner that does not include
covered funds for which a banking entity acts as sponsor or
organizes and offers pursuant to section 13(d)(1)(G) of the BHC Act,
or any covered fund in which such related covered fund invests.
Accordingly, these covered funds (and any covered fund in which such
covered fund acquired or retains a controlling investment) are not
generally subject to the prohibitions contained in Sec. --.16 of
the proposed rule.
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Consistent with the requirements of section 13(f)(1) of the BHC
Act, Sec. --.16(a)(1) of the proposed rule is more restrictive than
section 23A of the FR Act because Sec. --.16(a)(1) generally prohibits
a banking entity and any of its affiliates from entering into any such
transaction, while section 23A permits covered transactions with
affiliates so long as the transactions meet specified quantitative and
qualitative requirements.\331\
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\331\ Section 23A of the FR Act limits the aggregate amount of
covered transactions by a member bank to no more than (i) 10 per
centum of the capital stock and surplus of the member bank in the
case of any affiliate, and (ii) 20 per centum of the capital stock
and surplus of the member bank in the case of all affiliates. See 12
U.S.C. 371c(a). Conversely, section 13(f) of the BHC Act operates as
a general prohibition on such transactions without providing any
similar amount of permitted transactions.
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b. Transactions That Would Be a ``Covered Transaction''
Section 13(f) of the BHC Act applies to covered transactions as
defined in section 23A of the FR Act without incorporating any of the
provisions in section 23A that provide exemptions from the prohibitions
in that section for certain types of covered transactions.\332\
[[Page 68916]]
Section --.16 of the proposed rule adopts the same language as the
statute. The definition of ``covered transaction'' contained in section
23A of the FR Act itself includes an explicit exemption from the
definition of ``covered transaction'' for ``such purchase of real and
personal property as may be specifically exempted by the Board by order
or regulation.'' \333\ Since these transactions are, by definition,
excluded from the definition of ``covered transaction,'' any
transaction that is specifically exempted by the Board pursuant to this
specific authority would not be deemed to be a covered transaction as
defined in section 23A of the FR Act.
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\332\ The term ``covered transaction'' is defined in section 23A
of the FR Act to mean, with respect to an affiliate of a member
bank: (i) A loan or extension of credit to the affiliate, including
a purchase of assets subject to an agreement to repurchase; (ii) a
purchase of or an investment in securities issued by the affiliate;
(iii) a purchase of assets from the affiliate, except such purchase
of real and personal property as may be specifically exempted by the
Board by order or regulation; (iv) the acceptance of securities or
other debt obligations issued by the affiliate as collateral
security for a loan or extension of credit to any person or company;
(v) the issuance of a guarantee, acceptance, or letter of credit,
including an endorsement or standby letter of credit, on behalf of
an affiliate; (vi) a transaction with an affiliate that involves the
borrowing or lending of securities, to the extent that the
transaction causes a member bank or subsidiary to have credit
exposure to the affiliate; or (vii) a derivative transaction, as
defined in paragraph (3) of section 5200(b) of the Revised Statutes
of the United States (12 U.S.C. 84(b)), with an affiliate, to the
extent that the transaction causes a member bank or a subsidiary to
have credit exposure to the affiliate. See 12 U.S.C. 371c(b)(7), as
amended by section 608 of the Dodd-Frank Act.
\333\ Id. at 371c(b)(7)(C).
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c. Certain Transactions and Relationships Permitted
While section 13(f)(1) of the BHC Act operates as a general
prohibition on a banking entity's ability to enter into a transaction
with a related covered fund that would be a covered transaction as
defined under section 23A of the FR Act, other specific portions of the
statute expressly provide for, or make reference to, a banking entity's
ability to engage in certain transactions or relationships with such
funds.\334\ Section --.16(a)(2) of the proposed rule implements and
clarifies these authorities.
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\334\ See, e.g., 12 U.S.C. 1851(d)(1)(G), (d)(4), and (f)(3).
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i. Permitted Investments and Ownerships Interests
Section--.16(a)(2) of the proposed rule clarifies that a banking
entity may acquire or retain an ownership interest in a covered fund in
accordance with the requirements of subpart C of the proposed
rule.\335\ This clarification is proposed in order to remove any
ambiguity regarding whether the section prohibits a banking entity from
acquiring or retaining an interest in securities issued by a related
covered fund in accordance with the other provisions of the rule, since
the purchase of securities of a related covered fund would be a covered
transaction as defined by section 23A of the FR Act. There is no
evidence that Congress intended section 13(f)(1) of the BHC Act to
override the other provisions of section 13 with regard to the
acquisition or retention of ownership interests specifically permitted
by the section. Moreover, a contrary reading would make these more
specific sections that permit covered transactions between a banking
entity and a covered fund mere surplusage.
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\335\ See proposed rule Sec. --.16(a)(2)(i).
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ii. Prime Brokerage Transactions Also Permitted
Section --.16(a)(2)(ii) of the proposed rule implements section
13(f)(3)(A) of the BHC Act, which provides that a banking entity may
enter into any prime brokerage transaction with a covered fund in which
a covered fund managed, sponsored, or advised by such banking entity
has taken an ownership interest, so long as certain enumerated
conditions are satisfied.\336\ The proposed rule defines ``prime
brokerage transaction'' to mean one or more products or services
provided by the banking entity to a covered fund, such as custody,
clearance, securities borrowing or lending services, trade execution,
or financing, and data, operational, and portfolio management
support.\337\ To engage in a prime brokerage transaction with a covered
fund pursuant to Sec. --.16(a)(2)(ii) of the proposed rule, a banking
entity must be in compliance with the limitations set forth in Sec.
--.11 of the proposed rule with respect to a covered fund organized and
offered by such banking entity. In addition, as required by statute,
the chief executive officer (or equivalent officer) of the banking
entity must 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 such covered fund invests. Finally, the Board must not have
determined that such transaction is inconsistent with the safe and
sound operation and condition of the banking entity.
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\336\ See proposed rule Sec. --.16(a)(2)(ii).
\337\ See proposed rule Sec. --.10(b)(4).
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d. Restrictions on Transactions With Any Permitted Covered Fund
Section --.16(b) of the proposed rule implements sections 13(f)(2)
and 13(f)(3)(B) of the BHC Act and applies section 23B of the FR Act
\338\ to certain transactions and investments between a banking entity
and a covered fund as if such banking entity were a member bank and
such covered fund were an affiliate thereof.\339\ Section 23B provides
that transactions between a member bank and an affiliate must be on
terms and under circumstances, including credit standards, that are
substantially the same or at least as favorable to such banking entity
as those prevailing at the time for comparable transactions with or
involving other unaffiliated companies or, in the absence of comparable
transactions, on terms and under circumstances, including credit
standards, that in good faith would be offered to, or would apply to,
nonaffiliated companies.\340\
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\338\ 12 U.S.C. 371c-1.
\339\ See proposed rule Sec. --.16(b).
\340\ 12 U.S.C. 371c-1(a); 12 CFR 223.51.
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Section --.16(b) applies this requirement to transactions between a
banking entity that serves as investment manager, investment adviser,
commodity trading adviser, or sponsor to a covered fund and that fund
and any other fund controlled by that fund. It also applies this
condition to a permissible prime brokerage transaction in which a
banking entity may engage pursuant to Sec. --.16(a)(2)(ii) of the
proposed rule.\341\
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\341\ See 12 U.S.C. 1851(f)(2), (f)(3)(B); proposed rule Sec.
--.16(b).
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e. Request for Comment
The Agencies request comment on the proposed rule's approach to
implementing the limitations on certain relationships with covered
funds and, in particular, the manner in which the Agencies have
proposed to apply a banking entity's ability to make explicitly
permitted investments for these purposes, as described above. In
particular, the Agencies request comment on the following questions:
Question 314. Is the proposed rule's approach to implementing the
limitations on certain transactions with a covered fund effective? If
not, what alternative approach would be more effective and why?
Question 315. Should the approach include other elements? If so,
what elements and why? Should any of the proposed elements be revised
or eliminated? If so, why and how?
Question 316. What types of transactions or relationships that
currently exist between banking entities and a covered fund (or another
covered fund in which such covered fund makes a controlling investment)
would be prohibited under the proposed rule? What would be the effect
of the proposed rule on banking entities' ability to continue to meet
the needs and demands of their clients? Are there other transactions
between a banking entity and such covered funds that are not already
covered but that should be prohibited or limited under the proposed
rule?
Question 317. Should the Agencies provide a different definition of
``prime
[[Page 68917]]
brokerage transaction'' under the proposed rule? If so, what definition
would be appropriate? Are there any transactions that should be
included in the definition of ``prime brokerage transaction''? Are
there transactions or practices provided by banking entities that
should be excluded in order to mitigate the burdens of complying with
section 13 of the BHC Act?
Question 318. With respect to the CEO (or equivalent officer)
certification required under section 13(f)(3)(A)(ii) of the BHC Act and
Sec. --.16(a)(2)(ii)(B) of the proposed rule, what would be the most
useful, efficient method of certification (e.g., a new stand-alone
certification, a certification incorporated into an existing form or
filing, Web site certification, or certification filed directly with
the relevant Agency)?
8. Section --.17: Other Limitations on Permitted Covered Funds
Activities
Section --.17 of the proposed rule implements section 13(d)(2) of
the BHC Act, which places certain limitations on the permitted covered
fund activities and investments in which a banking entity may engage.
Consistent with the statute and Sec. --.8 of the proposed rule, Sec.
--.17 provides that no transaction, class of transactions, or activity
is permissible under Sec. Sec. --.11 through --.16 of the proposed
rule if the transaction, class of transactions, or activity would:
Involve or result in a material conflict of interest
between the banking entity and its clients, customers, or
counterparties;
Result, directly or indirectly, in a material exposure by
the banking entity to a high-risk asset or a high-risk trading
strategy; or
Pose a threat to the safety and soundness of the banking
entity or the financial stability of the United States.
Section --.17 of the proposed rule further defines ``material conflict
of interest,'' ``high-risk assets,'' and ``high-risk trading
strategies'' for these purposes, which are identical to the definitions
of the same terms for purposes of Sec. --.8 of the proposed rule
related to proprietary trading, and are described in detail in Part
III.B.6 of this Supplementary Information.\342\
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\342\ As noted in the discussion of the definition of ``material
conflict of interest in Part III.B.6 of this Supplementary
Information, the proposed disclosure provisions of that definition
are provided solely for purposes of the proposed rule's definition
of material conflict of interest, and do not affect a banking
entity's obligation to comply with additional or different
disclosure or other requirements with respect to a conflict under
applicable securities, banking, or other laws (e.g., section 27B of
the Securities Act, which governs conflicts of interest relating to
certain securitizations; section 206 of the Investment Advisers Act
of 1940, which applies to conflicts of interest between investment
advisers and their clients; or 12 CFR 9.12, which applies to
conflicts of interest in the context of a national bank's fiduciary
activities).
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The Agencies request comment on the proposed limitations on
permitted covered fund activities and investments, including with
respect to the questions in Part III.B.6 of the Supplemental
Information as they pertain to covered fund activities and investments
in particular.
D. Subpart D (Compliance Program Requirement) and Appendix C (Minimum
Standards for Programmatic Compliance)
Subpart D of the proposed rule, which implements section 13(e)(1)
of the BHC Act,\343\ requires certain banking entities to develop and
provide for the continued administration of a program reasonably
designed to ensure and monitor compliance with the prohibitions and
restrictions on covered trading activities and covered fund activities
and investments set forth in section 13 of the BHC Act and the proposed
rule.\344\ This compliance program requirement forms a key part of the
proposal's multi-faceted approach to implementing section 13 of the BHC
Act, and is intended to ensure that banking entities establish,
maintain and enforce compliance procedures and controls to prevent
violation or evasion of the prohibitions and restrictions on covered
trading activities and covered fund activities and investments.
---------------------------------------------------------------------------
\343\ See 12 U.S.C. 1851(e)(1).
\344\ See proposed rule Sec. --.20.
---------------------------------------------------------------------------
1. Section --.20: Compliance Program Mandate
The proposed rule adopts a tiered approach to implementing the
compliance program mandate, requiring a banking entity engaged in
covered trading activities or covered fund activities and investments
to establish a compliance program that contains specific elements and,
if the banking entity's activities are significant, meet a number of
minimum standards. If a banking entity does not engage in covered
trading activities and covered fund activities and investments, it must
ensure that its existing compliance policies and procedures include
measures that are designed to prevent the banking entity from becoming
engaged in such activities and making such investments and must develop
and provide for the required compliance program under proposed Sec.
--.20(a) of the proposed rule prior to engaging in such activities or
making such investments, but is not otherwise required to meet the
requirements of subpart D of the proposed rule.\345\
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\345\ See proposed rule Sec. --.20(d).
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Section --.20(a) of the proposed rule contains the core requirement
that each banking entity engaged in covered trading activities or
covered fund activities and investments must establish, maintain and
enforce a program reasonably designed to ensure and monitor compliance
with the prohibitions and restrictions on proprietary trading
activities and covered fund activities and investments set forth in
section 13 of the BHC Act and the proposed rule and that such program
must be suitable for the size, scope, and complexity of activities and
business structure of the banking entity. Section --.20(b) of the
proposed rule specifies the following six elements that each compliance
program established under subpart D must provide for, at a minimum:
Internal written policies and procedures reasonably
designed to document, describe, and monitor the covered trading
activities and covered fund activities and investments of the banking
entity to ensure that such activities and investments comply with
section 13 of the BHC Act and the proposed rule;
A system of internal controls reasonably designed to
monitor and identify potential areas of noncompliance with section 13
of the BHC Act and the proposed rule in the banking entity's covered
trading activities and covered fund activities and investments and to
prevent the occurrence of activities that are prohibited by section 13
of the BHC Act and the proposed rule;
A management framework that clearly delineates
responsibility and accountability for compliance with section 13 of the
BHC Act and the proposed rule;
Independent testing for the effectiveness of the
compliance program, conducted by qualified banking entity personnel or
a qualified outside party;
Training for trading personnel and managers, as well as
other appropriate personnel, to effectively implement and enforce the
compliance program; and
Making and keeping records sufficient to demonstrate
compliance with section 13 of the BHC Act and the proposed rule, which
a banking entity must promptly provide to the relevant supervisory
Agency upon request and retain for a period of no less than 5 years.
[[Page 68918]]
In addition, for a banking entity with significant covered trading
activities or covered fund activities and investments, Sec. --.20(c)
requires the compliance program established under subpart D to meet a
number of minimum standards, which are specified in Appendix C of the
proposed rule. In particular, a banking entity must comply with the
minimum standards specified in Appendix C of the proposed rule if:
With respect to its covered trading activities, it engages
in any covered trading activities and has, together with its affiliates
and subsidiaries, trading assets and liabilities the average gross sum
of which (on a worldwide consolidated basis), as measured as of the
last day of each of the four prior calendar quarters, (i) is equal to
or greater than $1 billion or (ii) equals 10 percent or more of its
total assets; and
With respect to its covered fund activities and
investments, it engages in any covered fund activities and investments
and either (i) has, together with its affiliates and subsidiaries,
aggregate investments in one or more covered funds the average value of
which is, as measured as of the last day of each of the four prior
calendar quarters, equal to or greater than $1 billion or (ii) sponsors
or advises, together with its affiliates and subsidiaries, one or more
covered funds the average total assets of which are, as measured as of
the last day of each of the four prior calendar quarters, equal to or
greater than $1 billion.
The application of detailed minimum standards to these types of
banking entities is intended to reflect the heightened compliance risks
of large covered trading and large covered fund activities and
investments and provide guidance to such banking entities regarding the
minimum compliance measures that would be required under the proposed
rule.
If a banking entity does not meet the thresholds specified in Sec.
--.20(c)(2), it need not comply with each of the minimum standards
specified in Appendix C. However, the proposed rule would require such
a banking entity to establish a compliance program that effectively
implements the six elements specified in Sec. --.20(b). Banking
entities engaged in a relatively small amount of covered fund
activities are encouraged to look to the minimum standards of Appendix
C for guidance. Generally, the Agencies would expect that the closer a
banking entity is to the thresholds specified in Sec. --.20(c)(2), the
more its compliance program should generally include the specific
requirements described in Appendix C. Within the bounds of subpart D
and Appendix C, a banking entity has discretion to structure and manage
its program for compliance with section 13 of the BHC Act and the
proposed rule in a manner that best reflects the unique organization
and operation of the banking entity and its affiliates and
subsidiaries, and is suitable taking account of the size, scope, and
complexity of activities in which the banking entity and its affiliates
and subsidiaries engage.
As described above, Sec. --.20(d) of the proposed rule clarifies
that, if a banking entity does not engage in covered trading activities
and/or covered fund activities or investments, it will have satisfied
the requirements of this section if its existing compliance policies
and procedures include measures that are designed to prevent the
banking entity from becoming engaged in such activities or making such
investments and which require the banking entity to develop and provide
for the compliance program required under paragraph (a) of this section
prior to engaging in such activities or making such investments.
2. Appendix C--Minimum Standards for Programmatic Compliance
Appendix C of the proposed rule specifies a variety of minimum
standards applicable to the compliance program of a banking entity with
significant covered trading activities or covered fund activities and
investments.\346\ Section I.A of proposed Appendix C sets forth the
purpose of the required compliance program, which is to ensure that
each banking entity establishes, maintains, and enforces an effective
compliance program, consisting of written policies and procedures,
internal controls, a management framework, independent testing,
training, and recordkeeping, that:
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\346\ The Agencies have proposed to include these minimum
standards as part of the regulation itself, rather than as
accompanying guidance, reflecting the compliance program's
importance within the general implementation framework.
---------------------------------------------------------------------------
Is designed to clearly document, describe, and monitor the
covered trading activities and covered fund activities or investments
and the risks of the banking entity related to such activities or
investments, identify potential areas of noncompliance, and prevent
activities or investments prohibited by, or that do not comply with,
section 13 of the BHC Act and the proposed rule;
Specifically addresses the varying nature of activities or
investments conducted by different units of the banking entity's
organization, including the size, scope, complexity, and risks of the
individual activity or investment;
Subjects the effectiveness of the compliance program to
independent review and testing;
Makes senior management and intermediate managers
accountable for the effective implementation of the compliance program,
and ensures that the board of directors or chief executive officer
(``CEO'') review the effectiveness of the compliance program; and
Facilitate supervision of the banking entity's covered
trading activities and covered fund activities or investments by the
Agencies.
A banking entity's compliance program should not be developed
through a generic, one-size-fits-all approach, but rather should
carefully take into account and reflect the unique manner in which a
banking entity operates, as well as the particular compliance risks and
challenges that its businesses present. In light of the complexities
presented in differentiating prohibited proprietary trading from
permitted market making-related activities in particular, the Agencies
expect that such a dynamic, carefully-tailored approach to internal
compliance will play an important role in ensuring that banking
entities comply with section 13's prohibitions and restrictions. In
addition, although this statement of purpose appears within the text of
proposed Appendix C, the Agencies note the statement equally describes
the general purpose of any compliance program required under subpart D
of the proposed rule, regardless of whether proposed Appendix C
specifically applies.
Section I.B of proposed Appendix C provides for several definitions
used throughout the appendix, including the definition of ``trading
unit'' and ``asset management unit'' to which the minimum standards
apply. The term ``trading unit'' is defined in the same way as in
Appendix A, as described in Part II.B.5 of the Supplementary
Information, and is intended to identify multiple layers of a banking
entity's organizational structure because any effective compliance
program will need to manage, limit and monitor covered trading activity
at each such level of organization in order to effectively support
compliance with the prohibition on proprietary trading. The term
``asset management unit'' is defined as any unit of organization of a
banking entity that makes an investment in, acts as sponsor to, or has
relationships with, a covered fund that the banking entity sponsors,
organizes and offers, or in which a covered fund
[[Page 68919]]
sponsored or advised by a banking entity invests.
Section I.C of proposed Appendix C incorporates by reference the
six elements that must be included in the compliance program under
Sec. --.20 of the proposed rule, and section I.D describes the
structure of a compliance program meeting the minimum standards. In
particular, section I.D permits a banking entity to establish a
compliance program on an enterprise-wide basis to satisfy the
requirements of Sec. --.20 of the proposed rule and the appendix,
which program could cover the banking entity and all of its affiliates
and subsidiaries collectively. In order to do so, the program must (i)
be clearly applicable, both by its terms and in operation, to all such
affiliates and subsidiaries, (ii) specifically address the requirements
set forth in proposed Appendix C, (iii) take into account and address
the consolidated organization's business structure, size, and
complexity, as well as the particular activities, risks, and applicable
legal requirements of each subsidiary and affiliate, and (iv) be
determined through periodic independent testing to be effective for the
banking entity and its affiliates and subsidiaries. In addition, the
enterprise-wide program would be subject to supervisory review and
examination by any Agency vested with rulewriting authority under
section 13 of the BHC Act with respect to the compliance program and
the activities of any banking entity for which the Agency has such
authority. Further, such Agency would have access to all records
related to the enterprise-wide compliance program pertaining to any
banking entity that is supervised by the Agency vested with such
rulewriting authority.
a. Internal Policies and Procedures
Section II of proposed Appendix C articulates minimum standards for
the first element of the compliance program, internal policies and
procedures, for both covered trading activities and covered fund
activities and investments. With respect to covered trading activities,
the proposal would require that internal policies and procedures: (i)
Specify how the banking entity identifies its trading accounts; (ii)
identify the trading activity in which the banking entity is engaged
and how that activity is organized; (iii) thoroughly articulate the
mission, strategy, risks, and compliance controls for each trading
unit; (iv) include for each trader a mandate that describes the scope
of his or her trading activity; (v) clearly articulate and document a
comprehensive description of the risks associated with the trading
unit's activities; (vi) document a comprehensive explanation of how the
mission and strategy of the trading unit, and its related risk levels,
comply with the proposed rule; and (vii) require the banking entity to
promptly address and remedy any violation of section 13 of the BHC Act
and the proposed rule. These internal policies and procedures would
require banking entities to have the data and standards to prevent
prohibited proprietary trading and to identify abnormalities and
discrepancies that may be indicative of prohibited proprietary trading.
The internal policies and procedures should also provide the Agencies
with a clear, comprehensive picture of a banking entity's covered
trading activities that can be effectively reviewed. With respect to
covered fund activities and investments, the proposal would require
that internal policies and procedures describe all covered fund
activities in which the banking entity engages and the procedures used
by the banking entity to ensure that it complies with the restrictions
of section 13 of the BHC Act and the proposed rule.
The Agencies expect that these internal policies and procedures
will be regularly reviewed and updated to reflect changes in business
practices, strategies, or laws and regulations, though frequent,
unexplained changes to policies and procedures or other aspects of the
compliance program--particularly changes to reduce their stringency--
would warrant additional scrutiny from banking entity management,
independent testing personnel, and Agency supervisors or examiners.
b. Internal Controls
Section III of proposed Appendix C articulates minimum standards
for the second element of the compliance program, internal controls.
With respect to covered trading activities, the proposal would require
internal controls that: (i) Are reasonably designed to ensure that the
covered trading activity is conducted in conformance with a trading
unit's authorized risks, instruments and products, as documented in the
banking entity's written policies and procedures; (ii) establish and
enforce risk limits for each trading unit; and (iii) perform robust
analysis and quantitative measurement of covered trading activity for
conformance with section 13 of the BHC Act and the proposed rule. In
particular, the banking entity must perform analysis and quantitative
measurement that is reasonably designed to: (i) Ensure that the
activity of each trading unit is appropriate to the mission, strategy,
and risk of each trading unit, as documented in the banking entity's
internal written policies and procedures; (ii) monitor and assist in
the identification of potential and actual prohibited trading activity;
and (iii) prevent the occurrence of prohibited proprietary trading.
This analysis and measurement should incorporate the quantitative
measurements calculated and reported under Appendix A of the proposed
rule, but should also include other analysis and measurements developed
by the banking entity that are specifically tailored to the business,
risks, practices, and strategies of its trading units. The Agencies
expect that the thoughtful use of these types of quantitative tools to
monitor the extent to which the activities of a trading unit are
consistent with its stated mission, strategy, and risk profile may help
identify, for both banking entities and Agencies, abnormalities or
discrepancies in permitted trading activity that may be indicative of
prohibited proprietary trading. In addition, these internal controls
must provide for regular monitoring of the effectiveness of the banking
entity's compliance program and require the banking entity to take
prompt action to address and remedy any deficiencies identified and to
provide timely notification to the relevant Agency of any investigation
and remedial action taken.
With respect to covered fund activities and investments, the
internal controls required under section III of proposed Appendix C
generally focus on ensuring that a banking entity has effective
controls in place to monitor its investments in, and relationships
with, covered funds to ensure its compliance with the covered fund
activity and investments restrictions, including controls that relate
to implementing remedies in the event of a violation of the
requirements of section 13 of the BHC Act and the proposed rule.
c. Responsibility and Accountability
Section IV of proposed Appendix C articulates minimum standards for
the third element of the compliance program, responsibility and
accountability. These standards focus on four key constituencies--the
board of directors, the CEO, senior management, and managers at each
trading unit and asset management unit level. Section IV makes clear
that the board of directors, or similar corporate body, and the CEO are
responsible for creating an appropriate ``tone at the top'' by setting
an appropriate culture of compliance and establishing clear policies
regarding the management of covered trading activities and covered fund
activities
[[Page 68920]]
and investments. Senior management must be made responsible for
communicating and reinforcing the culture of compliance established by
the board of directors and the CEO, for the actual implementation and
enforcement of the approved compliance program, and for taking
effective corrective action, where appropriate. Managers with
responsibility for one or more trading units or asset management units
of the banking entity that are engaged in covered trading activity or
covered fund activity and investments are accountable for effective
implementation and enforcement of the compliance program for the
applicable trading unit or asset management unit.
d. Independent Testing
Section V of proposed Appendix C articulates minimum standards for
the fourth element of the compliance program, independent testing. A
banking entity subject to the appendix must ensure that its independent
testing is conducted by a qualified independent party, such as the
banking entity's internal audit department, outside auditors,
consultants or other qualified independent parties. The independent
testing must examine both the banking entity's compliance program and
its actual compliance with the proposed rule. Such testing must include
not only the general adequacy and effectiveness of the compliance
program and compliance efforts, but also the effectiveness of each
element of the compliance program and the banking entity's compliance
with each provision of the proposed rule. This requirement is intended
to ensure that a banking entity continually reviews and assesses, in an
objective manner, the strength of its compliance efforts and promptly
identifies and remedies any weaknesses or matters requiring attention
within the compliance framework.
e. Training
Section VI of proposed Appendix C articulates minimum standards for
the fifth element of the compliance program, training. It proposes to
require that a banking entity provide adequate training to its trading
personnel and managers, as well as other appropriate personnel, in
order to effectively implement and enforce the compliance program. In
particular, personnel engaged in covered trading activities or covered
fund activities and investments should be educated with respect to
applicable prohibitions and restrictions, exemptions, and compliance
program elements to an extent sufficient to permit them to make
informed, day-to-day decisions that support the banking entity's
compliance with the proposed rule and section 13 of the BHC Act. In
particular, any personnel with discretionary authority to trade, in any
amount, should be appropriately trained regarding the differentiation
of prohibited proprietary trading and permitted trading activities and
given detailed guidance regarding what types of trading activities are
prohibited. Similarly, personnel providing investment management or
advisory services, or acting as general partner, managing member, or
trustee of a covered fund, should be appropriately trained regarding
what covered fund activities and investments are permitted and
prohibited.
f. Recordkeeping
Section VII of proposed Appendix C articulates minimum standards
for the sixth element of the compliance program, recordkeeping.
Generally, a banking entity must create records sufficient to
demonstrate compliance and support the operation and effectiveness of
its compliance program (i.e., records demonstrating the banking
entity's compliance with the requirements of section 13 of the BHC Act
and the proposed rule, any scrutiny or investigation by compliance
personnel or risk managers, and any remedies taken in the event of a
violation or non-compliance), and retain these records for no less than
five years in a form that allows the banking entity to promptly produce
these records to any relevant Agency upon request. Records created and
retained under the compliance program shall include trading records of
the trading units, including trades and positions of each such unit.
g. Request for Comment
The Agencies request comment on the compliance program requirement
contained in Sec. --.20 of the proposed rule and the minimum standards
specified in proposed Appendix C. In particular, the Agencies request
comment on the following questions:
Question 319. Is the proposed rule's inclusion of a compliance
program requirement effective in light of the purpose and language of
the statute? If not, what alternative would be more effective?
Question 320. Is the proposed application of Sec. --.20's
compliance program requirement to all banking entities engaged in
covered trading activity or covered trading investments and activities
and the minimum standards of proposed Appendix C to only banking
entities with significant covered trading or covered fund activities,
effective? If not, what alternative would be more effective? Should
proposed Appendix C apply to all banking entities? If so, why? Are the
thresholds proposed for determining whether a banking entity must
comply with proposed Appendix C appropriate? If not, what alternative
would be more effective?
Question 321. What implementation, operational, or other burdens or
expenses might be associated with the compliance program requirement?
How could those burdens or expenses be reduced or eliminated in a
manner consistent with the purpose and language of the statute?
Question 322. Do the proposed compliance program requirement and
minimum standards provide sufficient guidance and clarity regarding how
compliance programs should be structured? If not, what additional
guidance or clarity is needed? Do the proposed compliance program
requirement and minimum standards provide sufficient discretion to
banking entities to structure a compliance program that appropriately
reflects the unique nature of their businesses? If not, how could
additional discretion be provided in a manner consistent with the
purpose and language of the statute?
Question 323. Are the six proposed elements of a required
compliance program effective? If not, what alternative would be more
effective? Should elements be added or removed? If so, which ones and
why?
Question 324. For each of the six proposed elements of a required
compliance program for which minimum standards are provided in proposed
Appendix C, are the proposed minimum standards effective? If not, what
alternative would be more effective? Should minimum standards be added
or removed? If so, which ones and why?
Question 325. Does the requirement that a banking entity provide
timely notification to the relevant Agency provide sufficient guidance
as to what activities must be reported and how and when such reporting
should be made? Should more specific standards be provided (e.g.,
regarding the timing of reporting and the types of activities that must
be reported)? If so, what additional criteria should be implemented?
Should the notification requirement be applied explicitly to banking
entities that are not required to comply with the minimum standards
specified in Appendix C because they are below the thresholds specified
in Sec. --.20(c)(2)? Why or why not?
Question 326. Are there specific records that banking entities
should be
[[Page 68921]]
required to make and keep to document compliance with section 13 of the
BHC Act and the proposed rule? Please explain.
Question 327. What process should the Agencies use in determining
whether to require a banking entity that, based on its size, would not
be subject to Appendix C to comply with all or portions of the appendix
under section I.E of the proposed appendix? What considerations should
the Agencies take into account in making such a determination? Should
this requirement be implemented by an Agency order, by authority
delegated to Agency staff, or a different method? Please explain.
Question 328. Should the proposed rule permit banking entities to
comply with Appendix C of the proposed rule on an enterprise-wide
basis? If so, why? What are the advantages and disadvantages of an
enterprise-wide compliance program? Should the proposed appendix
provide additional clarity or discretion regarding how such an
enterprise-wide program should be structured? If so, how? Please
include a discussion relating to the infrastructure of an enterprise-
wide compliance program and its management. If enterprise-wide
compliance or similar programs are used in other contexts, please
describe your experience with such programs and how those experiences
influence your judgment concerning whether or not you would choose an
enterprise-wide compliance program in this context.
Question 329. Should the proposed rule permit banking entities to
comply with Sec. --.20(b) of the proposed rule on an enterprise-wide
basis? If so, why? What are the advantages and disadvantages of an
enterprise-wide compliance program for smaller banking entities that
are not subject to Appendix C? Please include a discussion relating to
the infrastructure of an enterprise-wide compliance program and its
management in the context of smaller banking entities. If enterprise-
wide compliance or similar programs are used in other contexts, please
describe your experience with such programs and how those experiences
influence your judgment concerning whether or not you would choose an
enterprise-wide compliance program in this context. Are there
particular reasons why a enterprise-wide compliance program should be
permitted for larger banking entities subject to the requirements of
Appendix C, but not those that are subject to Sec. --.20(b) of the
proposed rule?
Question 330. What are the particular challenges that should be
considered in connection with establishing a compliance program on an
enterprise-wide basis? How will such challenges be addressed? Can an
enterprise-wide compliance program be appropriately tailored to each of
the subsidiaries and affiliates of a banking entity?
Question 331. Are there efficiencies that can be gained through an
enterprise-wide compliance program? If so, how and what efficiencies?
Question 332. Would the complexities of various types of covered
trading activity be adequately reflected in an enterprise-wide
compliance program?
Question 333. Should only outside parties be permitted to conduct
independent testing for the effectiveness of the proposed compliance
program to satisfy certain minimum standards? If so, why? Under the
proposal, the independent testing requirement may be satisfied by
testing conducted by an internal audit department or a third party.
Should the rule specify the minimum standards for ``independence'' as
applied to internal and/or external parties testing the effectiveness
of the compliance program? For example, would an internal audit be
deemed to be independent if none of the persons involved in the testing
are involved with, or report to persons that are involved with,
activities implicated by section 13 of the BHC Act? Why or why not?
Question 334. Do you anticipate that banking entities that do not
meet the thresholds specified in Sec. --.20(c) would voluntarily
comply with the proposed minimum standards in Appendix C in order to
effectively implement the six elements specified in Sec. --.20(b)? Are
there specific minimum standards that would not be practical or would
be unattainable for a banking entity that does not meet the Sec.
--.20(c) thresholds? Please identify the minimum standard(s) and
explain.
Question 335. In light of the size, scope, complexity, and risk of
covered trading activities, do commenters anticipate the need to hire
new staff with particular expertise in order to establish, maintain,
and enforce the proposed compliance program requirement concerning
covered trading activities or any subset of covered trading activities?
Question 336. With respect to the proposed requirement that
training should occur with a frequency appropriate to the size and risk
profile of the banking entity's covered trading activities and covered
fund activities, should there be a minimum requirement that such
training shall be conducted no less than once every twelve (12) months?
If so, why?
Question 337. Should proposed rule's Appendix C be revised to
require a banking entity's CEO to annually certify that the banking
entity has in place processes to establish, maintain, enforce, review,
test and modify the compliance program established pursuant to Appendix
C in a manner that is reasonably designed to achieve compliance with
section 13 of the BHC Act and this proposal? If so, why? If so, what
would be the most useful, efficient method of certification (e.g., a
new stand-alone certification, a certification incorporated into an
existing form or filing, Web site certification, or certification filed
directly with the relevant Agency)? Would a central data repository
with a CEO attestation to the Agencies be a preferable approach?
Question 338. Do the proposed rule requirements relating to
establishment and implementation of a compliance program pose unique
concerns or challenges to issuers of asset-backed securities that are
banking entities, and if so, why? Are certain asset classes
particularly impacted by the proposed rule requirements, and if so,
how?
Question 339. How would existing issuers of asset-backed securities
that are banking entities pay for establishing and implementing a
compliance program? Should existing issuers of asset-backed securities
that cannot comply with the compliance program requirements be excluded
from the proposed definition of ``banking entity''? Should such
exclusion be limited, and if so, based on what factors? Are the
proposed thresholds specified in Sec. ----.20(c) of the proposed rule
and/or the allowance of an enterprise-wide compliance program as set
forth in Appendix C of the proposed rule sufficient to minimize these
concerns for issuers of asset-backed securities?
Question 340. With respect to future securitizations, what would be
the impact of the establishment and implementation of the compliance
program related to the provisions of the proposed rule as required by
Sec. --.20 of the proposed rule (including Appendix C, where
applicable)? Are the proposed thresholds specified in Sec. --.20(c) of
the proposed rule and/or the allowance of an enterprise-wide compliance
program as set forth in Appendix C of the proposed rule sufficient to
minimize these concerns for issuers of asset-backed securities?
Question 341. Would existing issuers of asset-backed securities
that are banking entities be able to establish and implement a
compliance program related to the provisions of the proposed rule as
required by Sec. --.20 of the
[[Page 68922]]
proposed rule (including Appendix C, where applicable)? If amendments
to transactional documents are necessary, are there any obstacles that
would make such amendments difficult to execute? If existing issuers of
asset-backed securities cannot establish and implement a compliance
program, what would be the impact on such existing issuers of asset-
backed securities and the holders of securities issued by a non-
compliant issuer of asset-backed securities? Is the allowance of an
enterprise-wide compliance program as set forth in Appendix C of the
proposed rule sufficient to minimize these concerns for issuers of
asset-backed securities?
Question 342. To rely on the exemptions for permitted underwriting,
market making-related, and risk-mitigating hedging activities, the
proposed rule requires banking entities to establish the internal
compliance program under Sec. --.20 and, where applicable, Appendix C,
designed to ensure compliance with the requirements of the applicable
exemption (e.g., policies and procedures, internal controls and
monitoring procedures, etc.). Do these requirements in the proposed
rule impose undue cumulative burdens, such that the marginal benefit of
a given requirement is not justified by the cost that the requirement
imposes? If so, why does the proposed rule impose cumulative burdens
and what are the costs of those burdens? Please explain the
circumstances under which these burdens may arise. Is there a way to
reduce or eliminate such burdens or requirements in a manner consistent
with the language and purpose of the statute? For any requirements that
impose undue burdens, are there other requirements that could be
substituted that would more efficiently ensure compliance with the
statute? Are there any requirements that the proposed rule imposes that
are particularly effective, and if so, how can the Agencies make better
use of these requirements?
Question 343. Are the six elements of the proposed compliance
program requirement mutually reinforcing and cost effective, or are
there redundancies in the six elements? Please explain any redundant
requirements in the policies and procedures, internal controls,
management framework, independent testing, training, and recordkeeping
requirements in Sec. --.20(b) of the proposed rule or proposed
Appendix C. Why are such requirements redundant, and how should the
redundancy be addressed and remedied in the rule?
Question 344. A banking entity that meets the $1 billion or greater
trading assets and liabilities threshold would be required under the
proposed rule to comply with both the reporting and recordkeeping
requirements in Appendix A with respect to quantitative measurements
and the compliance program requirement in Appendix C. Are the
requirements in these appendices mutually reinforcing and cost
effective, or do the appendices impose redundant requirements on
banking entities that meet the $1 billion threshold? Please explain any
redundant requirements in the appendices and how such redundancy should
be addressed and remedied in the rule.
Question 345. Proposed Appendix C incorporates the quantitative
measurements provided in proposed Appendix A in the internal controls
requirement for banking entities that are engaged in covered trading
activity and meet the $1 billion or greater trading assets and
liabilities threshold. Do the requirements in proposed Appendix A and
Appendix C impose undue cumulative burdens with respect to any elements
(e.g., quantitative measurements), such that the marginal benefit of a
given requirement is not justified by the cost that the requirement
imposes? Please explain why the proposed appendices impose cumulative
burdens, the costs of those burdens, and the circumstances under which
these burdens may arise. Is there a way to reduce or eliminate such
burdens or requirements in a manner consistent with the language and
purpose of the statute? For any requirements in the appendices that
impose undue burdens, are there other requirements that could be
substituted that would more efficiently ensure compliance with the
statute? Are there any requirements that the proposed appendices impose
that are particularly effective, and if so, how can the Agencies make
better use of these requirements?
Question 346. Should the relevant Agency prescribe any specific
method by which the board of directors or similar corporate body
reviews and approves the compliance program? For example, should the
relevant Agency require that: (i) A chief compliance officer or similar
officer present an annual compliance report including, as appropriate,
recommended actions to be taken by the banking entity to improve
compliance or correct any compliance deficiencies; (ii) the board
review any such recommendations and determine whether to approve them;
and (iii) the banking entity notify the relevant Agency if the board
declines to approve such recommendations, or approves different actions
than those recommended in the compliance report? What are the
advantages and disadvantages of such an approach?
3. Section --.21: Termination of Activities or Investments; Penalties
for Violations
Section --.21 of the proposed rule implements section 13(e)(2) of
the BHC Act, which requires the termination of activities or
investments that violate or function as an evasion of section 13 of the
Act.\347\ In particular, Sec. --.21(a) of the proposed rule requires
any banking entity that engages in an activity or makes an investment
in violation of section 13 of the BHC Act or the proposed rule or in a
manner that functions as an evasion of the requirements of section 13
of the BHC Act or the proposed rule, including through an abuse of any
activity or investment permitted under subparts B or C, or otherwise
violates the restrictions and requirements of section 13 of the BHC Act
or the proposed rule, to terminate the activity and, as relevant,
dispose of the investment.\348\ Section --.21(b) of the proposed rule
provides that if a relevant Agency finds reasonable cause to believe
any banking entity has engaged in an activity or made an investment
described in paragraph (a), the relevant Agency may, after due notice
and an opportunity for hearing, by order, direct the banking entity to
restrict, limit, or terminate the activity and, as relevant, dispose of
the investment.\349\
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\347\ See 12 U.S.C. 1851(e)(2).
\348\ See proposed rule Sec. --,21(a). The Agencies have
proposed to include Sec. --.21(a), in addition to the provisions of
Sec. --.21(b) of the proposed rule, to make clear that the
requirement to terminate an activity or, as relevant, dispose of an
investment would be triggered where a banking entity discovers a
violation or evasion, regardless of whether an Agency order has been
issued.
\349\ See proposed rule Sec. --,21(b).
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E. Subpart E--Conformance Provisions
Section 13(c)(6) of the BHC Act required the Board, acting alone,
to adopt rules implementing those provisions of section 13 of the BHC
Act that provide a banking entity or a nonbank financial company
supervised by the Board a period of time after the effective date of
section 13 of the BHC Act to bring the activities, investments, and
relationships of the banking entity or company that were commenced,
acquired, or entered into before the effective date of section 13 of
the BHC Act into compliance with that section and the agencies'
implementing regulations.\350\ The Board's Conformance Rule, which was
required
[[Page 68923]]
under section 13(c)(6) of the BHC Act, was issued on February 8,
2011.\351\ As noted in its issuing release, this period is intended to
give markets and firms an opportunity to adjust to section 13 of the
BHC Act.\352\
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\350\ See 12 U.S.C. 1851(c)(6).
