2013-31476

Federal Register, Volume 79 Issue 21 (Friday, January 31, 2014)[Federal Register Volume 79, Number 21 (Friday, January 31, 2014)]

[Rules and Regulations]

[Pages 5807-6075]

From the Federal Register Online via the Government Printing Office [www.gpo.gov]

[FR Doc No: 2013-31476]

[[Page 5807]]

Vol. 79

Friday,

No. 21

January 31, 2014

Part III

Commodity Futures Trading Commission

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17 CFR Part 75

Prohibitions and Restrictions on Proprietary Trading and Certain

Interests in, and Relationships With, Hedge Funds and Private Equity

Funds; Final Rule

Federal Register / Vol. 79 , No. 21 / Friday, January 31, 2014 /

Rules and Regulations

[[Page 5808]]

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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 75

RIN 3038-AD05

Prohibitions and Restrictions on Proprietary Trading and Certain

Interests in, and Relationships with, Hedge Funds and Private Equity

Funds

AGENCY: Commodity Futures Trading Commission.

ACTION: Final rule.

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SUMMARY: The Commodity Futures Trading Commission (``CFTC'' or

``Commission'') is adopting a final rule to implement Section 619 of

the Dodd-Frank Wall Street Reform and Consumer Protection Act (the

``Dodd-Frank Act''), which contains certain prohibitions and

restrictions on the ability of a banking entity and nonbank financial

company supervised by the Board of Governors of the Federal Reserve

System (the ``Board'') to engage in proprietary trading and have

certain interests in, or relationships with, a hedge fund or private

equity fund. Section 619 also requires the Board, the Federal Deposit

Insurance Corporation, the Office of the Comptroller of the Currency,

and the Securities and Exchange Commission to also issue regulations

implementing section 619 and directs the CFTC and those four agencies

to consult and coordinate with each other, as appropriate, in

developing and issuing the implementing rules, for the purposes of

assuring, to the extent possible, that such rules are comparable and

provide for consistent application and implementation. To that end,

although the Commission is adopting a final rule that is not a joint

rule with the other agencies, the CFTC and the other agencies have

worked closely together to develop the same rule text and supplementary

information, except for information specific to the CFTC or the other

agencies, as applicable. In particular, the CFTC's final rule is

numbered as part 75 of the Commission's regulations, the rule text

refers to the ``Commission'' instead of the ``[Agency]'' and one

section of the regulations addresses authority, purpose, scope, and

relationship to other authorities with respect to the Commission.

Furthermore, it is noted that the supplementary information generally

refers to the ``Agencies'' collectively when referring to deliberations

and considerations in developing the final rule by the CFTC together

with the other four agencies and references to the ``final rule''

should be deemed to refer to the final rule of the Commission as herein

adopted.

DATES: The final rule is effective April 1, 2014.

FOR FURTHER INFORMATION CONTACT: Erik Remmler, Deputy Director,

Division of Swap Dealer and Intermediary Oversight (``DSIO''), (202)

418-7630, [email protected]; Paul Schlichting, Assistant General

Counsel, Office of the General Counsel (``OGC''), (202) 418-5884,

[email protected]; Mark Fajfar, Assistant General Counsel, OGC,

(202) 418-6636, [email protected]; Michael Barrett, Attorney-Advisor,

DSIO, (202) 418-5598, [email protected]; Stephen Kane, Research

Economist, Office of the Chief Economist (``OCE''), (202) 418-5911,

[email protected]; or Stephanie Lau, Research Economist, OCE, (202) 418-

5218, [email protected]; Commodity Futures Trading Commission, Three

Lafayette Centre, 1155 21st Street NW., Washington, DC 20581.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Background

II. Notice of Proposed Rulemaking: Summary of General Comments

III. Scope

IV. CFTC-Specific Comments

V. Overview of Final Rule

A. General Approach and Summary of Final Rule

B. Proprietary Trading Restrictions

C. Restrictions on Covered Fund Activities and Investments

D. Metrics Reporting Requirement

E. Compliance Program Requirement

VI. Final Rule

A. Subpart B--Proprietary Trading Restrictions

1. Section 75.3: Prohibition on Proprietary Trading and Related

Definitions

a. Definition of ``Trading Account''

b. Rebuttable Presumption for the Short-Term Trading Account

c. Definition of ``Financial Instrument''

d. Proprietary Trading Exclusions

1. Repurchase and Reverse Repurchase Arrangements and Securities

Lending

2. Liquidity management activities

3. Transactions of Derivatives Clearing Organizations and

Clearing Agencies

4. Excluded Clearing-Related Activities of Clearinghouse Members

5. Satisfying an Existing Delivery Obligation

6. Satisfying an Obligation in Connection With a Judicial,

Administrative, Self-Regulatory Organization, or Arbitration

Proceeding

7. Acting Solely as Agent, Broker, or Custodian

8. Purchases or Sales Through a Deferred Compensation or Similar

Plan

9. Collecting a Debt Previously Contracted

10. Other Requested Exclusions

2. Section 75.4(a): Underwriting Exemption

a. Introduction

b. Overview

1. Proposed Underwriting Exemption

2. Comments on Proposed Underwriting Exemption

3. Final Underwriting Exemption

c. Detailed Explanation of the Underwriting Exemption

1. Acting as an Underwriter for a Distribution of Securities

a. Proposed Requirements That the Purchase or Sale Be Effected

Solely in Connection With a Distribution of Securities for Which the

Banking Entity Acts as an Underwriter and That the Covered Financial

Position Be a Security

i. Proposed Definition of ``Distribution''

ii. Proposed Definition of ``Underwriter''

iii. Proposed Requirement That the Covered Financial Position Be

a Security

b. Comments on the Proposed Requirements That the Trade Be

Effected Solely in Connection With a Distribution for Which the

Banking Entity is Acting as an Underwriter and That the Covered

Financial Position Be a Security

i. Definition of ``Distribution''

ii. Definition of ``Underwriter''

iii. ``Solely in Connection With'' Standard

c. Final Requirement That the Banking Entity Act as an

Underwriter for a Distribution of Securities and the Trading Desk's

Underwriting Position Be Related to Such Distribution

i. Definition of ``Underwriting Position''

ii. Definition of ``Trading Desk''

iii. Definition of ``Distribution''

iv. Definition of ``Underwriter''

v. Activities Conducted ``In Connection With'' a Distribution

2. Near Term Customer Demand Requirement

a. Proposed Near Term Customer Demand Requirement

b. Comments Regarding the Proposed Near Term Customer Demand

Requirement

c. Final Near Term Customer Demand Requirement

3. Compliance Program Requirement

a. Proposed Compliance Program Requirement

b. Comments on the Proposed Compliance Program Requirement

c. Final Compliance Program Requirement

4. Compensation Requirement

a. Proposed Compensation Requirement

b. Comments on the Proposed Compensation Requirement

c. Final Compensation Requirement

5. Registration Requirement

a. Proposed Registration Requirement

b. Comments on Proposed Registration Requirement

c. Final Registration Requirement

6. Source of Revenue Requirement

a. Proposed Source of Revenue Requirement

b. Comments on the Proposed Source of Revenue Requirement

c. Final Rule's Approach to Assessing Source of Revenue

3. Section 75.4(b): Market-Making Exemption

a. Introduction

b. Overview

1. Proposed Market-Making Exemption

2. Comments on the Proposed Market-Making Exemption

[[Page 5809]]