\351\ See Conformance Period for Entities Engaged in Prohibited
Proprietary Trading or Private Equity Fund or Hedge Fund Activities,
76 FR 8265 (Feb. 14, 2011).
\352\ See id. (citing 156 Cong. Rec. S5898 (daily ed. July 15,
2010) (statement of Sen. Merkley)).
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As part of the current proposal, the Board is proposing to relocate
the Board's Conformance Rule, which was added as Sec. Sec. 225.180-182
of the Board's Regulation Y, to subpart E of the Board's proposed
rule.\353\ The Board is also proposing to make certain conforming and
technical changes to the language and defined terms of the Board's
Conformance Rule in connection with its proposed relocation to subpart
E of the Board's current proposal. The Board is not, however, proposing
any substantive changes to the Board's Conformance Rule as part of this
proposed rule. In particular, the Board's Conformance Rule defined
certain terms related to section 13 of the BHC Act, including ``banking
entity,'' ``hedge fund and private equity fund,'' ``insured depository
institution,'' and ``Board.'' \354\ For the sake of consistency, the
Board is proposing to eliminate these definitions as they are now
defined elsewhere, and in more comprehensive a manner, in the proposed
rule.\355\ These alternative or replacement definitions are
substantially similar to those contained in the Board's Conformance
Rule and are discussed in further detail in Part III.A.2 of this
Supplementary Information.
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\353\ See Board proposed rule Sec. Sec. --.30 to --.32.
\354\ See Board's Conformance Rule Sec. Sec. 225.180(a)-(c),
(e).
\355\ See proposed rule Sec. Sec. --.2(e), (f), (p);
--.10(b)(1).
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In connection with incorporating provisions of the existing Board's
Conformance Rule into the current proposal, the Board notes that the
conformance period and extended transition period provided by section
13(c) of the BHC Act and the Board's Conformance Rule do not permit a
banking entity to engage in any new activity or make any new investment
in a covered fund without complying with the restrictions and
prohibitions of section 13 of the BHC Act and implementing rules
thereunder. The conformance period and extended transition period
provided by the Board's Conformance Rule permit a banking entity to
bring those of its existing activities and investments that do not
conform to the requirements of section 13 of the BHC Act and the
proposed rule into conformance. The Board's Conformance Rule does not
authorize a banking entity to engage in new or additional prohibited
activities or investments, and this restriction would continue to apply
under the current proposed rule.
With respect to proprietary trading, the Board expects that each
banking entity will identify those trading units of the banking entity
that are engaged in prohibited proprietary trading as of or after the
effective date of section 13 of the BHC Act and the type of proprietary
trading in which they are engaged. A banking entity is expected to
bring the prohibited proprietary trading activity of a trading unit
into compliance with the requirements of the proposed rule as soon as
practicable within the conformance period. A trading unit may not
expand its activity to include prohibited proprietary trading after the
effective date of the proposed rule. Similarly, a trading unit that is
not identified as engaging in proprietary trading as of the effective
date may not begin engaging in such activity after the effective date.
With respect to a covered fund activity or investment, the
conformance period (or, in the case of an illiquid fund for which a
banking entity has received Board approval, the extended transition
period) generally permits a banking entity to retain an existing
investment in a covered fund, make additional capital contributions to
a covered fund if contractually obligated to do so, or continue certain
existing relationships with a covered fund.\356\ However, pursuant to
the conformance period or extended transition period, a banking entity
may not make a new investment or capital contribution that it is not
contractually obligated to make in, or establish a new relationship
with, a covered fund after the effective date of the proposed
rule.\357\
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\356\ For instance, under the Board's Conformance Rule and the
current proposed rule, a banking entity may retain an existing
ownership interest in a covered fund under authority of the
conformance period or extended transition period without regard to
the per-fund or aggregate fund limitations contained in Sec. --.12
of the proposed rule. Additionally, a banking entity may continue to
serve as sponsor to a covered fund under authority of the
conformance period, but only if the banking entity acted as sponsor
to such fund as of the effective date of section 13 of the BHC Act
and the nature of the relationship was continuous. A banking entity
may also serve as sponsor of an illiquid fund pursuant to the
extended transition period, but only to the extent such service is
related to the banking entity's retention of its permitted ownership
interest in such fund.
\357\ In the case of a covered fund that a banking entity
organizes and offers, or begins to act as sponsor to, after the
effective date of section 13 of the BHC Act, the banking entity must
comply with the requirements of the proposed rule with respect to
its relationships with, and acquisition and retention of an
ownership interest in, such covered fund. For instance, after the
effective date of section 13 of the BHC Act, a banking entity may
only acquire and retain an ownership interest in that covered fund
as a permitted investment only (i) if the banking entity organizes
and offers or acts as sponsor to that fund, and (ii) in compliance
with the per-fund limitation and aggregate fund limitation of the
proposed rule. Similarly, a banking entity's relationship with such
covered fund would be subject to the limitations contained in the
proposed rule.
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Request for Comment
In light of the interplay between the Board's Conformance Rule and
the current proposed rule, the Board is requesting comment on whether
any of the conformance provisions should be revised. In particular, the
Board requests comment on the following question:
Question 347. Should any portion of the Board's Conformance Rule be
revised in light of other elements of the current proposed rule? If so,
why and how?
IV. Request for Comments
The Agencies are interested in receiving comments on all aspects of
the proposed rule.
V. Solicitation of Comments on Use of Plain Language
Section 722 of the Gramm-Leach-Bliley Act, Public Law 106-102, sec.
722, 113 Stat. 1338, 1471 (Nov. 12, 1999), requires the OCC, Board and
FDIC to use plain language in all proposed and final rules published
after January 1, 2000. The OCC, Board and FDIC invite public comments
on how to make this proposal easier to understand. For example:
Have we organized the material to suit your needs? If not,
how could this material be better organized?
Are the requirements in the proposed regulation clearly
stated? If not, how could the regulation be more clearly stated?
Does the proposed regulation contain language or jargon
that is not clear? If so, which language requires clarification?
Would a different format (grouping and order of sections,
use of headings, paragraphing) make the regulation easier to
understand? If so, what changes to the format would make the regulation
easier to understand?
What else could we do to make the regulation easier to
understand?
[[Page 68924]]
VI. The Economic Impact of the Proposed Rule Under Section 13 of the
BHC Act--Request for Comment
Section 13 of the BHC Act imposes on all banking entities
prohibitions and restrictions on proprietary trading and certain
interests in, and relationships with, a covered fund,\358\ which apply
to banking entities whether or not the Agencies adopt implementing
rules. In formulating the proposed rule to implement these provisions,
which is required by statute, the Agencies have chosen a multi-faceted
approach to establish a regulatory framework that provides for clear,
robust, and effective implementation of the statute's provisions in a
consistent manner, while also not unduly constraining the ability of
banking entities to engage in permitted activities and
investments.\359\ The Agencies have proposed this approach after
considering the Council's findings and recommendations regarding how to
implement section 13 of the BHC Act and a variety of alternatives
described throughout this Supplemental Information.\360\ The Agencies
seek comment, in particular, on the potential costs and benefits of
those aspects of the proposed rule that involve choices made, or the
exercise of discretion, by the Agencies in implementing section 13 of
the BHC Act.
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\358\ As noted above in connection with the conformance and
extended transition periods, the proposed rule would not require an
immediate application of these restrictions for any activity or
investment entered into prior to the effective date of section 13 of
the BHC Act (July 21, 2012). However, any activity or investment
entered into after the effective date would be required to comply
with section 13 of the BHC Act and the proposed rule, if adopted.
See Supplemental Information Part III.E.
\359\ See Supplemental Information Part II.A.
\360\ See 12 U.S.C. 1851(b)(2)(A); see also Financial Stability
Oversight Council, Study & Recommendations on Prohibitions on
Proprietary Trading & Certain Relationships with Hedge Funds &
Private Equity Funds (Jan. 2011), available at http://www.treasury.gov/initiatives/Documents/Volcker%20sec%20%20619%20study%20final%201%2018%2011%20rg.pdf.
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The Agencies recognize that there are economic impacts that may
arise from the proposed rule and its implementation of section 13 of
the BHC Act and invite comment on the manner in which the proposed rule
implements section 13 of the BHC Act, including commenters' views on
the potential economic impacts discussed in this Part of the
Supplemental Information. In addition, the Agencies seek comment on
whether the proposed rule represents a balanced and effective approach
to implementing section 13 of the BHC Act or whether alternative
approaches to implementing section 13 of the BHC Act exist that would
provide greater benefits or involve fewer costs, consistent with the
statutory purpose. We also request comment on the potential competitive
effects of the manner in which the proposed rule implements the
statute.\361\
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\361\ For example, implementation of section 13(d)(1)(H) of the
BHC Act may result in a competitive advantage for foreign-controlled
banking entities over U.S.-controlled banking entities with respect
to activities that occur solely outside of the United States.
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In addition to the questions posed throughout Part II of the
Supplemental Information with respect to the potential costs and
benefits of particular aspects of the statute and proposed rule, in
order to assist in the analysis of the economic impacts associated with
the final rule and any alternatives the Agencies may evaluate, the
Agencies encourage commenters to provide quantitative information about
the rule's impact on banking entities, their clients, customers, and
counterparties, specific markets or asset classes, and any other
entities potentially affected by the proposed rule with respect to:
1. The direct and indirect costs and benefits of compliance with
section 13 of the BHC Act, as proposed to be implemented;
2. The effect of section 13 of the BHC Act, as proposed to be
implemented, on competition; and
3. Any other economic impacts of the proposal.
In addition, to assist with potential estimates of the proposed
rule's quantitative impacts, we request specific comment on: (i) The
extent to which banking entities currently engage in proprietary
trading activity or covered funds activities or investments that are
prohibited or restricted by the statute, or have otherwise divested or
conformed such activities; and (ii) the potential costs and benefits or
other quantitative impacts of various aspects of the proposed rule,
such as the compliance program requirement, the required reporting of
quantitative measurements, and the conditions and requirements for
relying on the proposed exemptions.
To further facilitate public comment on the economic effects of the
manner in which the proposed rule implements the statute, the Agencies
have identified below a number of significant aspects of the proposed
rule and potential economic impacts that may result from section 13 of
the BHC Act's requirements, as proposed to be implemented. We seek
commenters' views on the likelihood of the potential economic impacts
identified in this Part and whether there are additional costs,
benefits, or other impacts that may arise from the proposed rule. To
the extent that such costs, benefits, or other impacts are
quantifiable, commenters are encouraged to identify, discuss, analyze,
and supply relevant data, information, or statistics related to such
costs, benefits, and other impacts and the quantification of such
costs, benefits, and other impacts. In addition, commenters are asked
to identify or estimate start-up, or non-recurring, costs separately
from costs or effects they believe would be ongoing.
A. Proprietary Trading Provisions
1. Definition of Trading Account
Section --.3 of the proposed rule, which implements the statutory
definition of ``trading account,'' provides a multi-pronged definition
of that term that is intended to ensure that banking entities do not
engage in ``hidden'' proprietary trading by characterizing trading
activity as being conducted outside a trading account. In addition to
positions taken principally for the purpose of short-term resale,
benefitting from short-term price movements, realizing short-term
arbitrage profits, or hedging another trading account position, the
proposed definition also includes: (i) With respect to a banking entity
subject to the Federal banking agencies' Market Risk Capital Rules, all
positions in financial instruments subject to the prohibition on
proprietary trading that are treated as ``covered positions'' under
those capital rules, other than certain foreign exchange and
commodities positions; and (ii) all positions acquired or taken by
certain registered securities and derivatives dealers (or, in the case
of financial institutions that are government securities dealers, that
have filed notice with an appropriate regulatory agency) in connection
with their activities that require such registration or notice.
Although these prongs of the definition are proposed to prevent evasion
of the statutory requirements, we seek comment on the extent to which
either of these two prongs may create a competitive disadvantage for
certain banking entities vis-[agrave]-vis competitors that are either
not subject to section 13 of the BHC Act and/or competitors subject to
different prongs of the proposed definition.
2. Exemption for Underwriting Activities
Section 13(d)(1)(B) of the BHC Act provides an exemption from the
prohibition on proprietary trading for purchases and sales in
connection with underwriting activities, to the extent
[[Page 68925]]
that such activities are designed not to exceed the reasonably expected
near term demands of clients, customers, or counterparties. In
implementing this exemption in Sec. --.4(a) of the proposed rule, the
Agencies have endeavored to establish a regime that clearly sets forth
the requirements for relying on the underwriting exemption established
in the statute to facilitate banking entities' compliance with the
statutory requirements. In considering potential requirements for the
underwriting exemption, and assessing the potential economic impacts of
each such requirement, the Agencies strived to propose an appropriate
balance between considerations related to: (i) The potential for
evasion of the statutory prohibition on proprietary trading through
misuse of the underwriting exemption; and (ii) the potential costs that
may arise from constraints on legitimate underwriting activities.
The Agencies have proposed to use, wherever practicable, common
terms from existing laws and regulations in the context of underwriting
to facilitate market participants' understanding and use of the
exemption and to promote consistency across laws and regulations.
Specifically, the proposed definitions of ``distribution'' and
``underwriter'' established in the proposed rule largely mirror the
definitions provided for these terms in the SEC's Regulation M. Because
the proposed rule uses a modified version of the Regulation M
definition of ``underwriter'' to include selling group members, the
proposed definition would permit the current market practice of members
of the underwriting syndicate entering into an agreement with other
selling group members to collectively distribute the securities, rather
than requiring all members of a distribution to join the underwriting
syndicate.
In addition, the definition of ``distribution'' from Regulation M
that the Agencies have proposed in Sec. --.4(a) of the proposed rule
is intended to ensure that the underwriting exemption does not unduly
constrain banking entities from providing underwriting services, while
at the same time preventing banking entities from relying on the
underwriting exemption to evade the proposed rule and the statutory
prohibition on proprietary trading. The Agencies anticipate that the
proposed approach to implementing the underwriting exemption should
permit legitimate forms of underwriting in which market participants
currently engage and, thus, should not unduly burden capital formation.
In addition, the proposed rule would permit underwriters to continue to
employ existing practices to stabilize a distribution of securities,
which stabilization promotes confidence among issuers, selling security
holders, and investors and further supports capital formation.
Under the proposed rule, the underwriting activities of a banking
entity must be designed to generate revenues primarily from fees,
commissions, underwriting spreads or other income, not from
appreciation in value of covered financial positions that the banking
entity holds related to such activities or the hedging of such covered
financial positions. This proposed requirement should promote investor
confidence by ensuring that the activities conducted in reliance on the
underwriting exemption are designed to benefit the interests of clients
seeking to bring their securities to market, not the interests of the
underwriters themselves. The proposed requirement should also help
prevent evasion of the statutory prohibition on proprietary trading, as
trading activity designed to generate revenues from appreciation in the
value of positions held by the banking entity would be indicative of
prohibited proprietary trading, not underwriting activity. We seek
comment on whether this approach of identifying underwriting activity
by reference to revenue source could also make underwriting less
profitable to the extent that it precludes or discourages certain types
of profitability for bona fide underwriting services.
In addition to commenters' views on the potential economic impacts
identified above, we request comment on whether the proposed rule may
cause some banking entities to choose to decrease the supply of
underwriting services in response to potential costs of the proposed
rule and whether this result would adversely affect competition among
underwriters or have a harmful impact on capital formation. In
addition, if banking entities were to pass the increased costs of
complying with the proposed exemption on to issuers, selling security
holders, or their customers, we seek comment on whether the effect
would be to increase the cost of raising capital and whether this would
harm capital formation to the extent that such cost increases were
sufficient to preclude issuers from accessing the capital markets. As
described above, the Agencies have designed the proposal to balance
such potential costs with provisions intended to permit banking
entities' legitimate underwriting activities to continue as provided by
the statute, while also establishing sufficient requirements to prevent
evasion of the statutory goals through misuse of the underwriting
exemption.
3. Exemption for Market Making-Related Activities
Section 13(d)(1)(B) of the BHC Act provides an exemption from the
prohibition on proprietary trading for purchases and sales in
connection with market making-related activities, to the extent that
such activities are designed not to exceed the reasonably expected near
term demands of clients, customers, or counterparties. In setting forth
the requirements for eligibility for this exemption in Sec. --.4(b) of
the proposed rule, the Agencies have endeavored to establish a regime
that clearly sets forth the requirements for relying on the exemption
for market making-related activity established in the statute to
facilitate banking entities' compliance with the statutory
requirements. In considering potential requirements for the market-
making exemption, and assessing the potential economic impacts of each
such requirement, the Agencies tried to strike an appropriate balance
between considerations related to: (i) The potential for evasion of the
statutory prohibition on proprietary trading through misuse of the
exemption for market making-related activity; (ii) the potential
difficulties related to distinguishing market making-related activity
from prohibited proprietary trading; and (iii) potential costs that may
arise from constraints on legitimate market making-related activities.
The Agencies have proposed to use, where practicable, terms and
concepts used in current laws and regulations in the context of market
making to promote clarity and consistency. Recognizing that there are
differences in market making activities between different types of
asset classes (e.g., liquid and illiquid instruments) and market
structures (e.g., organized trading facilities and the over-the-counter
markets), the Agencies have proposed to implement the market-making
exemption in a manner that accounts for these distinctions and permits
market making activities in different asset classes and market
structures. Permitting legitimate market making in its different forms
should promote market liquidity and efficiency by allowing banking
entities to continue to provide customer intermediation and liquidity
services in both liquid and illiquid instruments. The Agencies also
recognize, however, that market making-related activities in the over-
the-counter markets or activities involving less liquid instruments are
sometimes less transparent than similar activities on
[[Page 68926]]
organized trading facilities or in liquid markets. We seek comment on
whether, in order to comply with the statutory prohibition on
proprietary trading, some banking entities may be inclined to abstain
from some market-making activities in an effort to reduce the risk of
noncompliance. We also request comment on whether, if banking entities
did so, this could result in reduced liquidity for certain types of
trades or for certain less liquid instruments.
In addition, the proposed exemption permits anticipatory market
making, block positioning, and hedging of market making positions under
certain circumstances, which should further facilitate customer
intermediation and market liquidity and efficiency. However, certain
conditions are placed on such market making-related activities in the
proposal in an effort to ensure that such activities are, in fact,
market making-related activities, and are not hidden proprietary
trading activities subject to the statutory prohibition.
The proposal requires that the market making-related activities be
designed to generate revenues primarily from fees, commissions, bid/ask
spreads or other income not attributable to appreciation in the value
of covered financial positions a banking entity holds in trading
accounts or the hedging of such positions. This proposed requirement
should promote investor confidence by helping to ensure that market
making serves customer needs. The proposed requirement should also help
prevent evasion of the statutory prohibition on proprietary trading, as
trading activity designed to generate revenues from appreciation in the
value of positions held by the banking entity would be indicative of
prohibited proprietary trading, not market making-related activity. The
Agencies request comment on whether this approach of identifying market
making activity by reference to a market making trading unit's revenue
source would also make market making activity less profitable and
whether it would preclude or discourage certain types of profitability
for bona fide market making services. Commenters should also address
whether this requirement would reduce the willingness of some banking
entities to continue to provide market making-related services and
whether this could reduce liquidity, harm capital formation, or make
market making-related services more expensive. The Agencies note that,
in order to balance the potential for such effects with the statutory
purpose, the proposed rule does not expressly prohibit all types of
non-client income, and recognizes that the precise type and source of
revenues generated by bona fide market making services can and will
vary depending on the relevant market, asset, and facts and
circumstances.
4. Exemption for Risk-Mitigating Hedging Activities
Section 13(d)(1)(C) provides an exemption from the prohibition on
proprietary trading for risk-mitigating hedging activities in
connection with and related to individual or aggregated positions,
contracts, or other holdings of a banking entity that are designed to
reduce the specific risks to the banking entity in connection with and
related to such positions, contracts, or other holdings. The proposed
exemption requires that the hedging transaction be reasonably
correlated to these risks that the transaction is intended to hedge or
otherwise mitigate. This proposed requirement is intended to address
the potential for misuse of the exemption where a transaction is not
closely tied to risk mitigation, while also providing some flexibility
in the degree of correlation that is required in order to promote
consistency with the statutory goals and requirements.
In addition, the proposed exemption requires that the hedging
transaction: (i) Not give rise, at the inception of the hedge, to
significant exposures that are not themselves hedged in a
contemporaneous transaction; and (ii) be subject to continuing review,
monitoring, and management. Together, these proposed requirements are
designed to ensure that a banking entity does not use the hedging
exemption to conduct prohibited proprietary trading in the guise of
hedging activity and to prevent evasion of the proprietary trading
prohibition contained in section 13 of the BHC Act and the proposed
rule. These proposed requirements are intended to ensure that an exempt
hedging transaction will mitigate, not amplify, risk. Moreover, such
requirements should further the goals of compliance with the statutory
requirements and reducing banking entities' risks.
We seek comment on whether the proposed requirements for relying on
the hedging exemption are more restrictive than necessary to implement
the statutory language and purpose, and to prevent evasion of the
statutory provisions, and whether a banking entity's hedging activities
could be unduly constrained by the proposed rule. Further, commenters
should address the extent to which a banking entity may be unable or
unwilling to execute certain hedges and whether, as a result, a banking
entity could be limited in its means to reduce its risk. In addition,
would banking entities be dissuaded from engaging in other permitted
activities or activities outside the scope of the statute (e.g., long-
term investments) if the requirements of the proposed hedging exemption
unduly limits or prevents them from mitigating the risks associated
with such activities? We request comment on whether a reduction in
efficiency could result from a reduced ability of covered banking
entities to transfer risks to those more willing to bear them.
Commenters should also address whether the proposed rule would reduce a
banking entity's willingness to engage in permitted risk-mitigating
hedging activities in order to avoid costs related to ensuring
compliance with the exemption's requirements and whether this would
increase the banking entity's risk exposure. In order to balance the
potential for such effects with the statutory purpose, the proposed
rule attempts to implement the risk-mitigating hedging exemption in a
manner that recognizes that the precise nature and execution of risk
mitigation through hedging transactions can and will vary depending on
the relevant market, asset, and facts and circumstances, while also
establishing requirements designed to ensure that transactions relying
on the hedging exemption are, in fact, hedges and not hidden
proprietary trading prohibited by the statute.
The proposed exemption would require documentation with respect to
hedges established at a different level of organization than that
responsible for the underlying positions or risks that are being
hedged. This proposed documentation requirement is intended to
facilitate review by banking entities and Agency supervisors and
examiners in assessing whether the hedge position was established to
hedge or otherwise mitigate another unit's risks. Without such
documentation, there could be an increased risk of evasion of the
statute's prohibition on proprietary trading, as it would be difficult
to assess whether a purported hedging transaction was established to
mitigate another level of organization's risk or solely to profit from
price appreciation of the position established by the purported hedge.
We seek comment on the costs of the proposed documentation requirement
for certain hedging transactions, such as the costs related to systems
changes and maintenance, employee resources and time, and
recordkeeping.\362\ The
[[Page 68927]]
Agencies also request comment on the extent to which the proposed
documentation requirement would reduce the speed in which a banking
entity could execute a hedge at a different level within the entity and
whether this could reduce efficiency or result in a banking entity
being exposed to a greater amount of risk. Further, we seek commenters'
views on whether potentially slower execution times could also reduce
profitability associated with the position as it remains unhedged (or,
alternatively, increase profitability, depending on whether the value
of the unhedged position is increasing or decreasing in the market). To
balance the potential for such consequences with the statutory purpose,
the Agencies have proposed to apply the documentation requirement to
only a subset of hedging transactions that pose the greatest compliance
risk (i.e., hedges that are established at a different level of
organization than that establishing or responsible for the underlying
positions or risks that are being hedged). In addition, the Agencies
expect that the preparation of required documentation would become less
burdensome and more efficient over time as systems are developed and
personnel become more accustomed to the proposed requirement.
---------------------------------------------------------------------------
\362\ The Agencies note that, for some costs of the proposed
rule, hour burden estimates are provided in Part [internal cite to
PRA] of this Supplementary Information for purposes of the Agencies'
compliance with the Paperwork Reduction Act.
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5. Compensation Related to Permitted Activities
The proposed rule would require that the compensation arrangements
of persons performing underwriting, market making-related, and risk-
mitigating hedging activities be designed not to reward proprietary
risk-taking. These proposed requirements are intended to reduce
incentives for personnel of the banking entity to violate the statutory
prohibition on proprietary trading and expose the banking entity to
risks arising from prohibited proprietary trading. We request comment
on whether the proposed rule's requirements regarding compensation
arrangements would reduce the banking entity's ability to attract
talented and experienced trading personnel or would harm the banking
entity's ability to compete with entities that are not subject to
section 13 of the BHC Act and the proposed rule. In order to balance
the potential for such effects with the statutory goals, the proposed
rule does not expressly prescribe how a banking entity must compensate
its personnel or prohibit all types of compensation incentives related
to non-client income, but instead proposes an approach that leaves
banking entities with a degree of flexibility to compensate their
personnel as they deem appropriate.
6. Exemption for Trading on Behalf of Customers
Section --.6(b) of the proposed rule implements section 13(d)(1)(D)
of the BHC Act, which permits a banking entity, notwithstanding the
prohibition on proprietary trading, to purchase or sell a covered
financial position on behalf of customers. Because the statute does not
define when a transaction would be conducted on behalf of customers,
the proposed rule identifies three categories of transactions that
would qualify under this exemption. By providing that only transactions
meeting the terms of the three categories would be considered to be on
behalf of customers for purposes of the exemption, the proposed rule
addresses the potential for evasion of the statutory prohibition. At
the same time, the proposed rule also would not permit banking entities
to rely on the exemption with respect to other, unanticipated
transactions that banking entities may undertake on behalf of
customers. The Agencies seek comment on whether banking entities
currently engage in principal transactions on behalf of customers that
are not covered by the proposed exemption or other permitted activities
and whether the lack of an exemption in the proposed rule for such
activities would impact beneficial customer facilitation, market
liquidity, efficiency, or capital formation.
7. Exemption for Trading Outside of the United States
Section --.6(d) of the proposed rule implements section 13(d)(1)(H)
of the BHC Act, which permits certain foreign banking entities to
engage in proprietary trading that occurs ``solely outside of the
United States.'' The proposed exemption provides a number of specific
criteria for determining when trading will be considered to have
occurred solely outside of the United States to help prevent evasion of
the statutory restriction. The proposed exemption also provides a
definition of ``resident of the United States'' that is similar to the
SEC's definition of ``U.S. person'' in Regulation S, which should
promote consistency and understanding among market participants that
have experience with the concept from the SEC's Regulation S. In
addition, the proposed exemption clarifies when a foreign banking
entity will be considered to engage in such trading pursuant to
sections 4(c)(9) and 4(c)(13) of the BHC Act, as required by the
statute, including with respect to a foreign banking entity that is not
a ``foreign banking organization'' under the Board's Regulation K. This
implementation of section 13(d)(1)(H) of the BHC Act would permit
certain foreign banking entities that are not ``qualifying foreign
banking organizations'' under the Board's Regulation K to also rely on
the exemption, notwithstanding the fact such foreign banking entities
are not currently subject to the BHC Act generally or the Board's
Regulation K. As a result, such foreign banking entities should
encounter fewer costs related to complying with the proprietary trading
prohibitions than if they were unable to rely on the exemption in
section 13(d)(1)(H) of the BHC Act.
Despite the reference to section 4(c)(13) of the BHC Act, the
statute provides that the exemption for trading outside of the United
States is only available to banking entities that are not directly or
indirectly controlled by U.S. banking entities (i.e., not any U.S.
banking entities or their foreign subsidiaries and affiliates). Under
the statute, the prohibition on proprietary trading applies to the
consolidated, worldwide operations of U.S. firms. As required by
statute, the proposal prohibits U.S. banking entities from engaging in
proprietary trading unless the requirements of one or more relevant
exemptions (other than the exemption for trading by foreign banking
entities) are satisfied. As a result, the statute creates a competitive
difference between the foreign activities of U.S. banking entities,
which must monitor and limit their foreign activities in accordance
with the requirements of section 13 of the BHC Act, relative to the
foreign activities of foreign-based banking entities, which may not be
subject to restrictions similar to those in section 13 of BHC Act. The
Agencies seek commenters' views on whether the proposed rule's
implementation of section 13(d)(1)(H) of the BHC Act imposes additional
competitive differences, beyond those recognized above, and the
potential economic impact of such competitive differences.
8. Quantitative Measurements
Section --.7 of the proposed rule, which implements in part section
13(e)(1) of the BHC Act,\363\ requires
[[Page 68928]]
certain banking entities to comply with the reporting and recordkeeping
requirements specified in Appendix A of the proposed rule. Proposed
Appendix A requires a banking entity with significant trading
activities to furnish periodic reports to the relevant Agency regarding
various quantitative measurements of its trading activities and create
and retain records documenting the preparation and content of these
reports. The proposed measurements would vary depending on the scope,
type, and size of trading activities. In addition, proposed Appendix B
contains a detailed commentary regarding the characteristics of
permitted market making-related activities and how such activities may
be distinguished from trading activities that, even if conducted in the
context of banking entity's market making operations, would constitute
prohibited proprietary trading. These proposed requirements are
intended, in particular, to address some of the difficulties associated
with (i) identifying permitted market making-related activities and
distinguishing such activities from prohibited proprietary trading and
(ii) identifying certain trading activities resulting in material
exposure to high-risk assets or high-risk strategies. In combination,
Sec. --.7 and Appendix A of the proposed rule provide a quantitative
overlay designed to help banking entities and the Agencies identify
trading activities that warrant further analysis or review in a variety
of levels and contexts.
---------------------------------------------------------------------------
\363\ Section 13(e)(1) of the BHC Act requires the Agencies to
issue regulations regarding internal controls and recordkeeping to
ensure compliance with section 13. See 12 U.S.C. 1851(e)(1). Section
--.20 and Appendix C of the proposed rule also implement section
13(e)(1) of the BHC Act.
---------------------------------------------------------------------------
The various quantitative measurements that would be required to be
reported focus on assessing banking entities' risk management, sources
of revenue, revenues in relation to risk, customer servicing, and fee
generation. Aberrant patterns among the measurements with respect to
these areas would warrant further review to determine whether trading
activities have occurred that are proprietary in nature and whether
such activities may be exposing banking entities to disproportionate
risk. For example, quantitative measurements should provide banking
entities with a useful starting point for assessing whether their
trading activities are consistent with the proposed rule and whether
traders are exposing the entity to disproportionate risks. In addition,
proposed Appendix A applies a standardized description and general
method of calculating each quantitative measurement that, while taking
into account the potential variation among trading practices and asset
classes, is intended to facilitate reporting of sufficiently uniform
information across different banking entities so as to permit
horizontal reviews and comparisons of the quantitative profile of
trading units across firms. This proposed approach, which recognizes
that quantitative measurements must be applied with respect to
differences within a banking entity's structure, business lines, and
trading desks, should facilitate efficient application within firms and
efficient examination across firms. The proposed use of a suite of
quantitative measurements for these purposes may also limit erroneous
indications of potential violations or erroneous indications of
compliance (i.e., false positives and false negatives), thus allowing
banking entities and examiners and supervisors to focus upon the
measurements that may be most relevant in identifying prohibited
conduct. The uniformity of the proposed measurements across different
types of banking entities is also intended to ensure that banking
entities are calculating comparable measurements consistently and that
comparable measurements are being evaluated consistently by Agencies.
The Agencies expect that as the implementation of quantitative
measurements and the internal compliance and external oversight
processes become more efficient over time, banking entities will find
compliance efforts less burdensome.
The Agencies seek comment on the extent to which banking entities
will incur costs associated with implementing, monitoring, and
attributing financial and personnel resources for purposes of complying
with the requirements of proposed Appendix A. Specifically, please
discuss the extent to which banking entities are unlikely to currently
calculate certain quantitative measurements in the manner required
under the proposal (e.g., Spread Profit and Loss or Customer-facing
Trade Ratio) and whether this may result in significant start-up costs
associated with developing these measurements. Under the proposal,
banking entities would also need to dedicate personnel and supervisory
staff to review for potential aberrant patterns of activity that
warrant further review, as well as maintain appropriate records of that
review. In order to limit these calculation and surveillance costs to
the greatest extent practicable, the Agencies have proposed
measurements that, in many cases, are already calculated by many
banking entities to measure and manage trading risks and activities.
The costs to banking entities associated with calculating the proposed
quantitative metrics should also be mitigated by the tiered application
of Appendix A, which would require banking entities with the most
extensive trading activities to report the largest number of
quantitative measurements, while imposing fewer or no reporting
requirements on banking entities with smaller trading activities. By
limiting the application of aspects of Appendix A to firms with greater
than $1 billion in trading assets and liabilities, and all aspects of
the appendix only to entities with greater than $5 billion in trading
assets and liabilities, the costs imposed should be proportional to the
market reach and complexity of a banking entity's trading activities.
B. Covered Fund Activities
Subpart C implements the statutory provisions of section
13(a)(1)(B) of the BHC Act, which prohibit banking entities from
acquiring or retaining any equity, partnership, or other ownership
interest in, or sponsoring, a covered fund, and other provisions of
section 13 of the BHC Act which provide exemptions from, or otherwise
relate to, that prohibition. In implementing the covered funds
provisions of section 13 of the BHC Act, the Agencies have proposed to
define and interpret several terms used in implementing these
provisions and the goals of section 13. We seek comment on whether the
proposed rule represents a balanced and effective approach to
implementing the covered fund provisions of the statute.
1. General Scope
For banking entities that invest in, sponsor or have relationships
with one or more covered funds, the economic impact of complying with
the statute and the implementing rule will vary, depending on the size,
scope and complexity of their respective business, operations and
relationships with clients, customers and counterparties. Moreover, the
types of covered funds advised or sponsored by an adviser, the types of
business and other relationships that an adviser may conduct with such
funds and the adviser's other business activities, including
relationships with other third party advised covered funds, will affect
whether a covered fund activity would be subject to the statutory
prohibition, eligible for a particular exemption or subject to
particular internal control requirements as specified by the proposed
rule.
For example, with respect to a banking entity that does not
``sponsor,''
[[Page 68929]]
invest in, or otherwise provide ``prime brokerage transactions'' to, a
``covered fund,'' the statute, as implemented by the proposed rule,
would not substantively restrict the banking entity's activity;
instead, the proposed rule would only require the minimum internal
controls reasonably designed to prevent the entity from engaging in the
prohibited activities. As a result, we do not expect that the proposed
rule would have a significant effect on most banking entities, such as
investment advisers, that are primarily engaged in providing bona fide
trust, fiduciary, or advisory services to unrelated parties. Although
such advisers may incur some incremental costs to develop and implement
a compliance program reasonably designed to ensure that they do not
engage in otherwise prohibited activities, there should be no
significant costs associated with modifying existing business practices
and procedures. We request comment on the extent to which such banking
entities would be required to modify their existing business practices
and procedures to comply with the proposed rule. For instance, would a
registered investment adviser that only advises registered investment
companies and that does not trade for its own account incur costs,
benefits or other impacts in addition to costs to implement the minimum
internal controls reasonably designed to prevent it from engaging in
prohibited activities? Would an adviser that trades on behalf of itself
incur, with respect to such trading activities, additional costs,
benefits or other impacts described above relating to the proposed
restrictions on proprietary trading?
In contrast, a banking entity that seeks to invest in a covered
fund could only do so in reliance on an exemption specified in the
statute or the proposed rule, such as the exemption for organizing and
offering certain covered funds provided in section 13(d)(1)(G), as
implemented in Sec. --.11 of the proposed rule. Similarly, a banking
entity that seeks to enter into ``prime brokerage transactions'' with a
covered fund could only do so by meeting certain requirements under the
proposed rule. Accordingly, the economic impact of the proposed rule
will depend on whether an adviser's activities fall within the scope of
the terms as proposed such that the banking entity would be subject to
the limitations on covered fund activities. To the extent that these
terms or exemptions would result in more, or fewer, activities being
captured by the proposed rule, what are the attendant costs and
benefits that a covered banking may incur? We request commenters
provide empirical data where possible.
Definition of Covered Fund. The proposed rule's definition of
``covered fund'' includes hedge funds and private equity funds as
defined by statute, but also identifies two types of similar funds--
commodity pools and certain non-U.S. funds--that are subject to the
covered fund restrictions and prohibitions of section 13 of the BHC
Act, as implemented by the proposed rule. The Agencies have proposed to
include these funds since they are generally managed and structured
similar to a covered fund, but are not generally subject to the Federal
securities laws due to the instruments in which they invest or the fact
that they are not organized in the United States or one or more States.
We request comment on whether applying the definition of covered fund
in this way as proposed would increase the number of investment
vehicles or similar entities that would be subject to the limitations
under the proposed rule. Would this approach increase compliance costs
for banking entities that sponsor, invest in, or have certain
relationships with these types of funds?
The proposed rule also excludes certain types of investments in
covered funds, pursuant to section 13(d)(1)(J) of the BHC Act, which
authorizes the Agencies to exclude from the general covered fund
activity prohibition those activities that would promote the safety and
soundness of a banking entity. Section --.14 of the proposed rule would
exclude from the prohibition, among other things, a banking entity's
investments in covered funds related to bank owned life insurance,
certain joint ventures and interests in securitization vehicles
retained in compliance with the minimum credit risk retention
requirements of section 15G of the Exchange Act. We request comment on
the potential economic impact of the proposal to exclude these types of
investments from the general prohibition. For banking entities whose
only covered fund activities are those described in Sec. --.14, what
economic impact would be attributed to complying with this provision of
the proposed rule? Would these costs and benefits differ from those of
banking entities that conduct covered fund activities as well as engage
in activities described in Sec. --.14? As described in the
Supplementary Information, a banking entity that generally does not
engage in any prohibited activities is only required to adopt and
implement a compliance program reasonably designed to ensure that the
entity does not engage in prohibited activities. To what extent will
the proposed provisions in Sec. --.14 increase or mitigate any costs,
benefits or other impacts associated with the foregoing minimum
internal controls requirement?
Definition of Sponsor. Under the proposed rule, the term
``sponsor'' is defined by incorporating the definition set forth in
section 13(h)(5) of the BHC Act, but the Agencies have proposed to
clarify that the term trustee, as used in the definition of sponsor,
does not include a trustee that does not provide discretionary
investment services to a covered fund. This exception distinguishes a
trustee providing non-discretionary advisory services from trustees
providing services similar to those associated with entities serving as
general partner, managing member, commodity pool operator or investment
adviser of a covered fund. We request comment on the economic impact
associated with the proposed definition of ``sponsor.'' Will the
economic impact differ depending on the scope of a banking entity's
covered fund activities? For example, a banking entity whose only
relationship with a covered fund involves the provision of non-
discretionary investment services would not be a sponsor under the
proposed rule. We request comment on whether such a banking entity
would benefit from this exception. We also request comment on whether a
covered fund's investors and counterparties would bear any costs
associated with a banking entity's modification of its business
practices or its relationship to the covered fund.
Other Definitions. The covered fund provisions also define, among
other things, ``director'' and ``prime brokerage transaction.'' What
are the costs, benefits or other impacts associated with the way the
proposed rule defines these terms? For example, would the proposed
definition of ``prime brokerage transaction'' enable a banking entity
to provide services to a covered fund that would not ordinarily be
understood to be prime brokerage as long as it met certain conditions?
What costs, or benefits, for banking entities, clients, customers or
counterparties may be associated with this approach to defining prime
brokerage transaction?
2. Exemptions
In implementing the covered funds provisions of section 13 of the
BHC Act, the Agencies also have interpreted or defined terms contained
in the three principal exemptions related to covered fund activities by
a banking entity: (i) The exemption for organizing and offering covered
funds; (ii) the
[[Page 68930]]
exemption for investment in a covered fund in the case of risk-
mitigating hedging; and (iii) the exemption for covered fund activities
outside of the United States. We request comment generally on the
potential impact of these statutory exemptions, as implemented by the
proposed rule. The Agencies note that there are multiple factors that
could affect the impact of the statute and the proposed rule on a
banking entity's covered fund activities, including other conditions
set forth in the statute or the proposed rule that could mitigate costs
or enhance benefits associated with a particular element or condition
of an exemption.
Organize and Offer Exemption. Section --.11 of the proposed rule
implements the exemption set forth in section 13(d)(1)(G) of the BHC
Act and generally incorporates all of the conditions specified in the
statute. As required by the statute, the exemption for organizing and
offering covered funds is available only to banking entities that
provide bona fide trust, fiduciary, commodity trading or investment
advisory services, which must meet certain requirements. As a result,
the exemption should not preclude banking entities, such as registered
advisers or other advisers, from providing trust or advisory services
to their clients. We request comment on whether the proposed
requirements of the exemption would result in a banking entity
modifying its business practices or bearing higher costs to comply with
the limitations and requirements applicable to this statutory
exemption, as implemented by the proposed rule. These costs may
include, for example, developing a credible plan that documents how
advisory services would be provided to banking entity customers through
organizing and offering covered funds and making the specified
disclosures required by the exemption. We also request comment on
whether the banking entity will pass these costs on to covered fund
investors and counterparties.
In implementing this statutory exemption, the Agencies have defined
or clarified several key terms or requirements, including (i) the
definition of ownership interest and (ii) the method for calculating
the 3% ownership interest limit. The proposed definition of ownership
interest is designed to describe the typical types of relationships
through which an investor has exposure to the profits and losses of a
covered fund. Consistent with this approach, carried interest is not
included within the proposed definition of ownership interest. As
discussed in the Supplementary Information above, carried interest
generally entitles service providers, such as banking entities that
provide advisory services, to receive compensation for such services
determined as a share of a covered fund's profits. As a result, the
proposed rule does not treat carried interest as an ownership interest,
which could have costs and benefits. To help discern these costs and
benefits, we request comment on whether this is consistent with how
providers of advisory services view the receipt of such ``carried
interest'' (i.e., as compensation for services rather than as an
``ownership interest'' equivalent to an investor's interest that shares
in a fund's profits and losses). The proposed definition of carried
interest has limitations designed to prevent a banking entity from
circumscribing the proposed rule's limitations on ownership. For
instance, among other things, the proposed definition requires that the
``sole purpose and effect of the interest is to allow banking entity *
* * to share in the profits of the covered fund.'' \364\ For banking
entities receiving compensation that would satisfy all of the elements
of the proposed definition, there should be no burden associated with
modifying existing business practices. For other banking entities,
however, the conditions specified in the proposed definition could
result in more banking entities being deemed to hold ``ownership
interests'' and hence subject to the limitations under the statute and
the proposed rule, including the limitations on material conflicts of
interest, high-risk trading activities and exposure to high-risk
assets. We request comment on whether these banking entities would need
to modify their existing practices and develop alternatives, and, if
so, whether these modifications will impose costs and benefits. For
example, costs associated with modifying business practices could
include developing and implementing a compliance program in accordance
with the proposed rule; benefits that may arise as a result of
modifying business practices could include limiting the extent to which
material conflicts of interest may arise between clients, customer and
counterparties of banking entities. We also request comment on whether
such costs, if any, are likely to be passed on to fund investors,
clients and counterparties.
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\364\ Proposed rule Sec. --.10(b)(3)(i).
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As required by statute, a banking entity that seeks to invest in a
covered fund under the exemption for organizing and offering covered
funds could not, after the expiration of an initial one-year period
(plus any applicable extensions), hold more than 3% of the total
outstanding ownership interests of such fund. The proposed rule would
require that a banking entity calculate the per-fund limit whenever the
covered fund calculates its value or permits investor investments or
redemptions, but in no case less frequently than quarterly. We request
comment on whether this approach will limit any additional burden
associated with calculating the per-fund limit for banking entities
that invest in covered funds that determine their value on at least a
quarterly basis. We also request comment on whether such banking
entities will incur any additional significant costs in determining
their compliance with the 3% ownership limitation.
Risk-mitigating Hedging Exemption. The proposed rule specifies an
exemption from the general prohibition on covered fund activities in
the case of risk-mitigating hedging. Similar to the hedging exemption
in the case of proprietary trading (discussed above), the hedging
exemption for covered fund activities specifies a number of conditions
that are identical except for two conditions. In the case of the
hedging exemption for covered fund activities, the hedging must
generally ``offset'' the exposure of the banking entity to the
liabilities associated with (i) the facilitation of customer
transactions or (ii) compensation arrangements for certain employees.
Consistent with the statute, the proposed exemption would enable a
banking entity to invest in a covered fund without limit if the
investment is for risk-mitigating hedging purposes.
We request comment on whether the proposed requirements will have
benefits of furthering the goals of compliance with the statute and
reducing banking entities' risks. We also request comment on whether
the proposed requirements are more restrictive than necessary to
implement the statute and whether they could unnecessarily limit a
banking entity's hedging activities and ability to reduce risk.
Commenters should also address whether the proposed requirements will
dissuade banking entities from engaging in other permitted activities
(e.g., organizing and offering covered funds) or those activities
outside the scope of the statute to the extent that the exemption
prevents them from mitigating the risks associated with such
activities. We request comment on whether a reduction in efficiency
could result from a reduced ability of covered banking entities to
transfer risks to those more willing to bear them. Commentators should
also address whether the proposed rule could reduce
[[Page 68931]]
a banking entity's willingness to engage in permitted risk-mitigating
hedging activities in order to avoid costs related to ensuring
compliance with the exemption's requirements, and whether this would
increase the banking entity's risk exposure.
Exemption for Covered Fund Activities Outside of the United States.
Section --.13(c) of the proposed rule implements section 13(d)(1)(I) of
the BHC Act, which permits certain foreign banking entities to sponsor
or invest in covered funds ``solely outside of the United States,'' so
long as the covered fund is not offered or sold to a resident of the
United States. The proposed exemption provides a number of specific
criteria for determining when a banking entity will be considered to
have invested or sponsored a covered fund solely outside of the United
States. The proposed exemption provides a definition of ``resident of
the United States'' that is similar, but not identical, to the SEC's
definition of ``U.S. person'' in Regulation S, which should promote
consistency and understanding among market participants that have
experience with the concept from the SEC's Regulation S. In addition,
the proposed exemption clarifies when a foreign banking entity will be
considered to engage in such trading pursuant to sections 4(c)(9) and
4(c)(13) of the BHC Act, as required by the statute, including with
respect to a foreign banking entity that is not a ``foreign banking
organization'' under the Board's Regulation K. This implementation of
section 13(d)(1)(I) of the BHC Act would permit certain foreign banking
entities that are not ``qualifying foreign banking organizations''
under the Board's Regulation K to also rely on the exemption,
notwithstanding the fact such foreign banking entities are not
currently subject to the BHC Act generally or the Board's Regulation K.
As a result, such foreign banking entities should encounter fewer costs
related to complying with the covered fund activity prohibitions than
if they were unable to rely on the exemption in section 13(d)(1)(I) of
the BHC Act.
Despite the reference to section 4(c)(13) of the BHC Act, the
statute provides that the exemption for covered fund activities outside
of the United States is only available to banking entities that are not
directly or indirectly controlled by U.S. banking entities (i.e., not
any U.S. banking entities or their foreign subsidiaries and
affiliates). Under the statute, the prohibition and restrictions on
covered fund activities apply to the consolidated, worldwide operations
of U.S. firms. As required by statute, the proposal prohibits U.S.
banking entities from investing in or sponsoring covered funds unless
the requirements of one or more relevant exemptions (other than the
exemption for trading by foreign banking entities) are satisfied. As a
result, the statute creates a competitive difference between the
foreign activities of U.S. banking entities, which must monitor and
limit their foreign activities in accordance with the requirements of
section 13 of the BHC Act, relative to the foreign activities of
foreign-based banking entities, which may not be subject to
restrictions similar to those in section 13 of BHC Act. The Agencies
seek commenters' views on whether the proposed rule's implementation of
section 13(d)(1)(I) of the BHC Act imposes additional competitive
differences, beyond those discussed above, and the potential economic
impact of such competitive differences.
3. Securitizations
The Agencies recognize that by defining ``covered fund'' and
``banking entity'' broadly, securitization vehicles may be affected by
the restrictions and requirements of the proposed rule, and this may
give rise to various economic effects. The Agencies preliminarily
believe that the proposed rule should mitigate the impact of
securitization market participants and investors in some non-loan asset
classes (including, for example, banking entities that are participants
in a securitization that may acquire or retain ownership interests in a
securitization vehicle that falls within the definition of covered
fund) by excluding loan securitizations from the restrictions on
sponsoring or acquiring and retaining ownership interests in covered
funds.
Costs may be incurred to establish internal compliance programs to
track compliance for any securitization vehicle that falls within the
definition of banking entity. These costs may be minimized for future
securitization vehicles, however, because such securitizations may be
able both to incorporate any internal compliance program requirements
into their documentation prior to execution, and to minimize (or
eliminate) any activities that may trigger greater compliance costs.
The proposed rule should further minimize the costs of the internal
compliance programs by (i) allowing for enterprise-wide compliance
programs and minimal requirements for banking entities that do not
engage in covered trading activities and/or covered fund activities or
investments (each as described below), and (ii) allowing for reduced
compliance program requirements by establishing financial thresholds
for ``significant'' covered trading activities or covered fund
activities or investments (as described below).
There could be initial costs both for banking entities that have an
ownership interest in a securitization vehicle and for other
securitization participants to determine if a particular vehicle falls
within the definition of covered fund. Additional costs could be
incurred to the extent that banking entities divest their ownership
interests in any securitization vehicle that is a covered fund and is
not otherwise eligible for one of the exceptions allowed under the
proposed rule. This divestment could result in selling pressure that
may have a negative impact on the market prices for the vehicles that
fall within the definition of covered fund, which in turn could impact
all investors in those securitization vehicles. Additionally, under the
proposed rule banking entities would no longer be allowed to acquire
and retain such ownership interests, which may result in fewer
potential investors and reduced liquidity in the market for ownership
interests in these covered funds.
For example, the proposed rule could lead to significant potential
market impacts if, with respect to an issuance of asset-backed
securities secured by assets which are not loans, the market requires
credit risk retention in excess of the minimum requirements to be
adopted pursuant to Section 941 of the Dodd-Frank Act (i.e., the market
believes that 5% credit risk retention is insufficient to address
potential misalignment of incentives in a particular transaction). In
such circumstances, the proposed rule could reduce potential investors'
demand for such securitizations and could make such securitizations
more expensive.
C. Limitations on Permitted Activities for Material Conflicts of
Interest and High-Risk Assets and High-Risk Trading Strategies
Section 13(d)(2)(A)(i) of the BHC Act provides that an otherwise-
permitted activity would not qualify for a statutory exemption if it
would involve or result in a material conflict of interest. The
proposed rule's definition of material conflict of interest, as
discussed in more detail in Part II of the Supplementary Information,
would provide flexibility to banking entities and their clients,
customers, and counterparties with respect to how transactions are
structured, while also establishing a structure to prevent banking
entities from engaging in transactions and activities in reliance on a
statutory
[[Page 68932]]
exemption when the transaction or activity would have a materially
adverse effect on the clients, customers, or counterparties of the
banking entity. Specifically, the proposed definition would permit the
use of timely and effective disclosure and/or information barriers in
certain circumstances to address and mitigate conflicts of interest,
while prohibiting transactions or activities where such a conflict of
interest cannot be addressed or mitigated in the specified manner. The
Agencies have endeavored to establish a workable definition that sets
forth when a banking entity may not rely on an exemption because it
would involve or result in a material conflict of interest, consistent
with the statutory goals, to facilitate banking entities' compliance
with the statutory requirements. We seek comment on whether the
statutory prohibition, as implemented by the proposal, may impose costs
on banking entities or their clients, customers, or counterparties. For
instance, by permitting a client, customer or counterparty the option
of negating or mitigating the conflict after the banking entity has
disclosed the conflict, would the banking entity incur certain costs
related to terminating the transaction, providing compensation or other
means of mitigating the conflict, or administrative costs associated
with negotiating the extent of any such compensation or other means of
mitigating the conflict, depending on the actions of the client,
customer, or counterparty in response to the disclosure?
In addition, section 13(d)(2)(A)(ii) of the BHC Act provides that
an otherwise-permitted activity would not qualify for a statutory
exemption if it would result, directly or indirectly, in a material
exposure by the banking entity to high-risk assets or high-risk trading
strategies. This statutory limitation, as implemented in the proposed
rule, would prevent a banking entity from engaging in certain high-risk
activity. The Agencies request comment on whether the proposed
definitions of high-risk asset and high-risk trading strategy would
potentially reduce liquidity or create a reduction in efficiency for
assets or markets related to that high-risk activity.
D. Compliance Program
Under Sec. --.20 of the proposed rule, all covered banking
entities that are engaged in covered trading activities or covered fund
activities or investments would be required to have a compliance
program that provides for the following six elements, at a minimum: (i)
Internal written policies and procedures; (ii) internal controls; (iii)
a management framework; (iv) independent testing; (v) training; and
(vi) recordkeeping. For those banking entities with significant covered
trading activities or covered fund activities or investments under
Sec. --.20(c) of the proposed rule, additional standards in proposed
Appendix C must be met with respect to these six elements.\365\
Collectively, the six proposed requirements would facilitate a banking
entity's review and assessment of its compliance with section 13 of the
BHC Act and the proposed rule, including identifying potential areas of
deficiency in a banking entity's compliance program and providing the
banking entity the opportunity to take appropriate corrective or
disciplinary action, where warranted. The proposed compliance program
would also facilitate Agency examination and supervision for compliance
with the requirements of the statute and the proposed rule. By
requiring that a banking entity have in place specific, documented
elements (e.g., written policies and procedures and internal controls,
recordkeeping requirements), the proposed rule would ensure that Agency
examiners and supervisors can effectively review a banking entity's
activities and investments to assess compliance and, where a banking
entity is not in compliance with the proposed rule, take appropriate
action.
---------------------------------------------------------------------------
\365\ Proposed rule Sec. --.20 and Appendix C implement section
13(e) of the BHC Act, which requires the Agencies to issue
regulations regarding internal controls and recordkeeping to ensure
compliance with section 13.
---------------------------------------------------------------------------
Beyond the benefits recognized above, the individual elements of
the proposed compliance program should also provide certain benefits.
For example, the proposed management framework requirement is designed
to give management a greater incentive to comply with the proposed rule
and to ascertain that the employees they are responsible for overseeing
are also complying with the proposed rule. Further, by establishing a
management framework for compliance, the banking entity would be
required to set a strong compliance tone at the top of the banking
entity's organization and signal to its employees that management is
serious about compliance, which should foster a strong culture of
compliance throughout the banking entity. Similarly, the proposed
independent testing requirement would provide a third-party assessment
of a banking entity's compliance with the proposed rule, which should
provide assurances to the banking entity, its clients, customers, and
counterparties, and current or prospective investors that the banking
entity is in compliance with the proposed rule. In addition, the
proposed training requirement should help the various employees of a
banking entity that have responsibilities and obligations under the
proposed rule (e.g., complying with the requirements for permitted
market making-related activity) understand such responsibilities and
obligations and facilitate the banking entity's compliance with the
proposed rule. This proposed requirement may also promote market
confidence by assuring that trading personnel, and other appropriate
personnel of the banking entity, are familiar with their regulatory
responsibilities and are complying with the applicable laws and
regulations in their interactions with clients, customers, and
counterparties.
Because the six elements would be required to be established by all
banking entities, other than those that are not engaged in covered
trading activities or covered fund activities or investments, the
proposed compliance program requirement should promote consistency
across banking entities. However, the proposed elements are also
intended to give a banking entity a degree of flexibility in
establishing and maintaining its compliance program in order to address
the varying nature of activities or investments conducted by different
units of the banking entity's organization, including the size, scope,
complexity, and risks of the activity or investment.
We seek comment on whether developing and providing for the
continued administration of a compliance program under Sec. --.20 of
the proposed rule is likely to impose material costs on banking
entities. Costs related to the proposed compliance program requirement
are likely to be higher for those banking entities that are engaged in
significant covered trading or covered fund activities or investments
and, as a result, are required to comply with the more detailed,
specific requirements of proposed Appendix C. Potential costs related
to implementation of a compliance program under the proposal include
those associated with: Hiring additional personnel or other personnel
modifications, new or additional systems (including computer hardware
or software), developing exception reports, and consultation with
outside experts (e.g., attorneys, accountants). The proposed compliance
program requirement would also impose ongoing costs related to
maintenance and enforcement of the compliance program
[[Page 68933]]
elements, which may include those associated with: Ongoing system
maintenance, surveillance (e.g., reviewing and monitoring exception
reports), recordkeeping, independent testing, and training. For
example, the independent testing requirement in the proposal may
necessitate that additional resources be provided to the internal audit
department of the covered banking entity that is a registered broker-
dealer or security-based swap dealer, if such testing is conducted by a
qualified internal tester. Alternatively, if an outside party is used
to conduct the independent testing, the covered banking entity would
incur costs associated with paying the qualified outside party's for
its services. The Agencies do not anticipate significant costs related
to the proposed management framework requirement, as banking entities
should already have relevant management structures in place.
The tiered approach with which the proposal applies the proposed
compliance program requirement to banking entities of varying size
should reduce the costs associated with developing and providing for
the continued administration of a compliance program. In setting forth
the proposed compliance program requirement in Sec. --.20 of the
proposed rule and Appendix C, the Agencies have taken into
consideration the size, scope, and complexity of a banking entity's
covered trading activities and covered fund activities and investments
in developing requirements targeted to the compliance risks of large
and small banking entities. Specifically, banking entities that do not
meet the thresholds established in Sec. --.20(c) of the proposed rule
would not be required to comply with the more detailed and burdensome
requirements set forth in Appendix C. In addition, banking entities
that do not engage in covered trading activities and covered fund
activities and investments would not be required to establish a
compliance program under the proposed rule, and therefore should incur
only minimal costs associated with adding measures to their existing
compliance policies and procedures to prevent the banking entity from
becoming engaged in such activities or making such investments.
Together, these provisions have been proposed in order to permit a
banking entity to tailor its compliance program to its activities and
investments and, where possible, leverage its existing compliance
structures, all of which should minimize the incremental costs
associated with establishing a compliance program under the proposed
rule. However, banking entities that are engaged in significant covered
trading and covered fund activities and investments and thereby present
a heightened compliance risk due to the size and nature of their
activities and investments would be required to comply with the
additional standards set forth in proposed Appendix C.
Costs associated with the requirements of proposed Appendix C
should also be reduced by aspects of the proposed rule that would
permit a banking entity to establish an enterprise-wide compliance
program under certain circumstances. An enterprise-wide compliance
program would generally permit one compliance program to be established
for a banking entity and all of its affiliates and subsidiaries
collectively, rather than each legal entity being required to establish
its own separate compliance program. The Agencies expect that an
enterprise-wide compliance program should promote efficiencies and
economies of scale, and reduce costs, associated with establishing
separate compliance programs.
E. Additional Request for Comment
In addition to the requests for comment discussed above, we seek
commenters' views on the following additional questions related to the
potential economic impacts of the proposed framework for implementing
section 13 of the BHC Act:
Question 348. What are the expected costs and benefits of complying
with the requirements of the proposed rule? We seek commenters'
estimates of the aggregate cost or benefit that would be incurred or
received by banking entities subject to section 13 of the BHC Act to
comply. We also ask commenters to break out the costs or benefits of
compliance to banking entities with each individual aspect of the
proposed rule. Please provide an explanation of how cost or benefit
estimates were derived. Please also identify any costs or benefits that
would occur on a one time basis and costs that would recur. Would
particular costs or benefits decrease or increase over time? If certain
costs or benefits cannot be estimated, please discuss why such costs or
benefits cannot be estimated.
Question 349. Please identify any costs or benefits that would
occur on a one-time basis and costs or benefits that would recur (e.g.,
training and compliance monitoring). Please identify any costs or
benefits that you believe would decrease over time. Please identify any
costs or benefits that you believe may increase over time or remain
static.
Question 350. Are there circumstances in which registered dealers,
security-based swap dealers, and/or swap dealers (i) hold accounts
other than trading accounts or (ii) hold investment positions for
activities for which they are required to be registered? If so, would
including all such dealer positions within the trading account
definition create competitive burdens as well as additional burdens on
the operations of such dealers that may not be consistent with the
language and purpose of the statute? Please describe how this may
occur, and to what extent it may occur.
Question 351. Please identify the ways, if any, that banking
entities might alter the ways they currently conduct business as a
result of the costs that could be incurred to comply with the
requirements of the proposed rule. Do you anticipate that banking
entities will terminate any services or products currently offered to
clients, customers, or counterparties due to the proposed rule, if
adopted? Please explain.
Question 352. How would trading systems and practices used in
today's marketplace be impacted by the proposed rule? What would be the
costs and/or benefits of such changes in trading practices and systems?
Question 353. Would the proposed rule create any additional
implementation or operational costs or benefits associated with systems
(including computer hardware and software), surveillance, procedural,
recordkeeping, or personnel modifications, beyond those discussed in
the above analysis? Would smaller banking entities be
disproportionately impacted by any of these additional implementation
or operational costs?
Question 354. We seek specific comments on the costs and benefits
associated with systems changes on banking entities with respect to the
proposed rule, including the type of systems changes necessary and
quantification of costs associated with changing the systems, including
both start-up and maintenance costs. We request comments on the types
of jobs and staff that would be affected by systems modifications and
training with respect to the proposed rule, the number of labor hours
that would be required to accomplish these matters, and the
compensation rates of these staff members.
Question 355. Please discuss any human resources costs associated
with the proposed rule, along with any associated overhead costs.
[[Page 68934]]
Question 356. What are the benefits and costs associated with the
requirements for relying on the underwriting exemption? What impact
will these requirements have on capital formation, efficiency,
competition, liquidity, price efficiency, if any? Please estimate any
resulting benefits and costs or discuss why such benefits and costs
cannot be estimated. What alternatives, if any, may be more cost-
effective while still being consistent with the purpose and language of
the statute?
Question 357. What are the benefits and costs associated with the
requirements for relying on the exemption for market making-related
activity, including the requirement that such activity be consistent
with the commentary in Appendix B? What impact will these requirements
have on liquidity, price efficiency, capital formation, efficiency, and
competition, if any? Please estimate any resulting benefits and costs
or discuss why such benefits and costs cannot be estimated. What
alternatives, if any, may be more cost-effective while still being
consistent with the purpose and language of the statute?
Question 358. What are the benefits and costs associated with the
requirements for relying on the exemption for risk-mitigating hedging
activity, including the requirement that certain hedge transactions be
documented? What impact will these requirements have on liquidity,
price efficiency, capital formation, efficiency, and competition, if
any? Please estimate any resulting benefits and costs or discuss why
such benefits and costs cannot be estimated. What alternatives, if any,
may be more cost-effective while still being consistent with the
purpose and language of the statute?
Question 359. Are there traditional risk management activities of
banking entities that are not covered by the liquidity management and
risk-mitigating hedging exemptions as currently proposed? What risks do
banking entities face that go beyond market, counterparty/credit,
currency/foreign exchange, interest rate, and basis risk? Could the
proposed construction of the liquidity management and risk-mitigating
hedging exemptions increase the costs of management or impede the
ability of banking entities to effectively manage risk?
Question 360. To rely on the exemptions from the proposed rule for
permitted underwriting, market making-related activity, and risk-
mitigating hedging, banking entities must establish, maintain, and
enforce a compliance program, including written policies and procedures
and internal controls. Please discuss how the costs incurred, or
benefits received, by banking entities related to initial
implementation and ongoing maintenance of the compliance program would
impact their customers and their businesses with respect to
underwriting, market making, and hedging activity.
Question 361. Please discuss benefits and costs related to the
limitations on permitted activities for material conflicts of interest,
high-risk assets and trading strategies, and threats to the safety and
soundness of banking entities or to the financial stability of the U.S.
in the proposed rule. Are there particular benefits and costs related
to the proposed definitions of material conflict of interest, high-risk
asset, and high-risk trading strategy in the proposed rule? Would these
definitions have any unintended costs, such as creating undue burdens
and limitations on permitted underwriting, market making-related, or
hedging activity? Please explain. What alternatives, if any, may be
more cost-effective while still being consistent with the purpose and
language of the statute?
Question 362. Please discuss the benefits and costs related to the
definition of derivative in the proposed rule and the application of
the restrictions on proprietary trading to transactions in the
different types of derivatives covered by the definition. What
alternatives, if any, may be more cost-effective while still being
consistent with the purpose and language of the statute?
Question 363. What costs and benefits would be associated with
calculating, reviewing, and analyzing the proposed quantitative
measurements? What costs and benefits would be associated with
reporting the proposed quantitative measurements to an Agency? Please
identify any of the proposed quantitative measurements that are already
reported to an Agency and discuss whether the current reporting regime
would mitigate costs associated with the proposed rule. With respect to
any quantitative measurement that is not already reported to an Agency,
what are the costs and benefits of beginning to report the measurement?
Would banking entities have to create or purchase new systems or
implement changes to existing systems in order to report these
quantitative measurements? Please discuss the costs and benefits
associated with such systems changes.
Question 364. How much of the data necessary to calculate the
quantitative measurements in Appendix A is currently captured,
retained, and utilized by banking entities? If the applicable data is
not currently used by banking entities, is it readily available? Is it
possible to collect all of the data that is necessary for calculating
the required measurements? Please identify any data that banking
entities do not currently utilize that would need to be captured and
retained for purposes of proposed Appendix A and discuss the costs and
benefits of capturing and retaining such data.
Question 365. Do the costs and benefits of calculating, analyzing,
and reporting certain or all quantitative measurements differ between
trading units and their trading activities, including trading
strategies, asset classes, market structure, experience and market
share, and market competitiveness? Are any quantitative measurements
particularly costly to calculate or analyze for specific trading
activities or, alternatively, particularly beneficial? If so, which
quantitative measurement, what type of trading activity, and what
factor(s) of that trading activity makes the quantitative measurement
particularly costly or beneficial? Please discuss how these costs, if
any, could be mitigated or benefits, if any, could be enhanced.
Question 366. The proposed definition of trading unit would require
a tiered approach to calculating and reporting quantitative
measurements, such that the measurements would be calculated and
reported for different levels within the banking entity, with higher
levels encompassing smaller units (e.g., trading desks, business lines,
and all trading operations). What are the costs and benefits of
calculating the quantitative measurements for each level within the
definition of trading unit? Can the higher level calculations
incorporate the lower level calculations such that the higher level
calculations result in small, incremental costs? Why or why not? Are
there particular costs or benefits associated with calculating,
analyzing, and reporting a quantitative measurement at one of the
levels within the definition of trading unit that would not be
experienced at the other levels? Please explain. What are the costs, if
any, of ``noise,'' ``false positives,'' or ``false negatives'' with
respect to the quantitative measurements and calculations at different
levels? Can these costs be mitigated and, if so, how? What
alternatives, if any, may be more cost-effective while still being
consistent with the purpose and language of the statute?
Question 367. We seek comment on whether the requirement that
banking entities employ a suite of quantitative measurements may lead
to redundancies and/or inefficiencies in the application of the
measurements for
[[Page 68935]]
some types of trading units within some banking entities. Despite the
flexibility of Appendix A via recognition that quantitative
measurements will be applied with respect to differences within a
banking entity's structure, business lines, and trading desks, we seek
comment on whether the requirement of a mandatory suite of quantitative
measurements may prove burdensome. For instance, is the application of
certain quantitative measurements not efficient, appropriate, or
calculable for certain asset classes or trading units or would the
benefits of applying such quantitative measurements be negligible in
relation to the costs of applying such measurements? In addition, would
the overlay divert a banking entity from allocating resources toward
quantitative--or other--measurements that might prove more useful and
better tailored to its specific and unique trading practices?
Question 368. What are the benefits and costs of the recordkeeping
requirement in proposed Appendix A? Please explain and quantify, to the
extent possible. To what extent would the proposed recordkeeping
requirement impose new or additional costs and benefits beyond the
current recordkeeping obligations of different types of banking
entities (e.g., affiliated broker-dealers, affiliated investment
advisers, insured depository institutions, etc.)? What alternatives, if
any, may be more cost-effective while still being consistent with the
purpose and language of the statute?
Question 369. Please identify any cost savings that would be
achieved through the use of an enterprise-wide compliance program.
Alternatively, would you expect certain costs to increase when using an
enterprise-wide compliance program? Please explain. Please identify any
benefits that might be amplified or reduced when using an enterprise-
wide compliance program.
Question 370. Are there tools or elements in the contents of the
compliance program set forth in Sec. --.20(b) for which the costs may
be negligible because banking entities use the same or similar elements
for other purposes (e.g., satisfying other regulatory requirements,
risk management, etc.) and could utilize existing infrastructure for
purposes of the proposed rule? For example, could existing trader
mandates or an existing training program be expanded to meet the
requirements of the proposed rule, rather than developing an entirely
new infrastructure? Alternatively, would the proposed rule require
redundancies or duplications within a banking entity's infrastructure
(e.g., the trader mandates currently used for one purpose do not
conform to the requirements of the proposed rule, so a banking entity
would have to utilize both in different circumstances)? Please identify
and explain any such redundancies and how the rule could be modified to
reduce or eliminate such redundancies, if possible.
Question 371. How would the proposed rule affect compliance costs
(e.g., personnel or system changes) or benefits for each category of
banking entity: Small, medium, and large? Please discuss any
differences between the costs and benefits of the compliance program
required under Sec. --.20(b) for smaller banking entities and the
compliance program requirements of Appendix C for larger banking
entities. Are the differences between these benefits and costs
justified due to the differences in size and complexity of smaller and
larger banking entities?
Question 372. The definition of trading unit in proposed Appendix C
covers different levels of a banking entity and, as a result, requires
a tiered approach to establishing, maintaining, and enforcing the
compliance program requirements with respect to covered trading
activities. What are the costs and benefits of applying the compliance
program requirements at several levels within the banking entity? To
what extent does the ability to incorporate written policies and
procedures of lower-level units by reference, rather than establishing
separate written policies and procedures, mitigate the costs of the
proposed requirements? Are there other ways that the proposed
requirements could be made more cost-effective for the different levels
within the banking entity?
Question 373. How will the proposed definition of ``covered fund''
affect a banking entity's investment advisory activities, in particular
activities and relationships with investment funds that would be
treated as ``covered funds''? Please estimate any resulting costs or
benefits or discuss why such costs or benefits cannot be estimated.
Question 374. How have banking entities traditionally organized and
offered covered funds? What are the benefits and costs associated with
the proposed requirements for relying on the exception for organizing
and offering covered funds? Please estimate any resulting costs or
benefits or discuss why such costs or benefits cannot be estimated.
Question 375. What are the costs and benefits associated with the
way the proposed rule implements the ``customers of such services''
requirement in the exception for organizing and offering covered funds?
What alternative, if any, may be more cost-effective while still being
consistent with the language and purpose of the statute?
Question 376. Is it common for a banking entity to share a name
with the covered funds that it invests in or sponsors? If yes, what
entity in the banking structure typically shares a name with such
covered funds? What costs and benefits will result from the proposed
rule's implementation of the name sharing requirement in exception for
organizing and offering a covered fund? What alternatives, if any, may
be more cost-effective while still being consistent with the purpose of
the statute?
Question 377. Under what circumstances do directors and employees
of a banking entity invest in covered funds? What are the benefits and
costs associated with the proposed provisions regarding director and
employee investments in covered funds? What alternatives, if any, may
be more cost-effective while still being consistent with the purpose of
the statute?
Question 378. Do banking entities currently invest in or sponsor
SBICs and public welfare and qualified rehabilitation investments? If
yes, to what extent? What are the benefits and costs associated with
the proposed rule's implementation of the exception for investment in
SBICs and public welfare and qualified rehabilitation investments?
Question 379. Do banking entities currently invest in or sponsor
each of the vehicles that the proposed rule permits banking entities to
continue to invest in and sponsor under section 12(d)(1)(J) of the BHC
Act? If yes, to what extent? What are the benefits and costs associated
with the proposed rule's implementation of these exceptions?
Question 380. For banking entities that are affiliated investment
advisers, are there additional costs or benefits to complying with
section 13 of the BHC Act and the proposed rule? For example, do
affiliated investment advisers typically maintain records that would
enable them to demonstrate compliance with the 3% ownership limits or
restrictions on transactions that would be subject to sections 23A and
23B of the FR Act?
Question 381. Would complying with section 13 of the BHC Act and
the proposed rule affect an affiliated investment adviser's other
business activities (benefit or burden) that are not subject to
restrictions on proprietary
[[Page 68936]]
trading or other covered fund activities? For example, would advisers
incur additional burdens to distinguish covered fund activities from
non-covered fund activities?
Question 382. For banking entities that are affiliated investment
advisers, are there particular costs or benefits to complying with the
portions of Appendix C that are applicable to each asset management
unit of the adviser? Do these costs and benefits differ depending on
whether the adviser complies with Appendix C individually or on an
enterprise basis? Does the rule provide sufficient clarify for how
Appendix C applies to unregistered affiliates of an affiliated
investment adviser?
Question 383. To the extent applicable, please address each of the
questions above with respect to securitization vehicles that would be
included in the proposed definition of covered fund.
VII. Administrative Law Matters
A. Paperwork Reduction Act Analysis Request for Comment on Proposed
Information Collection
In accordance with section 3512 of the Paperwork Reduction Act of
1995 (44 U.S.C. 3501-3521) (``PRA''), the Agencies may not conduct or
sponsor, and a respondent is not required to respond to, an information
collection unless it displays a currently valid Office of Management
and Budget (``OMB'') control number. The OCC, FDIC, and Board will
obtain OMB control numbers. The information collection requirements
contained in this joint notice of proposed rulemaking, to the extent
they apply to insured financial institutions that are not under a
holding company, have been submitted by the OCC and FDIC to OMB for
review and approval under section 3506 of the PRA and section 1320.11
of OMB's implementing regulations (5 CFR 1320). The Board reviewed the
proposed rule under the authority delegated to the Board by OMB. The
Board will submit to OMB once the final rule is published and the
submission will include burden for Federal Reserve-supervised
institutions, as well as burden for OCC-, FDIC-, SEC-, and CFTC-
supervised institutions under a holding company. The OCC and the FDIC
will take burden for banking entities that are not under a holding
company. The CFTC has stated that it will be publishing a separate
proposed rulemaking in the near future. The burden estimates for CFTC-
supervised institutions, published in this proposed rule, are based on
the requirements set forth below and the assumption that the CFTC's
proposed rulemaking would contain substantively similar requirements.
The proposed rule contains requirements subject to the PRA. The
reporting requirements are found in sections --.7(a) and --.12(d); the
recordkeeping requirements are found in sections --.3(b)(2)(iii)(C),
--.5(c), --.7(a), --.11(b), --.13(b)(3), --.20(b), --.20(c), and
--.20(d); and the disclosure requirement is found in section
--.11(h)(1). The recordkeeping and disclosure burden for the following
sections is accounted for in the --.20(b) burden: --.4(a)(2)(i),
--.4(b)(2)(i), --.5(b)(1), --.5(b)(2)(i), --.5(b)(2)(v),
--.13(b)(2)(i), --.13(b)(2)(ii)(A), --.13(b)(2)(ii)(D), --.15(a)(1),
and --.17(b)(1). These information collection requirements would
implement section 619 of the Dodd-Frank Act, as mentioned in the
Abstract below. The respondent/recordkeepers are for-profit financial
institutions, including small businesses. A covered entity must retain
these records for a period that is no less than 5 years in a form that
allows it to promptly produce such records to [Agency] on request.
Comments are invited on:
(a) Whether the collections of information are necessary for the
proper performance of the Agencies' functions, including whether the
information has practical utility;
(b) The accuracy of the estimates of the burden of the information
collections, including the validity of the methodology and assumptions
used;
(c) Ways to enhance the quality, utility, and clarity of the
information to be collected;
(d) Ways to minimize the burden of the information collections on
respondents, including through the use of automated collection
techniques or other forms of information technology; and
(e) Estimates of capital or start up costs and costs of operation,
maintenance, and purchase of services to provide information.
All comments will become a matter of public record. Comments on
aspects of this notice that may affect reporting, recordkeeping, or
disclosure requirements and burden estimates should be sent to the
addresses listed in the ADDRESSES section of this Supplementary
Information. A copy of the comments may also be submitted to the OMB
desk officer for the Agencies: By mail to U.S. Office of Management and
Budget, 725 17th Street NW., 10235, Washington, DC 20503 or by
facsimile to (202) 395-5806, Attention, Commission and Federal Banking
Agency Desk Officer.
Proposed Information Collection
Title of Information Collection: Reporting, Recordkeeping, and
Disclosure Requirements Associated with Restrictions on Proprietary
Trading and Certain Relationships with Hedge Funds and Private Equity
Funds.
Frequency of Response: Annual, monthly, and on occasion.
Affected Public: Businesses or other for-profit.
Respondents
Board: State member banks, bank holding companies, savings and loan
holding companies, mutual holding companies, foreign banking
organizations, and other holding companies that control an insured
depository institution. The Board will take burden for all institutions
under a holding company including:
OCC-supervised institutions,
FDIC-supervised institutions,
Banking entities for which the CFTC is the primary
financial regulatory agency, as defined in section 2(12)(C) of the
Dodd-Frank Act, and
Banking entities for which the SEC is the primary
financial regulatory agency, as defined in section 2(12)(B) of the
Dodd-Frank Act.
OCC: National banks, federal savings associations, and federal
savings banks not under a holding company, and their respective
subsidiaries, and their affiliates not under a holding company. The OCC
will take the burden with respect to registered investment advisers and
commodity trading advisers and commodity pool operators that are
subsidiaries of national banks, federal savings associations, and
federal savings banks not under a bank holding company.
FDIC: State nonmember banks not under a holding company; state
savings associations and state savings banks not under a holding
company; subsidiaries of state nonmember banks, state savings
associations and state savings banks not under a holding company; and
foreign banks having an insured branch.
Abstract: Section 619 of the Dodd-Frank Act added a new section 13
to the BHC Act (to be codified at 12 U.S.C. 1851) that generally
prohibits any banking entity from engaging in proprietary trading or
from investing in, sponsoring, or having certain relationships with a
hedge fund or private equity fund, subject to certain exemptions. New
section 13 of the BHC Act also provides for nonbank financial companies
supervised by the Board that engage in such activities or have such
[[Page 68937]]
investments or relationships to be subject to additional capital
requirements, quantitative limits, or other restrictions.
Section --.3(b)(2)(iii)(C) would require a covered banking entity
to establish a documented liquidity management plan in order to rely on
an exclusion from the definition of ``trading account'' for certain
positions taken for the bona fide purpose of liquidity management.
Section --.5(c) would require that, with respect to any purchase,
sale, or series of purchases or sales conducted by a covered banking
entity pursuant to section --.5 for risk-mitigating hedging purposes
that is established at a level of organization that is different than
the level of organization establishing the positions, contracts, or
other holdings the risks of which the purchase, sale, or series of
purchases or sales are designed to reduce, the covered banking entity
document, at the time the purchase, sale, or series of purchases or
sales are conducted:
(1) The risk-mitigating purpose of the purchase, sale, or series of
purchases or sales;
(2) The risks of the individual or aggregated positions, contracts,
or other holdings of a covered banking entity that the purchase, sale,
or series of purchases or sales are designed to reduce; and
(3) The level of organization that is establishing the hedge.
Section --.7(a) would require a covered banking entity engaged in
any proprietary trading activity pursuant to sections --.4 through --.6
to comply with the reporting and recordkeeping requirements described
in Appendix A if the covered banking entity has, together with its
affiliates and subsidiaries, trading assets and liabilities the average
gross sum of which (on a worldwide consolidated basis) is, as measured
as of the last day of each of the four prior calendar quarters, equal
to or greater than $1 billion, as well as such other reporting and
recordkeeping requirements as a relevant Agency may impose to evaluate
the covered banking entity's compliance with this subpart.
Section --.11(b) would require that, with respect to any covered
fund that is organized and offered by a covered banking entity in
connection with the provision of bona fide trust, fiduciary, investment
advisory, or commodity trading advisory services and to persons that
are customers of such services of the covered banking entity, the
covered banking entity document how the covered banking entity intends
to provide advisory or similar services to its customers through
organizing and offering such fund.
Section --.11(h)(1) would require that, with respect to any covered
fund that is organized and offered by a covered banking entity in
connection with the provision of bona fide trust, fiduciary, investment
advisory, or commodity trading advisory services and to persons that
are customers of such services of the covered banking entity, the
covered banking entity clearly and conspicuously disclose, in writing,
to any prospective and actual investor in the covered fund (such as
through disclosure in the covered fund's offering documents):
(1) That ``any losses in [such covered fund] will be borne solely
by investors in [the covered fund] and not by [the covered banking
entity and its affiliates or subsidiaries]; therefore, [the covered
banking entity's and its affiliates' or subsidiaries'] losses in [such
covered fund] will be limited to losses attributable to the ownership
interests in the covered fund held by the [covered banking entity and
its affiliates or subsidiaries] in their capacity as investors in the
[covered fund]'';
(2) That such investor should read the fund offering documents
before investing in the covered fund;
(3) That the ``ownership interests in the covered fund are not
insured by the FDIC, and are not deposits, obligations of, or endorsed
or guaranteed in any way, by any banking entity'' (unless that happens
to be the case); and
(4) The role of the covered banking entity and its affiliates,
subsidiaries and employees in sponsoring or providing any services to
the covered fund.
Section --.12(d) would extend the time to divest an ownership
interest in a covered fund. Upon receipt of an application from a
covered banking entity, the Board may extend the period of time to meet
the requirements under paragraphs (a)(2)(i)(A) and (B) of that section
for up to 2 additional years, if the Board finds that an extension
would be consistent with safety and soundness and not detrimental to
the public interest. An application for extension must:
(1) Be submitted to the Board at least 90 days prior to the
expiration of the applicable time period;
(2) Provide the reasons for application, including information that
addresses the factors in paragraph (e)(2) of that section; and
(3) Explain the covered banking entity's plan for reducing the
permitted investment in a covered fund through redemption, sale,
dilution or other methods as required in paragraph (a)(2)(i) of that
section.
Section --.13(b)(3) would require that, with respect to any
acquisition or retention of an ownership interest in a covered fund by
a covered banking entity pursuant to Sec. --.13(b), the covered
banking entity must document, at the time the transaction is conducted:
(1) The risk-mitigating purpose of the acquisition or retention of
an ownership interest in a covered fund;
(2) The risks of the individual or aggregated obligation or
liability of a covered banking entity that the acquisition or retention
of an ownership interest in a covered fund is designed to reduce; and
(3) The level of organization that is establishing the hedge.
Section --.20(b) would require a compliance program with respect to
covered fund activities and investments that shall, at a minimum,
include:
(1) Internal written policies and procedures reasonably designed to
document, describe, and monitor the covered trading and covered fund
activities and investments of the covered banking entity to ensure that
such activities and investments are compliant with section 13 of the
BHC Act and this part;
(2) A system of internal controls reasonably designed to monitor
and identify potential areas of noncompliance with section 13 of the
BHC Act and this part in the covered banking entity's covered trading
and covered fund activities and investments and to prevent the
occurrence of activities or investments that are prohibited by section
13 of the BHC Act and this part;
(3) A management framework that clearly delineates responsibility
and accountability for compliance with section 13 of the BHC Act and
this part;
(4) Independent testing for the effectiveness of the compliance
program conducted by qualified personnel of the covered banking entity
or by a qualified outside party;
(5) Training for trading personnel and managers, as well as other
appropriate personnel, to effectively implement and enforce the
compliance program; and
(6) Maintenance of records sufficient to demonstrate compliance
with section 13 of the BHC Act and this part, which a covered banking
entity must promptly provide to the Agency upon request and retain for
a period of no less than 5 years.