a. Comments on the Overall Scope of the Proposed Exemption

b. Comments Regarding the Potential Market Impact of the

Proposed Exemption

3. Final Market-Making Exemption

c. Detailed Explanation of the Market-Making Exemption

1. Requirement to Routinely Stand Ready to Purchase and Sell

a. Proposed Requirement to Hold Self Out

b. Comments on the Proposed Requirement to Hold Self Out

i. The Proposed Indicia

ii. Treatment of Block Positioning Activity

iii. Treatment of Anticipatory Market Making

iv. High-Frequency Trading

c. Final Requirement to Routinely Stand Ready to Purchase and

Sell

i. Definition of ``Trading Desk''

ii. Definitions of ``Financial Exposure'' and ``Market-Maker

Inventory''

iii. Routinely Standing Ready to Buy and Sell

2. Near Term Customer Demand Requirement

a. Proposed Near Term Customer Demand Requirement

b. Comments Regarding the Proposed Near Term Customer Demand

Requirement

i. The Proposed Guidance for Determining Compliance With the

Near Term Customer Demand Requirement

ii. Potential Inventory Restrictions and Differences Across

Asset Classes

iii. Predicting Near Term Customer Demand

iv. Potential Definitions of ``Client,'' ``Customer,'' or

``Counterparty''

v. Interdealer Trading and Trading for Price Discovery or To

Test Market Depth

vi. Inventory Management

vii. Acting as an Authorized Participant or Market Maker in

Exchange-Traded Funds

viii. Arbitrage or Other Activities That Promote Price

Transparency and Liquidity

ix. Primary Dealer Activities

x. New or Bespoke Products or Customized Hedging Contracts

c. Final Near Term Customer Demand Requirement

i. Definition of ``Client,'' ``Customer,'' and ``Counterparty''

ii. Impact of the Liquidity, Maturity, and Depth of the Market

on the Analysis

iii. Demonstrable Analysis of Certain Factors

iv. Relationship to Required Limits

3. Compliance Program Requirement

a. Proposed Compliance Program Requirement

b. Comments on the Proposed Compliance Program Requirement

c. Final Compliance Program Requirement

4. Market Making-Related Hedging

a. Proposed Treatment of Market Making-Related Hedging

b. Comments on the Proposed Treatment of Market Making-Related

Hedging

c. Treatment of Market Making-Related Hedging in the Final Rule

5. Compensation Requirement

a. Proposed Compensation Requirement

b. Comments Regarding the Proposed Compensation Requirement

c. Final Compensation Requirement

6. Registration Requirement

a. Proposed Registration Requirement

b. Comments on the Proposed Registration Requirement

c. Final Registration Requirement

7. Source of Revenue Analysis

a. Proposed Source of Revenue Requirement

b. Comments Regarding the Proposed Source of Revenue Requirement

i. Potential Restrictions on Inventory, Increased Costs for

Customers, and Other Changes to Market-Making Services

ii. Certain Price Appreciation-Related Profits Are an Inevitable

or Important Component of Market Making

iii. Concerns Regarding the Workability of the Proposed Standard

in Certain Markets or asset classes

iv. Suggested Modifications to the Proposed Requirement

v. General Support for the Proposed Requirement or for Placing

Greater Restrictions on a Market Maker's Sources of Revenue

c. Final Rule's Approach to Assessing Revenues

8. Appendix B of the Proposed Rule

a. Proposed Appendix B Requirement

b. Comments on Proposed Appendix B

c. Determination to not Adopt Proposed Appendix B

9. Use of Quantitative Measurements

4. Section 75.5: Permitted Risk-Mitigating Hedging Activities

a. Summary of Proposal's Approach to Implementing the Hedging

Exemption

b. Manner of Evaluating Compliance with the Hedging Exemption

c. Comments on the Proposed Rule and Approach to Implementing

the Hedging Exemption

d. Final Rule

1. Compliance Program Requirement

2. Hedging of Specific Risks and Demonstrable Reduction of Risk

3. Compensation

4. Documentation Requirement

5. Section 75.6(a)-(b): Permitted Trading in Certain Government

and Municipal Obligations

a. Permitted Trading in U.S. Government Obligations

b. Permitted Trading in Foreign Government Obligations

c. Permitted Trading in Municipal Securities

d. Determination to Not Exempt Proprietary Trading in

Multilateral Development Bank Obligations

6. Section 75.6(c): Permitted Trading on Behalf of Customers

a. Proposed Exemption for Trading on Behalf of Customers

b. Comments on the Proposed Rule

c. Final Exemption for Trading on Behalf of Customers

7. Section 75.6(d): Permitted Trading by a Regulated Insurance

Company

8. Section 75.6(e): Permitted Trading Activities of a Foreign

Banking Entity

a. Foreign Banking Entities Eligible for the Exemption

b. Permitted Trading Activities of a Foreign Banking Entity

9. Section 75.7: Limitations on Permitted Trading Activities

a. Scope of ``Material Conflict of Interest''

1. Proposed rule

2. Comments on the Proposed Limitation on Material Conflicts of

Interest

a. Disclosure

b. Information Barriers

3. Final rule

b. Definition of ``High-Risk Asset'' and ``High-Risk Trading

Strategy''

1. Proposed Rule

2. Comments on Proposed Limitations on High-Risk Assets and

Trading Strategies

3. Final Rule

c. Limitations on Permitted Activities That Pose a Threat to

Safety and Soundness of the Banking Entity or the Financial

Stability of the United States

B. Subpart C--Covered Fund Activities and Investments

1. Section 75.10: Prohibition on Acquisition or Retention of

Ownership Interests in, and Certain Relationships With, a Covered

Fund

a. Prohibition Regarding Covered Fund Activities and Investments

b. ``Covered Fund'' Definition

1. Foreign Covered Funds

2. Commodity Pools

3. Entities Regulated Under the Investment Company Act

c. Entities Excluded From Definition of Covered Fund

1. Foreign Public Funds

2. Wholly-Owned Subsidiaries

3. Joint Ventures

4. Acquisition Vehicles

5. Foreign Pension or Retirement Funds

6. Insurance Company Separate Accounts

7. Bank Owned Life Insurance Separate Accounts

8. Exclusion for Loan Securitizations and Definition of Loan

a. Definition of Loan

b. Loan Securitizations

i. Loans

ii. Contractual Rights or Assets

iii. Derivatives

iv. SUBIs and Collateral Certificates

v. Impermissible Assets

9. Asset-Backed Commercial Paper Conduits

10. Covered Bonds

11. Certain Permissible Public Welfare and Similar Funds

12. Registered Investment Companies and Excluded Entities

13. Other Excluded Entities

d. Entities Not Specifically Excluded From the Definition of

Covered Fund

1. Financial Market Utilities

2. Cash Collateral Pools

3. Pass-Through REITS

4. Municipal Securities Tender Option Bond Transactions

5. Venture Capital Funds

6. Credit Funds

7. Employee Securities Companies

e. Definition of ``Ownership Interest''

f. Definition of ``Resident of the United States''

g. Definition of ``Sponsor''