Section --.20(c) would require the compliance program of a covered
banking entity to also comply with the requirements and other standards
contained in Appendix C if the covered banking entity: (i) Engages in
proprietary trading and has, together
[[Page 68938]]
with its affiliates and subsidiaries, trading assets and liabilities
the average gross sum of which (on a worldwide consolidated basis), as
measured as of the last day of each of the four prior calendar quarters
(A) is equal to or greater than $1 billion, or (B) equals 10 percent or
more of its total assets; or (ii) invests in, or has relationships
with, a covered fund and (A) the covered banking entity has, together
with its affiliates and subsidiaries, aggregate investments in one or
more covered funds, the average value of which is, as measured as of
the last day of each of the four prior calendar quarters, equal to or
greater than $1 billion, or (B) sponsors and advises, together with its
affiliates and subsidiaries, one or more covered funds, the average
total assets of which are, as measured as of the last day of each of
the four prior calendar quarters, equal to or greater than $1 billion.
Section --.20(d) would require a covered banking entity that does
not engage in activities or investments prohibited or restricted in
subpart B or subpart C of the proposed rule, in order to be deemed to
have satisfied the requirements of Sec. --.20, to ensure that its
existing compliance policies and procedures include measures that are
designed to prevent the covered banking entity from becoming engaged in
such activities or making such investments and which require the
covered banking entity to develop and provide for establishment of the
compliance program required under Sec. --.20(a) of the proposed rule
prior to engaging in such activities or making such investments.
Estimated Paperwork Burden
In determining the method for estimating the paperwork burden the
Agencies made the assumption that affiliated entities under a holding
company would act in concert with one another to take advantage of
efficiencies that may exist. The Agencies invite comment on whether it
is reasonable to assume that affiliated entities would act jointly to
implement a firm-wide program or whether they would act independently
to implement programs tailored to each entity. In addition, the
Agencies invite comment as to the accuracy of our estimates of the
burdens concerning the proposed collections of information and whether
all banking entities subject to the rule are appropriately accounted
for by the Agencies.
Estimated Burden Per Response
Section --.3(b)(2)(iii)(C) recordkeeping--1 hour (Initial setup 3
hours).
Section --.5(c) recordkeeping--6 hours for entities with $1 billion
or more in trading assets/liabilities, 35 hours for entities with $5
billion or more in trading assets/liabilities.
Section --.7(a) reporting--2 hours for entities with $1 billion or
more in trading assets/liabilities, 2 hours for entities with $5
billion or more in trading assets/liabilities (Initial setup 6 hours
for entities with $1 billion or more in trading assets/liabilities, 6
hours for entities with $5 billion or more in trading assets/
liabilities).
Section --.7(a) recordkeeping--350 hours for entities with $1
billion or more in trading assets/liabilities, 440 hours for entities
with $5 billion or more in trading assets/liabilities.
Section --.11(b) recordkeeping--10 hours.
Section --.11(h)(1) disclosure--0.10 hours.
Section --.12(d) reporting--20 hours (Initial setup 50 hours).
Section --.13(b)(3) recordkeeping--10 hours.
Section --.20(b) recordkeeping--265 hours (Initial setup 795
hours).\366\
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\366\ For the Board, the section --.20(b) burden hours are 266
hours (ongoing) and 796 hours (initial setup) because the Board is
accounting for the 1 hour disclosure burden for certain SEC- and
CFTC-supervised entities.
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Section --.20(c) recordkeeping--1,200 hours (Initial setup 3,600
hours).
Section --.20(d) recordkeeping--8 hours.
Board
Number of respondents: 10,000.
Total estimated annual burden: 6,283,620 hours (4,541,070 hours for
initial setup and 1,742,550 hours for ongoing compliance).
FDIC
Number of respondents: 1,139.
Total estimated annual burden: 46,428 hours (29,934 hours for
initial setup and 16,494 hours for ongoing compliance).
OCC
Number of respondents: 469.
Total estimated annual burden: 253,796 hours (187,643 hours for
initial setup and 66,153 hours for ongoing compliance).
B. Initial Regulatory Flexibility Act Analysis
The Regulatory Flexibility Act (``RFA''), 5 U.S.C. 601 et seq.,
requires an agency to consider whether the rules it proposes will have
a significant economic impact on a substantial number of small
entities.\367\ If so, the agency must prepare an initial and final
regulatory flexibility analysis respecting the significant economic
impact. Pursuant to section 605(b) of the RFA, the regulatory
flexibility analysis otherwise required under sections 603 and 604 of
the RFA is not required if an agency certifies that the rule will not
have a significant economic impact on a substantial number of small
entities. The Agencies have considered the potential impact of the
proposed rule on small entities in accordance with the RFA. The
proposed rule would not appear to have a significant economic impact on
small entities for several reasons.
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\367\ A banking organization is generally considered to be a
small banking entity for the purposes of the RFA if it has assets
less than or equal to $175 million. See also 13 CFR 121.1302(a)(6)
(noting factors that the Small Business Administration considers in
determining whether an entity qualifies as a small business,
including receipts, employees, and other measures of its domestic
and foreign affiliates).
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First, while the proposed rule will affect all banking
organizations, including those that have been defined to be ``small
businesses'' under the RFA, only certain limited requirements would be
imposed on entities that engage in little or no covered trading
activities or covered fund activities and investments. Significantly,
the reporting and recordkeeping requirements of Sec. --.7 and Appendix
A of the proposed rule apply only to banking entities with average
trading assets and liabilities on a consolidated, worldwide basis equal
to or greater than $1 billion for the preceding year. This is a
threshold that a small banking entity typically would not meet.
Second, the scope and size of the compliance program requirements
set forth in subpart D and Appendix C of the proposed rule would vary
based on the size and activities of each covered banking entity. Only
banking entities with average trading assets and liabilities on a
worldwide consolidated basis equal to or greater than $1 billion or 10
percent or more of their total assets, or that have aggregate
investments in, or sponsor or advise, covered funds with aggregate
total assets of more than $1 billion must establish, maintain and
enforce a full compliance program under the proposed rule. Banking
entities that engage in trading activities or covered fund activities
and investments under these thresholds must adopt, at a minimum, only
the six core compliance requirements set forth in Sec. --.20 of the
proposed rule. Banking entities that do not engage in any covered
trading or fund activities, typical of small banking entities, must
ensure only that their compliance programs include measures designed to
[[Page 68939]]
prevent the entities from becoming engaged in covered activities unless
they first adopt a compliance program. These compliance requirements
would not appear to have a significant economic impact on a substantial
number of small entities.
OCC, FDIC, and SEC: For the reasons stated above, the head of the
OCC, FDIC, and the SEC certifies, for the covered banking entities
subject to each such Agency's jurisdiction, that the proposed rule
would not result in a significant economic impact on a substantial
number of small entities. The OCC, FDIC, and SEC encourage written
comments regarding this certification, and request that commenters
describe the nature of any impact on small entities and provide
empirical data to illustrate and support the extent of the impact.
Board: For the reasons stated above, the proposed rules would not
appear to have a significant economic impact on small entities subject
to the Board's jurisdiction. The Board welcomes written comments
regarding this initial regulatory flexibility analysis, and requests
that commenters describe the nature of any impact on small entities and
provide empirical data to illustrate and support the extent of the
impact. A final regulatory flexibility analysis will be conducted after
consideration of comment received during the public comment period.
C. OCC Unfunded Mandates Reform Act of 1995 Determination
Section 202 of the Unfunded Mandates Reform Act of 1995, Public Law
104-4 (2 U.S.C. 1532) (``Unfunded Mandates Act''), requires that an
agency prepare a budgetary impact statement before promulgating any
rule likely to result in a Federal mandate that may result in the
expenditure by state, local, and tribal governments, in the aggregate,
or by the private sector of $100 million or more, as adjusted by
inflation, in any one year. If a budgetary impact statement is
required, Section 205 of the Unfunded Mandates Act also requires an
agency to identify and consider a reasonable number of regulatory
alternatives before promulgating a rule.
The OCC has completed an assessment whether any mandates imposed by
the proposed rule may result in expenditures of $100 million or more
annually, as adjusted by inflation, by state, local, and tribal
governments, or by the private sector as required by the Unfunded
Mandates Act. The OCC focused its analysis on the impact of the various
compliance, recordkeeping, reporting, disclosure, and training
requirements in the proposed rule and, as provided for under section
201 of the Unfunded Mandates Act (2 U.S.C. 1531), excluded the cost of
requirements specifically set forth in the statute. Overall, the OCC
determined that this proposed rule will not result in expenditures by
state, local, and tribal governments, or by the private sector, of $100
million or more in any one year. Accordingly, this proposal is not
subject to Section 202 of the Unfunded Mandates Act.
The OCC also will need to prepare an impact statement for the final
rule, for purposes of the Unfunded Mandates Act and the Congressional
Review Act, Public Law 104-121 (5 U.S.C. 801-808). Comments provided on
the costs and benefits of the proposed rule, in response to the
analysis and questions posed in the Supplemental Information Part
VII.D, will help to inform this assessment.
D. SEC: Small Business Regulatory Enforcement Fairness Act
Under the Small Business Regulatory Enforcement Fairness Act of
1996,\368\ a rule is ``major'' if it has resulted, or is likely to
result, in:
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\368\ Public Law 104-121, Title II, 110 Stat. 857 (1996).
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An annual effect on the U.S. economy of $100 million or
more;
A major increase in costs or prices for consumers or
individual industries; or
Significant adverse effects on competition, investment, or
innovation.
The SEC requests comment on whether its proposed rule would be a
``major'' rule for purposes of the Small Business Regulatory
Enforcement Fairness Act. In addition, the SEC solicits comment and
empirical data on:
The potential effect on the U.S. economy on an annual
basis;
Any potential increase in costs or prices for consumer or
individual industries; and
Any potential effect on competition, investment, or
innovation.
VIII. SEC: Additional Matters
A. Statutory Authority and ``Covered Banking Entity'' Definition
1. Statutory authority
Section --.1 of the proposed rule implementing section 13 of the
BHC Act cites section 13 of the BHC Act, pursuant to which the SEC is
adopting the entirety of the proposed rule with respect to ``covered
banking entities,'' as that term is defined in the SEC's proposed
rule.\369\ Section --.1 also cites the SEC's independent authority
under certain sections of the Exchange Act to adopt Sec. Sec. --.5(c),
--.7(a), --.20, and Appendices A and C of the proposed rule.\370\
Compliance with such provisions, if adopted, will be subject to
examination and enforcement under the Exchange Act for certain covered
banking entities.
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\369\ The SEC notes that the SEC is only proposing rules as they
would be applicable to the banking entities for which the SEC has
regulatory authority, as set forth in section 13(b)(2)(B)(IV) of the
BHC Act, e.g., registered broker-dealers. Accordingly, the SEC
proposal should be read in the context of these regulated entities
and comments to the SEC should focus on these entities. For
instance, the SEC is particularly interested in the impact of the
proposed rules on the activities of such entities.
\370\ 15 U.S.C. 78o(c)(3)(A), 78o-10(f), (j), 78q(a), 78w.
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2. ``Covered Banking Entity'' Definition
The proprietary trading and covered fund activity prohibition set
forth in section 13 of the BHC Act, as proposed to be implemented in
Sec. --.3(a) and Sec. --.10(a) of the proposed rule, would apply to
any ``covered banking entity.''\371\ The term ``banking entity'' is
generally defined under section 13 of the BHC Act to include any
insured depository institution, 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, and any affiliates and subsidiaries of these entities.\372\
Section --.2(j) of the proposed rule implementing section 13 of BHC Act
would define the term ``covered banking entity.'' This term is used in
each Agency's proposed rule to describe the specific types of banking
entities to which that Agency's rule would apply.
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\371\ Proposed rule Sec. --.3(a) provides ``Except as otherwise
provided in this subpart, a covered banking entity may not engage in
proprietary trading.'' Proposed rule Sec. --.10(a) provides
``Except as otherwise provided in this subpart, a covered banking
entity may not, as principal, directly or indirectly, acquire or
retain any ownership interest in or sponsor a covered fund.''
\372\ See 12 U.S.C. 1851(h)(1); proposed rule Sec. --.2(e).
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As discussed in Part I of the Supplementary Information, the
authority for adopting regulations to implement section 13 of the BHC
Act is divided between the Agencies in the manner provided in section
13(b)(2).\373\
[[Page 68940]]
Section 13 of the BHC Act generally prohibits a banking entity from
engaging in proprietary trading or investing in or sponsoring a hedge
fund or private equity fund, and section 13(b)(2)(B)(i)(IV) of the BHC
Act directs the SEC to issue rules implementing that section with
respect to any entity for which the SEC is the primary financial
regulatory agency, as that term is defined in section 2 of the Dodd-
Frank Act.\374\ The SEC has proposed to restate that statutory
provision in defining ``covered banking entity'' for purposes of the
SEC's proposed rule.\375\
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\373\ See 12 U.S.C. 1851(b)(2). Under section 13(b)(2)(B) of the
BHC Act, rules implementing section 13's prohibitions and
restrictions must be issued by: (i) The appropriate Federal banking
agencies (i.e., the Board, the OCC, and the FDIC), jointly, with
respect to insured depository institutions; (ii) the Board, with
respect to any company that controls an insured depository
institution, or that is treated as a bank holding company for
purposes of section 8 of the International Banking Act, any nonbank
financial company supervised by the Board, and any subsidiary of any
of the foregoing (other than a subsidiary for which an appropriate
Federal banking agency, the SEC, or the CFTC is the primary
financial regulatory agency); (iii) the CFTC with respect to any
entity for which it is the primary financial regulatory agency, as
defined in section 2 of the Dodd-Frank Act; and (iv) the SEC with
respect to any entity for which it is the primary financial
regulatory agency, as defined in section 2 of the Dodd-Frank Act.
See id.
\374\ Under section 2(12)(B) of the Dodd-Frank Act, the term
``primary financial regulatory agency'' means the SEC with respect
to (i) SEC-registered brokers and dealers, with respect to the
activities of the broker or dealer that require the broker or dealer
to be registered as such under the Exchange Act; (ii) SEC-registered
investment companies, with respect to the activities of the
investment company that require the investment company to be
registered under the Investment Company Act; (iii) SEC-registered
investment advisers, with respect to the investment advisory
activities of such company and activities that are incidental to
such advisory activities; (iv) SEC-registered clearing agencies,
with respect to the activities of the clearing agency that require
the agency to be registered under the Exchange Act; (v) SEC-
registered nationally recognized statistical rating organizations;
(vi) SEC-registered transfer agents; (vii) national securities
exchanges registered with the SEC; (viii) national securities
associations registered with the SEC; (ix) SEC-registered securities
information processors; (x) the Municipal Securities Rulemaking
Board; (xi) the Public Company Accounting Oversight Board; (xii) the
Securities Investor Protection Corporation; and (xiii) SEC-
registered security-based swap execution facilities, security-based
swap data repositories, security-based swap dealers, and major
security-based swap participants, with respect to the security-based
swap activities of the person that require such person to be
registered under the Exchange Act. See section 2(12)(B) of the Dodd-
Frank Act. The SEC notes that, with respect to SEC-registered
clearing agencies, to the extent a clearing agency acquires or takes
a position in one or more covered financial positions in connection
with clearing securities transactions, such positions would be
excluded from the definition of trading account under the proposal.
See proposed rule Sec. --.3(b)(2)(iii)(D). As a result of this
proposed exclusion, clearing agencies' positions taken in connection
with clearing securities transactions would not involve proprietary
trading, as defined under the proposal, and would not be subject to
the prohibition on proprietary trading in Sec. --.3(a) of the
proposed rule. As discussed further below, the proposal is designed
to reduce any burdens on covered banking entities that do not engage
in proprietary trading and covered fund activities and investments.
\375\ See SEC proposed rule Sec. --.2(j).
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The SEC recognizes that some entities that would be included in the
SEC's proposed definition of ``covered banking entity'' generally do
not engage in covered trading activities and covered fund activities
and investments. The SEC notes that, to the extent the covered banking
entity does not engage in activities and investments covered by section
13 of the BHC Act and the proposed rule, the proposal is reasonably
designed to reduce and alleviate any burdens on such a covered banking
entity, while also preventing evasion of the proposed rule.
Specifically, a covered banking entity that does not engage in
activities and investments prohibited or restricted by section 13 of
the BHC Act and the proposed rule would only be required to include
measures in its existing compliance policies and procedures that are
reasonably designed to prevent the covered banking entity from becoming
engaged in such activities and making such investments under the
proposed rule.\376\
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\376\ See proposed rule Sec. --.20(d). However, to the extent
that the covered banking entity becomes engaged in such activities
or investments, it would be required to develop a more detailed
compliance program, as set forth in Sec. --.20(b) of the proposed
rule.
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The SEC requests comment on the proposed definition of ``covered
banking entity.'' In particular, the SEC requests comment on the
following questions:
Question SEC-1. Is the SEC's proposed definition of the term
``covered banking entity'' sufficiently clear? If not, why not? Please
suggest an alternative definition.
Question SEC-2. Is the SEC's proposed definition of the term
``covered banking entity'' appropriate, or is it over- or under-
inclusive? Please explain.
Question SEC-3. Should any of the covered banking entities included
in the SEC's proposed definition of ``covered banking entity'' be
excluded? If so, which entities, why, and on what basis? Should the
SEC's proposed rule provide specific guidance or exemptions for any
such entities?
Question SEC-4. Would particular types of entities incur costs or
burdens that are greater than other types of entities that are included
in the SEC's proposed definition of ``covered banking entity''? If so,
should any such difference be addressed or mitigated? How?
Question SEC-5. Are all of the provisions in the proposed rule
relevant to the business conducted by SEC covered banking entities? If
not, which provisions are not relevant and how should this be addressed
in the rule? Are there differences between the SEC's covered banking
entities and other types of banking entities subject to the rules of
the Federal banking agencies or the CFTC that have not been
sufficiently accounted for in the proposed rule? If so, what are these
differences and how should the SEC's rule account for such differences
in a manner that is consistent with the statutory requirement that the
Agencies' rules be consistent and comparable, to the extent possible?
B. Consideration of the Impact of Reporting and Recordkeeping and
Compliance Program Proposed Rules on Competition and on the Promotion
of Efficiency, Competition, and Capital Formation
Section 3(f) of the Exchange Act requires the SEC, whenever it
engages in rulemaking and is required to consider or determine whether
an action is necessary or appropriate in the public interest, to
consider, in addition to the protection of investors, whether the
action would promote efficiency, competition, and capital
formation.\377\ In addition, section 23(a)(2) of the Exchange Act
requires the SEC, when adopting rules under the Exchange Act, to
consider the impact such rules would have on competition.\378\ Section
23(a)(2) of the Exchange Act also prohibits the SEC from adopting any
rule that would impose a burden on competition not necessary or
appropriate in furtherance of the purposes of the Exchange Act. The
SEC's consideration of the factors specified in Exchange Act sections
3(f) and 23(a)(2) is limited to those portions of the proposal that, in
addition to being proposed under section 13 of the BHC Act, are also
being proposed pursuant to the SEC's authority under the Exchange Act
with respect to covered banking entities that are registered broker-
dealers and security-based swap dealers. The remaining portions of the
joint proposed rule are being proposed exclusively under the authority
set forth in Section 13 of the BHC Act, which does not require
consideration of the factors specified in Exchange Act sections 3(f)
and 23(a)(2).
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\377\ 15 U.S.C. 78c(f).
\378\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------
As discussed above in Part III.B.5 of the Supplementary
Information, Sec. --.7(a) of the proposed rule and proposed Appendix A
require covered banking entities that meet, together with their
affiliates and subsidiaries, the $1 billion gross trading assets and
liabilities threshold to: (i) Calculate and report certain quantitative
measurements, and (ii) create and retain records related to such
quantitative measurements. Further, under Sec. --.7(a) of the proposed
rule and proposed Appendix A, a larger number of
[[Page 68941]]
quantitative measurements are required to be calculated and reported by
covered banking entities that, together with their affiliates and
subsidiaries, have over $5 billion gross trading assets and
liabilities. In addition, such measurements are required to be
calculated and reported for a broader scope of trading activities if a
covered banking entity meets the $5 billion threshold.
The reporting and recordkeeping requirements in Sec. --.7(a) and
Appendix A of the proposed rule are likely to impose certain costs on
covered banking entities that meet the $1 billion gross trading assets
and liabilities threshold, including costs associated with
implementing, monitoring, and attributing financial and personnel
resources for purposes of complying with the reporting and
recordkeeping requirements. Moreover, such costs will likely be greater
for covered banking entities that meet the $5 billion threshold.
Incurring these costs may marginally reduce the ability of covered
banking entities that are registered broker-dealers and security-based
swap dealers to compete with their non-banking entity counterparts or
with banking entities that do not meet the $1 billion threshold.
Further, as a result of these costs, the proposal may impose additional
competitive burdens on registered broker-dealers and security-based
swap dealers that, together with their affiliates and subsidiaries,
meet the $5 billion threshold, and may affect their ability to compete
with: (i) Banking entities with $1 to $5 billion gross trading assets
and liabilities; (ii) banking entities below the $1 billion threshold;
and (iii) non-banking entities. In addition, registered broker-dealers
and security-based swap dealers that are covered banking entities
meeting the $1 billion threshold may need to redirect resources from
other functions of the broker-dealer or security-based swap dealer in
order to comply with the reporting and recordkeeping requirements.
Reallocating available resources within the registered broker-dealer or
security-based swap dealer may reduce efficiency within the covered
banking entity and may have a marginal negative impact on the extent to
which the registered broker-dealer or security-based swap dealer
continues to perform certain functions, which may include those that
serve customers or provide other market benefits. If this were to
occur, registered broker-dealers and security-based swap dealers that
are covered banking entities meeting the $5 billion threshold may face
greater efficiency effects because they will likely need to devote more
time and resources to the enhanced reporting and recordkeeping
requirements set forth in the proposal for such covered banking
entities. The increased cost of doing business that may result from the
proposed reporting and recordkeeping requirements could also cause a
registered broker-dealer or security-based swap dealer that is a
covered banking entity to pass some of the costs along to customers and
clients of their services, such as market making or underwriting. On
the other hand, the reporting and recordkeeping requirements in Sec.
--.7(a) and Appendix A could have positive efficiency effects because
these measures generally may improve compliance within covered banking
entities and thereby reduce the potential consequences associated with
noncompliance.
The reporting and recordkeeping requirements may create an
incentive for covered banking entities that are registered broker-
dealers and security-based swap dealers to reduce their average gross
sum of trading assets and liabilities, together with their affiliates
and subsidiaries, below the $5 billion threshold or $1 billion in order
to avoid the costs of complying with some or all of the requirements in
Sec. --.7(a) of the proposed rule and Appendix A. To the extent the
proposed rule creates such an incentive, a covered banking entity that
is a registered broker-dealer or security-based swap dealer may reduce
the amount of its trading activities to be below the applicable
threshold. If a registered broker-dealer or security-based swap dealer
that is a covered banking entity decreased the extent to which it
engaged in trading activities, the resulting effects could be decreased
competitiveness of the registered broker-dealer or security-based swap
dealer in the broader market and reduced market efficiency and
liquidity. Whether there will be a competitive impact will depend on
the way in which a registered broker-dealer or security-based swap
dealer that is a covered banking entity chooses to reduce its trading
activities. For example, if the reporting and recordkeeping requirement
lead a covered banking entity to minimize its trading in a particular
product, this may lead to a decreased competitiveness in the trading of
that particular product. The reporting and recordkeeping requirements,
however, could enhance efficiency by improving covered banking
entities' compliance and thereby reduce the potential consequences
associated with noncompliance.
Further, a majority of the quantitative measurements in proposed
Appendix A would only be required to be calculated and reported for
trading units engaged in market making-related activity under Sec.
--.4(b) of the proposed rule. To the extent that the costs associated
with the requirements in Appendix A create a disincentive for covered
banking entities that are registered broker-dealers or security-based
swap dealers to engage in the full range of market making-related
activity that is permitted under the rule, such covered banking
entities may reduce the size or scope of their market making
activities. If this were to occur to a significant extent, the overall
reduction in market making activities would likely have a negative
impact on market efficiency and liquidity and, as a related matter,
capital formation by causing certain banking entities to provide fewer
market making-related services. This potential reduction in market
making on the part of certain registered broker-dealers or security-
based swap dealers that are covered banking entities may cause some
demand for market making-related services to migrate to smaller banking
entities not meeting the $1 billion threshold and non-banking entities.
At the same time, the quantitative measurements required under Appendix
A could have positive efficiency effects by generally improving
compliance and thereby reduce the potential consequences associated
with noncompliance.
The documentation requirements of Sec. --.5(c) of the proposed
rule, which provides that risk-mitigating hedging transactions must be
documented in a specified manner if the hedging transaction is
established at a level of organization that is different than the level
of organization establishing or responsible for the position, contract,
or other holding that is being hedged, may have a negative impact on
efficiency by reducing the speed with which a covered banking entity
could execute a hedge at a different level within the entity. To the
extent that the proposed documentation requirement makes it more costly
or difficult for a covered banking entity that is a registered broker-
dealer or security-based swap dealer to establish hedges at a different
level within the entity, this requirement may result in increased risks
or reduced profitability of the broker-dealer or security-based swap
dealer, which could negatively affect the competitiveness of the
broker-dealer or security-based swap dealer. Further, greater
difficulties or increased costs, such as those related to potential
[[Page 68942]]
systems changes and maintenance, employee resources and time, and
recordkeeping, related to establishing a hedge at a different level
within the covered banking entity may cause the registered broker-
dealer or security-based swap dealer to reduce its underwriting or
market making-related activities under the proposed rule in order to
avoid costs related to hedging underwriting or market making positions,
which could likewise harm efficiency and capital formation.
Alternatively, such costs could be passed through to clients or
customers of the registered broker-dealer or security-based swap dealer
which, in turn, could harm capital formation.
As discussed above in Part III.D of the Supplemental Information,
Sec. --.20 of the proposed rule requires all covered banking entities
to develop and provide for the continued administration of a program
reasonably designed to ensure and monitor compliance with the
prohibitions and restrictions of section 13 of the BHC Act and the
proposed rule, unless such covered banking entity does not engage in
activities or investments prohibited or restricted by subpart B or
subpart C of the proposed rule.\379\ In addition, covered banking
entities that meet the thresholds in Sec. --.20(c) of the proposed
rule are required to satisfy the additional standards and requirements
in proposed Appendix C with respect to their compliance program.
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\379\ See proposed rule Sec. Sec. --.20(a), (d).
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The SEC recognizes that the compliance program requirements in the
proposal are likely to impose certain costs, including implementation
and ongoing maintenance costs associated with hiring additional
personnel or other personnel modifications, new or additional systems
(including computer hardware or software), ongoing system maintenance,
developing exception reports, surveillance (e.g., reviewing and
monitoring exception reports), consultation with outside experts (e.g.,
attorneys, accountants), recordkeeping, independent testing, and
training. These costs may increase competitive burdens on registered
broker-dealers and security-based swap dealers that are covered banking
entities. For example, the increased compliance costs related to
implementation and ongoing maintenance of the six elements of the
compliance program (i.e., written policies and procedures, internal
controls, a management framework, independent testing, training, and
recordkeeping), as part of the overall cost of doing business, may make
it more difficult for covered banking entities that are registered
broker-dealers and security-based swap dealers to compete with non-
banking entity broker-dealers and security-based swap dealers. Further,
there may be additional competitive burdens for covered banking
entities that are registered broker-dealers and security-based swap
dealers that, together with their affiliates and subsidiaries, meet the
thresholds in Sec. --.20(c), which determines the covered banking
entities that must comply with the minimum standards in proposed
Appendix C, as there are likely to be increased compliance costs
related to the more specific requirements for the compliance program
requirements set forth in Appendix C. Since the thresholds in Sec.
--.20(c) are based on the size of the registered broker-dealer or
security-based swap dealer, together with its affiliates and
subsidiaries, and the size of their collective covered trading
activities and covered fund activities and investments, the demand for
these trading activities may migrate to smaller banking entities or
non-banking entities.
In addition, the costs associated with implementation and ongoing
maintenance of the compliance program requirements in Sec. --.20 of
the proposed rule and Appendix C, where applicable, could cause the
covered banking entity to redirect resources from other business
activities that are generally beneficial to market efficiency, such as
market making and other customer-related services. This potential
reallocation of resources could have a marginal negative effect on
competition, efficiency, and capital formation. For example, the
independent testing requirement in the proposal may necessitate that
additional resources be provided to the internal audit department of
the covered banking entity that is a registered broker-dealer or
security-based swap dealer, if such testing is conducted by a qualified
internal tester. Alternatively, if an outside party is used to conduct
the independent testing, the covered banking entity would incur costs
associated with paying the qualified outside party for its services,
which would reduce the resources available for other activities of the
covered banking entity.
Further, Sec. Sec. --.4(a), --.4(b), and --.5 of the proposed
rule, which permit underwriting, market making-related, and risk-
mitigating hedging activities, require a covered banking entity to
establish the compliance program required in the proposed rule in order
to rely on the exemptions. To the extent that the burdens associated
with the compliance program requirements in the proposed rule create an
incentive for registered broker-dealers and security-based swap dealers
that are covered banking entities to forgo these permitted activities,
rather than incur the costs related to establishing and maintaining a
compliance program, there would likely be a negative impact on
efficiency, competition, and capital formation as a result of reduced
market making and underwriting services available to customers and
clients of such services.
The SEC requests comment on the competitive or anticompetitive
effects of the elements of the proposed rule that are proposed under
Exchange Act authority with respect to covered banking entities that
are registered broker-dealers and security-based swap dealers. The SEC
also seeks comment on the efficiency and capital formation effects of
these components of the proposal, if adopted. The SEC encourages
commenters to identify, discuss, analyze, and supply relevant data,
information, or statistics regarding any such effects.
C. Registered Investment Advisers
As discussed above, under the proposed rule, a covered banking
entity as defined in Sec. --.2(j) would generally be subject to the
substantive requirements contained in the SEC's rule. These substantive
requirements implement the provisions on proprietary trading and
covered fund activities under section 13 of the BHC Act. Thus for
example, a covered banking entity that is a registered dealer would be
required to comply with subparts A through D of the SEC's proposed
rule, including Appendices A, B and C, where applicable. With respect
to covered fund activities, investments or relationships set forth in
subpart C and Sec. --.20 of subpart D (``covered fund restrictions''),
however, the SEC's proposed rule would require that a covered banking
entity that is a covered banking entity because it is an investment
adviser for which the SEC is the primary financial regulatory agency
under section 2(12)(B)(iii) of the Dodd-Frank Act (a ``registered
adviser'') comply with the covered fund restrictions issued by the
appropriate Federal banking agency that regulates the banking entity
specified in Sec. --.2(e)(1), (2) and (3) with which the registered
adviser is affiliated.\380\ Under
[[Page 68943]]
this approach, a registered adviser would be required to comply with
the rules and related guidance issued by the appropriate Federal
banking agency. The SEC would, however, retain enforcement authority
over all activities of registered advisers (i.e., both proprietary
trading and covered fund restrictions).
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\380\ A registered adviser would, however, be required to comply
with the provisions that implement the proprietary trading
restrictions set forth in subparts A, B and Sec. --.20 of subpart D
of the proposed rule as promulgated by the SEC, including Appendix
C, where applicable.
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The covered fund restrictions of section 13 of the BHC Act and the
proposed implementing rules make reference to or incorporate a number
of banking law and supervision concepts that traditionally appear in
Federal banking law and are interpreted and applied by the Federal
banking agencies. For example, as discussed in greater detail in the
Supplementary Information, the limitations on ownership interests in a
covered fund set forth in the statute and the proposed rule generally
reference the tier 1 capital of the affiliated insured depository
institution or the affiliated holding company. Similarly, capital
deductions under the proposed rule refer to the tier 1 capital of the
affiliated insured depository institution or the affiliated holding
company. In addition, the covered fund restrictions of the statute and
the proposed rule incorporate by reference sections 23A and 23B of the
FR Act and are administered by the Federal banking agencies. These
sections of the FR Act restrict and limit transactions between certain
banking organizations and their affiliates, some of which are based on
a percentage of bank capital. Further, other covered fund restrictions,
including for example exemptions for investments involving the public
welfare and bank-owned life insurance and the extension of time to
divest of investments after the seeding period, reference other banking
laws or regulations that are administered by the Federal banking
agencies.
In light of these considerations, the SEC's proposed rule would
require a registered adviser to comply with the covered fund
restrictions contained in subpart C and Sec. .--20 of subpart D of
rules implementing section 13 of the BHC that are issued by the
appropriate Federal banking agency that regulates the banking entity
with which the registered adviser is affiliated. Under the proposed
approach, a registered adviser complying with the SEC's rule would do
so by complying with the rule issued by the appropriate Federal banking
agency, including any related interpretations or guidance regarding
such requirements. Similarly, under the proposed approach, the
foregoing determinations regarding capital or other banking law
requirements that may be applicable to a registered adviser would be
made by the appropriate Federal banking agency that regulates the
banking entity with which the registered adviser is affiliated. This
approach would mitigate the burdens of complying with the covered fund
restrictions for registered advisers and would avoid creating
incentives for covered fund activities to be moved from a registered
adviser to a bank.\381\
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\381\ Unless it advises a registered investment company, a bank
(as defined in section 202(a)(2) of the Advisers Act) that relies on
the exclusion from the definition of investment adviser under
section 202(a)(11)(A) of the Advisers Act would not be required to
register under the Advisers Act. If such a bank provided advisory
services, the bank would not be a ``covered banking entity'' under
the SEC's proposed rules because its primary financial regulatory
agency would not be the SEC.
---------------------------------------------------------------------------
The SEC's proposed rule specifies that a registered adviser must
comply with the covered fund restrictions contained in subpart C and
Sec. --.20 of subpart D that are issued by the appropriate Federal
banking agency that regulates the banking entity with which the
registered adviser is affiliated. Subpart C, which uses terms defined
in subpart A, specifies the covered fund restrictions. Subpart D Sec.
--.20 requires the establishment of a compliance program when engaging
in covered fund activities. A registered adviser complying with subpart
C and Sec. --.20 of subpart D, as issued by the appropriate Federal
banking agency, would also rely on interpretative guidance issued by
the appropriate Federal banking agency with respect to those subparts
of the proposed rule. Because Sec. --.20 of subpart D relates to both
the prohibitions and restrictions on proprietary trading activity as
well as the prohibitions and restrictions on covered fund activities
and investments, a registered adviser would be required to comply with
the relevant covered fund provisions issued by the appropriate Federal
banking agency. A registered adviser, however, would be subject to the
provisions set forth in subpart D of the SEC's proposed rule, including
Sec. --.20, that relate to covered trading activities.
Nothing set forth in the discussion above, or in Sec. --.10(a)(2)
of the SEC's proposed rule, however, is intended, or shall be deemed,
to limit the SEC's authority under any other provision of law,
including pursuant to section 13 of the BHC Act.
The SEC request comment on its proposed approach to implementing
section 13 of the BHC Act as it applies to registered advisers with
respect to the covered fund restrictions. In particular, the SEC
requests comment on the following:
Question SEC-5. Should the SEC instead require registered advisers
to comply with the covered fund restrictions proposed by the SEC,
instead of those issued the appropriate Federal banking agency? If so,
could this create incentives to move the advisory business between the
registered adviser and its affiliated bank? Are there benefits to this
alternate approach? If so, please explain.
Question SEC-6. Are there other alternative approaches to the
proposed rule that would be more effective? If yes, what alternatives
and why?
Question SEC-7. Would registered advisers affiliated with insured
depository institutions benefit from the proposed approach? Why or why
not?
Question SEC-8. Would a registered adviser that is affiliated with
insured depository institutions that are regulated by multiple Federal
banking agencies encounter additional burdens in implementing the
proposed approach? With respect to these registered advisers, which
Federal banking agency's rules should be applicable to the registered
adviser? For example, should the registered adviser be subject to the
rules applicable to the registered adviser's immediate parent that is
an insured depository institution?
Question SEC-9. Is the proposed requirement that registered
advisers comply with the covered fund restrictions in Sec. --.20
issued by the Federal banking agency that regulates the banking entity
specified in Sec. --.2(e)(1), (2) and (3) of the proposed rule with
which the registered adviser is affiliated sufficiently clear? Are
there particular compliance program requirements in Sec. --.20 with
respect to the covered fund restrictions that overlap with the
proprietary trading restrictions, such that it would be difficult to
identify which requirements are related to the covered fund
restrictions and which requirements are related to the proprietary
trading restrictions? If so, which requirements and how should this
overlap be addressed? Should registered advisers be required to comply
with Sec. --.20 of the SEC's rule in its entirety? Why or why not?
Question SEC-10. Will the SEC's proposed approach limit the
potential for inconsistent application of the proposed rules with
respect to affiliates of entities specified in Sec. --.2(e)(1), (2)
and (3)? Why or why not?
Question SEC-11. Will the SEC's proposed approach be effective in
avoiding the creation of incentives for covered fund activities to move
from a
[[Page 68944]]
registered adviser to a bank? Why or why not?
Text of the Proposed Common Rules
(All Agencies)
The text of the proposed common rules appears below:
PART [ ]--PROPRIETARY TRADING AND CERTAIN INTERESTS IN AND
RELATIONSHIPS WITH COVERED FUNDS
Subpart A--Authority and Definitions
Sec.
--.1 Authority, purpose, scope, and relationship to other
authorities. [Reserved]
--.2 Definitions.
Subpart B--Proprietary Trading
--.3 Prohibition on proprietary trading.
--.4 Permitted underwriting and market making-related activities.
--.5 Permitted risk-mitigating hedging activities.
--.6 Other permitted proprietary trading activities.
--.7 Reporting and recordkeeping requirements applicable to trading
activities.
--.8 Limitations on permitted proprietary trading activities.
--.9 [Reserved]
Subpart C--Covered Fund Activities and Investments
--.10 Prohibition on acquiring or retaining an ownership interest in
and having certain relationships with a covered fund.
--.11 Permitted organizing and offering of a covered fund.
--.12 Permitted investment in a covered fund.
--.13 Other permitted covered fund activities and investments.
--.14 Covered fund activities and investments determined to be
permissible.
--.15 Internal controls, reporting and recordkeeping requirements
applicable to covered fund activities and investments.
--.16 Limitations on relationships with a covered fund.
--.17 Other limitations on permitted covered fund activities and
investments.
--.18 [Reserved]
--.19 [Reserved]
Subpart D--Compliance Program Requirement; Violations
--.20 Program for monitoring compliance; enforcement.
--.21 Termination of activities or investments; penalties for
violations.
Appendix A to Part [ ]--Reporting and Recordkeeping Requirements for
Covered Trading Activities
Appendix B to Part [ ]--Commentary Regarding Identification of
Permitted Market Making-Related Activities
Appendix C to Part [ ]--Minimum Standards for Programmatic
Compliance
Subpart A--Authority and Definitions
Sec. --.1 Authority, purpose, scope, and relationship to other
authorities. [Reserved]
Sec. --.2 Definitions.
Unless otherwise specified, for purposes of this part:
(a) Affiliate has the same meaning as in section 2(k) of the BHC
Act (12 U.S.C. 1841(k)).
(b) Applicable accounting standards means U.S. generally accepted
accounting principles or such other accounting standards applicable to
a covered banking entity that [Agency] determines are appropriate, that
the covered banking entity uses in the ordinary course of its business
in preparing its consolidated financial statements.
(c) BHC Act means the Bank Holding Company Act of 1956 (12 U.S.C.
1841 et seq.).
(d) Bank holding company has the same meaning as in section 2 of
the BHC Act (12 U.S.C. 1841).
(e) Banking entity means:
(1) Any insured depository institution;
(2) Any company that controls an insured depository institution;
(3) Any company that is treated as a bank holding company for
purposes of section 8 of the International Banking Act of 1978 (12
U.S.C. 3106); and
(4) Any affiliate or subsidiary of any entity described in
paragraphs (e)(1), (2), or (3) of this section, other than an affiliate
or subsidiary that is:
(i) A covered fund that is organized, offered and held by a banking
entity pursuant to Sec. --.11 and in accordance with the provisions of
subpart C of this part, including the provisions governing
relationships between a covered fund and a banking entity; or
(ii) An entity that is controlled by a covered fund described in
paragraph (e)(4)(i) of this section.
(f) Board means the Board of Governors of the Federal Reserve
System.
(g) Buy and purchase each include any contract to buy, purchase, or
otherwise acquire. For security futures products, such terms include
any contract, agreement, or transaction for future delivery. With
respect to a commodity future, such terms include any contract,
agreement, or transaction for future delivery. With respect to a
derivative, such terms include the execution, termination (prior to its
scheduled maturity date), assignment, exchange, or similar transfer or
conveyance of, or extinguishing of rights or obligations under, a
derivative, as the context may require.
(h) CFTC means the Commodity Futures Trading Commission.
(i) Commodity Exchange Act means the Commodity Exchange Act (7
U.S.C. 1 et seq.).
(j) [Reserved]
(k) Depository institution has the same meaning as in section 3(c)
of the Federal Deposit Insurance Act (12 U.S.C. 1813(c)).
(l) (i) Derivative means:
(A) Any swap, as that term is defined in section 1a(47) of the
Commodity Exchange Act (7 U.S.C. 1a(47)), or security-based swap, as
that term is defined in section 3(a)(68) of the Exchange Act (15 U.S.C.
78c(a)(68)), and as those terms are further jointly defined by the CFTC
and SEC by joint regulation, interpretation, guidance, or other action,
in consultation with the Board pursuant to section 712(d) of the Dodd-
Frank Wall Street Reform and Consumer Protection Act (15 U.S.C.
8302(d));
(B) Any purchase or sale of a nonfinancial commodity for deferred
shipment or delivery that is intended to be physically settled;
(C) Any foreign exchange forward (as that term is defined in
section 1a(24) of the Commodity Exchange Act (7 U.S.C. 1a(24)) or
foreign exchange swap (as that term is defined in section 1a(25) of the
Commodity Exchange Act (7 U.S.C. 1a(25));
(D) Any agreement, contract, or transaction in foreign currency
described in section 2(c)(2)(C)(i) of the Commodity Exchange Act (7
U.S.C. 2(c)(2)(C)(i));
(E) Any agreement, contract, or transactions in a commodity other
than foreign currency described in section 2(c)(2)(D)(i) of the
Commodity Exchange Act (7 U.S.C. 2(c)(2)(D)(i)); and
(F) Any transaction authorized under section 19 of the Commodity
Exchange Act (7 U.S.C. 23(a) or (b));
(ii) A derivative does not include:
(A) Any consumer, commercial, or other agreement, contract, or
transaction that the CFTC and SEC have further defined by joint
regulation, interpretation, guidance, or other action as not within the
definition of swap, as that term is defined in section 1a(47) of the
Commodity Exchange Act (7 U.S.C. 1a(47)), or security-based swap, as
that term is defined in section 3(a)(68) of the Exchange Act (15 U.S.C.
78c(a)(68));
(B) Any identified banking product, as defined in section 402(b) of
the Legal Certainty for Bank Products Act of 2000 (7 U.S.C. 27(b)),
that is subject to section 403(a) of that Act (7 U.S.C. 27a(a)).
(m) Exchange Act means the Securities Exchange Act of 1934 (15
U.S.C. 78a et seq.).
[[Page 68945]]
(n) Federal banking agencies means the Board, the Office of the
Comptroller of the Currency, and the Federal Deposit Insurance
Corporation.
(o) Foreign banking organization has the same meaning as in Sec.
211.21(o) of the Board's Regulation K (12 CFR 211.21(o)).
(p) Insured depository institution has the same meaning as in
section 3(c) of the Federal Deposit Insurance Act (12 U.S.C. 1813(c)),
but does not include any insured depository institution that is
described in section 2(c)(2)(D) of the BHC Act (12 U.S.C.
1841(c)(2)(D)).
(q) Loan means any loan, lease, extension of credit, or secured or
unsecured receivable.
(r) Nonbank financial company supervised by the Board has the
meaning specified in section 102 of the Financial Stability Act of 2010
(12 U.S.C. 5311).
(s) Qualifying foreign banking organization means a foreign banking
organization that qualifies as such under Sec. 211.23(a) of the
Board's Regulation K (12 CFR 211.23(a)).
(t) Resident of the United States means:
(1) Any natural person resident in the United States;
(2) Any partnership, corporation or other business entity organized
or incorporated under the laws of the United States or any State;
(3) Any estate of which any executor or administrator is a resident
of the United States;
(4) Any trust of which any trustee, beneficiary or, if the trust is
revocable, any settlor is a resident of the United States;
(5) Any agency or branch of a foreign entity located in the United
States;
(6) Any discretionary or non-discretionary account or similar
account (other than an estate or trust) held by a dealer or fiduciary
for the benefit or account of a resident of the United States;
(7) Any discretionary account or similar account (other than an
estate or trust) held by a dealer or fiduciary organized or
incorporated in the United States, or (if an individual) a resident of
the United States; or
(8) Any person organized or incorporated under the laws of any
foreign jurisdiction formed by or for a resident of the United States
principally for the purpose of engaging in one or more transactions
described in Sec. --.6(d)(1) or Sec. --.13(c)(1).
(u) SEC means the Securities and Exchange Commission.
(v) Sale and sell each include any contract to sell or otherwise
dispose of. For security futures products, such terms include any
contract, agreement, or transaction for future delivery. With respect
to a commodity future, such terms include any contract, agreement, or
transaction for future delivery. With respect to a derivative, such
terms include the execution, termination (prior to its scheduled
maturity date), assignment, exchange, or similar transfer or conveyance
of, or extinguishing of rights or obligations under, a derivative, as
the context may require.
(w) Security has the meaning specified in section 3(a)(10) of the
Exchange Act (15 U.S.C. 78c(a)(10)).
(x) Security future has the meaning specified in section 3(a)(55)
of the Exchange Act (15 U.S.C. 78c(a)(55)).
(y) Securities Act means the Securities Act of 1933 (15 U.S.C. 77a
et seq.).
(z) Separate account means an account established and maintained by
an insurance company subject to regulation by a State insurance
regulator or a foreign insurance regulator under which income, gains,
and losses, whether or not realized, from assets allocated to such
account, are, in accordance with the applicable contract, credited to
or charged against such account without regard to other income, gains,
or losses of the insurance company.
(aa) State means any State, territory or possession of the United
States, and the District of Columbia.
(bb) Subsidiary has the same meaning as in section 2(d) of the BHC
Act (12 U.S.C. 1841(d)).
Subpart B--Proprietary Trading
Sec. --.3 Prohibition on proprietary trading.
(a) Prohibition. Except as otherwise provided in this subpart, a
covered banking entity may not engage in proprietary trading.
(b) Definition of ``proprietary trading'' and related terms. For
purposes of this subpart:
(1) Proprietary trading means engaging as principal for the trading
account of the covered banking entity in any purchase or sale of one or
more covered financial positions. Proprietary trading does not include
acting solely as agent, broker, or custodian for an unaffiliated third
party.
(2) Trading account.
(i) Trading account means any account that is used by a covered
banking entity to:
(A) Acquire or take one or more covered financial positions
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 described in paragraphs
(b)(2)(i)(A)(1), (2), or (3) of this section;
(B) Acquire or take one or more covered financial positions, other
than positions that are foreign exchange derivatives, commodity
derivatives, or contracts of sale of a commodity for future delivery,
that are market risk capital rule covered positions, if the covered
banking entity, or any affiliate of the covered banking entity that is
a bank holding company, calculates risk-based capital ratios under the
market risk capital rule as defined in paragraph (c)(8) of this
section; or
(C) Acquire or take one or more covered financial position for any
purpose, if the covered banking entity is:
(1) A dealer or municipal securities dealer that is registered with
the SEC under the Exchange Act, to the extent the position is acquired
or taken in connection with the activities of the dealer or municipal
securities dealer that require it to be registered under that Act;
(2) A government securities dealer that is registered, or that has
filed notice, with an appropriate regulatory agency (as that term is
defined in section 3(a)(34) of the Exchange Act (15 U.S.C. 78c(a)(34)),
to the extent the position is acquired or taken in connection with the
activities of the government securities dealer that require it to be
registered, or to file notice, under that Act;
(3) A swap dealer that is registered with the CFTC under the
Commodity Exchange Act, to the extent the position is acquired or taken
in connection with the activities of the swap dealer that require it to
be registered under that Act;
(4) A security-based swap dealer that is registered with the SEC
under the Exchange Act, to the extent the position is acquired or taken
in connection with the activities of the security-based swap dealer
that require it to be registered under that Act; or
(5) Engaged in the business of a dealer, swap dealer, or security-
based swap dealer outside of the United States to the extent the
position is acquired or taken in connection with the activities of such
business.
(ii) Rebuttable presumption for certain positions. An account shall
be presumed to be a trading account if it is used to acquire or take a
covered financial position, other than a covered financial position
described in paragraph (b)(2)(i)(B) or (C) of this section, that the
covered banking entity
[[Page 68946]]
holds for a period of sixty days or less, unless the covered banking
entity can demonstrate, based on all the facts and circumstances, that
the covered financial position, either individually or as a category,
was not acquired or taken principally for any of the purposes described
in paragraph (b)(2)(i)(A) of this section.
(iii) An account shall not be deemed a trading account for purposes
of paragraph (b)(2)(i) of this section to the extent that such account
is used to acquire or take a position in one or more covered financial
positions:
(A) That arise under a repurchase or reverse repurchase agreement
pursuant to which the covered banking entity has simultaneously agreed,
in writing, to both purchase and sell a stated asset, at stated prices,
and on stated dates or on demand with the same counterparty;
(B) That arise under a transaction in which the covered banking
entity lends or borrows a security temporarily to or from another party
pursuant to a written securities lending agreement under which the
lender retains the economic interests of an owner of such security, and
has the right to terminate the transaction and to recall the loaned
security on terms agreed by the parties;
(C) For the bona fide purpose of liquidity management and in
accordance with a documented liquidity management plan of the covered
banking entity that:
(1) Specifically contemplates and authorizes the particular
instrument to be used for liquidity management purposes, its profile
with respect to market, credit and other risks, and the liquidity
circumstances in which the particular instrument may or must be used;
(2) Requires that any transaction contemplated and authorized by
the plan be principally for the purpose of managing the liquidity of
the covered banking entity, and not for the purpose of short-term
resale, benefitting from actual or expected short-term price movements,
realizing short-term arbitrage profits, or hedging a position taken for
such short-term purposes;
(3) Requires that any position taken for liquidity management
purposes be highly liquid and limited to financial instruments the
market, credit and other risks of which the covered banking entity does
not expect to give rise to appreciable profits or losses as a result of
short-term price movements;
(4) Limits any position taken for liquidity management purposes,
together with any other positions taken for such purposes, to an amount
that is consistent with the banking entity's near-term funding needs,
including deviations from normal operations, as estimated and
documented pursuant to methods specified in the plan; and
(5) Is consistent with [Agency]'s supervisory requirements,
guidance and expectations regarding liquidity management; or
(D) That are acquired or taken by a covered banking entity that is
a derivatives clearing organization registered under section 5b of the
Commodity Exchange Act (7 U.S.C. 7a-1) or a clearing agency registered
with the SEC under section 17A of the Exchange Act (15 U.S.C. 78q-1) in
connection with clearing derivatives or securities transactions.
(3) Covered financial position.
(i) Covered financial position means any position, including any
long, short, synthetic or other position, in:
(A) A security, including an option on a security;
(B) A derivative, including an option on a derivative; or
(C) A contract of sale of a commodity for future delivery, or
option on a contract of sale of a commodity for future delivery.
(ii) A covered financial position does not include any position
that is:
(A) A loan;
(B) A commodity; or
(C) Foreign exchange or currency.
(c) Definition of other terms related to proprietary trading. For
purposes of this subpart:
(1) Commodity has the same meaning as in section 1a(9) of the
Commodity Exchange Act (7 U.S.C. 1a(9)), except that a commodity does
not include any security;
(2) Contract of sale of a commodity for future delivery means a
contract of sale (as that term is defined in section 1a(13) of the
Commodity Exchange Act (7 U.S.C. 1a(13)) for future delivery (as that
term is defined in section 1a(27) of the Commodity Exchange Act (7
U.S.C. 1a(27)).
(3) Exempted security has the same meaning as in section
3(a)(12)(A) of the Exchange Act (15 U.S.C. 78c(a)(12)(A)).
(4) Foreign insurance regulator means the insurance commission, or
a similar official or agency, of one or more countries other than the
United States that is engaged in the supervision of insurance companies
under foreign insurance law.
(5) General account means, with respect to an insurance company,
all of the assets of the insurance company that are not legally
segregated and allocated to separate accounts under applicable State or
foreign law.
(6) Government securities has the same meaning as in section
3(a)(42) of the Exchange Act (15 U.S.C. 78c(a)(42)).
(7) Market risk capital rule covered position means a covered
position as that term is defined for purposes of:
(i) In the case of a covered banking entity that is a bank holding
company or insured depository institution, the market risk capital rule
that is applicable to the covered banking entity; and
(ii) In the case of a covered banking entity that is affiliated
with a bank holding company, other than a covered banking entity to
which a market risk capital rule is applicable, the market risk capital
rule that is applicable to the affiliated bank holding company.
(8) Market risk capital rule means 12 CFR 3, Appendix B, 12 CFR
208, Appendix E, 12 CFR 225, Appendix E, and 12 CFR 325, Appendix C, as
applicable.
(9) Municipal securities has the same meaning as in section
3(a)(29) of the Exchange Act (15 U.S.C. 78c(a)(29)).
(10) Security-based swap has the meaning specified in section
3(a)(68) of the Exchange Act (15 U.S.C. 78c(a)(68)).
(11) Swap has the meaning specified in section 1a(47) of the
Commodity Exchange Act (7 U.S.C. 1a(47)).
(12) State insurance regulator means the insurance commission, or a
similar official or agency, of a State that is engaged in the
supervision of insurance companies under State insurance law.
Sec. --.4 Permitted underwriting and market making-related
activities.
(a) Underwriting activities.
(1) Permitted underwriting activities. The prohibition on
proprietary trading contained in Sec. ----.3(a) does not apply to the
purchase or sale of a covered financial position by a covered banking
entity that is made in connection with the covered banking entity's
underwriting activities.
(2) Requirements. For purposes of paragraph (a)(1) of this section,
a purchase or sale of a covered financial position shall be deemed to
be made in connection with a covered banking entity's underwriting
activities only if:
(i) The covered banking entity has established the internal
compliance program required by subpart D of this part that is designed
to ensure the covered banking entity's compliance with the requirements
of paragraph (a)(2) of this section, including reasonably designed
written policies and procedures, internal controls, and independent
testing;
(ii) The covered financial position is a security;
(iii) The purchase or sale is effected solely in connection with a
distribution of securities for which the covered banking entity is
acting as underwriter;
[[Page 68947]]
(iv) The covered banking entity is:
(A) With respect to a purchase or sale effected in connection with
a distribution of one or more covered financial positions that are
securities, other than exempted securities, security-based swaps,
commercial paper, bankers' acceptances, or commercial bills:
(1) A dealer that is registered with the SEC under section 15 of
the Exchange Act (15 U.S.C. 78o), or a person that is exempt from
registration or excluded from regulation as a dealer thereunder; or
(2) Engaged in the business of a dealer outside of the United
States and subject to substantive regulation of such business in the
jurisdiction where the business is located;
(B) With respect to a purchase or sale effected as part of a
distribution of one or more covered financial positions that are
municipal securities, a municipal securities dealer that is registered
under section 15B of the Exchange Act (15 U.S.C. 78o-4) or exempt from
registration thereunder; or
(C) With respect to a purchase or sale effected as part of a
distribution of one or more covered financial positions that are
government securities, a government securities dealer that is
registered, or that has filed notice, under section 15C of the Exchange
Act (15 U.S.C. 78o-5) or exempt from registration thereunder;
(v) The underwriting activities of the covered banking entity with
respect to the covered financial position are designed not to exceed
the reasonably expected near term demands of clients, customers, or
counterparties;
(vi) The underwriting activities of the covered banking entity are
designed to generate revenues primarily from fees, commissions,
underwriting spreads or other income not attributable to:
(A) Appreciation in the value of covered financial positions
related to such activities; or
(B) The hedging of covered financial positions related to such
activities; and
(vii) The compensation arrangements of persons performing
underwriting activities are designed not to reward proprietary risk-
taking.
(3) Definition of distribution. For purposes of paragraph (a) of
this section, a distribution of securities means an offering of
securities, whether or not subject to registration under the Securities
Act, that is distinguished from ordinary trading transactions by the
magnitude of the offering and the presence of special selling efforts
and selling methods.
(4) Definition of underwriter. For purposes of paragraph (a) of
this section, underwriter means:
(i) A person who has agreed with an issuer of securities or selling
security holder:
(A) To purchase securities for distribution;
(B) To engage in a distribution of securities for or on behalf of
such issuer or selling security holder; or
(C) To manage a distribution of securities for or on behalf of such
issuer or selling security holder; and
(ii) A person who has an agreement with another person described in
paragraph (a)(4)(i) of this section to engage in a distribution of such
securities for or on behalf of the issuer or selling security holder.
(b) Market making-related activities.
(1) Permitted market making-related activities. The prohibition on
proprietary trading contained in Sec. ----.3(a) does not apply to the
purchase or sale of a covered financial position by a covered banking
entity that is made in connection with the covered banking entity's
market making-related activities.
(2) Requirements. For purposes of paragraph (b)(1) of this section,
a purchase or sale of a covered financial position shall be deemed to
be made in connection with a covered banking entity's market making-
related activities only if:
(i) The covered banking entity has established the internal
compliance program required by subpart D that is designed to ensure the
covered banking entity's compliance with the requirements of paragraph
(b)(2) of this section, including reasonably designed written policies
and procedures, internal controls, and independent testing;
(ii) The trading desk or other organizational unit that conducts
the purchase or sale holds itself out as being willing to buy and sell,
including through entering into long and short positions in, the
covered financial position for its own account on a regular or
continuous basis;
(iii) The market making-related activities of the trading desk or
other organizational unit that conducts the purchase or sale are, with
respect to the covered financial position, designed not to exceed the
reasonably expected near term demands of clients, customers, or
counterparties;
(iv) The covered banking entity is:
(A) With respect to a purchase or sale of one or more covered
financial positions that are securities, other than exempted
securities, security-based swaps, commercial paper, bankers'
acceptances, or commercial bills:
(1) A dealer that is registered with the SEC under section 15 of
the Exchange Act (15 U.S.C. 78o), or a person that is exempt from
registration or excluded from regulation as a dealer thereunder; or
(2) Engaged in the business of a dealer outside of the United
States and subject to substantive regulation of such business in the
jurisdiction where the business is located;
(B) With respect to a purchase or sale of one or more covered
financial positions that are swaps:
(1) A swap dealer that is registered with the CFTC under the
Commodity Exchange Act (7 U.S.C. 1a) or a person that is exempt from
registration thereunder; or
(2) Engaged in the business of a swap dealer outside the United
States and subject to substantive regulation of such business in the
jurisdiction where the business is located;
(C) With respect to a purchase or sale of one or more covered
financial positions that are security-based swaps:
(1) A security-based swap dealer that is registered with the SEC
under section 15F of the Exchange Act (15 U.S.C. 78o-10) or a person
that is exempt from registration thereunder; or
(2) Engaged in the business of a security-based swap dealer outside
of the United States and subject to substantive regulation of such
business in the jurisdiction where the business is located;
(D) With respect to a purchase or sale of one or more covered
financial positions that are municipal securities, a municipal
securities dealer that is registered under section 15B of the Exchange
Act (15 U.S.C. 78o-4) or a person that is exempt from registration
thereunder; or
(E) With respect to a purchase or sale of one or more covered
financial positions that are government securities, a government
securities dealer that is registered, or that has filed notice, under
section 15C of the Exchange Act (15 U.S.C. 78o-5) or a person that is
exempt from registration thereunder;
(v) The market making-related activities of the trading desk or
other organizational unit that conducts the purchase or sale are
designed to generate revenues primarily from fees, commissions, bid/ask
spreads or other income not attributable to:
(A) Appreciation in the value of covered financial positions it
holds in trading accounts; or
(B) The hedging of covered financial positions it holds in trading
accounts;
(vi) The market making-related activities of the trading desk or
other organizational unit that conducts the purchase or sale are
consistent with the
[[Page 68948]]
commentary provided in Appendix B; and
(vii) The compensation arrangements of persons performing the
market making-related activities are designed not to reward proprietary
risk-taking.
(3) Market making-related hedging. For purposes of paragraph (b)(1)
of this section, a purchase or sale of a covered financial position
shall also be deemed to be made in connection with a covered banking
entity's market making-related activities if:
(i) The covered financial position is purchased or sold to reduce
the specific risks to the covered banking entity in connection with and
related to individual or aggregated positions, contracts, or other
holdings acquired pursuant to paragraph (b) of this section; and
(ii) The purchase or sale meets all of the requirements described
in Sec. --.5(b) and, if applicable, Sec. --.5(c).
Sec. ----.5 Permitted risk-mitigating hedging activities.
(a) Permitted risk-mitigating hedging activities. The prohibition
on proprietary trading contained in Sec. ----.3(a) does not apply to
the purchase or sale of a covered financial position by a covered
banking entity that is made in connection with and related to
individual or aggregated positions, contracts, or other holdings of a
covered banking entity and is designed to reduce the specific risks to
the covered banking entity in connection with and related to such
positions, contracts, or other holdings.
(b) Requirements. For purposes of paragraph (a) of this section, a
purchase or sale of a covered financial position shall be deemed to be
in connection with and related to individual or aggregated positions,
contracts, or other holdings of a covered banking entity and designed
to reduce the specific risks to the covered banking entity in
connection with and related to such positions, contracts, or other
holdings only if:
(1) The covered banking entity has established the internal
compliance program required by subpart D designed to ensure the covered
banking entity's compliance with the requirements of paragraph (b) of
this section, including reasonably designed written policies and
procedures regarding the instruments, techniques and strategies that
may be used for hedging, internal controls and monitoring procedures,
and independent testing;
(2) The purchase or sale:
(i) Is made in accordance with the written policies, procedures and
internal controls established by the covered banking entity pursuant to
subpart D of this part;
(ii) Hedges or otherwise mitigates one or more specific risks,
including market risk, counterparty or other credit risk, currency or
foreign exchange risk, interest rate risk, basis risk, or similar
risks, arising in connection with and related to individual or
aggregated positions, contracts, or other holdings of a covered banking
entity;
(iii) Is reasonably correlated, based upon the facts and
circumstances of the underlying and hedging positions and the risks and
liquidity of those positions, to the risk or risks the purchase or sale
is intended to hedge or otherwise mitigate;
(iv) Does not give rise, at the inception of the hedge, to
significant exposures that were not already present in the individual
or aggregated positions, contracts, or other holdings of a covered
banking entity and that are not hedged contemporaneously;
(v) Is subject to continuing review, monitoring and management by
the covered banking entity that:
(A) Is consistent with the written hedging policies and procedures
required under paragraph (b)(1) of this section; and
(B) Maintains a reasonable level of correlation, based upon the
facts and circumstances of the underlying and hedging positions and the
risks and liquidity of those positions, to the risk or risks the
purchase or sale is intended to hedge or otherwise mitigate; and
(C) Mitigates any significant exposure arising out of the hedge
after inception; and
(vi) The compensation arrangements of persons performing the risk-
mitigating hedging activities are designed not to reward proprietary
risk-taking.
(c) Documentation. With respect to any purchase, sale, or series of
purchases or sales conducted by a covered banking entity pursuant to
this Sec. --.5 for risk-mitigating hedging purposes that is
established at a level of organization that is different than the level
of organization establishing or responsible for the positions,
contracts, or other holdings the risks of which the purchase, sale, or
series of purchases or sales are designed to reduce, the covered
banking entity must, at a minimum, document, at the time the purchase,
sale, or series of purchases or sales are conducted:
(1) The risk-mitigating purpose of the purchase, sale, or series of
purchases or sales;
(2) The risks of the individual or aggregated positions, contracts,
or other holdings of a covered banking entity that the purchase, sale,
or series of purchases or sales are designed to reduce; and
(3) The level of organization that is establishing the hedge.
Sec. --.6 Other permitted proprietary trading activities.
(a) Permitted trading in government obligations.
(1) The prohibition on proprietary trading contained in Sec.
--.3(a) does not apply to the purchase or sale by a covered banking
entity of a covered financial position that is:
(i) An obligation of the United States or any agency thereof;
(ii) An obligation, participation, or other instrument of or issued
by the Government National Mortgage Association, the Federal National
Mortgage Association, the Federal Home Loan Mortgage Corporation, a
Federal Home Loan Bank, the Federal Agricultural Mortgage Corporation
or a Farm Credit System institution chartered under and subject to the
provisions of the Farm Credit Act of 1971 (12 U.S.C. 2001 et seq.); or
(iii) An obligation of any State or any political subdivision
thereof.
(2) An obligation or other instrument described in paragraphs
(a)(1)(i), (ii) or (iii) of this section shall include both general
obligations and limited obligations, such as revenue bonds.
(b) Permitted trading on behalf of customers. (1) The prohibition
on proprietary trading contained in Sec. --.3(a) does not apply to the
purchase or sale of a covered financial position by a covered banking
entity on behalf of customers.
(2) For purposes of paragraph (b)(1) of this section, a purchase or
sale of a covered financial position by a covered banking entity shall
be considered to be on behalf of customers if:
(i) The purchase or sale:
(A) Is conducted by a covered banking entity acting as investment
adviser, commodity trading advisor, trustee, or in a similar fiduciary
capacity for a customer;
(B) Is conducted for the account of the customer; and
(C) Involves solely covered financial positions of which the
customer, and not the covered banking entity or any subsidiary or
affiliate of the covered banking entity, is beneficial owner (including
as a result of having long or short exposure under the relevant covered
financial position);
(ii) The covered banking entity is acting as riskless principal in
a transaction in which the covered banking entity, after receiving an
order to purchase (or sell) a covered financial
[[Page 68949]]
position from a customer, purchases (or sells) the covered financial
position for its own account to offset a contemporaneous sale to (or
purchase from) the customer; or
(iii) The covered banking entity is an insurance company that
purchases or sells a covered financial position for a separate account,
if:
(A) The insurance company is directly engaged in the business of
insurance and subject to regulation by a State insurance regulator or
foreign insurance regulator;
(B) The insurance company purchases or sells the covered financial
position solely for a separate account established by the insurance
company in connection with one or more insurance policies issued by
that insurance company;
(C) All profits and losses arising from the purchase or sale of a
covered financial position are allocated to the separate account and
inure to the benefit or detriment of the owners of the insurance
policies supported by the separate account, and not the insurance
company; and
(D) The purchase or sale is conducted in compliance with, and
subject to, the insurance company investment and other laws,
regulations, and written guidance of the State or jurisdiction in which
such insurance company is domiciled.
(c) Permitted trading by a regulated insurance company. The
prohibition on proprietary trading contained in Sec. --.3(a) does not
apply to the purchase or sale of a covered financial position by an
insurance company or any affiliate of an insurance company if:
(1) The insurance company is directly engaged in the business of
insurance and subject to regulation by a State insurance regulator or
foreign insurance regulator;
(2) The insurance company or its affiliate purchases or sells the
covered financial position solely for the general account of the
insurance company;
(3) The purchase or sale is conducted in compliance with, and
subject to, the insurance company investment laws, regulations, and
written guidance of the State or jurisdiction in which such insurance
company is domiciled; and
(4) The appropriate Federal banking agencies, after consultation
with the Financial Stability Oversight Council and the relevant
insurance commissioners of the States, have not jointly determined,
after notice and comment, that a particular law, regulation, or written
guidance described in paragraph (c)(3) of this section is insufficient
to protect the safety and soundness of the covered banking entity, or
of the financial stability of the United States.
(d) Permitted trading outside of the United States.
(1) The prohibition on proprietary trading contained in Sec.
--.3(a) does not apply to the purchase or sale of a covered financial
position by a covered banking entity if:
(i) The covered banking entity is not directly or indirectly
controlled by a banking entity that is organized under the laws of the
United States or of one or more States;
(ii) The purchase or sale is conducted pursuant to paragraph (9) or
(13) of section 4(c) of the BHC Act; and
(iii) The purchase or sale occurs solely outside of the United
States.
(2) A purchase or sale shall be deemed to be conducted pursuant to
paragraph (9) or (13) of section 4(c) of the BHC Act only if:
(i) With respect to a covered banking entity that is a foreign
banking organization, the banking entity is a qualifying foreign
banking organization and is conducting the purchase or sale in
compliance with subpart B of the Board's Regulation K (12 CFR 211.20
through 211.30); or
(ii) With respect to a covered banking entity that is not a foreign
banking organization, the covered banking entity meets at least two of
the following requirements:
(A) Total assets of the covered banking entity held outside of the
United States exceed total assets of the covered banking entity held in
the United States;
(B) Total revenues derived from the business of the covered banking
entity outside of the United States exceed total revenues derived from
the business of the covered banking entity in the United States; or
(C) Total net income derived from the business of the covered
banking entity outside of the United States exceeds total net income
derived from the business of the covered banking entity in the United
States.
(3) A purchase or sale shall be deemed to have occurred solely
outside of the United States only if:
(i) The covered banking entity conducting the purchase or sale is
not organized under the laws of the United States or of one or more
States;
(ii) No party to the purchase or sale is a resident of the United
States;
(iii) No personnel of the covered banking entity who is directly
involved in the purchase or sale is physically located in the United
States; and
(iv) The purchase or sale is executed wholly outside of the United
States.
Sec. --.7 Reporting and recordkeeping requirements applicable to
trading activities.
A covered banking entity engaged in any proprietary trading
activity permitted under Sec. Sec. --.4 through --.6 shall comply
with:
(a) The reporting and recordkeeping requirements described in
Appendix A to this part, if the covered banking entity has, together
with its affiliates and subsidiaries, trading assets and liabilities
the average gross sum of which (on a worldwide consolidated basis) is,
as measured as of the last day of each of the four prior calendar
quarters, equal to or greater than $1 billion;
(b) The recordkeeping requirements required under Sec. --.20 and
appendix C to this part, as applicable; and
(c) Such other reporting and recordkeeping requirements as [Agency]
may impose to evaluate the covered banking entity's compliance with
this subpart.
Sec. --.8 Limitations on permitted proprietary trading activities.
(a) No transaction, class of transactions, or activity may be
deemed permissible under Sec. Sec. --.4 through --.6 if the
transaction, class of transactions, or activity would:
(1) Involve or result in a material conflict of interest between
the covered banking entity and its clients, customers, or
counterparties;
(2) Result, directly or indirectly, in a material exposure by the
covered banking entity to a high-risk asset or a high-risk trading
strategy; or
(3) Pose a threat to the safety and soundness of the covered
banking entity or to the financial stability of the United States.
(b) Definition of material conflict of interest. For purposes of
this section, a material conflict of interest between a covered banking
entity and its clients, customers, or counterparties exists if the
covered banking entity engages in any transaction, class of
transactions, or activity that would involve or result in the covered
banking entity's interests being materially adverse to the interests of
its client, customer, or counterparty with respect to such transaction,
class of transactions, or activity, unless:
(1) Timely and effective disclosure and opportunity to negate or
substantially mitigate. Prior to effecting the specific transaction or
class or type of transactions, or engaging in the specific activity,
for which a conflict of interest may arise, the covered banking entity:
(i) Makes clear, timely, and effective disclosure of the conflict
of interest,
[[Page 68950]]
together with other necessary information, in reasonable detail and in
a manner sufficient to permit a reasonable client, customer, or
counterparty to meaningfully understand the conflict of interest; and
(ii) Makes such disclosure explicitly and effectively, and in a
manner that provides the client, customer, or counterparty the
opportunity to negate, or substantially mitigate, any materially
adverse effect on the client, customer, or counterparty created by the
conflict of interest; or
(2) Information barriers. The covered banking entity has
established, maintained, and enforced information barriers that are
memorialized in written policies and procedures, such as physical
separation of personnel, or functions, or limitations on types of
activity, that are reasonably designed, taking into consideration the
nature of the covered banking entity's business, to prevent the
conflict of interest from involving or resulting in a materially
adverse effect on a client, customer, or counterparty. A covered
banking entity may not rely on such information barriers if, in the
case of any specific transaction, class or type of transactions or
activity, the banking entity knows or should reasonably know that,
notwithstanding the covered banking entity's establishment of
information barriers, the conflict of interest may involve or result in
a materially adverse effect on a client, customer, or counterparty.
(c) Definition of high-risk asset and high-risk trading strategy.
For purposes of this section:
(1) High-risk asset means an asset or group of related assets that
would, if held by a covered banking entity, significantly increase the
likelihood that the covered banking entity would incur a substantial
financial loss or would fail.
(2) High-risk trading strategy means a trading strategy that would,
if engaged in by a covered banking entity, significantly increase the
likelihood that the covered banking entity would incur a substantial
financial loss or would fail.
Sec. --.9 [Reserved]
Subpart C--Covered Funds Activities and Investments
Sec. --.10 Prohibition on acquiring or retaining an ownership
interest in and having certain relationships with a covered fund.
(a) Prohibition. Except as otherwise provided in this subpart, a
covered banking entity may not, as principal, directly or indirectly,
acquire or retain any ownership interest in or sponsor a covered fund.
(b) Definitions. For purposes of this part:
(1) Covered fund means:
(i) An issuer that would be an investment company, as defined in
the Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.), but for
section 3(c)(1) or 3(c)(7) of that Act (15 U.S.C. 80a-3(c)(1) or (7));
(ii) A commodity pool, as defined in section 1a(10) of the
Commodity Exchange Act (7 U.S.C. 1a(10));
(iii) Any issuer, as defined in section 2(a)(22) of the Investment
Company Act of 1940 (15 U.S.C. 80a-2(a)(22)), that is organized or
offered outside of the United States that would be a covered fund as
defined in paragraphs (b)(1)(i), (ii), or (iv) of this section, were it
organized or offered under the laws, or offered to one or more
residents, of the United States or of one or more States; and
(iv) Any such similar fund as the appropriate Federal banking
agencies, the SEC, and the CFTC may determine, by rule, as provided in
section 13(b)(2) of the BHC Act.
(2) Director has the same meaning as provided in Sec. 215.2(d)(1)
of the Board's Regulation O (12 CFR 215.2(d)(1)).
(3) Ownership interest.
(i) Ownership interest means any equity, partnership, or other
similar interest (including, without limitation, a share, equity
security, warrant, option, general partnership interest, limited
partnership interest, membership interest, trust certificate, or other
similar instrument) in a covered fund, whether voting or nonvoting, or
any derivative of such interest.
(ii) Ownership interest does not include, with respect to a covered
fund:
(A) Carried interest. An interest held by a covered banking entity
(or an affiliate, subsidiary or employee thereof) in a covered fund for
which the covered banking entity (or an affiliate, subsidiary or
employee thereof) serves as investment manager, investment adviser or
commodity trading adviser, so long as:
(1) The sole purpose and effect of the interest is to allow the
covered banking entity (or the affiliate, subsidiary or employee
thereof) to share in the profits of the covered fund as performance
compensation for services provided to the covered fund by the covered
banking entity (or the affiliate, subsidiary or employee thereof),
provided that the covered banking entity (or the affiliate, subsidiary
or employee thereof) may be obligated under the terms of such interest
to return profits previously received;
(2) All such profit, once allocated, is distributed to the covered
banking entity (or the affiliate, subsidiary or employee thereof)
promptly after being earned or, if not so distributed, the reinvested
profit of the covered banking entity (or the affiliate, subsidiary or
employee thereof) does not share in the subsequent profits and losses
of the covered fund;
(3) The covered banking entity (or the affiliate, subsidiary or
employee thereof) does not provide funds to the covered fund in
connection with acquiring or retaining this interest; and
(4) The interest is not transferable by the covered banking entity
(or the affiliate, subsidiary or employee thereof) except to another
affiliate or subsidiary thereof.
(4) Prime brokerage transaction means one or more products or
services provided by a covered banking entity to a covered fund, such
as custody, clearance, securities borrowing or lending services, trade
execution, or financing, data, operational, and portfolio management
support.
(5) Sponsor, with respect to a covered fund, means:
(i) To serve as a general partner, managing member, trustee, or
commodity pool operator of a covered fund;
(ii) In any manner to select or to control (or to have employees,
officers, or directors, or agents who constitute) a majority of the
directors, trustees, or management of a covered fund; or
(iii) To share with a covered fund, for corporate, marketing,
promotional, or other purposes, the same name or a variation of the
same name.
(6) Trustee. (i) For purposes of this subpart, a trustee does not
include a trustee that does not exercise investment discretion with
respect to a covered fund, including a directed trustee, as that term
is used in section 403(a)(1) of the Employee's Retirement Income
Security Act (29 U.S.C. 1103(a)(1)).
(ii) Any covered banking entity that directs a person identified in
paragraph (b)(6)(i) of this section, or that possesses authority and
discretion to manage and control the assets of a covered fund for which
such person identified in paragraph (b)(6)(i) of this section serves as
trustee, shall be considered a trustee of such covered fund.
Sec. --.11 Permitted organizing and offering of a covered fund.
Section --.10(a) does not prohibit a covered banking entity from,
directly or indirectly, organizing and offering a covered fund,
including serving as a general partner, managing member, trustee, or
commodity pool operator of the covered fund and in any manner
[[Page 68951]]
selecting or controlling (or having employees, officers, directors, or
agents who constitute) a majority of the directors, trustees, or
management of the covered fund, including any necessary expenses for
the foregoing, only if:
(a) The covered banking entity provides bona fide trust, fiduciary,
investment advisory, or commodity trading advisory services;
(b) The covered fund is organized and offered only in connection
with the provision of bona fide trust, fiduciary, investment advisory,
or commodity trading advisory services and only to persons that are
customers of such services of the covered banking entity, pursuant to a
credible plan or similar documentation outlining how the covered
banking entity intends to provide advisory or similar services to its
customers through organizing and offering such fund;
(c) The covered banking entity does not acquire or retain an
ownership interest in the covered fund except as permitted under this
subpart;
(d) The covered banking entity complies with the restrictions under
Sec. --.16 of this subpart;
(e) The covered 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 such covered fund
invests;
(f) The covered fund, for corporate, marketing, promotional, or
other purposes:
(1) Does not share the same name or a variation of the same name
with the covered banking entity (or an affiliate or subsidiary
thereof); and
(2) Does not use the word ``bank'' in its name;
(g) No director or employee of the covered banking entity takes or
retains an ownership interest in the covered fund, except for any
director or employee of the covered banking entity who is directly
engaged in providing investment advisory or other services to the
covered fund; and
(h) The covered banking entity:
(1) Clearly and conspicuously discloses, in writing, to any
prospective and actual investor in the covered fund (such as through
disclosure in the covered fund's offering documents):
(i) That ``any losses in [such covered fund] will be borne solely
by investors in [the covered fund] and not by [the covered banking
entity and its affiliates or subsidiaries]; therefore, [the covered
banking entity's and its affiliates' or subsidiaries'] losses in [such
covered fund] will be limited to losses attributable to the ownership
interests in the covered fund held by the [covered banking entity and
its affiliates or subsidiaries] in their capacity as investors in the
[covered fund]'';
(ii) That such investor should read the fund offering documents
before investing in the covered fund;
(iii) That the ``ownership interests in the covered fund are not
insured by the FDIC, and are not deposits, obligations of, or endorsed
or guaranteed in any way, by any banking entity'' (unless that happens
to be the case);
(iv) The role of the covered banking entity and its affiliates,
subsidiaries and employees in sponsoring or providing any services to
the covered fund; and
(2) Complies with any additional rules of the appropriate Federal
banking agencies, the SEC, or the CFTC, as provided in section 13(b)(2)
of the BHC Act, designed to ensure that losses in such covered fund are
borne solely by investors in the covered fund and not by the covered
banking entity and its affiliates or subsidiaries.
Sec. --.12 Permitted investment in a covered fund.
(a) Authority and limitations on permitted investments in covered
funds. (1) The prohibition contained in Sec. --.10(a) does not apply
with respect to a covered banking entity acquiring and retaining any
ownership interest in a covered fund that the covered banking entity or
an affiliate or subsidiary thereof organizes and offers, for the
purposes of:
(i) Establishment. Establishing the covered fund and providing the
fund with sufficient initial equity for investment to permit the fund
to attract unaffiliated investors as required by paragraph (a)(2)(i) of
this section; or
(ii) De minimis investment. Making and retaining an investment in
the covered fund that does not exceed 3 percent of the total
outstanding ownership interests in the fund.
(2) Ownership limits.
(i) With respect to an investment in any covered fund pursuant to
paragraph (a)(1)(i) of this section, the covered banking entity:
(A) Must actively seek unaffiliated investors to reduce through
redemption, sale, dilution, or other methods the aggregate amount of
all ownership interests of the covered banking entity in any covered
fund under Sec. --.12 to the amount permitted in paragraph
(a)(2)(i)(B) of this section; and
(B) May not exceed 3 percent of the total amount or value of
outstanding ownership interests of the fund not later than 1 year after
the date of establishment of the fund (or such longer period as may be
provided by the Board pursuant to paragraph (e) of this section); and
(ii) The aggregate value of all ownership interests of the covered
banking entity in all covered funds under Sec. --.12 may not exceed 3
percent of the tier 1 capital of the covered banking entity, as
provided under paragraph (c) of this section.
(b) Limitations on investments in a single covered fund. For
purposes of determining whether a covered banking entity is in
compliance with the limitations and restrictions on permitted
investments in covered funds contained in paragraph (a) of this
section, a covered banking entity shall calculate its amount and value
of a permitted investment in a single covered fund as follows:
(1) Attribution of ownership interests to a covered banking entity.
The amount and value of a banking entity's permitted investment in any
single covered fund shall include:
(i) Controlled investments. Any ownership interest held under Sec.
--.12 by any entity that is controlled, directly or indirectly, by the
covered banking entity for purposes of this part; and
(ii) Noncontrolled investments. The pro rata share of any ownership
interest held under Sec. --.12 by any covered fund that is not
controlled by the covered banking entity but in which the covered
banking entity owns, controls, or holds with the power to vote more
than 5 percent of the voting shares.
(2) Calculation of amount of ownership interests in a single
covered fund. For purposes of determining whether an investment in a
single covered fund does not exceed 3 percent of the total outstanding
ownership interests of the fund under paragraph (a)(2)(i)(B) of this
section:
(i) The aggregate amount of all ownership interests of the covered
banking entity shall be the greater of (without regard to committed
funds not yet called for investment):
(A) The value of any investment or capital contribution made with
respect to all ownership interests held under Sec. --.12 by the
covered banking entity in the covered fund, divided by the value of all
investments or capital contributions, respectively, made by all persons
in that covered fund; or
(B) The total number of ownership interests held under Sec. --.12
by the covered banking entity in a covered fund divided by the total
number of ownership interests held by all persons in that covered fund.
(ii) Inclusion of certain parallel investments. To the extent that
a covered banking entity is contractually obligated to directly invest
in, or is
[[Page 68952]]
found to be acting in concert through knowing participation in a joint
activity or parallel action toward a common goal of investing in, one
or more investments with a covered fund that is organized and offered
by the covered banking entity, whether or not pursuant to an express
agreement, such investments shall be included in any calculation
required under paragraph (a)(2) of this section.
(3) Timing of single covered fund investment calculation. The
aggregate amount of all ownership interests of a covered banking entity
in a single covered fund may at no time exceed the limits in this
paragraph after the conclusion of the period provided in paragraph
(a)(2)(i)(B) of this section.
(4) Methodology and standards for calculation. For purposes of
determining the amount or value of its investment in a covered fund
under this paragraph (b), a covered banking entity must calculate its
investment in the same manner and according to the same standards
utilized by the covered fund for determining the aggregate value of the
fund's assets and ownership interests.