1. Definition of Sponsor With Respect to Securitizations

[[Page 5810]]

2. Section 75.11: Activities Permitted in Connection With

Organizing and Offering a Covered Fund

a. Scope of Exemption

1. Fiduciary Services

2. Compliance With Investment Limitations

3. Compliance With Section 13(f) of the BHC Act

4. No Guarantees or Insurance of Fund Performance

5. Limitation on Name Sharing With a Covered Fund

6. Limitation on Ownership by Directors and Employees

7. Disclosure Requirements

b. Organizing and Offering an Issuing Entity of Asset-Backed

Securities

c. Underwriting and Market Making for a Covered Fund

3. Section 75.12: Permitted Investment in a Covered Fund

a. Proposed Rule

b. Duration of Seeding Period for New Covered Funds

c. Limitations on Investments in a Single Covered Fund (``Per-

Fund Limitation'')

d. Limitation on Aggregate Permitted Investments in all Covered

funds (``Aggregate Funds Limitation'')

e. Capital Treatment of an Investment in a Covered Fund

f. Attribution of Ownership Interests to a Banking Entity

g. Calculation of Tier 1 Capital

h. Extension of Time To Divest Ownership Interest in a Single

Fund

4. Section 75.13: Other Permitted Covered Fund Activities

a. Permitted Risk-Mitigating Hedging Activities

b. Permitted Covered Fund Activities and Investments Outside of

the United States

1. Foreign Banking Entities Eligible for the Exemption

2. Activities or Investments Solely Outside of the United States

3. Offered for Sale or Sold to a Resident of the United States

4. Definition of ``Resident of the United States''

c. Permitted Covered Fund Interests and Activities by a

Regulated Insurance Company

5. Section 75.14: Limitations on Relationships With a Covered

Fund

a. Scope of Application

b. Transactions That Would Be a ``Covered Transaction''

c. Certain Transactions and Relationships Permitted

1. Permitted Investments and Ownerships Interests

2. Prime Brokerage Transactions

d. Restrictions on Transactions With Any Permitted Covered Fund

6. Section 75.15: Other Limitations on Permitted Covered Fund

Activities

C. Subpart D and Appendices A and B--Compliance Program,

Reporting, and Violations

1. Section 75.20: Compliance Program Mandate

a. Program Requirement

b. Compliance Program Elements

c. Simplified Programs for Less Active Banking Entities

d. Threshold for Application of Enhanced Minimum Standards

2. Appendix B: Enhanced Minimum Standards for Compliance

Programs

a. Proprietary Trading Activities

b. Covered Fund Activities or Investments

c. Enterprise-Wide Programs

d. Responsibility and Accountability

e. Independent Testing

f. Training

g. Recordkeeping

3. Section 75.20(d) and Appendix A: Reporting and Recordkeeping

Requirements Applicable to Trading Activities

a. Approach to Reporting and Recordkeeping Requirements Under

the Proposal

b. General Comments on the Proposed Metrics

c. Approach of the Final Rule

d. Proposed Quantitative Measurements and Comments on Specific

Metrics

4. Section 75.21: Termination of Activities or Investments;

Authorities for Violations

VII. Administrative Law Matters

A. Paperwork Reduction Act Analysis

B. Regulatory Flexibility Act Analysis

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'') (codified at 12 U.S.C. 1851) that generally

prohibits any banking entity 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.\2\ New section 13 of

the BHC Act also provides that a nonbank financial company designated

by the Financial Stability Oversight Council (``FSOC'') for supervision

by the Board (while not a banking entity under section 13 of the BHC

Act) would be subject to additional capital requirements, quantitative

limits, or other restrictions if the company engages in certain

proprietary trading or covered fund activities.\3\

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\1\ Dodd-Frank Wall Street Reform and Consumer Protection Act,

Public Law 111-203, 124 Stat. 1376 (2010).

\2\ See 12 U.S.C. 1851.

\3\ See 12 U.S.C. 1851(a)(2) and (f)(4). The Agencies note that

two of the three companies currently designated by FSOC for

supervision by the Board are affiliated with insured depository

institutions, and are therefore currently banking entities for

purposes of section 13 of the BHC Act. The Agencies are continuing

to review whether the remaining company engages in any activity

subject to section 13 of the BHC Act and what, if any, requirements

apply under section 13.

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Section 13 of the BHC Act generally prohibits banking entities from

engaging as principal in proprietary trading for the purpose of selling

financial instruments in the near term or otherwise with the intent to

resell in order to profit from short-term price movements.\4\ Section

13(d)(1) expressly exempts from this prohibition, subject to

conditions, certain activities, including:

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\4\ See 12 U.S.C. 1851(a)(1)(A) and (B).

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Trading in U.S. government, agency and municipal

obligations;

Underwriting and market making-related activities;

Risk-mitigating hedging activities;

Trading on behalf of customers;

Trading for the general account of insurance companies;

and

Foreign trading by non-U.S. banking entities.\5\

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\5\ See id. at 1851(d)(1).

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Section 13 of the BHC Act also generally prohibits banking entities

from acquiring or retaining an ownership interest in, or sponsoring, a

hedge fund or private equity fund. Section 13 contains several

exemptions that permit banking entities to make limited investments in

hedge funds and private equity funds, subject to a number of

restrictions designed to ensure that banking entities do not rescue

investors in these funds from loss and are not themselves exposed to

significant losses from investments or other relationships with these

funds.

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 that these activities be subject to additional capital

charges, quantitative limits, or other restrictions.\6\

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\6\ See 12 U.S.C. 1851(a)(2) and (d)(4).

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II. Notice of Proposed Rulemaking: Summary of General Comments

Authority for developing and adopting regulations to implement the

prohibitions and restrictions of section 13 of the BHC Act is divided

among the Board, the Federal Deposit Insurance Corporation (``FDIC''),

the Office of the Comptroller of the Currency (``OCC''), the Securities

and Exchange Commission (``SEC''), and the Commodity Futures Trading

Commission (``CFTC'').\7\ As required by

[[Page 5811]]

section 13(b)(2) of the BHC Act, the Board, OCC, FDIC, and SEC in

October 2011 invited the public to comment on proposed rules

implementing that section's requirements.\8\ The period for filing

public comments on this proposal was extended for an additional 30

days, until February 13, 2012.\9\ In January 2012, the CFTC requested

comment on a proposal for the same common rule to implement section 13

with respect to those entities for which it is the primary financial

regulatory agency and invited public comment on its proposed

implementing rule through April 16, 2012.\10\ The statute 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.\11\

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\7\ 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.