(c) Aggregate permitted investments in all covered funds. (1) For
purposes of determining the aggregate value of all permitted
investments in all covered funds by a covered banking entity under
paragraph (a)(2)(ii) of this section, the aggregate value of all
ownership interests held by that covered banking entity shall be the
sum of the value of each investment in a covered fund held under Sec.
--.12, as determined in accordance with applicable accounting
standards.
(2) Calculation of tier 1 capital. For purposes of determining
compliance with paragraph (a)(2)(ii) of this section:
(i) Entities that are required to hold and report tier 1 capital.
If a covered banking entity is required to calculate and report tier 1
capital, the covered banking entity's tier 1 capital shall be equal to
the amount of tier 1 capital calculated by that covered banking entity
as of the last day of the most recent calendar quarter that has ended,
as reported to its primary financial regulatory agency, as defined in
section 2(12) of the Dodd-Frank Wall Street Reform and Consumer
Protection Act; and
(ii) If a covered banking entity is not required to calculate and
report tier 1 capital, the covered banking entity's tier 1 capital
shall be determined to be equal to:
(A) In the case of a covered banking entity that is controlled,
directly or indirectly, by a depository institution that calculates and
reports tier 1 capital, the amount of tier 1 capital reported by such
controlling depository institution pursuant to paragraph (c)(2)(i) of
this section;
(B) In the case of a covered banking entity that is not controlled,
directly or indirectly, by a depository institution that calculates and
reports tier 1 capital:
(1) Bank holding company subsidiaries. If the covered banking
entity is a subsidiary of a bank holding company or company that is
treated as a bank holding company, the amount of tier 1 capital
reported by the top-tier affiliate of such covered banking entity that
calculates and reports tier 1 capital, pursuant to paragraph (c)(2)(i)
of this section; and
(2) Other holding companies and any subsidiary or affiliate
thereof. If the covered banking entity is not a subsidiary of a bank
holding company or a company that is treated as a bank holding company,
the total amount of shareholders' equity of the top-tier affiliate
within such organization as of the last day of the most recent calendar
quarter that has ended, as determined under applicable accounting
standards.
(3) A covered banking entity's aggregate permitted investment in
all covered funds shall be calculated as of the last day of each
calendar quarter.
(d) Capital treatment for a permitted investment in a covered fund.
For purposes of calculating capital pursuant to the applicable capital
rules, a covered banking entity shall deduct the aggregate value of all
permitted investments in all covered funds made or retained by a
covered banking entity pursuant to this section (as determined under
paragraph (c)(1) of this section) from the banking entity's tier 1
capital (as determined under paragraph (c)(2) of this section).
(e) Extension of time to divest an ownership interest. (1) Upon
application by a covered banking entity, the Board may extend the
period of time to meet the requirements under paragraphs (a)(2)(i)(A)
and (B) of this section for up to 2 additional years, if the Board
finds that an extension would be consistent with safety and soundness
and not detrimental to the public interest. An application for
extension must:
(i) Be submitted to the Board at least 90 days prior to the
expiration of the applicable time period;
(ii) Provide the reasons for application, including information
that addresses the factors in paragraph (e)(2) of this section; and
(iii) Explain the covered banking entity's plan for reducing the
permitted investment in a covered fund through redemption, sale,
dilution or other methods as required in paragraph (a)(2)(i) of this
section.
(2) Factors governing Board determinations. In reviewing any
application under paragraph (e)(1) of this section, the Board may
consider all the facts and circumstances related to the permitted
investment in a covered fund, including:
(i) Whether the investment would:
(A) Involve or result in material conflicts of interest between the
covered banking entity and its clients, customers or counterparties;
(B) Result, directly or indirectly, in a material exposure by the
covered banking entity to high-risk assets or high-risk trading
strategies;
(C) Pose a threat to the safety and soundness of the covered
banking entity; or
(D) Pose a threat to the financial stability of the United States;
(ii) Market conditions;
(iii) The contractual terms governing the covered banking entity's
interest in the covered fund;
(iv) The date on which the covered fund is expected to have
attracted sufficient investments from investors unaffiliated with the
covered banking entity to enable the covered banking entity to comply
with the limitations in paragraph (a)(2)(i) of this section;
(v) The total exposure of the covered banking entity to the
investment and the risks that disposing of, or maintaining, the
investment in the covered fund may pose to the covered banking entity
and the financial stability of the United States;
(vi) The cost to the covered banking entity of divesting or
disposing of the investment within the applicable period;
(vii) Whether the divestiture or conformance of the investment
would involve or result in a material conflict of interest between the
covered banking entity and unaffiliated clients, customers or
counterparties to which it owes a duty;
(viii) The covered banking entity's prior efforts to reduce through
redemption, sale, dilution, or other methods its ownership interests in
the covered fund, including activities related to the marketing of
interests in such covered fund; and
(ix) Any other factor that the Board believes appropriate.
(3) Consultation. In the case of a covered banking entity that is
primarily regulated by another Federal banking agency, the SEC, or the
CFTC, the Board will consult with such agency prior to approval of an
application by the covered banking entity for an extension under
paragraph (e)(1) of this section.
[[Page 68953]]
(4) Authority to impose restrictions on activities or investment
during any extension period. (i) The Board may impose such conditions
on any extension approved under paragraph (e)(1) of this section as the
Board determines are necessary or appropriate to protect the safety and
soundness of the covered banking entity or the financial stability of
the United States, address material conflicts of interest or other
unsound banking practices, or otherwise further the purposes of section
13 of the BHC Act (12 U.S.C. 1851) and this part.
(ii) Consultation. In the case of a covered banking entity that is
primarily regulated by another Federal banking agency, the SEC, or the
CFTC, the Board will consult with such agency prior to imposing
conditions on the approval of a request by the covered banking entity
for an extension under paragraph (e)(1) of this section.
Sec. --.13 Other permitted covered fund activities and investments.
(a) Permitted investments in SBICs and related investments. The
prohibition contained in Sec. --.10(a) does not apply with respect to
acquiring or retaining an ownership interest in, or acting as sponsor
to, a covered fund by a covered banking entity or an affiliate or
subsidiary thereof:
(1) In one or more small business investment companies, as defined
in section 102 of the Small Business Investment Act of 1958 (15 U.S.C.
662);
(2) That is designed primarily to promote the public welfare, of
the type permitted under paragraph (11) of section 5136 of the Revised
Statutes of the United States (12 U.S.C. 24), including the welfare of
low- and moderate-income communities or families (such as providing
housing, services, or jobs); or
(3) That is a qualified rehabilitation expenditure with respect to
a qualified rehabilitation building or certified historic structure, as
such terms are defined in section 47 of the Internal Revenue Code of
1986 or a similar State historic tax credit program.
(b) Permitted risk-mitigating hedging activities.
(1) The prohibition contained in Sec. --.10(a) does not apply with
respect to an ownership interest in a covered fund by a covered banking
entity, provided that the acquisition or retention of the ownership
interest is:
(i) Made in connection with and related to individual or aggregated
obligations or liabilities of the covered banking entity that are:
(A) Taken by the covered banking entity when acting as intermediary
on behalf of a customer that is not itself a banking entity to
facilitate the exposure by the customer to the profits and losses of
the covered fund, or
(B) Directly connected to a compensation arrangement with an
employee that directly provides investment advisory or other services
to the covered fund; and
(ii) Designed to reduce the specific risks to the covered banking
entity in connection with and related to such obligations or
liabilities.
(2) Requirements. For purposes of paragraph (b)(1) of this section,
acquiring or retaining an ownership interest in a covered fund by a
covered banking entity shall be a permissible risk-mitigating hedging
activity under this section only if:
(i) The covered banking entity has established the internal
compliance program required by subpart D designed to ensure the covered
banking entity's compliance with the requirements of this paragraph
(b)(2) of this section including reasonably designed written policies
and procedures regarding the instruments, techniques and strategies
that may be used for hedging, internal controls and monitoring
procedures, and independent testing;
(ii) The acquisition or retention of an ownership interest in a
covered fund:
(A) Is made in accordance with the written policies, procedures and
internal controls established by the covered banking entity pursuant to
subpart D;
(B) Hedges or otherwise mitigates an exposure to a covered fund
through an offsetting exposure to the same covered fund and in the same
amount of ownership interest in that covered fund that:
(1) Arises out of a transaction conducted solely to accommodate a
specific customer request with respect to, or
(2) Is directly connected to its compensation arrangement with an
employee that directly provides investment advisory or other services
to, that covered fund;
(C) Does not give rise, at the inception of the hedge, to
significant exposures that were not already present in individual or
aggregated positions, contracts, or other holdings of a covered banking
entity and that are not hedged contemporaneously; and
(D) Is subject to continuing review, monitoring and management by
the covered banking entity that:
(1) Is consistent with its written hedging policies and procedures;
(2) Maintains a substantially similar offsetting exposure to the
same amount and type of ownership interest, based upon the facts and
circumstances of the underlying and hedging positions and the risks and
liquidity of those positions, to the risk or risks the purchase or sale
is intended to hedge or otherwise mitigate; and
(3) Mitigates any significant exposure arising out of the hedge
after inception; and
(iii) The compensation arrangements of persons performing the risk-
mitigating hedging activities are designed not to reward proprietary
risk-taking.
(3) Documentation. With respect to any acquisition or retention of
an ownership interest in a covered fund by a covered banking entity
pursuant to this paragraph (b), the covered banking entity must
document, at the time the transaction is conducted:
(i) The risk-mitigating purpose of the acquisition or retention of
an ownership interest in a covered fund;
(ii) The risks of the individual or aggregated obligation or
liability of a covered banking entity that the acquisition or retention
of an ownership interest in a covered fund is designed to reduce; and
(iii) The level of organization that is establishing the hedge.
(c) Certain permitted covered fund activities and investments
outside of the United States.
(1) The prohibition contained in Sec. --.10(a) does not apply to
the acquisition or retention of any ownership interest in, or the
sponsorship of, a covered fund by a covered banking entity if:
(i) The covered banking entity is not directly or indirectly
controlled by a banking entity that is organized under the laws of the
United States or of one or more States;
(ii) The activity is conducted pursuant to paragraph (9) or (13) of
section 4(c) of the BHC Act;
(iii) No ownership interest in such covered fund is offered for
sale or sold to a resident of the United States; and
(iv) The activity occurs solely outside of the United States.
(2) An activity shall be considered to be conducted pursuant to
paragraph (9) or (13) of section 4(c) of the BHC Act only if:
(i) With respect to a covered banking entity that is a foreign
banking organization, the covered banking entity is a qualifying
foreign banking organization and is conducting the activity in
compliance with subpart B of the Board's Regulation K (12 CFR 211.20 et
seq.); or
(ii) With respect to a covered banking entity that is not a foreign
banking organization, the covered banking entity
[[Page 68954]]
meets at least two of the following requirements:
(A) Total assets of the covered banking entity held outside of the
United States exceed total assets of the covered banking entity held in
the United States;
(B) Total revenues derived from the business of the covered banking
entity outside of the United States exceed total revenues derived from
the business of the covered banking entity in the United States; or
(C) Total net income derived from the business of the covered
banking entity outside of the United States exceeds total net income
derived from the business of the covered banking entity in the United
States.
(3) An activity shall be considered to have occurred solely outside
of the United States only if:
(i) The covered banking entity engaging in the activity is not
organized under the laws of the United States or of one or more States;
(ii) No subsidiary, affiliate, or employee of the covered banking
entity that is involved in the offer or sale of an ownership interest
in the covered fund is incorporated or physically located in the United
States or in one or more States; and
(iii) No ownership interest in such covered fund is offered for
sale or sold to a resident of the United States.
(d) Loan securitizations. The prohibition contained in Sec.
--.10(a) does not apply with respect to the acquisition or retention by
a covered banking entity of any ownership interest in, or acting as
sponsor to, a covered fund that is an issuer of asset-backed
securities, the assets or holdings of which are solely comprised of:
(1) Loans;
(2) Contractual rights or assets directly arising from those loans
supporting the asset-backed securities; and
(3) Interest rate or foreign exchange derivatives that:
(i) Materially relate to the terms of such loans or contractual
rights or assets; and
(ii) Are used for hedging purposes with respect to the
securitization structure.
Sec. --.14 Covered fund activities determined to be permissible.
(a) The prohibition contained in Sec. --.10(a) does not apply to
the acquisition or retention by a covered banking entity of any
ownership interest in or acting as sponsor to:
(1) Bank owned life insurance. A separate account which is used
solely for the purpose of allowing a covered banking entity to purchase
an insurance policy for which the covered banking entity is the
beneficiary, provided that the covered banking entity that purchases
the insurance policy:
(i) Does not control the investment decisions regarding the
underlying assets or holdings of the separate account; and
(ii) Holds its ownership interest in the separate account in
compliance with applicable supervisory guidance regarding bank owned
life insurance.
(2) Certain other covered funds. Any of the following entities that
would otherwise qualify as a covered fund:
(i) A joint venture between the covered banking entity or one of
its affiliates and any other person, provided that the joint venture:
(A) Is an operating company; and
(B) Does not engage in any activity or make any investment that is
prohibited under this part;
(ii) An acquisition vehicle, provided that the sole purpose and
effect of such entity is to effectuate a transaction involving the
acquisition or merger of one entity with or into the covered banking
entity or one of its affiliates;
(iii) An issuer of an asset-backed security, but only with respect
to that amount or value of economic interest in a portion of the credit
risk for an asset-backed security that is retained by a covered banking
entity that is a ``securitizer'' or ``originator'' in compliance with
the minimum requirements of section 15G of the Exchange Act (15 U.S.C.
78o-11) and any implementing regulations issued thereunder;
(iv) A wholly-owned subsidiary of the covered banking entity that
is:
(A) Engaged principally in performing bona fide liquidity
management activities described in Sec. --.3(b)(2)(iii)(C); and
(B) Carried on the balance sheet of the covered banking entity; and
(v) A covered fund that is an issuer of asset-backed securities
described in Sec. --.13(d), the assets or holdings of which are solely
comprised of:
(A) Loans;
(B) Contractual rights or assets directly arising from those loans
supporting the asset-backed securities; and
(C) Interest rate or foreign exchange derivatives that:
(1) Materially relate to the terms of such loans or contractual
rights or assets, and
(2) Are used for hedging purposes with respect to the
securitization structure.
(b) The prohibition contained in Sec. --.10(a) does not apply to
the acquisition or retention by a covered banking entity of any
ownership interest in, or acting as sponsor to, a covered fund, but
only if such ownership interest is acquired or retained by a covered
banking entity (or an affiliate or subsidiary thereof):
(1) In the ordinary course of collecting a debt previously
contracted in good faith, if the covered banking entity divests the
ownership interest within applicable time periods provided for by
[Agency]; or
(2) Pursuant to and in compliance with the conformance or extended
transition period authorities provided for in subpart E of the Board's
rules implementing section 13 of the BHC Act (12 CFR 248.30 through
248.35).
Sec. --.15 Internal controls, reporting and recordkeeping
requirements applicable to covered fund activities and investments.
A covered banking entity engaged in any covered fund activity or
making or holding any investment permitted under this subpart shall
comply with:
(a) The internal controls, reporting, and recordkeeping
requirements required under Sec. --.20 and appendix C to this part, as
applicable; and
(b) Such other reporting and recordkeeping requirements as [Agency]
may deem necessary to appropriately evaluate the covered banking
entity's compliance with this subpart.
Sec. --.16 Limitations on relationships with a covered fund.
(a) Relationships with a covered fund.
(1) Except as provided for in paragraph (a)(2) of this section, no
covered banking entity that serves, directly or indirectly, as the
investment manager, investment adviser, commodity trading advisor, or
sponsor to a covered fund, or that organizes and offers a covered fund
pursuant to Sec. --.11, and no affiliate of such entity, may enter
into a transaction with the covered fund, or with any other covered
fund that is controlled by such covered fund, that would be a covered
transaction as defined in section 23A of the Federal Reserve Act (12
U.S.C. 371c), as if such covered banking entity and the affiliate
thereof were a member bank and the covered fund were an affiliate
thereof.
(2) Notwithstanding paragraph (a)(1) of this section, a covered
banking entity may:
(i) Acquire and retain any ownership interest in a covered fund in
accordance with the requirements of this subpart; and
(ii) Enter into any prime brokerage transaction with any covered
fund in which a covered fund managed,
[[Page 68955]]
sponsored, or advised by such covered banking entity (or an affiliate
or subsidiary thereof) has taken an ownership interest, if:
(A) The covered banking entity is in compliance with each of the
limitations set forth in Sec. --.11 with respect to a covered fund
organized and offered by such covered banking entity (or an affiliate
or subsidiary thereof);
(B) The chief executive officer (or equivalent officer) of the top-
tier affiliate of the covered banking entity certifies in writing
annually (with a duty to update the certification if the information in
the certification materially changes) that the covered 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 such covered fund invests; and
(C) The Board has not determined that such transaction is
inconsistent with the safe and sound operation and condition of the
covered banking entity.
(b) Restrictions on transactions with covered funds. A covered
banking entity that serves, directly or indirectly, as the investment
manager, investment adviser, commodity trading advisor, or sponsor to a
covered fund, or that organizes and offers a covered fund pursuant to
Sec. --.11, shall be subject to section 23B of the Federal Reserve Act
(12 U.S.C. 371c-1), as if such covered banking entity were a member
bank and such covered fund were an affiliate thereof.
(c) Restrictions on prime brokerage transactions. A prime brokerage
transaction permitted under paragraph (a)(2)(ii) of this section shall
be subject to section 23B of the Federal Reserve Act (12 U.S.C. 371c-1)
as if the counterparty were an affiliate of the covered banking entity.
Sec. --.17 Other limitations on permitted covered fund activities.
(a) No transaction, class of transactions, or activity may be
deemed permissible under Sec. Sec. --.11 through --.14 and Sec. --.16
if the transaction, class of transactions, or activity would:
(1) Involve or result in a material conflict of interest between
the covered banking entity and its clients, customers, or
counterparties;
(2) Result, directly or indirectly, in a material exposure by the
covered banking entity to a high-risk asset or a high-risk trading
strategy; or
(3) Pose a threat to the safety and soundness of the covered
banking entity or the financial stability of the United States.
(b) Definition of material conflict of interest. For purposes of
this section, a material conflict of interest between a covered banking
entity and its clients, customers, or counterparties exists if the
covered banking entity engages in any transaction, class of
transactions, or activity that would involve or result in the covered
banking entity's interests being materially adverse to the interests of
its client, customer, or counterparty with respect to such transaction,
class of transactions, or activity, unless:
(1) Timely and effective disclosure and opportunity to negate or
substantially mitigate. Prior to effecting the specific transaction or
class or type of transactions, or engaging in the specific activity,
for which a conflict of interest may arise, the covered banking entity:
(i) Makes clear, timely, and effective disclosure of the conflict
of interest, together with other necessary information, in reasonable
detail and in a manner sufficient to permit a reasonable client,
customer, or counterparty to meaningfully understand the conflict of
interest; and
(ii) Makes such disclosure explicitly and effectively, and in a
manner that provides the client, customer, or counterparty the
opportunity to negate, or substantially mitigate, any materially
adverse effect on the client, customer, or counterparty created by the
conflict of interest; or
(2) Information barriers. The covered banking entity has
established, maintained, and enforced information barriers that are
memorialized in written policies and procedures, such as physical
separation of personnel, or functions, or limitations on types of
activity, that are reasonably designed, taking into consideration the
nature of the covered banking entity's business, to prevent the
conflict of interest from involving or resulting in a materially
adverse effect on a client, customer, or counterparty. A covered
banking entity may not rely on such information barriers if, in the
case of any specific transaction, class or type of transactions or
activity, the banking entity knows or should reasonably know that,
notwithstanding the covered banking entity's establishment of
information barriers, the conflict of interest may involve or result in
a materially adverse effect on a client, customer, or counterparty.
(c) Definition of high-risk asset and high-risk trading strategy.
For purposes of this section:
(1) High-risk asset means an asset or group of related assets that
would, if held by a covered banking entity, significantly increase the
likelihood that the covered banking entity would incur a substantial
financial loss or would fail.
(2) High-risk trading strategy means a trading strategy that would,
if engaged in by a covered banking entity, significantly increase the
likelihood that the covered banking entity would incur a substantial
financial loss or would fail.
Sec. --.18 [Reserved]
Sec. --.19 [Reserved]
Subpart D--Compliance Program Requirement; Violations
Sec. --.20 Program for monitoring compliance; enforcement.
(a) Program requirement. Except as provided in paragraph (d) of
this section, each covered banking entity shall develop and provide for
the continued administration of a program reasonably designed to ensure
and monitor compliance with the prohibitions and restrictions on
proprietary trading and covered fund activities and investments set
forth in section 13 of the BHC Act and this part, and such program
shall be appropriate for the size, scope and complexity of activities
and business structure of the covered banking entity.
(b) Contents of compliance program. The compliance program required
by paragraph (a) of this section, at a minimum, shall include:
(1) Internal written policies and procedures reasonably designed to
document, describe, and monitor trading activities subject to subpart B
of this part and activities and investments with respect to a covered
fund subject to subpart C of this part (including those permitted under
Sec. Sec. --.4 through --.6 or Sec. Sec. --.11 through --.16) to
ensure that such activities and investments comply with section 13 of
the BHC Act and this part;
(2) A system of internal controls reasonably designed to monitor
and identify potential areas of noncompliance with section 13 of the
BHC Act and this part in the covered banking entity's trading
activities subject to subpart B of this part and activities and
investments with respect to a covered fund subject to subpart C of this
part (including those permitted under Sec. Sec. --.4 through --.6 or
Sec. Sec. --.11 through --.16) and to prevent the occurrence of
activities or investments that are prohibited by section 13 of the BHC
Act and this part;
(3) A management framework that clearly delineates responsibility
and accountability for compliance with section 13 of the BHC Act and
this part;
(4) Independent testing for the effectiveness of the compliance
program
[[Page 68956]]
conducted by qualified personnel of the covered banking entity or by a
qualified outside party;
(5) Training for trading personnel and managers, as well as other
appropriate personnel, to effectively implement and enforce the
compliance program; and
(6) Making and keeping records sufficient to demonstrate compliance
with section 13 of the BHC Act and this part, which a covered banking
entity must promptly provide to [Agency] upon request and retain for a
period of no less than 5 years.
(c) Additional standards. (1) In the case of any covered banking
entity described in paragraph (c)(2) of this section, the compliance
program required by paragraph (a) of this section shall also satisfy
the requirements and other standards contained in Appendix C to this
part.
(2) A covered banking entity is subject to paragraph (c)(1) of this
section if:
(i) The covered banking entity engages in proprietary trading and
has, together with its affiliates and subsidiaries, trading assets and
liabilities the average gross sum of which (on a worldwide consolidated
basis), as measured as of the last day of each of the four prior
calendar quarters:
(A) Is equal to or greater than $1 billion; or
(B) Equals 10 percent or more of its total assets;
(ii) The covered banking entity invests in, or has relationships
with, a covered fund and:
(A) The covered banking entity has, together with its affiliates
and subsidiaries, aggregate investments in one or more covered funds,
the average value of which is, as measured as of the last day of each
of the four prior calendar quarters, equal to or greater than $1
billion; or
(B) Sponsors or advises, together with its affiliates and
subsidiaries, one or more covered funds, the average total assets of
which are, as measured as of the last day of each of the four prior
calendar quarters, equal to or greater than $1 billion; or
(iii) [The Agency] deems it appropriate.
(d) No program required for certain banking entities. To the extent
that a covered banking entity does not engage in activities or
investments prohibited or restricted by subpart B or subpart C of this
part, a covered banking entity will have satisfied the requirements of
this section if its existing compliance policies and procedures include
measures that are designed to prevent the covered banking entity from
becoming engaged in such activities or making such investments and
which require the covered banking entity to develop and provide for the
compliance program required under paragraph (a) of this section prior
to engaging in such activities or making such investments.
Sec. --.21 Termination of activities or investments; penalties for
violations.
(a) Any covered banking entity that engages in an activity or makes
an investment in violation of section 13 of the BHC Act or this part or
in a manner that functions as an evasion of the requirements of section
13 of the BHC Act or this part, including through an abuse of any
activity or investment permitted under subparts B or C, or otherwise
violates the restrictions and requirements of section 13 of the BHC Act
or this part, shall terminate the activity and, as relevant, dispose of
the investment.
(b) After due notice and an opportunity for hearing, if [Agency]
finds reasonable cause to believe any covered banking entity has
engaged in an activity or made an investment described in paragraph
(a), the [Agency] may, by order, direct the banking entity to restrict,
limit, or terminate the activity and, as relevant, dispose of the
investment.
(c) [Reserved]
Appendix A to Part [ ]--Reporting and Recordkeeping Requirements for
Covered Trading Activities
I. Purpose
This appendix sets forth reporting and recordkeeping
requirements that certain covered banking entities must satisfy in
connection with the restrictions on proprietary trading set forth in
subpart B of this part (``proprietary trading restrictions'').
Pursuant to Sec. --.7, this appendix generally applies to a covered
banking entity that has, together with its affiliates and
subsidiaries, trading assets and liabilities the average gross sum
of which (on a worldwide consolidated basis) is, as measured as of
the last day of each of the four prior calendar quarters, equal to
or greater than $1 billion. These entities are required to furnish
periodic reports to [Agency] regarding a variety of quantitative
measurements of their covered trading activities, which vary
depending on the scope and size of covered trading activities, and
create and maintain records documenting the preparation and content
of these reports. The requirements of this appendix should be
incorporated into the covered banking entity's internal compliance
program under Sec. --.20 and appendix C to this part.
The purpose of this appendix is to assist covered banking
entities and [Agency] in:
(i) Better understanding and evaluating the scope, type, and
profile of the covered banking entity's trading activities;
(ii) Monitoring the covered banking entity's trading activities;
(iii) Identifying trading activities that warrant further review
or examination by the covered banking entity to verify compliance
with the proprietary trading restrictions;
(iv) Evaluating whether the trading activities of trading units
engaged in market making-related activities subject to Sec. --.4(b)
are consistent with the requirements governing permitted market
making-related activities;
(v) Evaluating whether the covered trading activities of trading
units that are engaged in permitted trading activity subject to
Sec. Sec. --.4, --.5, or --.6(a) (i.e., underwriting and market
making-related related activity, risk-mitigating hedging, or trading
in certain government obligations) are consistent with the
requirement that such activity not result, directly or indirectly,
in a material exposure to high-risk assets or high-risk trading
strategies;
(vi) Identifying the profile of particular trading activities of
the covered banking entity, and the individual trading units of the
banking entity, to help establish the appropriate frequency and
scope of examination by [Agency] of such activities; and
(vii) Assessing and addressing the risks associated with the
covered banking entity's covered trading activities.
The quantitative measurements that must be furnished pursuant to
this appendix are not intended to serve as a dispositive tool for
the identification of permissible or impermissible activities.
In addition to the quantitative measurements required in this
appendix, a covered banking entity may need to develop and implement
other quantitative measurements in order to effectively monitor its
covered trading activities for compliance with section 13 of the BHC
Act and this part and to have an effective compliance program, as
required by Sec. --.20 and appendix C to this part. The
effectiveness of particular quantitative measurements may differ
based on the profile of the banking entity's businesses in general
and, more specifically, of the particular trading unit, including
types of instruments traded, trading activities and strategies, and
history and experience (e.g., whether the trading desk is an
established, successful market maker or a new entrant to a
competitive market). In all cases, covered banking entities must
ensure that they have robust measures in place to identify and
monitor the risks taken in their trading activities, to ensure that
the activities are within risk tolerances established by the covered
banking entity, and to monitor and examine for compliance with the
proprietary trading restrictions in this part.
On an ongoing basis, covered banking entities should carefully
monitor, review, and evaluate all furnished quantitative
measurements, as well as any others that they choose to utilize in
order to maintain compliance with section 13 of the BHC Act and this
part. All measurement results that indicate a heightened risk of
impermissible proprietary trading, including with respect to
otherwise-permitted activities under Sec. Sec. --.4 through --.6
that result in a material exposure to high-risk assets or high-risk
trading strategies, should be escalated within the banking entity
for review, further analysis, explanation to [Agency], and
[[Page 68957]]
remediation, where appropriate. Many of the quantitative
measurements discussed in this appendix will also be helpful to
covered banking entities in identifying and managing the risks
related to their covered trading activities.
II. Definitions
The terms used in this appendix have the same meanings as set
forth in Sec. Sec. --.2 and --.3. In addition, for purposes of this
appendix, the following definitions apply:
Covered trading activity means proprietary trading, as defined
in paragraph (b)(1) of Sec. --.3.
Trading unit means each of the following units of organization
of a covered banking entity:
(i) Each discrete unit that is engaged in the coordinated
implementation of a revenue-generation strategy and that
participates in the execution of any covered trading activity; \1\
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\1\ [The Agency] expects that this will generally be the
smallest unit of organization used by the covered banking entity to
structure and control its risk-taking activities and employees, and
will include each unit generally understood to be a single ``trading
desk.''
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(ii) Each organizational unit that is used to structure and
control the aggregate risk-taking activities and employees of one or
more trading units described in paragraph (i); \2\
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\2\ [The Agency] expects that this will generally include
management or reporting divisions, groups, sub-groups, or other
intermediate units of organization used by the covered banking
entity to manage one or more discrete trading units (e.g., ``North
American Credit Trading,'' ``Global Credit Trading,'' etc.).
---------------------------------------------------------------------------
(iii) All trading operations, collectively; and
(iv) Any other unit of organization specified by [Agency] with
respect to a particular banking entity.
Calculation period means the period of time for which a
particular quantitative measurement must be calculated.
III. Reporting and Recordkeeping of Quantitative Measurements
A. Scope of Required Reporting
General scope. The quantitative measurements that must be
furnished by a covered banking entity depend on the aggregate size
of the covered banking entity's trading activities and the
activities in which its trading units engage, as follows:
(i) With respect to any covered banking entity that is engaged
in any covered trading activity, and has trading assets and
liabilities the average gross sum of which (on a worldwide
consolidated basis) is, as measured as of the last day of each of
the four prior calendar quarters, equal to or greater than $5
billion:
(a) Each trading unit of the covered banking entity that is
engaged in market making-related activities subject to Sec. --.4(b)
must furnish the following quantitative measurements, calculated in
accordance with this appendix:
Value-at-Risk and Stress VaR;
VaR Exceedance;
Risk Factor Sensitivities;
Risk and Position Limits;
Comprehensive Profit and Loss;
Portfolio Profit and Loss;
Fee Income and Expense;
Spread Profit and Loss;
Comprehensive Profit and Loss Attribution;
Pay-to-Receive Spread Ratio;
Unprofitable Trading Days Based on Comprehensive Profit
and Loss and Unprofitable Trading Days Based on Portfolio Profit and
Loss;
Skewness of Portfolio Profit and Loss and Kurtosis of
Portfolio Profit and Loss;
Volatility of Comprehensive Profit and Loss and
Volatility of Portfolio Profit and Loss;
Comprehensive Profit and Loss to Volatility Ratio and
Portfolio Profit and Loss to Volatility Ratio;
Inventory Risk Turnover;
Inventory Aging; and
Customer-facing Trade Ratio; and
(b) Each trading unit of the covered banking entity that is
engaged in permitted trading activity subject to Sec. Sec. --.4(a),
--.5, or --.6(a) must furnish the following quantitative
measurements, calculated in accordance with this appendix:
Value-at-Risk and Stress VaR;
Risk Factor Sensitivities;
Risk and Position Limits;
Comprehensive Profit and Loss; and
Comprehensive Profit and Loss Attribution; and
(ii) With respect to any covered banking entity that is engaged
in any covered trading activity, and has trading assets and
liabilities the average gross sum of which (on a worldwide
consolidated basis) is, as measured as of the last day of each of
the four prior calendar quarters, equal to or greater than $1
billion and less than $5 billion, each trading unit of the covered
banking entity that is engaged in market making-related activities
under Sec. --.4(b) must furnish the following quantitative
measurement, calculated in accordance with this appendix:
Comprehensive Profit and Loss;
Portfolio Profit and Loss;
Fee Income and Expense;
Spread Profit and Loss;
Value-at-Risk;
Comprehensive Profit and Loss Attribution;
Volatility of Comprehensive Profit and Loss and
Volatility of Portfolio Profit and Loss; and
Comprehensive Profit and Loss to Volatility Ratio and
Portfolio Profit and Loss to Volatility Ratio.
B. Frequency of Required Calculation and Reporting
A covered banking entity must calculate any applicable
quantitative measurement for each trading day. A covered banking
entity must report each applicable quantitative measurement to
[Agency] on a monthly basis, or on any other reporting schedule
requested by [Agency]. All quantitative measurements for any
calendar month must be reported to [Agency] no later than 30 days
after the end of that calendar month or on any other time basis
requested by [Agency].\3\
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\3\ For example, under section IV.B.1 of this appendix, a
banking entity is required to report to [Agency] the Comprehensive
Profit and Loss quantitative measurement, as calculated for all
trading days in June of any year, no later than July 30 of that
year.
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C. Recordkeeping
A covered banking entity must, for any quantitative measurement
furnished to [Agency] pursuant to this appendix and Sec. --.7,
create and maintain records documenting the preparation and content
of these reports, as well as such information as is necessary to
permit [Agency] to verify the accuracy of such reports, for a period
of 5 years.
IV. Quantitative Measurements
A. Risk-Management Measurements
1. Value-at-Risk and Stress Value-at-Risk
Description: For purposes of this appendix, Value-at-Risk
(``VaR'') is the commonly used percentile measurement of the risk of
future financial loss in the value of a given portfolio over a
specified period of time, based on current market conditions. For
purposes of this appendix, Stress Value-at-Risk (``Stress VaR'') is
the percentile measurement of the risk of future financial loss in
the value of a given portfolio over a specified period of time,
based on market conditions during a period of significant financial
stress.
General Calculation Guidance: Banking entities should compute
and report VaR and Stress VaR by employing generally accepted
standards and methods of calculation. VaR should reflect a loss in a
trading unit that is expected to be exceeded less than one percent
of the time over a one-day period. For those banking entities that
are subject to regulatory capital requirements imposed by a Federal
banking agency, VaR and Stress VaR should be computed and reported
in a manner that is consistent with such regulatory capital
requirements. In cases where a trading unit does not have a
standalone VaR or Stress VaR calculation but is part of a larger
portfolio for which a VaR or Stress VaR calculation is performed, a
VaR or Stress VaR calculation that includes only the trading unit's
holdings should be performed consistent with the VaR or Stress VaR
model and methodology used by the larger portfolio.
Calculation Period: One trading day.
2. VaR Exceedance
Description: For purposes of this appendix, VaR Exceedance is
the difference between VaR and Portfolio Profit and Loss, exclusive
of Spread Profit and Loss, for a trading unit for any given
calculation period.
Calculation Period: One trading day.
3. Risk Factor Sensitivities
Description: For purposes of this appendix, Risk Factor
Sensitivities are changes in a trading unit's Portfolio Profit and
Loss, exclusive of Spread Profit and Loss, that are expected to
occur in the event of a change in a trading unit's ``risk factors''
(i.e., one or more underlying market variables that are
[[Page 68958]]
significant sources of the trading unit's profitability and risk).
General Calculation Guidance: A covered banking entity should
report the Risk Factor Sensitivities that are monitored and managed
as part of the trading unit's overall risk management policy. The
underlying data and methods used to compute a trading unit's Risk
Factor Sensitivities should depend on the specific function of the
trading unit and the internal risk management models employed. The
number and type of Risk Factor Sensitivities that are monitored and
managed by a trading unit, and furnished to [Agency], should depend
on the explicit risks assumed by the trading unit. In general,
however, reported Risk Factor Sensitivities should be sufficient to
account for a preponderance of the price variation in the trading
unit's holdings.
Trading units should take into account any relevant factors in
calculating Risk Factor Sensitivities, including, for example, the
following with respect to particular asset classes:
Commodity derivative positions: sensitivities with
respect to the related commodity type (e.g., precious metals, oil
and petroleum or agricultural products), the maturity of the
positions, volatility and/or correlation sensitivities (expressed in
a manner that demonstrates any significant non-linearities), and the
maturity profile of the positions;
Credit positions: sensitivities with respect to credit
spread factors that are sufficiently granular to account for
specific credit sectors and market segments, the maturity profile of
the positions, and sensitivities to interest rates at all relevant
maturities;
Credit-related derivative positions: credit positions
sensitivities and volatility and/or correlation sensitivities
(expressed in a manner that demonstrates any significant non-
linearities), and the maturity profile of the positions;
Equity positions: sensitivity to equity prices and
sensitivities that differentiate between important equity market
sectors and segments, such as a small capitalization equities and
international equities;
Equity derivative positions: equity position
sensitivities and volatility and/or correlation sensitivities
(expressed in a manner that demonstrates any significant non-
linearities), and the maturity profile of the positions;
Foreign exchange derivative positions: sensitivities
with respect to major currency pairs and maturities, sensitivity to
interest rates at relevant maturities, and volatility and/or
correlation sensitivities (expressed in a manner that demonstrates
any significant non-linearities), as well as the maturity profile of
the positions; and
Interest rate positions, including interest rate
derivative positions: sensitivities with respect to major interest
rate categories and maturities and volatility and/or correlation
sensitivities (expressed in a manner that demonstrates any
significant non-linearities), as well as the maturity profile of the
positions.
The methods used by a covered banking entity to calculate
sensitivities to a common factor shared by multiple trading units,
such as an equity price factor, should be applied consistently
across its trading units so that the sensitivities can be compared
from one trading unit to another.
Calculation Period: One trading day.
4. Risk and Position Limits
Description: For purposes of this appendix, Risk and Position
Limits are the constraints that define the amount of risk that a
trading unit is permitted to take at a point in time, as defined by
the covered banking entity for a specific trading unit.
General Calculation Guidance: Risk and Position Limits should be
reported in the format used by the covered banking entity for the
purposes of risk management of each trading unit. Risk and Position
Limits are often expressed in terms of risk measures, such as VaR
and Risk Factor Sensitivities, but may also be expressed in terms of
other observable criteria, such as net open positions. When criteria
other than VaR or Risk Factor Sensitivities are used to define the
Risk and Position Limits, both the value of the Risk and Position
Limits and the value of the variables used to assess whether these
limits have been reached should be reported.
Calculation Period: One trading day.
B. Source-of-Revenue Measurements
1. Comprehensive Profit and Loss
Description: For purposes of this appendix, Comprehensive Profit
and Loss is the net profit or loss of a trading unit's material
sources of trading revenue, including, for example, dividend and
interest income and expense, over a specific period of time. A
trading unit's Comprehensive Profit and Loss for any given
calculation period should generally equal the sum of the trading
unit's (i) Portfolio Profit and Loss and (ii) Fee Income.
General Calculation Guidance: Comprehensive Profit and Loss
generally should be computed using data on the value of a trading
unit's underlying holdings, the prices at which those holdings were
bought and sold, and the value of any fees, commissions, sales
credits, spreads, dividends, interest income and expense, or other
sources of income from trading activities, whether realized or
unrealized. Comprehensive Profit and Loss should not include: (i)
compensation costs or other costs required to operate the unit, such
as information technology costs; or (ii) charges and adjustments
made for internal reporting and management purposes, such as
accounting reserves.
Calculation Period: One trading day.
2. Portfolio Profit and Loss
Description: For purposes of this appendix, Portfolio Profit and
Loss is a trading unit's net profit or loss on its underlying
holdings over a specific period of time, whether realized or
unrealized. Portfolio Profit and Loss should generally include any
increase or decrease in the market value of a trading unit's
holdings, including, for example, any dividend, interest income, or
expense of a trading unit's holdings. Portfolio Profit and Loss
should not include direct fees, commissions, sales credits, or other
sources of trading revenue that are not directly related to the
market value of the trading unit's holdings.
General Calculation Guidance: In general, Portfolio Profit and
Loss should be computed using data on a trading unit's underlying
holdings and the prices at which those holdings are marked for
valuation purposes. Portfolio Profit and Loss should not include:
compensation costs or other costs required to operate the trading
unit, such as information technology costs; or charges and
adjustments made for internal reporting and management purposes,
such as accounting reserves.
Calculation Period: One trading day.
3. Fee Income and Expense
Description: For purposes of this appendix, Fee Income and
Expense generally includes direct fees, commissions and other
distinct income for services provided by or to a trading unit over a
specific period of time.
General Calculation Guidance: Fee Income and Expense should be
computed using data on direct fees that are earned by the trading
unit for services it provides to clients, customers, or
counterparties, such as fees earned for structured transactions or
sales commissions and credits earned for fulfilling a customer
request, whether realized or unrealized, and similar fees paid by
the trading unit to other service providers.
Calculation Period: One trading day.
4. Spread Profit and Loss
Description: For purposes of this appendix, Spread Profit and
Loss is the portion of Portfolio Profit and Loss that generally
includes revenue generated by a trading unit from charging higher
prices to buyers than the trading unit pays to sellers of comparable
instruments over the same period of time (i.e., charging a
``spread,'' such as the bid-ask spread).
General Calculation Guidance: Spread Profit and Loss generally
should be computed using data on the prices at which comparable
instruments are either bought or sold by the trading unit, as well
as the turnover of these instruments. Spread Profit and Loss should
be measured with respect to both the purchase and the sale of any
position, and should include both (i) the spreads that are earned by
the trading unit to execute transactions (expressed as positive
amounts), and (ii) the spreads that are paid by the trading unit to
initiate transactions (expressed as negative amounts). Spread Profit
and Loss should be computed by calculating the difference between
the bid price or the ask price (whichever is paid or received) and
the mid-market price. The mid-market price is the average of bid and
ask.
For some asset classes in which a trading unit is engaged in
market making-related activities, bid-ask or similar spreads are
widely disseminated, constantly updated, and readily available, or
otherwise reasonably ascertainable. For purposes of calculating the
Spread Profit and Loss attributable to a transaction in such asset
classes, the trading unit should utilize the prevailing bid-ask or
similar spread on the relevant position at the time the purchase or
sale is completed.
For other asset classes in which a trading unit is engaged in
market making-related activities, bid-ask or similar spreads may not
[[Page 68959]]
be widely disseminated on a consistent basis or otherwise reasonably
ascertainable. A covered banking entity must identify any trading
unit engaged in market making-related activities in an asset class
for which the covered banking entity believes bid-ask or similar
spreads are not widely disseminated on a consistent basis or are not
otherwise reasonably ascertainable and must be able to demonstrate
that bid-ask or similar spreads for the asset class are not
reasonably ascertainable. In such cases, the trading unit should
calculate the Spread Profit and Loss for the relevant purchase or
sale of a position in a particular asset class by using whichever of
the following three alternatives the banking entity believes more
accurately reflects prevailing bid-ask or similar spreads for
transactions in that asset class:
(i) End of Day Spread Proxy: A proxy based on the bid-ask or
similar spread that is used to estimate, or is otherwise implied by,
the market price at which the trading entity marks (or in the case
of a sale, would have marked) the position for accounting purposes
at the close of business on the day it executes the purchase or sale
(``End of Day Spread Proxy'');
(ii) Historical Data Spread Proxy: A proxy based on historical
bid-ask or similar spread data in similar market conditions
(``Historical Data Spread Proxy''); or
(iii) Any other proxy that the banking entity can demonstrate
accurately reflects prevailing bid-ask or similar spreads for
transactions in the specific asset class.
A covered banking entity selecting any of these alternatives
should be able to demonstrate that the alternative it has chosen
most accurately reflects prevailing bid-ask or similar spreads for
the relevant asset class. If a covered banking entity chooses to
calculate Spread Profit and Loss for a particular trading unit using
the End of Day Spread Proxy, then the banking entity should
separately identify the portion of Spread Profit and Loss that is
attributable to positions acquired and disposed of on the same
trading day. If a banking entity chooses to calculate Spread Profit
and Loss for a particular trading unit using the Historical Data
Spread Proxy, the covered banking entity should be able to
demonstrate that the Historical Data Proxy is appropriate and
continually monitor market conditions and adjust, as necessary, the
Historical Data Proxy to reflect any changes.
Calculation Period: One trading day.
5. Comprehensive Profit and Loss Attribution
Description: For purposes of this appendix, Comprehensive Profit
and Loss Attribution is an attribution analysis that divides the
trading unit's Comprehensive Profit and Loss into the separate
sources of risk and revenue that have caused any observed variation
in Comprehensive Profit and Loss. This attribution analysis should
attribute Comprehensive Profit and Loss to specific market and risk
factors that can be accurately and consistently measured over time.
Any component of Comprehensive Profit and Loss that cannot be
specifically identified in the attribution analysis should be
identified as an unexplained portion of the Comprehensive Profit and
Loss.
General Calculation Guidance: The specific market and risk
factors used by a trading unit in the attribution analysis should be
tailored to the trading activities undertaken by the unit. These
factors should be measured consistently over time to facilitate
historical comparisons. The attribution analysis should also
identify any significant factors that have a consistent and regular
influence on Comprehensive Profit and Loss, such as Risk Factor
Sensitivities that have a significant influence on portfolio income,
customer spreads, bid-ask spreads, or commissions that are earned.
Factors that influence Comprehensive Profit and Loss across
different trading units should be measured and included in the
attribution analysis in a comparable fashion.
Calculation Period: One trading day.
C. Revenue-Relative-to-Risk Measurements
1. Volatility of Comprehensive Profit and Loss and Volatility of
Portfolio Profit and Loss
Description: For purposes of this appendix, Volatility of
Comprehensive Profit and Loss generally is the standard deviation of
the trading unit's Comprehensive Profit and Loss estimated over a
given calculation period. For purposes of this appendix, Volatility
of Portfolio Profit and Loss generally is the standard deviation of
the trading unit's Portfolio Profit and Loss, exclusive of Spread
Profit and Loss, estimated over a given calculation period.
Calculation Period: 30 days, 60 days, and 90 days.
2. Comprehensive Profit and Loss to Volatility Ratio and Portfolio
Profit and Loss to Volatility Ratio
Description: For purposes of this appendix, Comprehensive Profit
and Loss to Volatility Ratio is a ratio of Comprehensive Profit and
Loss to the Volatility of Comprehensive Profit and Loss for a
trading unit over a given calculation period. For purposes of this
appendix, Portfolio Profit and Loss to Volatility Ratio is a ratio
of Portfolio Profit and Loss, exclusive of Spread Profit and Loss,
to the Volatility of Portfolio Profit and Loss, exclusive of Spread
Profit and Loss, for a trading unit over a given calculation period.
Calculation Period: 30 days, 60 days, and 90 days.
3. Unprofitable Trading Days Based on Comprehensive Profit and Loss and
Unprofitable Trading Days Based on Portfolio Profit and Loss
Description: For purposes of this appendix, Unprofitable Trading
Days Based on Comprehensive Profit and Loss is the number or
proportion of trading days on which a trading unit's Comprehensive
Profit and Loss is less than zero over a given calculation period.
For purposes of this appendix, Unprofitable Trading Days Based on
Portfolio Profit and Loss, exclusive of Spread Profit and Loss, is
the number or proportion of trading days on which a trading unit's
Portfolio Profit and Loss, exclusive of Spread Profit and Loss, is
less than zero over a given calculation period.
Calculation Period: 30 days, 90 days, and 360 days.
4. Skewness of Portfolio Profit and Loss and Kurtosis of Portfolio
Profit and Loss
Description: Skewness of Portfolio Profit and Loss and Kurtosis
of Portfolio Profit and Loss should be calculated using standard
statistical methods with respect to Portfolio Profit and Loss,
exclusive of Spread Profit and Loss.
Calculation Period: 30 days, 60 days, and 90 days.
D. Customer-Facing Activity Measurements
1. Inventory Risk Turnover
Description: For purposes of this appendix, Inventory Risk
Turnover is a ratio that measures the amount of risk associated with
a trading unit's inventory, as measured by Risk Factor
Sensitivities, that is turned over by the trading unit over a
specific period of time. For each Risk Factor Sensitivity, the
numerator of the Inventory Risk Turnover ratio generally should be
the absolute value of the Risk Factor Sensitivity associated with
each transaction over the calculation period. The denominator of the
Inventory Risk Turnover ratio generally should be the value of each
Risk Factor Sensitivity for all of the trading unit's holdings at
the beginning of the calculation period.
General Calculation Guidance: As a general matter, a trading
unit should measure and report the Inventory Risk Turnover ratio for
each of the Risk Factor Sensitivities calculated and furnished for
that trading unit.
Calculation Period: 30 days, 60 days, and 90 days.
2. Inventory Aging
Description: For purposes of this appendix, Inventory Aging
generally describes the trading unit's aggregate assets and
liabilities and the amount of time that those assets and liabilities
have been held for the following periods: 0-30 days; 30-60 days; 60-
90 days; 90-180 days; 80-360 days; and greater than 360 days.
Inventory Aging should measure the age profile of the trading unit's
assets and liabilities.
General Calculation Guidance: In general, Inventory Aging should
be computed using a trading unit's trading activity data and should
identify the trading unit's aggregate assets and liabilities. In
addition, Inventory Aging should include two schedules, an asset-
aging schedule and a liability-aging schedule. The asset-aging
schedule should record the value of the trading unit's assets that
have been held for: 0-30 days; 30-60 days; 60-90 days; 90-180 days;
180-360 days; and greater than 360 days. The liability-aging
schedule should record the value of the trading unit's liabilities
that have been held for: 0-30 days; 30-60 days; 60-90 days; 90-180
days; 180-360 days; and more than 360 days.
Calculation Period: 30 days, 60 days, and 90 days.
3. Customer-Facing Trade Ratio
Description: For purposes of this appendix, the Customer-Facing
Trade Ratio is a ratio comparing the number of transactions
involving a counterparty that is a customer of the trading unit to
the number of transactions involving a counterparty that is
[[Page 68960]]
not a customer of the trading unit. For purposes of calculating the
Customer-Facing Trade Ratio, a counterparty is considered to be a
customer of the trading unit if the counterparty is neither a
counterparty to a transaction executed on a designated contract
market registered under the Commodity Exchange Act or national
securities exchange registered under the Exchange Act, nor a broker-
dealer, swap dealer, security-based swap dealer, any other entity
engaged in market making-related activities, or any affiliate
thereof. A broker-dealer, swap dealer, or security-based swap
dealer, any other entity engaged in market making-related
activities, or any affiliate thereof may be considered a customer of
the trading unit for these purposes if the covered banking entity
treats that entity as a customer and has documented how and why the
entity is treated as such.
Calculation Period: 30 days, 60 days, and 90 days.
E. Payment of Fees, Commissions, and Spreads Measurement
1. Pay-to-Receive Spread Ratio
Description: For purposes of this appendix, the Pay-to-Receive
Spread Ratio is a ratio comparing the amount of Spread Profit and
Loss and Fee Income that is earned by a trading unit to the amount
of Spread Profit and Loss and Fee Income that is paid by the trading
unit.
General Calculation Guidance: The Pay-to-Receive Spread Ratio
will depend on the amount of Spread Profit and Loss and Fee Income
that is earned by the trading unit for facilitating buy and sell
orders and the amount of Spread Profit and Loss that is paid by a
trading unit as it initiates buy and sell orders. The Pay-to-Receive
Spread Ratio generally should be computed using the calculation of
Spread Profit and Loss described in this appendix, except that
spread paid should include the aggregate Spread Profit and Loss of
all transactions producing a negative Spread Profit and Loss, and
spread received should include the aggregate Spread Profit and Loss
of all transactions producing a positive Spread Profit and Loss.
Calculation Period: One trading day.
Appendix B: Commentary Regarding Identification of Permitted Market
Making-Related Activities
I. Purpose
This appendix provides commentary describing the features of
permitted market making-related activities and distinctions between
permitted market making-related activities and prohibited
proprietary trading. The appendix applies to all covered banking
entities that are engaged in market making-related activities in
reliance on Sec. --.4(b). The following commentary must be
incorporated into the covered banking entity's internal compliance
program under Sec. --.20, as applicable.
II. Definitions
The terms used in this appendix have the same meanings as those
set forth in Sec. Sec. --.2 and --.3 and Appendix A.
III. Commentary
Section 13 of the BHC Act and Sec. --.3 prohibit any covered
banking entity from engaging in proprietary trading, which is
generally defined as engaging as principal for the trading account
of the covered banking entity in any transaction to purchase or sell
a covered financial position. However, section 13(d)(1)(B) of the
BHC Act and Sec. --.4(b) permit a covered banking entity to engage
in proprietary trading that would otherwise be prohibited if the
activity is conducted in connection with the covered banking
entity's market making-related activities, to the extent that such
activities are designed not to exceed the reasonably expected near
term demands of clients, customers, and counterparties. This
commentary is intended to assist covered banking entities in
identifying permitted market making-related activities and
distinguishing such activities from trading activities that, even if
conducted in the context of the covered banking entity's market
making operations, would constitute prohibited proprietary trading.
A. Overview of Market Making-Related Activities
In the context of trading activities in which a covered banking
entity acts as principal, market making-related activities generally
involve the covered banking entity either (i) in the case of market
making in a security that is executed on an organized trading
facility or exchange, passively providing liquidity by submitting
resting orders that interact with the orders of others on an
organized trading facility or exchange and acting as a registered
market maker, where such exchange or organized trading facility
provides the ability to register as a market maker,\1\ or (ii) in
other cases, providing an intermediation service to its customers by
assuming the role of a counterparty that stands ready to buy or sell
a position that the customer wishes to sell or buy. A market maker's
``customers'' generally vary depending on the asset class and market
in which the market maker is providing intermediation services. In
the context of market making in a security that is executed on an
organized trading facility or an exchange, a ``customer'' is any
person on behalf of whom a buy or sell order has been submitted by a
broker-dealer or any other market participant. In the context of
market making in a covered financial position in an over-the-counter
market, a ``customer'' generally would be a market participant that
makes use of the market maker's intermediation services, either by
requesting such services or entering into a continuing relationship
with the market maker with respect to such services.\2\
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\1\ The status of being a registered market maker is not, on its
own, a sufficient basis for relying on the exemption for market
making-related activity contained in Sec. --.4(b). Registration as
a market maker generally involves filing a prescribed form with an
exchange or organized trading facility, in accordance with its rules
and procedures, and complying with the applicable requirements for
market makers set forth in the rules of that exchange or organized
trading facility. See, e.g., Nasdaq Rule 4612, New York Stock
Exchange Rule 104, CBOE Futures Exchange Rule 515, BATS Exchange
Rule 11.5.
\2\ In certain cases, depending on the conventions of the
relevant market (e.g., the over-the-counter derivatives market),
such a ``customer'' may consider itself or refer to itself more
generally as a ``counterparty.''
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The primary purpose of market making-related activities is to
intermediate between buyers and sellers of similar positions, for
which service market makers are compensated, resulting in more
liquid markets and less volatile prices. The purpose of such
activities is not to earn profits as a result of movements in the
price of positions and risks acquired or retained; rather, a market
maker generally manages and limits the extent to which it is exposed
to movements in the price of principal positions and risks that it
acquires or retains, or in the price of one or more material
elements of those positions. To the extent that it can, a market
maker will eliminate some or all of the price risks to which it is
exposed. However, in some cases, the risks posed by one or more
positions may be sufficiently complex or specific that the risk
cannot be fully hedged. In other cases, although it may be possible
to hedge the risks posed by one or more positions, the cost of doing
so may be so high as to effectively make market making in those
positions uneconomic if complete hedges were acquired. In such
cases, in order to provide effective intermediation services, market
makers are required to retain at least some risk for at least some
period of time with respect to price movements of retained principal
positions and risks. The size and type of risk that must be retained
in such cases may vary widely depending on the type and size of the
positions, the liquidity of the specific market, and the market's
structure. As the liquidity of positions increases, the frequency
with which a market maker must take or retain risk in order to make
a market in those positions generally decreases.
The profitability of market making-related activities relies on
forms of revenue that reflect the value of the intermediation
services that are provided to the market maker's customers. These
revenues typically take the form of explicit fees and commissions
or, in markets where no such fees or commission are charged, a bid-
ask or similar spread that is generated by charging higher prices to
buyers than is paid to sellers of comparable instruments. In the
case of a derivative contract, these revenues reflect the difference
between the cost of entering into the derivative contract and the
cost of hedging incremental, residual risks arising from the
contract. These types of ``customer revenues'' provide the primary
source of a market maker's profitability. Typically, a market maker
holds at least some risk with respect to price movements of retained
principal positions and risks. As a result, the market maker also
incurs losses or generates profits as price movements actually
occur, but such losses or profits are incidental to customer
revenues and significantly limited by the banking entity's hedging
activities. Customer revenues, not revenues from price movements,
predominate. The appropriate proportion of ``customer revenues'' to
profits
[[Page 68961]]
and losses resulting from price movements of retained principal
positions and risks varies depending on the type of positions
involved, the typical fees, commissions, and spreads payable for
transactions in those positions, and the risks of those positions.
As a general matter, the proportion of ``customer revenues''
generated when making a market in certain positions increases as the
fees, commissions, or spreads payable for those positions increase,
the volatility of those positions' prices decrease, and the prices
for those positions are less transparent.
Because a market maker's business model entails managing and
limiting the extent to which it is exposed to movements in the
prices of retained principal positions and risks while generating
customer revenues that are earned, regardless of movements in the
price of retained principal positions and risks, a market maker
typically generates significant revenue relative to the risks that
it retains. Accordingly, a market maker will typically demonstrate
consistent profitability and low earnings volatility under normal
market conditions. The appropriate extent to which a market maker
will demonstrate consistent profitability and low earnings
volatility varies depending on the type of positions involved, the
liquidity of the positions, the price transparency of the positions,
and the volatility of the positions' prices. As a general matter,
consistent profitability will decrease and earnings volatility will
increase as the liquidity of the positions decrease, the volatility
of the positions' prices increase, and the prices for the positions
are less transparent.
As the primary purpose of market making-related activities is to
provide intermediation services to its customers, market makers
focus their activities on servicing customer demands and typically
only engage in transactions with non-customers to the extent that
these transactions directly facilitate or support customer
transactions. In particular, a market maker generally only transacts
with non-customers to the extent necessary to hedge or otherwise
manage the risks of its market making-related activities, including
managing its risk with respect to movements of the price of retained
principal positions and risks, to acquire positions in amounts
consistent with reasonably expected near term demand of its
customers, or to sell positions acquired from its customers. The
appropriate proportion of a market maker's transactions that are
with customers versus non-customers varies depending on the type of
positions involved and the extent to which the positions are
typically hedged in non-customer transactions. In the case of a
derivatives market maker that engages in dynamic hedging, the number
of non-customer transactions significantly outweighs the number of
customer transactions, as the derivatives market maker must
constantly enter into transactions to appropriately manage its
retained principal positions and risks as market prices for the
positions and risks move and additional transactions with customers
change the risk profile of the market maker's retained principal
positions.
Because a market maker generates revenues primarily by
transacting with, and providing intermediation services to,
customers, a market maker typically engages in transactions that
earn fees, commissions, or spreads as payment for its services.
Transactions in which the market maker pays fees, commissions, or
spreads--i.e., where it pays another market maker for providing it
with liquidity services--are much less frequent, although in some
cases obtaining liquidity services from another market maker and
paying fees, commissions, or spreads may be necessary to prudently
manage its risk with respect to price movements of retained
principal positions and risks. The appropriate proportion of a
market maker's transactions that earn, rather than pay, fees,
commissions or spreads varies depending on the type of positions
involved, the liquidity of the positions, and the extent to which
market trends increase the volatility of its risk with respect to
price movements of retained principal positions and risks. As a
general matter, the proportion of a market maker's transactions that
earn rather than pay fees, commissions or spreads decreases as the
liquidity of the positions decreases, and the extent to which the
price volatility of retained principal positions and risks
increases.
Finally, because the primary purpose of market making-related
activities is to provide intermediation services to its customers, a
market maker does not provide compensation incentives to its
personnel that primarily reward proprietary risk-taking. Although a
market maker may take into account revenues resulting from movements
in the price of retained principal positions and risks to the extent
that such revenues reflect the effectiveness with which personnel
have effectively managed the risk of movements in the price of
retained principal positions and risks, a market maker that provides
compensation incentives relating to revenues generally does so
through incentives that primarily reward customer revenues and
effective customer service.
B. Overview of Prohibited Proprietary Trading Activities
Like permitted market making-related activities, prohibited
proprietary trading involves the taking of principal positions by a
covered banking entity. Unlike permitted market making-related
activities, the purpose of prohibited proprietary trading is to
generate profits as a result of, or otherwise benefit from, changes
in the price of positions and risks taken. Whereas a market maker
attempts to eliminate some or all of the price risks inherent in its
retained principal positions and risks by hedging or otherwise
managing those risks in a reasonable period of time after positions
are acquired or risks arise, a proprietary trader seeks to
capitalize on those risks, and generally only hedges or manages a
portion of those risks when doing so would improve the potential
profitability of the risk it retains. A proprietary trader does not
have ``customers'' because a proprietary trader simply seeks to
obtain the best price and execution in purchasing or selling its
proprietary positions. A proprietary trader generates few if any
fees, commissions, or spreads from its trading activities because it
is not providing an intermediation service to any customer or other
third party. Instead, a proprietary trader is likely to pay fees,
commissions, or spreads to other market makers when obtaining their
liquidity services is beneficial to execution of its trading
strategy. Because a proprietary trader seeks to generate profits
from changes in the price of positions taken, a proprietary trader
typically provides compensation incentives to its personnel that
primarily reward successful proprietary risk taking.
C. Distinguishing Permitted Market Making-Related Activities From
Prohibited Proprietary Trading
Because both permitted market making-related activities and
prohibited proprietary trading involve the taking of principal
positions, certain challenges arise in distinguishing permitted
market making-related activities and prohibited proprietary trading,
particularly in cases where both of these activities occur in the
context of a market making operation. Particularly during periods of
significant market disruption, it may be difficult to distinguish
between retained principal positions and risks that appropriately
support market making-related activities and positions taken, or
positions or risks not hedged, for proprietary purposes.
In connection with these challenges, [Agency] will apply the
following factors in distinguishing permitted market making-related
activities from trading activities that, even if conducted in the
context of the covered banking entity's market making operations,
would constitute prohibited proprietary trading. The particular
types of trading activity described in this appendix may involve the
aggregate trading activities of a single trading unit, a significant
number or series of transactions occurring at one or more trading
units, or a single significant transaction, among other potential
scenarios. In addition to meeting the terms of this appendix, any
transaction or activity for which a covered banking entity intends
to rely on the market making exemption in Sec. --.4(b) must also
satisfy all the requirements specified in Sec. --.4(b), as well as
the other applicable requirements and conditions of this part.
1. Risk Management
Absent explanatory facts and circumstances, particular trading
activity in which a trading unit retains risk in excess of the size
and type required to provide intermediation services to customers
will be considered to be prohibited proprietary trading, and not
permitted market making-related activity.
[The Agency] will base a determination of whether a trading unit
retains risk in excess of the size and type required for these
purposes on all available facts and circumstances, including a
comparison of retained principal risk to: The amount of risk that is
generally required to execute a particular market making function;
hedging options that are available in the market and permissible
under the covered banking entity's hedging policy at the time the
particular trading activity occurred; the trading unit's prior
levels of retained risk and its hedging practices with respect to
similar
[[Page 68962]]
positions; and the levels of retained risk and the hedging practices
of other trading units with respect to similar positions.
To help assess the extent to which a trading unit's risks are
potentially being retained in excess of amounts required to provide
intermediation services to customers, [Agency] will utilize the VaR
and Stress VaR, VaR Exceedance, and Risk Factor Sensitivities
quantitative measurements, as applicable, among other risk
measurements described in appendix A to this part and any other
relevant factor. This assessment will focus primarily on the risk
measurements relative to: The risk required for conducting market
making-related activities, and any significant changes in the risk
over time and across similarly situated trading units and banking
entities.
Explanatory facts and circumstances might include, among other
things, market-wide changes in risk, changes in the specific
composition of market making-related activities, temporary market
disruptions, or other market changes that result in previously used
hedging or other risk management techniques no longer being possible
or cost-effective.
2. Source of Revenues
Absent explanatory facts and circumstances, particular trading
activity in which a trading unit primarily generates revenues from
price movements of retained principal positions and risks, rather
than customer revenues, will be considered to be prohibited
proprietary trading, and not permitted market making-related
activity.
[The Agency] will base a determination of whether a trading
activity primarily generates revenues from price movements of
retained principal positions and risks, rather than customer
revenues, on all available facts and circumstances, including: an
evaluation of the revenues derived from price movements of retained
principal positions and risks relative to its customer revenues; and
a comparison of these revenue figures to the trading unit's prior
revenues with respect to similar positions, and the revenues of
other covered banking entities' trading units with respect to
similar positions.
To help assess the extent to which a trading unit's revenues are
potentially derived from movements in the price of retained
principal positions and risks, [Agency] will utilize the
Comprehensive Profit and Loss, Portfolio Profit and Loss, Fee Income
and Expense, and Spread Profit and Loss quantitative measurements,
as applicable, both individually and in combination with one another
(e.g., by comparing the ratio of Spread Profit and Loss to Portfolio
Profit and Loss), and any other relevant factor.
Explanatory facts and circumstances might include, among other
things: general upward or downward price trends in the broader
markets in which the trading unit is making a market, provided
revenues from price movements in retained principal positions and
risks are consistent; sudden market disruptions or other changes
causing significant, unanticipated alterations in the price of
retained principal positions and risks; sudden and/or temporary
changes in the market (e.g., narrowing of bid/ask spreads) that
cause significant, unanticipated reductions in customer revenues; or
efforts to expand or contract a trading unit's market share.
3. Revenues Relative to Risk
Absent explanatory facts and circumstances, particular trading
activity will be considered to be prohibited proprietary trading,
and not permitted market making-related activity, if the trading
unit: generates only very small or very large amounts of revenue per
unit of risk taken; does not demonstrate consistent profitability;
or demonstrates high earnings volatility.
[The Agency] will base such a determination on all available
facts and circumstances, including: an evaluation of the amount of
revenue per unit of risk taken, earnings volatility, profitability,
exposure to risks, and overall level of risk taking for the
particular trading activities; and a comparison of these figures to
the trading unit's prior results with respect to similar positions,
and the results of other covered banking entities' trading units
with respect to similar positions.
To help assess the riskiness of revenues and the amount of
revenue per unit of risk taken, [Agency] will utilize the Volatility
of Comprehensive Profit and Loss and Volatility of Portfolio Profit
and Loss, Comprehensive Profit and Loss to Volatility Ratio and
Portfolio Profit and Loss to Volatility Ratio, and Comprehensive
Profit and Loss Attribution quantitative measurements, as
applicable, and any other relevant factor.
To help assess the extent to which a trading unit demonstrates
consistent profitability, [Agency] will utilize the Unprofitable
Trading Days Based on Comprehensive Profit and Loss and Unprofitable
Trading Days Based on Portfolio Profit and Loss quantitative
measurements, as applicable, and any other relevant factor.
To help assess the extent to which a trading unit is exposed to
outsized risk, [Agency] will utilize the Skewness of Portfolio
Profit and Loss and Kurtosis of Profit and Loss quantitative
measurements, as applicable, and any other relevant factor.
Explanatory facts and circumstances might include, among other
things: market disruptions or other changes causing significant,
unanticipated increases in a trading unit's risk with respect to
movements in the price of retained principal positions and risks;
market disruptions or other changes causing significant,
unanticipated increases in the volatility of positions in which the
trading unit makes a market; sudden and/or temporary changes in the
market (e.g., narrowing of bid-ask spreads) that cause significant,
unanticipated reductions in customer revenues and decrease overall
profitability; or efforts to expand or contract a trading unit's
market share.
4. Customer-Facing Activity
Absent explanatory facts and circumstances, particular trading
activity will be considered to be prohibited proprietary trading,
and not permitted market making-related activity, if the trading
unit: does not transact through a trading system that interacts with
orders of others or primarily with customers of the banking entity's
market making desk to provide liquidity services; or retains
principal positions and risks in excess of reasonably expected near
term customer demands.
[The Agency] will base such a determination on all available
facts and circumstances, including, among other things: An
evaluation of the extent to which a trading unit's transactions are
with customers versus non-customers and the frequency with which the
trading unit's retained principal positions and risks turn over; and
a comparison of these figures to the trading unit's prior results
with respect to similar positions and market situations, and the
results of other covered banking entities' trading units with
respect to similar positions.
To help assess the extent to which a trading unit's transactions
are with customers versus non-customers, [Agency] will utilize the
Customer-Facing Trade Ratio quantitative measurement, as applicable,
and any other relevant factor. To help assess the frequency with
which the trading unit's retained principal positions and risks turn
over, [Agency] will utilize the Inventory Risk Turnover and
Inventory Aging quantitative measurements, as applicable, and any
other relevant factor.
With respect to a particular trading activity in which a trading
unit either does not transact through a trading system that
interacts with orders of others or primarily with customers of the
banking entity's market making desk to provide liquidity services,
explanatory facts and circumstances might include, among other
things: sudden market disruptions or other changes causing
significant increases in a trading unit's hedging transactions with
non-customers; or substantial intermediary trading required to
satisfy customer demands and hedging management. With respect to
particular trading activity in which a trading unit retains
principal positions and risks in excess of reasonably expected near
term customer demands, explanatory facts and circumstances might
include, among other things: sudden market disruptions or other
changes causing a significant reduction in actual customer demand
relative to expected customer demand; documented and reasonable
expectations for temporary increases in customer demand in the near
term; and sudden market disruptions or other changes causing a
significant reduction in the value of retained principal positions
and risks, such that it would be imprudent for the trading unit to
dispose of the positions in the near term.
5. Payment of Fees, Commissions, and Spreads
Absent explanatory facts and circumstances, particular trading
activity in which a trading unit routinely pays rather than earns
fees, commissions, or spreads will be considered to be prohibited
proprietary trading, and not permitted market making-related
activity.
[The Agency] will base such a determination on all available
facts and circumstances, including, among other things: An
evaluation of the frequency with which the trading unit pay fees,
[[Page 68963]]
commissions, or spreads and the relative amount of fees,
commissions, or spreads that is paid versus earned; and a comparison
of these figures to the trading unit's prior results with respect to
similar positions, and the results of other covered banking
entities' trading units with respect to similar positions.
To help assess the extent to which a trading unit is paying
versus earning fees, commissions, and spreads, [Agency] will utilize
the Pay-to-Receive Spread Ratio quantitative measurement, as
applicable, and any other relevant factor.
Explanatory facts and circumstances might include, among other
things, sudden market disruptions or other changes causing
significant, increases in a trading unit's hedging transactions with
non-customers for which it must pay fees, commissions, or spreads,
sudden, unanticipated customer demand for liquidity that requires
the trading unit itself to pay fees, commissions, or spreads to
other market makers for liquidity services to obtain the inventory
needed to meet that customer demand, or significant, unanticipated
reductions in fees, commissions, or spreads earned by the trading
unit. Explanatory facts and circumstances might also include a
trading unit's efforts to expand or contract its market share.
6. Compensation Incentives
Absent explanatory facts and circumstances, the trading activity
of a trading unit that provides compensation incentives to employees
that primarily reward proprietary risk taking will be considered to
be prohibited proprietary trading, and not permitted market making-
related activity.
[The Agency] will base such a determination on all available
facts and circumstances, including, among other things, an
evaluation of: the extent to which compensation incentives are
provided to trading unit personnel that reward revenues from
movements in the price of retained principal positions and risks;
the extent to which compensation incentives are provided to trading
unit personnel that reward customer revenues; and the compensation
incentives provided by other covered banking entities to similarly-
situated personnel.
* * * * *
Appendix C: Minimum Standards for Programmatic Compliance
I. Overview
A. Purpose
This appendix sets forth the minimum standards with respect to
the establishment, maintenance, and enforcement by banking entities
of internal compliance programs for ensuring and monitoring
compliance with the prohibitions and restrictions on proprietary
trading and covered fund activities or investments set forth in
section 13 of the BHC Act and this part.
This appendix requires that banking entities establish,
maintain, and enforce an effective compliance program, consisting of
written policies and procedures, internal controls, a management
framework, independent testing, training, and recordkeeping, that:
Is reasonably designed to clearly document, describe,
and monitor the covered trading and covered fund activities or
investments and the risks of the covered banking entity related to
such activities or investments, identify potential areas of
noncompliance, and prevent activities or investments prohibited by,
or that do not comply with, section 13 of the BHC Act and this part;
Specifically addresses the varying nature of activities
or investments conducted by different units of the covered banking
entity's organization, including the size, scope, complexity, and
risks of the individual activities or investments;
Subjects the effectiveness of the compliance program to
independent review and testing;
Makes senior management and intermediate managers
accountable for the effective implementation of the compliance
program, and ensures that the board of directors and CEO review the
effectiveness of the compliance program; and
Facilitates supervision and examination of the covered
banking entity's covered trading and covered fund activities or
investments by the Agencies.
B. Definitions
The terms used in this Appendix have the same meanings as set
forth in Sec. Sec. --.2, --.3, and --.10. In addition, for purposes
of this appendix, the following definitions apply:
Asset management unit means any unit of organization of a
covered banking entity that makes investments in, or acts as sponsor
to, covered funds, or has relationships with covered funds, that the
covered banking entity (or an affiliate of subsidiary thereof) has
sponsored, organized and offered, or in which a covered fund
sponsored or advised by the covered banking entity invests.
Compliance program means the internal compliance program
established by a covered banking entity in accordance with Sec.
--.20 and this appendix.
Covered fund activity or investment means sponsoring any covered
fund or making investments in, or otherwise having relationships
with, any covered fund for which the covered banking entity (or an
affiliate or subsidiary thereof) acts as sponsor or organizes and
offers.
Covered fund restrictions means the restrictions on covered fund
activities or investments set forth in subpart C.
Covered trading activity means proprietary trading, as defined
in Sec. --.3(b)(1).
Trading unit means each of the following units of organization
of a covered banking entity:
(i) Each discrete unit that is engaged in the coordinated
implementation of a revenue-generation strategy and that
participates in the execution of any covered trading activity; \1\
---------------------------------------------------------------------------
\1\ [The Agency] expects that this will generally be the
smallest unit of organization used by the covered banking entity to
structure and control its risk-taking activities and employees, and
will include each unit generally understood to be a single ``trading
desk.''
---------------------------------------------------------------------------
(ii) Each organizational unit that is used to structure and
control the aggregate risk-taking activities and employees of one or
more trading units described in paragraph (i); \2\
---------------------------------------------------------------------------
\2\ [The Agency] expects that this will generally include
management or reporting divisions, groups, sub-groups, or other
intermediate units of organization used by the covered banking
entity to manage one or more discrete trading units (e.g., ``North
American Credit Trading,'' ``Global Credit Trading,'' etc.).
---------------------------------------------------------------------------
(iii) All trading operations, collectively; and
(iv) Any other unit of organization specified by [Agency] with
respect to a particular banking entity.
C. Required Elements
Section --.20 requires that covered banking entities establish,
maintain, and enforce a compliance program reasonably designed to
ensure and monitor compliance with the prohibitions and restrictions
on proprietary trading and covered fund activities or investments
that effectively implements, at a minimum, the six elements required
under paragraph (b) of Sec. --.20.
D. Compliance Program Structure
Each covered banking entity subject to Sec. --.20(c) must be
governed by a compliance program meeting the requirements of this
appendix. A covered banking entity may establish a compliance
program on an enterprise-wide basis to satisfy the requirements of
Sec. --.20 and this appendix with respect to the covered banking
entity and all of its affiliates and subsidiaries collectively,
provided that: the program is clearly applicable, both by its terms
and in operation, to all such affiliates and subsidiaries; the
program specifically addresses the requirements set forth in this
appendix; the program takes into account and addresses the
consolidated organization's business structure, size, and
complexity, as well as the particular activities, risks, and
applicable legal requirements of each subsidiary and affiliate; and
the program is determined through periodic independent testing to be
effective for the covered banking entity and all of its subsidiaries
and affiliates. An enterprise-wide program established pursuant to
this Appendix will be subject to supervisory review and examination
by any Agency vested with rulewriting authority under section 13 of
the BHC Act with respect to the compliance program and the
activities or investments of any banking entity for which the Agency
has such authority. Further, such Agency will have access to all
records related to the enterprise-wide compliance program pertaining
to any banking entity that is supervised by the Agency vested with
such rulewriting authority.
E. Applicability
This appendix applies only to covered banking entities described
in Sec. --.20(c)(2). In addition, [Agency] may require any covered
banking entity to comply with all or portions of this appendix if
[Agency] deems it appropriate for purposes the covered banking
entity's compliance with this part.
[[Page 68964]]
Nothing in this appendix limits the authority of [Agency] under
any other provision of law or regulation to take supervisory,
examination, or enforcement action, including action to address
unsafe or unsound practices or conditions, deficient capital levels,
or violations of law.
II. Internal Policies and Procedures
A. Covered Trading Activities
A covered banking entity must establish, maintain, and enforce
written policies and procedures reasonably designed to document,
describe, and monitor the covered banking entity's covered trading
activities and the risks taken in these activities, as follows:\3\
---------------------------------------------------------------------------
\3\ These policies and procedures must be updated with a
frequency sufficient for the covered banking entity to adequately
control the applicable trading unit for purposes of this part.
---------------------------------------------------------------------------
Identification of trading account: The covered banking entity's
policies and procedures must specify how the banking entity
evaluates the covered financial positions it acquires or takes and
determines which of its accounts are trading accounts for purposes
of subpart B of this part.
Identification of trading units and organization structure: The
covered banking entity's written policies and procedures must
identify and document each trading unit within the organization and
map each trading unit to the division, business line, or other
organizational structure that the covered banking entity uses to
manage or oversee the trading unit's activities.
Description of missions and strategies: The covered banking
entity's written policies and procedures for each trading unit must
clearly articulate and document a comprehensive description of the
mission (i.e., the nature of the business conducted) and strategy
(i.e., business model for the generation of revenues) of the trading
unit, and include a description of:
How revenues are intended to be generated by the
trading unit;
The activities that the trading unit is authorized to
conduct, including (i) authorized instruments and products and (ii)
authorized hedging strategies and instruments;
The expected holding period of, and the market risk
associated with, covered financial positions in its trading account;
The types of clients, customers, and counterparties
with whom trading is conducted by the trading unit;
How the trading unit, if engaged in market making-
related activity under Sec. --.4(b) of this part, identifies its
customers for purposes of computing the Customer-Facing Trade Ratio,
if applicable, including documentation explaining when, how, and why
a broker-dealer, swap dealer, security-based swap dealer, any other
entity engaged in market making-related activities, or any affiliate
thereof is considered to be a customer of the trading unit for those
purposes; and
The compensation structure of the employees associated
with the trading unit.
Trader mandates: The covered banking entity must establish,
maintain, document, and enforce trader mandates for each trading
unit. At a minimum, trader mandates must:
Clearly inform each trader of the prohibitions and
requirements set forth in section 13 of the BHC Act and this part
and his or her responsibilities for compliance with such
requirements;
Set forth appropriate parameters for each trader
engaged in covered trading activities, including:
[cir] The conditions for relying on the applicable exemptions in
Sec. Sec. --.4 through --.6;
[cir] The financial contracts, products, and underlying assets
that the trader is permitted to trade pursuant to the covered
banking entity's internal controls;
[cir] The risk limits of the trader's trading unit, and the
types and levels of risk that may be taken; and
[cir] The applicable trading unit's hedging policy.
Description of risks and risk management processes: The written
policies and procedures for each trading unit must clearly
articulate and document a comprehensive description of the risks
associated with the trading unit. Such descriptions must include, at
a minimum, the following elements:
A description of the supervisory and risk management
structure governing the trading units, including a description of
processes for initial and senior-level review of new products and
new strategies;
A description of the types of risks that may be taken
to implement the mission and strategy of the trading unit, including
an enumeration of material risks resulting from the activities in
which the trading unit is engaged (including but not limited to all
significant price risks, such as basis, volatility and correlation
risks, as well as any significant counterparty credit risk
associated with the trading activity);
An articulation of the amount of risk allocated by the
covered banking entity to such trading unit to implement the
documented mission and strategy of the trading unit;
An explanation of how the risks allocated to such
trading unit will be measured; and
An explanation of why the allocated risk levels are
appropriate to the mission and strategy of the trading unit.
Hedging policies and procedures. The covered banking entity must
establish, maintain, and enforce policies and procedures for all of
its trading units regarding the use of risk-mitigating hedging
instruments and strategies. At a minimum, these hedging policies and
procedures must articulate the following:
The manner in which the covered banking entity will
determine that the risks generated by each trading unit have been
properly and effectively hedged;
The instruments, techniques and strategies the covered
entity will use to hedge the risk of the positions or portfolios;
The level of the organization at which hedging activity
and management will occur;
The manner in which hedging strategies will be
monitored;
The risk management processes used to control unhedged
or residual risks; and
The independent testing of hedging techniques and
strategies.
Explanation of compliance. The covered banking entity's written
policies and procedures must clearly articulate and document a
comprehensive explanation of how the mission and strategy of each
trading unit, and its related risk levels, comply with this part.
Such explanation must:
Identify which portions of the risk-taking activity of
the trading unit would or would not constitute covered trading
activity;
Identify activities of the trading unit that will be
conducted in reliance on exemptions contained in Sec. Sec. --.4
through --.6, including an explanation of:
o How and where the activity occurs; and
o Which exemption is being relied on and how the activity meets
the specific requirements for reliance on the applicable exemption.
Describe how the covered banking entity monitors for
and prohibits potential or actual material exposure to high-risk
assets or high-risk trading strategies presented by each trading
unit, which must take into account potential or actual exposure to:
[cir] Assets whose values cannot be externally priced or, where
valuation is reliant on pricing models, whose model inputs cannot be
externally validated;
[cir] Assets whose changes in values cannot be adequately
mitigated by effective hedging;
[cir] New products with rapid growth, including those that do
not have a market history;
[cir] Assets or strategies that include significant embedded
leverage;
[cir] Assets or strategies that have demonstrated significant
historical volatility;
[cir] Assets or strategies for which the application of capital
and liquidity standards would not adequately account for the risk;
and
[cir] Assets or strategies that result in large and significant
concentrations to sectors, risk factors, or counterparties;
Explain how each trading unit will comply with the
reporting and recordkeeping requirements of Sec. --.7 and Appendix
A ;
Describe how the covered banking entity monitors for
and prohibits potential or actual material conflicts of interest
between the covered banking entity and its clients, customers, or
counterparties present in each trading unit; and
Describe how the covered banking entity monitors for
and prohibits potential or actual transactions or activities that
may threaten the safety and soundness of the covered banking entity.
Remediation of violations. The covered banking entity's written
policies and procedures must require the covered banking entity to
promptly document, address and remedy any violation of section 13 of
the BHC Act or this part, and document all proposed and actual
remediation efforts. Further, such policies and procedures must
include specific procedures that are reasonably designed to
implement and monitor any required remediation and that assess the
extent to which any violation indicates that modification to the
covered banking entity's compliance program is warranted.
[[Page 68965]]
With respect to any trading unit that is either used by the
covered banking entity to structure and control the aggregate risk-
taking activities and employees of one or more other trading units,
or comprised of the entire trading operation of the covered banking
entity, the description of missions and strategies, description of
risks and risk management processes, and explanation of compliance
for such trading units may incorporate by reference the policies and
procedures of the underlying trading units that the trading unit
oversees and manages in the aggregate.
B. Covered Fund Activities or Investments
A covered banking entity must establish, maintain, and enforce
written policies and procedures that are reasonably designed to
document, describe, and monitor the covered banking entity's covered
fund activities or investments and the risks taken in these
activities or investments, as follows.