\8\ See 76 FR 68846 (Nov. 7, 2011) (``Joint Proposal'').

\9\ See 77 FR 23 (Jan. 23, 2012) (extending the comment period

to February 13, 2012).

\10\ See 77 FR 8332 (Feb 14, 2012) (``CFTC Proposal'').

\11\ See 12 U.S.C. 1851(b)(2)(B)(ii). The Secretary of the

Treasury, as Chairperson of the FSOC, is responsible for

coordinating the Agencies' rulemakings under section 13 of the BHC

Act. See id.

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The proposed rules invited comment on a multi-faceted regulatory

framework to implement section 13 consistent with the statutory

language. In addition, the Agencies invited comments on the potential

economic impacts of the proposed rule and posed a number of questions

seeking information on the costs and benefits associated with each

aspect of the proposal, as well as on any significant alternatives that

would minimize the burdens or amplify the benefits of the proposal in a

manner consistent with the statute. The Agencies also encouraged

commenters to provide quantitative information and data about the

impact of the proposal on entities subject to section 13, as well as on

their clients, customers, and counterparties, specific markets or asset

classes, and any other entities potentially affected by the proposed

rule, including non-financial small and mid-size businesses.

The Agencies received over 18,000 comments addressing a wide

variety of aspects of the proposal, including definitions used by the

proposal and the exemptions for market making-related activities, risk-

mitigating hedging activities, covered fund activities and investments,

the use of quantitative metrics, and the reporting proposals. The vast

majority of these comments were from individuals using a version of a

short form letter to express support for the proposed rule. More than

600 comment letters were unique comment letters, including from members

of Congress, domestic and foreign banking entities and other financial

services firms, trade groups representing banking, insurance, and the

broader financial services industry, U.S. state and foreign

governments, consumer and public interest groups, and individuals. To

improve understanding of the issues raised by commenters, the Agencies

met with a number of these commenters to discuss issues relating to the

proposed rule, and summaries of these meetings are available on each of

the Agency's public Web sites.\12\ The CFTC staff also hosted a public

roundtable on the proposed rule.\13\ Many of the commenters generally

expressed support for the broader goals of the proposed rule. At the

same time, many commenters expressed concerns about various aspects of

the proposed rule. Many of these commenters requested that one or more

aspects of the proposed rule be modified in some manner in order to

reflect their viewpoints and to better accommodate the scope of

activities that they argued were encompassed within section 13 of the

BHC Act. The comments addressed all major sections of the proposed

rule.

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\12\ See http://www.regulations.gov/#!docketDetail;D=OCC-2011-

0014 (OCC); http://www.federalreserve.gov/newsevents/reform_systemic.htm (Board); http://www.fdic.gov/regulations/laws/federal/2011/11comAD85.html (FDIC); http://www.sec.gov/comments/s7-41-11/s74111.shtml (SEC); and http://www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_28_VolckerRule/index.htm (CFTC).

\13\ See Commodity Futures Trading Commission, CFTC Staff to

Host a Public Roundtable to Discuss the Proposed Volcker Rule (May

24, 2012), available at http://www.cftc.gov/PressRoom/PressReleases/pr6263-12; transcript available at http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/transcript053112.pdf.

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Section 13 of the BHC Act also required the FSOC to conduct a study

(``FSOC study'') and make recommendations to the Agencies by January

21, 2011 on the implementation of section 13 of the BHC Act. The FSOC

study was issued on January 18, 2011. The FSOC study 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.\14\

The FSOC 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.\15\ The Agencies carefully considered the FSOC study and

its recommendations.

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\14\ See Financial Stability Oversight Counsel, 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. (``FSOC

study''). See 12 U.S.C. 1851(b)(1). Prior to publishing its study,

FSOC requested public comment on a number of issues to assist in

conducting its study. See 75 FR 61758 (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.

\15\ See FSOC study at 5-6.

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In formulating this final rule, the Agencies carefully reviewed all

comments submitted in connection with the rulemaking and considered the

suggestions and issues they raise in light of the statutory

restrictions and provisions as well as the FSOC study. The Agencies

have sought to reasonably respond to all of the significant issues

commenters raised. The Agencies believe they have succeeded in doing so

notwithstanding the complexities involved. The Agencies also carefully

considered different options suggested by commenters in light of

potential costs and benefits in order to effectively implement section

13 of the BHC Act. The Agencies made numerous changes to the final rule

in response to the issues and information provided by commenters. These

modifications to the rule and explanations that address comments are

described in more detail in the section-by-section description of the

final rule. To enhance uniformity in both rules that implement section

13 and administration of the requirements of that section, the Agencies

have been regularly consulting with each other in the development of

this final rule.

Some commenters requested that the Agencies repropose the rule and/

or delay adoption pending the collection of

[[Page 5812]]

additional information.\16\ As described in part above, the Agencies

have provided many and various types of opportunities for commenters to

provide input on implementation of section 13 of the BHC Act and have

collected substantial information in the process. In addition to the

official comment process described above, members of the public

submitted comment letters in advance of the official comment period for

the proposed rules and met with staff of the Agencies to explain issues

of concern; the public also provided substantial comment in response to

a request for comment from the FSOC regarding its findings and

recommendations for implementing section 13.\17\ The Agencies provided

a detailed proposal and posed numerous questions in the preamble to the

proposal to solicit and explore alternative approaches in many areas.

In addition, the Agencies have continued to receive comment letters

after the extended comment period deadline, which the Agencies have

considered. Thus, the Agencies believe interested parties have had

ample opportunity to review the proposed rules, as well as the comments

made by others, and to provide views on the proposal, other comment

letters, and data to inform our consideration of the final rules.

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\16\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); ABA

(Keating); Chamber (Nov. 2011); Chamber (Nov. 2013); Members of

Congress (Dec. 2011); IIAC; Real Estate Roundtable; Ass'n. of German

Banks; Allen & Overy (Clearing); JPMC; Goldman (Prop. Trading); BNY

Mellon et al.; State Street (Feb. 2012); ICI Global; Chamber (Feb.

2012); Soci[eacute]t[eacute] G[eacute]n[eacute]rale; HSBC; Western

Asset Mgmt.; Abbott Labs et al. (Feb. 2012); PUC Texas; Columbia

Mgmt.; ICI (Feb. 2012); IIB/EBF; British Bankers' Ass'n.; ISDA (Feb.

2012); Comm. on Capital Markets Regulation; Ralph Saul (Apr. 2012);

BPC.

\17\ See 75 FR 61758 (Oct. 6, 2010).

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In addition, the Agencies have been mindful of the importance of

providing certainty to banking entities and financial markets and of

providing sufficient time for banking entities to understand the

requirements of the final rule and to design, test, and implement

compliance and reporting systems. The further substantial delay that

would necessarily be entailed by reproposing the rule would extend the

uncertainty that banking entities would face, which could prove

disruptive to banking entities and the financial markets.

The Agencies note, as discussed more fully below, that the final

rule incorporates a number of modifications designed to address the

issues raised by commenters in a manner consistent with the statute.

The preamble below also discusses many of the issues raised by

commenters and explains the Agencies' response to those comments.

To achieve the purpose of the statute, without imposing unnecessary

costs, the final rule builds on the multi-faceted approach in the

proposal, which includes development and implementation of a compliance

program at each banking entity engaged in trading activities or that

makes investments subject to section 13 of the BHC Act; the collection

and evaluation of data regarding these activities as an indicator of

areas meriting additional attention by the banking entity and the

relevant agency; appropriate limits on trading, hedging, investment and

other activities; and supervision by the Agencies. To allow banking

entities sufficient time to develop appropriate systems, the Agencies

have provided for a phased-in schedule for the collection of data,

limited data reporting requirements only to banking entities that

engage in significant trading activity, and agreed to review the merits

of the data collected and revise the data collection as appropriate

over the next 21 months. Importantly, as explained in detail below, the

Agencies have also reduced the compliance burden for banking entities

with total assets of less than $10 billion. The final rule also

eliminates compliance burden for firms that do not engage in covered

activities or investments beyond investing in U.S. government

obligations, agency guaranteed obligations, or municipal obligations.

Moreover, the Agencies believe the data that will be collected in

connection with the final rule, as well as the compliance efforts made

by banking entities and the supervisory experience that will be gained

by the Agencies in reviewing trading and investment activity under the

final rule, will provide valuable insights into the effectiveness of

the final rule in achieving the purpose of section 13 of the BHC Act.

The Agencies remain committed to implementing the final rule, and

revisiting and revising the rule as appropriate, in a manner designed

to ensure that the final rule faithfully implements the requirements

and purposes of the statute.\18\

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\18\ If any provision of this rule, or the application thereof

to any person or circumstance, is held to be invalid, such

invalidity shall not affect other provisions or application of such

provisions to other persons or circumstances that can be given

effect without the invalid provision or application.

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Finally, the Board has determined, in accordance with section 13 of

the BHC Act, to provide banking entities with additional time to

conform their activities and investments to the statute and the final

rule. The restrictions and prohibitions of section 13 of the BHC Act

became effective on July 21, 2012.\19\ The statute provided banking

entities a period of two years to conform their activities and

investments to the requirement of the statute, until July 21, 2014.

Section 13 also permits the Board to extend this conformance period,

one year at a time, for a total of no more than three additional

years.\20\ Pursuant to this authority and in connection with this

rulemaking, the Board has in a separate action extended the conformance

period for an additional year until July 21, 2015.\21\ The Board will

continue to monitor developments to determine whether additional

extensions of the conformance period are in the public interest,

consistent with the statute. Accordingly, the Agencies do not believe

that a reproposal or further delay is necessary or appropriate.

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\19\ See 12 U.S.C. 1851(c)(1).

\20\ See 12 U.S.C. 1851(c)(2); see also Conformance Period for

Entities Engaged in Prohibited Proprietary Trading or Private Equity

Fund or Hedge Fund Activities, 76 FR 8265 (Feb. 14, 2011) (citing

156 Cong. Rec. S5898 (daily ed. July 15, 2010) (statement of Sen.

Merkley)).

\21\ See, Board Order Approving Extension of Conformance Period,

available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20131210b1.pdf.

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Commenters have differing views on the overall economic impacts of

section 13 of the BHC Act.

Some commenters remarked that proprietary trading restrictions will

have detrimental impacts on the economy such as: Reduction in

efficiency of markets, economic growth, and in employment due to a loss

in liquidity.\22\ In particular, a commenter expressed concern that

there may be high transition costs as non-banking entities replace some

of the trading activities currently performed by banking entities.\23\

Another commenter focused on commodity markets remarked about the

potential reduction in commercial output and curtailed resource

exploration due to a lack of hedging counterparties.\24\ Several

commenters stated that section 13 of the BHC Act will reduce access to

debt markets--especially for smaller companies--raising the costs of

capital for firms and lowering the returns on certain investments.\25\

Further, some commenters mentioned that U.S. banks may be competitively

disadvantaged relative to foreign banks due to proprietary trading

restrictions and compliance costs.\26\

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\22\ See, e.g., Oliver Wyman (Dec. 2011); Chamber (Dec. 2011);

Thakor Study; Prof. Duffie; IHS.

\23\ See Prof. Duffie.

\24\ See IHS.

\25\ See, e.g., Chamber (Dec. 2011); Thakor Study; Oliver Wyman

(Dec. 2011); IHS.

\26\ See, e.g., RBC; Citigroup (Feb. 2012); Goldman (Covered

Funds).

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[[Page 5813]]

On the other hand, other commenters stated that restricting

proprietary trading activity by banking entities may reduce systemic

risk emanating from the financial system and help to lower the

probability of the occurrence of another financial crisis.\27\ One

commenter contended that large banking entities may have a moral hazard

incentive to engage in risky activities without allocating sufficient

capital to them, especially if market participants believe these

institutions will not be allowed to fail.\28\ Commenters argued that

large banking entities may engage in activities that increase the

upside return at the expense of downside loss exposure which may

ultimately be borne by Federal taxpayers \29\ and that subsidies

associated with bank funding may create distorted economic

outcomes.\30\ Furthermore, some commenters remarked that non-banking

entities may fill much of the void in liquidity provision left by

banking entities if banking entities reduce their current trading

activities.\31\ Finally, some commenters mentioned that hyper-liquidity

that arises from, for instance, speculative bubbles, may harm the

efficiency and price discovery function of markets.\32\

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\27\ See, e.g., Profs. Admati & Pfleiderer; AFR (Nov. 2012);

Better Markets (Dec. 2011); Better Markets (Feb. 2012); Occupy;

Johnson & Prof. Stiglitz; Paul Volcker.

\28\ See Occupy.

\29\ See Profs. Admati & Pfleiderer; Better Markets (Feb. 2012);

Occupy; Johnson & Prof. Stiglitz; Paul Volcker.

\30\ See Profs. Admati & Pfleiderer; Johnson & Prof. Stiglitz.

\31\ See AFR et al. (Feb. 2012); Better Markets (Apr. 16, 2012);

David McClean; Public Citizen; Occupy.

\32\ See Johnson & Prof. Stiglitz (citing Thomas Phillipon

(2011)); AFR et al. (Feb. 2012); Occupy.

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The Agencies have taken these concerns into account in the final

rule. As described below with respect to particular aspects of the

final rule, the Agencies have addressed these issues by reducing

burdens where appropriate, while at the same time ensuring that the

final rule serves its purpose of promoting healthy economic activity.