Identification of covered funds: The covered banking entity's
policies and procedures must specify how the covered banking entity
identifies covered funds that the covered banking entity sponsors,
organizes and offers, or in which covered banking entity invests.
Identification of asset management units and organization
structure: The covered banking entity's written policies and
procedures must identify and document each asset management unit
within the organization and map each asset management unit to the
division, business line, or other organizational structure that the
covered banking entity uses to manage or oversee the asset
management unit's activities or investments.
Description of sponsorship activities related to covered funds:
The covered banking entity's written policies and procedures for
each asset management unit must clearly articulate and document a
comprehensive description of the mission (i.e., the nature of the
business conducted) and strategy (i.e., business model for the
generation of revenues) of the asset management unit related to its
sponsorship or organizing and offering of covered funds, including a
description of how such activities comply with this part and, in
particular:
The activities that the asset management unit is
authorized to conduct, including the nature of any trust, fiduciary,
investment advisory, or commodity trading advisory services offered
to customers of the covered banking entity;
The types of customers to whom the asset management
unit provides such services and to whom ownership interests in
covered funds are sold;
The extent of any co-investment activities of the
covered banking entity (including its directors or employees) in
covered funds offered to such customers; and
How the asset management unit complies with the
requirements of subpart C of this part.
Description of investment activities of covered funds: The
covered banking entity's written policies and procedures for each
asset management unit must clearly articulate and document a
comprehensive description of the mission (i.e., the nature of the
business conducted) and strategy (i.e., business model for the
generation of revenues) of the asset management unit related to its
investments in covered funds, including a description of how such
activities comply with this part and, in particular:
The asset management unit's practices with respect to
seed capital investments in covered funds, including how the asset
management unit reduces its investments in covered funds to amounts
that are permitted de minimis investments within the required period
of time;
The asset management unit's practices with respect to
co-investments in covered funds, including certain parallel
investments as identified in Sec. --.12;
How the asset management unit complies with the
requirements of Sec. --.12 with respect to individual and aggregate
investments in covered funds;
With respect to other permitted covered fund activities
or investment, how the asset management unit complies with the
requirements of Sec. Sec. --.13 and --.14;
How the asset management unit complies with the
limitations on relationships with a covered fund under Sec. --.16;
How the covered banking entity monitors for and
prohibits potential or actual material conflicts of interest between
the covered banking entity and its clients, customers, or
counterparties related to the asset management unit;
How the covered banking entity monitors for and
prohibits potential or actual transactions or activities that may
threaten the safety and soundness of the covered banking entity
related to the asset management unit; and
How the covered banking entity monitors for and
prohibits potential or actual material exposure to high-risk assets
or high-risk trading strategies presented by each asset management
unit.
Remediation of violations. The covered banking entity's written
policies and procedures must require the covered banking entity to
promptly document, address and remedy any violation of section 13 of
the BHC Act or this part, and document all proposed and actual
remediation efforts. Further, such policies and procedures must
include specific procedures that are designed to implement, monitor,
and enforce any required remediation and that assess the extent to
which any violation indicates that modification to the covered
banking entity's compliance program is warranted.
III. Internal Controls
A. Covered Trading Activities
A covered banking entity must establish, maintain, and enforce
written internal controls that are reasonably designed to ensure
that the trading activity of each trading unit is appropriate and
consistent with the description of mission, strategy, and risk
mitigation for each trading unit contained in its written policies
and procedures. These written internal controls must also be
reasonably designed and established to effectively monitor and
identify for further analysis any covered trading activity that may
indicate potential violations of section 13 of the BHC Act and this
part and to prevent actual violations of section 13 of the BHC Act
and this part. Further, the internal controls must describe
procedures for remedying violations of section 13 of the BHC Act and
this part. The written internal controls must include, at a minimum,
the following.
Authorized risks, instruments, and products. The covered banking
entity must implement and enforce internal controls for each trading
unit that are reasonably designed to ensure that trading activity is
conducted in conformance with the trading unit's authorized risks,
instruments, and products, as documented in the covered banking
entity's written policies and procedures and trader mandates. At a
minimum, these internal controls must monitor and govern:
The types and levels of risks that may be taken by each
trading unit, consistent with the covered banking entity's written
policies and procedures;
The type of hedging instruments used, hedging
strategies employed, and the amount of risk effectively hedged,
consistent with the covered banking entity's written policies and
procedures; and
The financial contracts, products and underlying assets
that the trading unit may trade, consistent with covered banking
entity's written policies and procedures.
Risk limits. The covered banking entity must establish and
enforce risk limits appropriate for each trading unit, which shall
include limits based on probabilistic and non-probabilistic measures
of potential loss (e.g., Value-at-Risk and notional exposure,
respectively), measured under normal and stress market conditions.
Analysis and quantitative measurements. The covered banking
entity must perform robust analysis and quantitative measurement of
its covered trading activities that is reasonably designed to ensure
that the trading activity of each trading unit is consistent with
its mission, strategy and risk management process, as documented in
the covered banking entity's written policies and procedures;
monitor and assist in the identification of potential and actual
prohibited proprietary trading activity; and prevent the occurrence
of prohibited proprietary trading. In addition to the quantitative
measurements reported by the covered banking entity to [Agency]
pursuant to appendix A to this part, each covered banking must
develop and implement, to the extent necessary to facilitate
compliance with this part, additional quantitative measurements
specifically tailored to the particular risks, practices, and
strategies of its trading units. The covered banking entity's
analysis and quantitative measurement must incorporate the
quantitative measurements reported by the covered banking entity to
[Agency] pursuant to Appendix A and include, at minimum, the
following:
Internal controls and written policies and procedures
reasonably designed to ensure the accuracy and integrity of
quantitative measurements;
[[Page 68966]]
Ongoing, timely monitoring and review of calculated
quantitative measurements;
Heightened review of a quantitative measurement when
such quantitative measurement raises any question regarding
compliance with section 13 of the BHC Act and this part, which shall
include in-depth analysis, appropriate escalation procedures, and
documentation related to the review, including the establishment of
numerical thresholds for each trading unit for purposes of
triggering such heightened review; and
Immediate review and compliance investigation of the
trading unit's activities, escalation to senior management with
oversight responsibilities for the applicable trading unit, timely
notification to [Agency], appropriate remedial action (e.g.,
divesting of impermissible positions, cessation of impermissible
activity, disciplinary actions), and documentation of the
investigation findings and remedial action taken when the
quantitative measurement, considered together with the facts and
circumstances, suggests a reasonable likelihood that the trading
unit has violated any part of section 13 of the BHC Act and this
part.
Surveillance of compliance program effectiveness. The covered
banking entity must regularly monitor the effectiveness of its
compliance program and take prompt action to address and remedy any
deficiencies identified. Any actions taken to remedy deficiencies
and violations shall be documented and maintained as a record of the
banking entity.
B. Covered Fund Activities
A covered banking entity must establish, maintain, and enforce
internal controls that are reasonably designed to ensure that the
covered fund activities or investments of its asset management units
are appropriate and consistent with the description of the asset
management unit's mission, strategy, and risk management process
contained in the covered banking entity's written policies and
procedures. The internal controls must, at a minimum, be designed to
ensure that the covered banking entity complies with the
requirements of Sec. --.11 for any covered fund in which it
invests, acts as sponsor, or organizes and offers, as well as the
following:
Monitoring investments in a covered fund. The covered banking
entity must implement and enforce internal controls in a way that
monitors and limits the covered banking entity's individual and
aggregate investments in covered funds. At a minimum, the covered
banking entity shall establish, maintain, and enforce internal
controls reasonably designed to ensure that such investments are in
compliance with section 13 of the BHC Act and this part at all
times, including:
Monitoring the amount and timing of seed capital
investments for compliance with the limitations (including but not
limited to the redemption, sale or disposition requirements of Sec.
--.12);
Calculating the individual and aggregate levels of
ownership interests in covered funds required by Sec. --.12;
Describing procedures for remedying violations of
section 13 of the BHC Act and this part;
Attributing the appropriate instruments to the
individual and aggregate ownership interest calculations above; and
Making the appropriate required disclosures, in
writing, to prospective and actual investors in any covered fund
organized and offered or sponsored by the covered banking entity, as
provided under Sec. --.11(h).
Monitoring relationships with a covered fund. The covered
banking entity must implement and enforce internal controls in a way
that monitors and limits the covered banking entity's sponsorship
of, and relationships with, covered funds. At a minimum, the covered
banking entity shall establish, maintain, and enforce internal
controls reasonably designed to ensure that such activities and
relationships are in compliance with section 13 of the BHC Act and
this part at all times, including monitoring for and preventing any
relationship or transaction between the covered banking entity and a
covered fund that is prohibited under Sec. --.16.
Surveillance of compliance program effectiveness. The covered
banking entity must regularly monitor the effectiveness of its
compliance program and take prompt action to address and remedy any
deficiencies identified. Any actions taken to remedy deficiencies
and violations shall be documented and maintained as a record of the
covered banking entity.
IV. Responsibility and Accountability for the Compliance Program
A covered banking entity must establish, maintain, and enforce a
management framework to manage its business and employees with a
view to preventing violations of section 13 of the BHC Act and this
part. A covered banking entity must have an appropriate management
framework reasonably designed to ensure that: appropriate personnel
are made responsible and accountable for the effective
implementation and enforcement of the compliance program; a clear
reporting line with a chain of responsibility is delineated; and the
board of directors, or similar corporate body, and CEO reviews and
approves the compliance program. This management framework must
include, at a minimum:
Corporate governance. The covered banking entity must ensure
that its compliance program is reduced to writing, approved by the
board of directors or similar corporate body, and noted in the
minutes.
Trader mandates. The covered banking entity must establish,
maintain, and enforce the trader mandates required by this appendix
to clearly inform each trader within a trading unit of his or her
responsibilities for compliance with section 13 of the BHC Act and
this part.
Management procedures. The covered banking entity must
establish, maintain, and enforce management procedures that are
reasonably designed to achieve compliance with section 13 of the BHC
Act and this part, which, at a minimum, provide for:
The designation of at least one person with authority
to carry out the management responsibilities of the covered banking
entity for each trading unit;
Written procedures addressing the management of the
activities of the covered banking entity that are reasonably
designed to achieve compliance with section 13 of the BHC Act and
this part, including:
[cir] Procedures for the review by a manager of activities of
the trading unit and the quantitative measurements pursuant to
appendix A and any other quantitative measurements developed and
tailored to the particular risks, practices, and strategies of the
covered banking entity's trading units;
[cir] A description of the management system, including the
titles, qualifications, and locations of managers and the specific
responsibilities of each person with respect to the covered banking
entity's trading units; and
[cir] Procedures for determining compensation arrangements for
traders engaged in underwriting or market making-related activities
under Sec. --.4 or risk-mitigating hedging activities under Sec.
--.5 so that such compensation arrangements are designed not to
reward proprietary risk taking.
Business line managers. Managers with responsibility for one or
more trading units or asset management units of the covered banking
entity engaged in covered trading activities or covered fund
activities or investments are accountable for the effective
implementation and enforcement of the compliance program with
respect to the applicable trading unit or asset management unit.
Senior management. Senior management is responsible for
communicating and reinforcing the culture of compliance with section
13 of the BHC Act and this part, as established by the board of
directors or similar corporate body, and implementing and enforcing
the approved compliance program. Senior management must also ensure
that effective corrective action is taken when failures in
compliance with section 13 of the BHC Act and this part are
identified.\4\ Senior management and control personnel charged with
overseeing compliance with section 13 of the BHC Act and this part
should report to the board, or an appropriate committee thereof, on
the effectiveness of the compliance program and compliance matters
with a frequency appropriate to the size, scope, and risk profile of
the covered banking entity's covered trading activities and covered
fund activities or investments, which shall be at least once every
twelve months.
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\4\ Such corrective action may include, among other things
divesture of the position, cessation of the activity, or
disciplinary measures.
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Board of directors, or similar corporate body, and CEO. The
board of directors, or similar corporate body, and CEO are
responsible for setting an appropriate culture of compliance with
this part and establishing clear policies regarding the management
of covered trading activities and covered fund activities or
investments in compliance with section 13 of the BHC Act and this
part. The board of directors or similar corporate body must ensure
that senior management is fully capable, qualified, and properly
motivated to manage compliance with this part in light of
[[Page 68967]]
the organization's business activities. The board of directors or
similar corporate body must also ensure that senior management has
established appropriate incentives to support compliance with this
part, including the implementation of a compliance program meeting
the requirements of this appendix into management goals and
compensation structures across the covered banking entity.
V. Independent Testing
A covered banking entity must ensure that independent testing is
conducted by a qualified independent party, such as the covered
banking entity's internal audit department, outside auditors,
consultants, or other qualified independent parties, regarding the
effectiveness of the covered banking entity's compliance program
established pursuant to this appendix and Sec. --.20 and the
covered banking entity's compliance with this part. A banking entity
must take appropriate action to remedy any concerns identified by
the independent testing (e.g., remedying deficiencies in its written
policies and procedures and internal controls, etc.).
The required independent testing must occur with a frequency
appropriate to the size, scope, and risk profile of the covered
banking entity's covered trading and covered fund activities or
investments, which shall be no less than once every twelve months.
This independent testing must include an evaluation of:
The overall adequacy and effectiveness of the covered
banking entity's compliance program, including an analysis of the
extent to which the program contains all the required elements of
this appendix;
The effectiveness of the covered banking entity's
written policies and procedures;
The effectiveness of the covered banking entity's
internal controls, including an analysis and documentation of
instances in which such internal controls have been breached, and
how such breaches were addressed and resolved; and
The effectiveness of the covered banking entity's
management procedures.
VI. Training
Covered banking entities must provide adequate training to
trading personnel and managers of the covered banking entity, as
well as other appropriate personnel, as determined by the covered
banking entity, in order to effectively implement and enforce the
compliance program. This training should occur with a frequency
appropriate to the size and the risk profile of the covered banking
entity's covered trading activities and covered fund activities or
investments. The training may be conducted by internal personnel or
independent parties deemed appropriate by the covered banking entity
based on its size and risk profile.
VII. Recordkeeping
Covered banking entities must create and retain records
sufficient to demonstrate compliance and support the operations and
effectiveness of the compliance program. A covered banking entity
must retain these records for a period that is no less than 5 years
in a form that allows it to promptly produce such records to
[Agency] on request.
END OF COMMON RULE
[END OF COMMON TEXT]
Adoption of the Common Rule Text
The proposed adoption of the common rules by the agencies, as
modified by agency-specific text, is set forth below:
DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
12 CFR Chapter I
List of Subjects in 12 CFR Part 44
Banks, Banking, Compensation, Credit, Derivatives, Government
securities, Insurance, Investments, National banks, Penalties,
Reporting and recordkeeping requirements, Risk, Risk retention,
Securities, Trusts and trustees.
Authority and Issuance
For the reasons stated in the Common Preamble, the Office of the
Comptroller of the Currency proposes to amend chapter I of Title 12,
Code of Federal Regulations as follows:
PART 44--PROPRIETARY TRADING AND CERTAIN INTEREST IN AND
RELATIONSHIPS WITH COVERED FUNDS
1. The authority citation for part 44 is added to read as follows:
Authority: 7 U.S.C. 27 et seq., 12 U.S.C. 1, 24, 92a, 93a, 161,
1461, 1462a, 1463, 1464, 1813(q), 1818, 1851, 3101 3102, 3108, 5412.
2. Part 44 is added as set forth at the end of the Common Preamble.
3. Part 44 is amended by
a. Removing ``[Agency]'' wherever it appears and adding in its
place ``the OCC''; and
b. Removing ``[The Agency]'' wherever it appears and adding in its
place ``The OCC''.
4. Section 44.1 is added to read as follows:
Sec. 44.1 Authority, purpose, and scope.
(a) Authority. This part is issued by [Agency] under section 13 of
the Bank Holding Company Act of 1956, as amended (12 U.S.C. 1851).
(b) Purpose. Section 13 of the Bank Holding Company Act establishes
prohibitions and restrictions on proprietary trading and investments in
or relationships with covered funds by certain banking entities,
including national banks, Federal branches and agencies of foreign
banks, Federal savings associations, and certain subsidiaries thereof.
This part implements section 13 of the Bank Holding Company Act by
defining terms used in the statute and related terms, establishing
prohibitions and restrictions on proprietary trading and investments in
or relationships with covered funds, and explaining the statute's
requirements.
(c) Scope. This part implements section 13 of the Bank Holding
Company Act with respect to covered banking entities described in Sec.
44.2(j). This part takes effect on July 21, 2012.
(d) Relationship to other authorities. Except as otherwise provided
under section 13 of the Bank Holding Company Act, and notwithstanding
any other provision of law, the prohibitions and restrictions under
section 13 of Bank Holding Company Act shall apply to the activities of
a covered banking entity, even if such activities are authorized for a
covered banking entity under other applicable provisions of law.
(e) Preservation of authority. Nothing in this part limits in any
way the authority of the OCC to impose penalties for violation of this
part by any covered banking entity provided under any other applicable
statute.
5. Paragraph (j) of Sec. 44.2 is added to read as follows:
Sec. 44.2 Definitions.
* * * * *
(j) Covered banking entity means any banking entity that is:
(1) A national bank;
(2) A Federal branch or agency of a foreign bank;
(3) A Federal savings association or a Federal savings bank; and
(4) Any subsidiary of a company described in paragraph (j)(1)
through (3) of this section, other than a subsidiary for which the CFTC
or SEC is the primary financial regulatory agency as defined in section
2(12) of the Dodd-Frank Wall Street Reform and Consumer Protection Act
(12 U.S.C. 5301(12)).
* * * * *
BOARD OF GOVERNORS OF THE FEDERAL RESERVE
12 CFR Chapter II
List of Subjects in 12 CFR Part 248
Administrative practice and procedure, Banks and banking, Capital,
Compensation, Conflict of interests, Credit, Derivatives, Foreign
banking, Government securities, Holding companies, Insurance, Insurance
companies, Investments, Penalties, Reporting and recordkeeping
requirements, Risk, Risk retention, Securities, Trusts and trustees.
[[Page 68968]]
Authority and Issuance
For the reasons set forth in the Supplementary Information, the
Board of Governors of the Federal Reserve System proposes to add the
text of the common rule as set forth at the end of the Supplementary
Information as Part 248 to 12 CFR Chapter II as follows:
PART 248--PROPRIETARY TRADING AND RELATIONSHIPS WITH COVERED FUNDS
(REGULATION VV)
6. The authority citation for part 248 is added to read as follows:
Authority: 12 U.S.C. 1851, 12 U.S.C. 221 et seq., 12 U.S.C.
1818, 12 U.S.C. 1841 et seq., and 12 U.S.C. 3103 et seq.
7. Part 248 is added as set forth at the end of the Common
Preamble.
8. Part 248 is amended by:
A. Removing ``[Agency]'' wherever it appears and adding in its
place ``the Board''; and
B. Removing ``[The Agency]'' wherever it appears and adding in its
place ``The Board''.
9. Section 248.1 is added to read as follows:
Sec. 248.1 Authority, purpose, scope, and relationship to other
authorities.
(a) Authority. This part \1\ (Regulation VV) is issued by the Board
under section 13 of the Bank Holding Company Act of 1956, as amended
(12 U.S.C. 1851), as well as under the Federal Reserve Act, as amended
(12 U.S.C. 221 et seq.); section 8 of the Federal Deposit Insurance
Act, as amended (12 U.S.C. 1818); the Bank Holding Company Act of 1956,
as amended (12 U.S.C. 1841 et seq.); and the International Banking Act
of 1978, as amended (12 U.S.C. 3101 et seq.).
---------------------------------------------------------------------------
\1\ Code of Federal Regulations, title 12, chapter II, part 248.
---------------------------------------------------------------------------
(b) Purpose. Section 13 of the Bank Holding Company Act establishes
prohibitions and restrictions on proprietary trading and investments in
or relationships with covered funds by certain banking entities,
including state members banks, bank holding companies, savings and loan
holding companies, other companies that control an insured depository,
foreign banking organizations, and certain subsidiaries thereof. This
part implements section 13 of the Bank Holding Company Act by defining
terms used in the statute and related terms, establishing prohibitions
and restrictions on proprietary trading and investments in or
relationships with covered funds, and explaining the statute's
requirements.
(c) Scope. This part implements section 13 of the Bank Holding
Company Act with respect to covered banking entities described in Sec.
248.2(j). This part takes effect on July 21, 2012.
(d) Relationship to other authorities. Except as otherwise provided
in under section 13 of the Bank Holding Company Act, and
notwithstanding any other provision of law, the prohibitions and
restrictions under section 13 of Bank Holding Company Act shall apply
to the activities of a covered banking entity, even if such activities
are authorized for a covered banking entity under other applicable
provisions of law.
10. In Sec. 248.2, paragraph (c) is revised, and paragraph (j) is
added to read as follows:
Sec. 248.2 Definitions.
* * * * *
(c) Nothing in this part limits in any way the authority of the
Board, under the BHC Act (including section 8 of such Act) and other
provisions of law, to impose penalties for violation by any company or
individual.
* * * * *
(j) Covered banking entity means any banking entity that is:
(1) A state member bank (as defined in 12 CFR 208.2(g));
(2) A bank holding company;
(3) A savings and loan holding company (as defined in 12 U.S.C.
1467a);
(4) A foreign banking organization (as defined in 12 CFR
211.21(o));
(5) Any company that controls an insured depository institution;
and
(6) Any subsidiary of a company described in paragraph (j)(1)
through (5) of this section, other than a subsidiary for which the OCC,
FDIC, CFTC, or SEC is the primary financial regulatory agency (as
defined in section 2(12) of the Dodd-Frank Wall Street Reform and
Consumer Protection Act (12 U.S.C. 5301(12)).
11-12. Add subpart E to read as follows:
Subpart E--Conformance Period and Extended Transition Period
Authorities
Sec.
248.30 Definitions.
248.31 Conformance periods for banking entities engaged in
prohibited proprietary trading or covered fund activities or
investments.
248.32 Conformance period for nonbank financial companies supervised
by the Board engaged in prohibited proprietary trading or covered
fund activities and investments.
Subpart E--Conformance Period and Extended Transition Period
Authorities
Sec. 248.30 Definitions.
For purposes of this subpart:
(a) Illiquid fund means a covered fund that:
(1) As of May 1, 2010:
(i) Was principally invested in illiquid assets; or
(ii) Was invested in, and contractually committed to principally
invest in, illiquid assets; and
(2) Makes all investments pursuant to, and consistent with, an
investment strategy to principally invest in illiquid assets.
(b) Illiquid assets means any real property, security, obligation,
or other asset that:
(1) Is not a liquid asset;
(2) Because of statutory or regulatory restrictions applicable to
the covered fund or asset, cannot be offered, sold, or otherwise
transferred by covered fund to a person that is unaffiliated with the
relevant banking entity; or
(3) Because of contractual restrictions applicable to the covered
fund or asset, cannot be offered, sold, or otherwise transferred by the
covered fund for a period of 3 years or more to a person that is
unaffiliated with the relevant banking entity.
(c) Liquid asset means:
(1) Cash or cash equivalents;
(2) An asset that is traded on a recognized, established exchange,
trading facility or other market on which there exist independent, bona
fide offers to buy and sell so that a price reasonably related to the
last sales price or current bona fide competitive bid and offer
quotations can be determined for the particular asset almost
instantaneously;
(3) An asset for which there are bona fide, competitive bid and
offer quotations in a recognized inter-dealer quotation system or
similar system or for which multiple dealers furnish bona fide,
competitive bid and offer quotations to other brokers and dealers on
request;
(4) An asset the price of which is quoted routinely in a widely
disseminated publication that is readily available to the general
public or through an electronic service that provides indicative data
from real-time financial networks;
(5) An asset with an initial term of one year or less and the
payments on which at maturity may be settled, closed-out, or paid in
cash or one or more other liquid assets described in paragraphs (c)(1),
(2), (3), or (4) of this section; and
[[Page 68969]]
(6) Any other asset that the Board determines, based on all the
facts and circumstances, is a liquid asset.
(d) Principally invested and related definitions.--A covered fund:
(1) Is principally invested in illiquid assets if at least 75
percent of the fund's consolidated total assets are--
(i) Illiquid assets; or
(ii) Risk-mitigating hedges entered into in connection with and
related to individual or aggregated positions in, or holdings of,
illiquid assets;
(2) Is contractually committed to principally invest in illiquid
assets if the fund's organizational documents, other documents that
constitute a contractual obligation of the fund, or written
representations contained in the fund's offering materials distributed
to potential investors provide for the fund to be principally invested
in assets described in paragraph (d)(1) of this section at all times
other than during temporary periods, such as the period prior to the
initial receipt of capital contributions from investors or the period
during which the fund's investments are being liquidated and capital
and profits are being returned to investors; and
(3) Has an investment strategy to principally invest in illiquid
assets if the fund:
(i) Markets or holds itself out to investors as intending to
principally invest in assets described in paragraph (d)(1) of this
section; or
(ii) Has a documented investment policy of principally investing in
assets described in paragraph (d)(1) of this section.
Sec. 248.31 Conformance periods for banking entities engaged in
prohibited proprietary trading or covered fund activities or
investments.
(a) Conformance Period. (1) In general.--Except as provided in
paragraph (a)(2) or (3) of this section, a banking entity shall bring
its activities and investments into compliance with the requirements of
section 13 of the BHC Act (12 U.S.C. 1851) and this part no later than
2 years after July 21, 2012.
(2) New banking entities.--A company that was not a banking entity,
or a subsidiary or affiliate of a banking entity, as of July 21, 2010,
and becomes a banking entity, or a subsidiary or affiliate of a banking
entity, after that date shall bring its activities and investments into
compliance with the requirements of section 13 of the BHC Act (12
U.S.C. 1851) and this part before the later of:
(i) The conformance date determined in accordance with paragraph
(a)(1) of this section; or
(ii) 2 years after the date on which the company becomes a banking
entity or a subsidiary or affiliate of a banking entity.
(3) Extended conformance period. The Board may extend the two-year
period under paragraph (a) (1) or (2) of this section by not more than
three separate one-year periods, if, in the judgment of the Board, each
such one-year extension is consistent with the purposes of section 13
of the BHC Act (12 U.S.C. 1851) and this part and would not be
detrimental to the public interest.
(b) Illiquid funds. (1) Extended transition period. The Board may
further extend the period provided by paragraph (a) of this section
during which a banking entity may acquire or retain an ownership
interest in, or otherwise provide additional capital to, a covered fund
if:
(i) The fund is an illiquid fund; and
(ii) The acquisition or retention of such interest, or provision of
additional capital, is necessary to fulfill a contractual obligation of
the banking entity that was in effect on May 1, 2010.
(2) Duration limited. The Board may grant a banking entity only one
extension under paragraph (b)(1) of this section and such extension:
(i) May not exceed 5 years beyond any conformance period granted
under paragraph (a)(3) of this section; and
(ii) Shall terminate automatically on the date during any such
extension on which the banking entity is no longer under a contractual
obligation described in paragraph (b)(1)(ii) of this section.
(3) Contractual obligation. For purposes of this paragraph (b):
(i) A banking entity has a contractual obligation to take or retain
an ownership interest in an illiquid fund if the banking entity is
prohibited from redeeming all of its ownership interests in the fund,
and from selling or otherwise transferring all such ownership interests
to a person that is not an affiliate of the banking entity--
(A) Under the terms of the banking entity's ownership interest in
the fund or the banking entity's other contractual arrangements with
the fund or unaffiliated investors in the fund; or
(B) If the banking entity is the sponsor of the fund, under the
terms of a written representation made by the banking entity in the
fund's offering materials distributed to potential investors;
(ii) A banking entity has a contractual obligation to provide
additional capital to an illiquid fund if the banking entity is
required to provide additional capital to such fund--
(A) Under the terms of its ownership interest in the fund or the
banking entity's other contractual arrangements with the fund or
unaffiliated investors in the fund; or
(B) If the banking entity is the sponsor of the fund, under the
terms of a written representation made by the banking entity in the
fund's offering materials distributed to potential investors; and
(iii) A banking entity shall be considered to have a contractual
obligation for purposes of paragraph (b)(3)(i) or (ii) of this section
only if:
(A) The obligation may not be terminated by the banking entity or
any of its subsidiaries or affiliates under the terms of its agreement
with the fund; and
(B) In the case of an obligation that may be terminated with the
consent of other persons, the banking entity and its subsidiaries and
affiliates have used their reasonable best efforts to obtain such
consent and such consent has been denied.
(c) Approval Required to Hold Interests in Excess of Time Limit.
The conformance period in paragraph (a) of this section may be extended
in accordance with paragraph (a)(3) or (b) only with the approval of
the Board. A banking entity that seeks the Board's approval for an
extension of the conformance period under paragraph (a)(3) or for an
extended transition period under paragraph (b)(1) must:
(1) Submit a request in writing to the Board at least 180 days
prior to the expiration of the applicable time period;
(2) Provide the reasons why the banking entity believes the
extension should be granted, including information that addresses the
factors in paragraph (d)(1) of this section; and
(3) Provide a detailed explanation of the banking entity's plan for
divesting or conforming the activity or investment(s).
(d) Factors governing Board determinations.
(1) Extension requests generally.--In reviewing any application by
a specific company for an extension under paragraph (a)(3) or (b)(1) of
this section, the Board may consider all the facts and circumstances
related to the activity, investment, or fund, including, to the extent
relevant:
(i) Whether the activity or investment:
(A) Involves or results in material conflicts of interest between
the banking entity and its clients, customers or counterparties;
(B) Would result, directly or indirectly, in a material exposure by
the banking entity to high-risk assets or high-risk trading strategies;
(C) Would pose a threat to the safety and soundness of the banking
entity; or
[[Page 68970]]
(D) Would pose a threat to the financial stability of the United
States;
(ii) Market conditions;
(iii) The nature of the activity or investment;
(iv) The date that the banking entity's contractual obligation to
make or retain an investment in the fund was incurred and when it
expires;
(v) The contractual terms governing the banking entity's interest
in the fund;
(vi) The degree of control held by the banking entity over
investment decisions of the fund;
(vii) The types of assets held by the fund, including whether any
assets that were illiquid when first acquired by the fund have become
liquid assets, such as, for example, because any statutory, regulatory,
or contractual restrictions on the offer, sale, or transfer of such
assets have expired;
(viii) The date on which the fund is expected to wind up its
activities and liquidate, or its investments may be redeemed or sold;
(ix) The total exposure of the banking entity to the activity or
investment and the risks that disposing of, or maintaining, the
investment or activity may pose to the banking entity or the financial
stability of the United States;
(x) The cost to the banking entity of divesting or disposing of the
activity or investment within the applicable period;
(xi) Whether the divestiture or conformance of the activity or
investment would involve or result in a material conflict of interest
between the banking entity and unaffiliated clients, customers or
counterparties to which it owes a duty;
(xii) The banking entity's prior efforts to divest or conform the
activity or investment(s), including, with respect to an illiquid fund,
the extent to which the banking entity has made efforts to terminate or
obtain a waiver of its contractual obligation to take or retain an
equity, partnership, or other ownership interest in, or provide
additional capital to, the illiquid fund; and
(xiii) Any other factor that the Board believes appropriate.
(2) Timing of Board review. The Board will seek to act on any
request for an extension under paragraph (a)(3) or (b)(1) of this
section no later than 90 calendar days after the receipt of a complete
record with respect to such request.
(3) Consultation. In the case of a banking entity that is primarily
supervised by another Federal banking agency, the SEC, or the CFTC, the
Board will consult with such agency prior to the approval of a request
by the banking entity for an extension under paragraph (a)(3) or (b)(1)
of this section.
(e) Authority to impose restrictions on activities or investments
during any extension period.
(1) In general. The Board may impose such conditions on any
extension approved under paragraph (a)(3) or (b)(1) of this section as
the Board determines are necessary or appropriate to protect the safety
and soundness of the banking entity or the financial stability of the
United States, address material conflicts of interest or other unsound
banking practices, or otherwise further the purposes of section 13 of
the BHC Act (12 U.S.C. 1851) and this part.
(2) Consultation. In the case of a banking entity that is primarily
supervised by another Federal banking agency, the SEC, or the CFTC, the
Board will consult with such agency prior to imposing conditions on the
approval of a request by the banking entity for an extension under
paragraph (a)(3) or (b)(1) of this section.
Sec. 248.32 Conformance period for nonbank financial companies
supervised by the Board engaged in prohibited proprietary trading or
covered fund activities and investments.
(a) Divestiture requirement. A nonbank financial company supervised
by the Board shall come into compliance with all applicable
requirements of section 13 of the Bank Holding Company Act (12 U.S.C.
1851) and this subpart, including any capital requirements or
quantitative limitations adopted thereunder and applicable to the
company, not later than 2 years after the date the company becomes a
nonbank financial company supervised by the Board.
(b) Extensions. The Board may, by rule or order, extend the two-
year period under paragraph (a) of this section by not more than three
separate one-year periods, if, in the judgment of the Board, each such
one-year extension is consistent with the purposes of section 13 of the
BHC Act (12 U.S.C. 1851) and this part and would not be detrimental to
the public interest.
(c) Approval required to hold interests in excess of time limit. A
nonbank financial company supervised by the Board that seeks the
Board's approval for an extension of the conformance period under
paragraph (b) of this section must:
(1) Submit a request in writing to the Board at least 180 days
prior to the expiration of the applicable time period;
(2) Provide the reasons why the nonbank financial company
supervised by the Board believes the extension should be granted; and
(3) Provide a detailed explanation of the company's plan for
conforming the activity or investment(s) to any applicable requirements
established under section 13(a)(2) or (f)(4) of the Bank Holding
Company Act (12 U.S.C. 1851(a)(2) and (f)(4)).
(d) Factors governing Board determinations.
(1) In general. In reviewing any application for an extension under
paragraph (b) of this section, the Board may consider all the facts and
circumstances related to the nonbank financial company and the request
including, to the extent determined relevant by the Board, the factors
described in Sec. 225.181(d)(1) of this chapter.
(2) Timing. The Board will seek to act on any request for an
extension under paragraph (b) of this section no later than 90 calendar
days after the receipt of a complete record with respect to such
request.
(e) Authority to impose restrictions on activities or investments
during any extension period. The Board may impose conditions on any
extension approved under paragraph (b) of this section as the Board
determines are necessary or appropriate to protect the safety and
soundness of the nonbank financial company or the financial stability
of the United States, address material conflicts of interest or other
unsound practices, or otherwise further the purposes of section 13 of
the BHC Act (12 U.S.C. 1851) and this part.
FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Chapter III
List of Subjects in 12 CFR Part 351
Banks, banking, Capital, Compensation, Conflict of interests,
Credit, Derivatives, Government securities, Insurance, Insurance
companies, Investments, Penalties, Reporting and recordkeeping
requirements, Risk, Risk retention, Securities, State nonmember banks,
State savings associations, Trusts and trustees.
Authority and Issuance
For the reasons set forth in the Supplementary Information, the
Federal Deposit Insurance Corporation proposes to add the text of the
common rule as set forth at the end of the Supplementary Information as
Part 351 to chapter III of Title 12, Code of Federal Regulations,
modified as follows:
[[Page 68971]]
PART 351--PROPRIETARY TRADING AND RELATIONSHIPS WITH COVERED FUNDS
13. The authority citation for part 351 is added to read as
follows:
Authority: 12 U.S.C. 1851; 12 U.S.C. 1801 et seq., and 3103 et
seq.
14. Part 351 is added as set forth at the end of the Common
Preamble.
15. Part 351 is amended by:
a. Removing ``[Agency]'' wherever it appears and adding in its
place ``the FDIC''; and
b. Removing ``[The Agency]'' wherever it appears and adding in its
place ``The FDIC''.
16. Section 351.1 is added to read as follows:
Sec. 351.1 Authority, purpose, scope, and relationship to other
authorities.
(a) Authority. This part is issued by the FDIC under section 13 of
the Bank Holding Company Act of 1956, as amended (12 U.S.C. 1851).
(b) Purpose. Section 13 of the Bank Holding Company Act establishes
prohibitions and restrictions on proprietary trading and investments in
or relationships with covered funds by certain banking entities,
including any insured depository institution for which the FDIC is the
appropriate Federal banking agency. This part implements section 13 of
the Bank Holding Company Act by defining terms used in the statute and
related terms, establishing prohibitions and restrictions on
proprietary trading and investments in or relationships with covered
funds, and explaining the statute's requirements.
(c) Scope. This part implements section 13 of the Bank Holding
Company Act with respect to any insured depository institution for
which the FDIC is the appropriate Federal banking agency. This part
takes effect on July 21, 2012.
(d) Relationship to other authorities. Except as otherwise provided
in under section 13 of the Bank Holding Company Act, and
notwithstanding any other provision of law, the prohibitions and
restrictions under section 13 of Bank Holding Company Act shall apply
to the activities of a covered banking entity, even if such activities
are authorized for a covered banking entity under other applicable
provisions of law.
17. Paragraph (j) of Sec. 351.2 is added to read as follows:
Sec. 351.2 Definitions.
* * * * *
(j) Covered banking entity means any banking entity that is an
insured depository institution for which the FDIC is the appropriate
Federal banking agency, as that term is defined in section 3(q) of the
Federal Deposit Insurance Act (12 U.S.C. 1813(q)).
* * * * *
SECURITIES AND EXCHANGE COMMISSION
List of Subjects in 17 CFR Part 255
Banks, Brokers, Dealers, Investment advisers, Recordkeeping,
Reporting, Securities.
Authority and Issuance
For the reasons set forth in the Supplementary Information, the
Securities and Exchange Commission proposes to add the text of the
common rule as set forth at the end of the Supplementary Information as
Part 255 to chapter II of Title 17, Code of Federal Regulations,
modified as follows:
PART 255--PROPRIETARY TRADING AND RELATIONSHIPS WITH COVERED FUNDS
18. The authority for part 255 is added to read as follows:
Authority: 12 U.S.C. 1851, 15 U.S.C. 78o(c)(3)(A), 78o-10(f),
(j), 78q(a), 78w.
19. Part 255 is added as set forth at the end of the Common
Preamble.
20. Part 255 is amended by:
a. Removing ``[Agency]'' wherever it appears and adding in its
place ``SEC''; and
b. Removing ``[The Agency]'' wherever it appears and adding in its
place ``The SEC.''
21. Section 255.1 is added to read as follows:
Sec. 255.1 Authority, purpose, scope, and relationship to other
authorities.
(a) Authority. This part \1\ is issued by the SEC under section 13
of the Bank Holding Company Act of 1956, as amended (12 U.S.C. 1851)
and sections 15(c)(3)(A), 15F(f), 15F(j), 17(a), and 23 of the
Securities Exchange Act of 1934 (15 U.S.C. 78o(c)(3)(A), 78o-10(f),
(j), 78q(a), 78w.).
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\1\ Code of Federal Regulations, title 17, chapter II, part 255.
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(b) Purpose. Section 13 of the Bank Holding Company Act establishes
prohibitions and restrictions on proprietary trading and investments in
or relationships with covered funds by certain banking entities,
including registered broker-dealers, registered investment advisers,
and registered security-based swap dealers, among others identified in
section 2(12)(B) of the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 (12 U.S.C. 5301(12)(B)). This part implements
section 13 of the Bank Holding Company Act by defining terms used in
the statute and related terms, establishing prohibitions and
restrictions on proprietary trading and investments in or relationships
with covered funds, and explaining the statute's requirements.
(c) Scope. This part implements section 13 of the Bank Holding
Company Act with respect to covered banking entities described in Sec.
255.2(j). This part takes effect on July 21, 2012.
(d) Relationship to other authorities. Except as otherwise provided
in under section 13 of the BHC Act, and notwithstanding any other
provision of law, the prohibitions and restrictions under section 13 of
BHC Act shall apply to the activities of a covered banking entity, even
if such activities are authorized for a covered banking entity under
other applicable provisions of law.
22. Paragraph (j) of Sec. 255.2 is added to read as follows:
Sec. 225.2 Definitions.
* * * * *
(j) Covered banking entity means any entity described in paragraph
(e) of this section for which the SEC is the primary financial
regulatory agency, as defined in section 2(12)(B) of the Dodd-Frank
Wall Street Reform and Consumer Protection Act of 2010 (12 U.S.C.
5301(12)(B)).
23. Section 225.10(a) is revised to read as follows:
Sec. 255.10 Prohibition on acquiring or retaining an ownership
interest in and having certain relationships with a covered fund.
* * * * *
(a)(1) General prohibition. Except as otherwise provided in this
subpart, a covered banking entity may not, as principal, directly or
indirectly, acquire or retain any ownership interest in or sponsor a
covered fund.
(2) Registered investment advisers. A covered banking entity that
is a covered banking entity because it is an investment adviser
identified in section 2(12)(B)(iii) of the Dodd-Frank Wall Street
Reform and Consumer Protection Act of 2010 shall comply with the
restrictions on covered fund activities or investments set forth in
subpart C and Sec. ----.20 of subpart D issued by the agency
identified in section 3(q) of the Federal Deposit Insurance Act (12
U.S.C. 1813(q)) that regulates the banking entity described in Sec.
255.2 (e)(1), (2) or (3) with which the investment adviser is
affiliated.
[[Page 68972]]
Note to paragraph (a): Nothing set forth in paragraph (a)(2) of
this section shall limit the SEC's authority under any other
provision of law, including pursuant to section 13 of the Bank
Holding Company Act.
* * * * *
Dated: October 7, 2011.
John Walsh,
Acting Comptroller of the Currency.
By order of the Board of Governors of the Federal Reserve
System, October 11, 2011.
Jennifer J. Johnson,
Secretary of the Board.
By order of the Board of Directors.
Dated at Washington, DC, this 11th day of October, 2011.
Federal Deposit Insurance Corporation.
Robert E. Feldman,
Executive Secretary.
By the Securities and Exchange Commission.
Dated: October 12, 2011.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2011-27184 Filed 11-4-11; 8:45 am]
BILLING CODE 6210-01-P; 8011-11-P; 4810-33-P; 6714-01-P