In that regard, the Agencies have sought to achieve the balance

intended by Congress under section 13 of the BHC Act. Several comments

suggested that a costs and benefits analysis be performed by the

Agencies.\33\ On the other hand, some commenters\34\ correctly stated

that a costs and benefits analysis is not legally required.\35\

However, the Agencies find certain of the information submitted by

commenters concerning costs and benefits and economic effects to be

relevant to consideration of the rule, and so have considered this

information as appropriate, and, on the basis of these and other

considerations, sought to achieve the balance intended by Congress in

section 619 of the Dodd-Frank Act. The relevant comments are addressed

therein.\36\

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\33\ See SIFMA et al. (Covered Funds) (Feb. 2012); BoA; ABA

(Keating); Chamber (Feb. 2012); Soci[eacute]t[eacute]

G[eacute]n[eacute]rale; FTN; SVB; ISDA (Feb. 2012); Comm. on Capital

Market Regulation; Real Estate Roundtable.

\34\ See, e.g., Better Markets (Feb. 2012); Randel Pilo.

\35\ For example, with respect to the CFTC, Section 15(a) of the

CEA requires such consideration only when ``promulgating a

regulation under this [Commodity Exchange] Act.'' This final rule is

not promulgated under the CEA, but under the BHC Act. CEA section

15(a), therefore, does not apply.

\36\ This CFTC Rule is being promulgated exclusively under

section 13 of the BHC. Therefore, the Commission did not conduct a

cost benefit consideration under Section 15(a) of the Commodity

Exchange Act. Similarly, Executive Orders 12866 and 13563,

referenced by some commenters, do not impose obligations on the

CFTC.

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III. Scope

Under section 13 of the BHCA, the CFTC's final rule will be

applicable to a banking entity for which the CFTC is a ``primary

financial regulatory agency'' for that banking entity, as the term is

defined by section 2(12) of the Dodd-Frank Act. Accordingly, the final

rule may apply to banking entities \37\ that are, for example,

registered swap dealers,\38\ futures commission merchants, commodity

trading advisors and commodity pool operators. The CFTC's final rule

may also apply to other types of CFTC registrants that are banking

entities, but it is likely that many such other registrants will have

little or no activities that would implicate the provisions of the

final rule. For example, registered introducing brokers are not likely

to undertake proprietary trading or invest in covered funds because

their activities are generally limited to brokering. Furthermore, the

CFTC's final rule will not apply to CFTC registrants who are not

banking entities. In addition, it is noted that the CFTC may have

overlapping jurisdiction with other Agencies in exercising authority

under each Agency's respective final rules. Finally, it is important to

note that the jurisdictional scope of the final rule does not limit the

regulatory authority of the CFTC or the other Agencies under other

applicable provisions of law.

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\37\ See final rule Sec. 75.2(c).

\38\ The CFTC notes that provisionally registered swap dealers

are registered swap dealers subject to all of the regulatory

requirements applicable to registered swap dealers except as may

otherwise be expressly provided in the CFTC's regulations.

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The CFTC believes that many affiliated banking entities would

undertake some or all of the compliance activities under the final rule

on an affiliated enterprise-wide basis. As of the adoption of the final

rule, the CFTC estimates that there are approximately 110 registered

swap dealers and futures commission merchants that would be banking

entities individually and that grouping these banking entities together

based on legal affiliation would result in about 45 different business

enterprises.

IV. CFTC-specific comments

In addition to the information sought both by the other Agencies

and the CFTC, the CFTC's proposal \39\ included 15 additional questions

specifically regarding the approach the CFTC should take in regards to

certain sections of the rule. The relevant sections included provisions

that were either directly related to the CFTC (e.g., definition of

commodity pool, clearing exemption) and others that appeared not to be

(e.g., underwriting, market making of SEC entities, securitization).

Many commenters sent general responses that touched on issues related

to these 15 CFTC-specific questions, while other commenters organized

their responses by question.\40\ The CFTC has considered these

commenters' views, and has responded as set forth in the relevant

sections below.

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\39\ See 77 FR 8332 (Feb 14, 2012).

\40\ See, e.g., SIFMA (March Letter); Alfred Brock; Occupy the

SEC.

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V. Overview of Final Rule

The Agencies are adopting this final rule to implement section 13

of the BHC Act with a number of changes to the proposal, as described

further below. The final rule adopts a risk-based approach to

implementation that relies on a set of clearly articulated

characteristics of both prohibited and permitted activities and

investments and is designed to effectively accomplish the statutory

purpose of reducing risks posed to banking entities by proprietary

trading activities and investments in or relationships with covered

funds. As explained more fully below in the section-by-section

analysis, the final rule has been designed to ensure that banking

entities do not engage in prohibited activities or investments and to

ensure that banking entities engage in permitted trading and investment

activities in a manner designed to identify, monitor and limit the

risks posed by these activities and investments. For instance, the

final rule requires that any banking entity that is engaged in activity

subject to section 13 develop and administer a compliance program that

is appropriate to the size,

[[Page 5814]]

scope and risk of its activities and investments. The rule requires the

largest firms engaged in these activities to develop and implement

enhanced compliance programs and regularly report data on trading

activities to the Agencies. The Agencies believe this will permit

banking entities to effectively engage in permitted activities, and the

Agencies to enforce compliance with section 13 of the BHC Act. In

addition, the enhanced compliance programs will help both the banking

entities and the Agencies identify, monitor, and limit risks of

activities permitted under section 13, particularly involving banking

entities posing the greatest risk to financial stability.

A. General Approach and Summary of Final Rule

The Agencies have designed the final rule to achieve the purposes

of section 13 of the BHC Act, which include prohibiting banking

entities from engaging in proprietary trading or acquiring or retaining

an ownership interest in, or having certain relationships with, a

covered fund, while permitting banking entities to continue to provide,

and to manage and limit the risks associated with providing, client-

oriented financial services that are critical to capital generation for

businesses of all sizes, households and individuals, and that

facilitate liquid markets. These client-oriented financial services,

which include underwriting, market making, and asset management

services, are important to the U.S. financial markets and the

participants in those markets. 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.

As noted above, the final rule takes a multi-faceted approach to

implementing section 13 of the BHC Act. In particular, the final rule

includes a framework that clearly describes the key characteristics of

both prohibited and permitted activities. The final rule also requires

banking entities to establish a comprehensive compliance program

designed to ensure compliance with the requirements of the statute and

rule in a way that takes into account and reflects the banking entity's

activities, size, scope and complexity. With respect to proprietary

trading, the final rule also requires the large firms that are active

participants in trading activities 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.

As a matter of structure, the final rule is generally divided into

four subparts and contains two appendices, as follows:

Subpart A of the final 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 final rule prohibits proprietary trading,

defines terms relevant to covered trading activity, establishes

exemptions from 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 final 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 final rule generally requires banking

entities to establish a compliance program regarding compliance with

section 13 of the BHC Act and the final rule, including written

policies and procedures, internal controls, a management framework,

independent testing of the compliance program, training, and

recordkeeping;

Appendix A of the final rule details the quantitative

measurements that certain banking entities may be required to compute

and report with respect to certain trading activities;

Appendix B of the final rule details the enhanced minimum

standards for programmatic compliance that certain banking entities

must meet with respect to their compliance program, as required under

subpart D.

B. Proprietary Trading Restrictions

Subpart B of the final rule implements the statutory prohibition on

proprietary trading and the various exemptions to this prohibition

included in the statute. Section 75.3 of the final rule contains the

core prohibition on proprietary trading and defines a number of related

terms, including ``proprietary trading'' and ``trading account.'' The

final rule's definition of proprietary trading generally parallels the

statutory definition and covers engaging as principal for the trading

account of a banking entity in any transaction to purchase or sell

specified types of financial instruments.\41\

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\41\ See final rule Sec. 75.3(a).

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The final rule's definition of trading account also is consistent

with the statutory definition.\42\ In particular, the definition of

trading account in the final rule includes three classes of positions.

First, the definition includes the purchase or sale of one or more

financial instruments 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.\43\ For purposes of this part of the definition, the final

rule also contains a rebuttable presumption that the purchase or sale

of a financial instrument by a banking entity is for the trading

account of the banking entity if the banking entity holds the financial

instrument for fewer than 60 days or substantially transfers the risk

of the financial instrument within 60 days of purchase (or sale).\44\

Second, with respect to a banking entity subject to the Federal banking

agencies' Market Risk Capital Rules, the definition includes the

purchase or sale of one or more financial instruments subject to the

prohibition on proprietary trading that are treated as ``covered

positions and trading positions'' (or hedges of other market risk

capital rule covered positions) under those capital rules, other than

certain foreign exchange and commodities positions.\45\ Third, the

definition includes the purchase or sale of one or more financial

instruments by a banking entity that is licensed or registered or

required to be licensed or registered to engage in the business of a

dealer, swap dealer, or security-based swap dealer to the extent the

instrument is purchased or sold in connection with the activities that

require the banking entity to be licensed or registered as such or is

engaged in those businesses outside of the United States, to the extent

the instrument is purchased or sold in connection with the activities

of such business.\46\

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\42\ See final rule Sec. 75.3(b).

\43\ See final rule Sec. 75.3(b)(1)(i).

\44\ See final rule Sec. 75.3(b)(2).

\45\ See final rule Sec. 75.3(b)(1)(ii).

\46\ See final rule Sec. 75.3(b)(1)(iii).

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The definition of proprietary trading also contains clarifying

exclusions for certain purchases and sales of financial instruments

that generally do not involve the requisite short-term trading intent,

such as the purchase and sale of financial instruments arising under

certain repurchase and reverse repurchase arrangements or securities

[[Page 5815]]

lending transactions and securities acquired or taken for bona fide

liquidity management purposes.\47\

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\47\ See final rule Sec. 75.3(d).

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In section 75.3, the final rule also defines a number of other

relevant terms, including the term ``financial instrument.'' This term

is used to define the scope of financial instruments subject to the

prohibition on proprietary trading. Consistent with the statutory

language, such financial instruments include securities, derivatives,

commodity futures, and options on such instruments, but do not include

loans, spot foreign exchange or spot physical commodities.\48\

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\48\ See final rule Sec. 75.3(c).

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In section 75.4, the final rule implements the statutory exemptions

for underwriting and market making-related activities. For each of

these permitted activities, the final rule defines the exempt activity

and provides a number of requirements that must be met in order for a

banking entity to rely on the applicable exemption. As more fully

discussed below, these include establishment and enforcement of a

compliance program targeted to the activity; limits on positions,

inventory and risk exposure addressing the requirement that activities

be designed not to exceed the reasonably expected near term demands of

clients, customers, or counterparties; limits on the duration of

holdings and positions; defined escalation procedures to change or

exceed limits; analysis justifying established limits; internal

controls and independent testing of compliance with limits; senior

management accountability and limits on incentive compensation. In

addition, the final rule requires firms with significant market-making

or underwriting activities to report data involving several metrics

that may be used by the banking entity and the Agencies to identify

trading activity that may warrant more detailed compliance review.

These requirements are generally designed to ensure that the

banking entity's trading activity is limited to underwriting and market

making-related activities and does not include prohibited proprietary

trading.\49\ These requirements are also intended to work together to

ensure that banking entities identify, monitor and limit the risks

associated with these activities.

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\49\ See final rule Sec. 75.4(a), (b).

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In section 75.5, the final rule implements the statutory exemption

for risk-mitigating hedging. As with the underwriting and market-making

exemptions, Sec. 75.5 of the final rule 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 hedging activity is limited to risk-mitigating

hedging in purpose and effect.\50\ Section 75.5 also requires banking

entities to document, at the time the transaction is executed, the

hedging rationale for certain transactions that present heightened

compliance risks.\51\ 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.

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\50\ See final rule Sec. 75.5.

\51\ See final rule Sec. 75.5(c).

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In section 75.6, the final 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 of the United States. Section

75.6(a) of the final rule describes the government obligations in which

a banking entity may trade, which include U.S. government and agency

obligations, obligations and other instruments of specified government

sponsored entities, and State and municipal obligations.\52\ Section

75.6(b) of the final rule permits trading in certain foreign government

obligations by affiliates of foreign banking entities in the United

State and foreign affiliates of a U.S. banking entity abroad.\53\

Section 75.6(c) of the final rule describes permitted trading on behalf

of customers and identifies the types of transactions that would

qualify for the exemption.\54\ Section 75.6(d) of the final rule

describes permitted trading by a regulated insurance company or an

affiliate thereof for the general account of the insurance company, and

also permits those entities to trade for a separate account of the

insurance company.\55\ Finally, Sec. 75.6(e) of the final rule

describes trading permitted outside of the United States by a foreign

banking entity.\56\ The exemption in the final rule clarifies when a

foreign banking entity will qualify 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 the BHC Act. As explained in detail below, the

exemption also provides that the risk as principal, the decision-

making, and the accounting for this activity must occur solely outside

of the United States, consistent with the statute.

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\52\ See final rule Sec. 75.6(a).

\53\ See final rule Sec. 75.6(b).

\54\ See final rule Sec. 75.6(c).

\55\ See final rule Sec. 75.6(d).

\56\ See final rule Sec. 75.6(e).

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In section 75.7, the final 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.\57\ This section also describes the terms material conflict of

interest, high-risk asset, and high-risk trading strategy for these

purposes.

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\57\ See final rule Sec. 75.7.

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C. Restrictions on Covered Fund Activities and Investments

Subpart C of the final rule implements the statutory prohibition

on, directly or indirectly, acquiring and retaining an ownership

interest in, or having certain relationships with, a covered fund, as

well as the various exemptions to this prohibition included in the

statute. Section 75.10 of the final rule contains the core prohibition

on covered fund activities and investments and defines a number of

related terms, including ``covered fund'' and ``ownership

interest.''\58\ The definition of covered fund contains a number of

exclusions for entities that may rely on exclusions from the Investment

Company Act of 1940 contained in section 3(c)(1) or 3(c)(7) of that Act

but that are not engaged in investment activities of the type

contemplated by section 13 of the BHC Act. These include, for example,

exclusions for wholly owned subsidiaries, joint ventures, foreign

pension or retirement funds, insurance company separate accounts, and

public welfare investment funds. The final rule also implements the

statutory rule of construction in section 13(g)(2) and provides that a

securitization of loans, which would include loan securitization,

qualifying asset backed commercial paper conduit, and qualifying

covered bonds, is not covered by section 13 or the final rule.\59\

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\58\ See final rule Sec. 75.10(b).

\59\ The Agencies believe that most securitization transactions

are currently structured so that the issuing entity with respect to

the securitization is not an affiliate of a banking entity under the

BHC Act. However, with respect to any securitization that is an

affiliate of a banking entity and that does not meet the

requirements of the loan securitization exclusion, the related

banking entity will need to determine how to bring the

securitization into compliance with this rule.

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[[Page 5816]]

The definition of ``ownership interest'' in the final rule provides

further guidance regarding the types of interests that would be

considered to be an ownership interest in a covered fund.\60\ As

described in this Supplementary Information, these interests may take

various forms. The definition of ownership interest also explicitly

excludes from the definition ``restricted profit interest'' that is

solely performance compensation for services provided to the covered

fund by the banking entity (or an employee or former employee thereof),

under certain circumstances.\61\ Section 75.10 of the final rule also

defines a number of other relevant terms, including the terms ``prime

brokerage transaction,'' ``sponsor,'' and ``trustee.''

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\60\ See final rule Sec. 75.10(d)(6).

\61\ See final rule Sec. 75.10(b)(6)(ii).

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In section 75.11, the final rule implements the exemption for

organizing and offering a covered fund provided for under section

13(d)(1)(G) of the BHC Act. Section 75.11(a) of the final 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, subject to certain limits contained in section 13

of the BHC Act.\62\ The requirements are discussed in detail in Part

VI.B.2. of this Supplementary Information. Section 75.11 also explains

how these requirements apply to covered funds that are issuing entities

of asset-backed securities, as well as implements the statutory

exemption for underwriting and market-making ownership interests of a

covered fund, including explaining the limitations imposed on such

activities under the final rule.

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\62\ See 156 Cong. Rec. S5889 (daily ed. July 15, 2010)

(statement of Sen. Hagan).

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In section 75.12, the final 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

or holds pursuant to other authority under Sec. 75.11.\63\ This

section implements section 13(d)(4) of the BHC Act and related

provisions. Section 13(d)(4)(A) of the BHC Act permits a banking entity

to make an investment in a covered fund that the banking entity

organizes and offers, 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 75.12

of the final 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. In addition, Sec. 75.12 requires that the aggregate value

of all investments in covered funds, plus any earnings on these

investments, be deducted from the capital of the banking entity for

purposes of the regulatory capital requirements, and explains how that

deduction must occur. Section 75.12 of the final rule also clarifies

how a banking entity must calculate its compliance with these

investment limitations (including by deducting such investments from

applicable capital, as relevant), and 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. This section also

explains how a banking entity must apply the covered fund investment

limits to a covered fund that is an issuing entity of asset backed

securities or a covered fund that is part of a master-feeder or fund-

of-funds structure.

---------------------------------------------------------------------------

\63\ See final rule Sec. 75.12.

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In section 75.13, the final rule implements the statutory

exemptions described in sections 13(d)(1)(C), (D), (F), and (I) of the

BHC Act that permit a banking entity: (i) To acquire and retain an

ownership interest in a covered fund as a risk-mitigating hedging

activity related to employee compensation; (ii) in the case of a non-

U.S. banking entity, to acquire and retain an ownership interest in, or

act as sponsor to, a covered fund solely outside the United States; and

(iii) to acquire and retain an ownership interest in, or act as sponsor

to, a covered fund by an insurance company for its general or separate

accounts.\64\

---------------------------------------------------------------------------

\64\ See final rule Sec. 75.13(a)-(c).

---------------------------------------------------------------------------

In section 75.14, the final 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 Federal Reserve Act.\65\

Section 75.14(a)(2) of the final rule describes the transactions

between a banking entity and a covered fund that remain permissible

under the statute and the final rule. Section 75.14(b) of the final

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 Federal Reserve 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 12 U.S.C. 371c; see also final rule Sec. 75.14.

\66\ 12 U.S.C. 371c-1.

---------------------------------------------------------------------------

In section 75.15, the final 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 describes material conflict of interest, high-risk asset,

and high-risk trading strategy for these purposes.

---------------------------------------------------------------------------

\67\ See final rule Sec. 75.15.

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D. Metrics Reporting Requirement

Under the final rule, a banking entity that meets relevant

thresholds specified in the rule must furnish the following

quantitative measurements for each of its trading desks engaged in

covered trading activity calculated in accordance with Appendix A:

Risk and Position Limits and Usage;

Risk Factor Sensitivities;

Value-at-Risk and Stress VaR;

Comprehensive Profit and Loss Attribution;

Inventory Turnover;

Inventory Aging; and

Customer Facing Trade Ratio.

The final rule raises the threshold for metrics reporting from the

proposal to capture only firms that engage in significant trading

activity, identified at specified aggregate trading asset and liability

thresholds, and delays the dates for reporting metrics through a

phased-in approach based on the size of trading assets and liabilities.

Specifically, the Agencies have delayed the reporting of metrics until

June 30, 2014 for the largest banking entities that, together with

their affiliates and subsidiaries, have trading assets and liabilities

the average gross sum of which equal or exceed $50 billion on a

worldwide consolidated basis over the previous four calendar quarters

(excluding trading assets and liabilities involving obligations of or

guaranteed by the

[[Page 5817]]

United States or any agency of the United States). Banking entities

with $25 billion or more in trading assets and liabilities and banking

entities with $10 billion or more in trading assets and liabilities

would also be required to report these metrics beginning on April 30,

2016, and December 31, 2016, respectively.

Under the final rule, a banking entity required to report metrics

must calculate any applicable quantitative measurement for each trading

day. Each banking entity required to report must report each applicable

quantitative measurement to its primary supervisory Agency on the

reporting schedule established in the final rule unless otherwise

requested by the primary supervisory Agency for the entity. The largest

banking entities with $50 billion in consolidated trading assets and

liabilities must report the metrics on a monthly basis. Other banking

entities required to report metrics must do so on a quarterly basis.

All quantitative measurements for any calendar month must be reported

no later than 10 days after the end of the calendar month required by

the final rule unless another time is requested by the primary

supervisory Agency for the entity except for a transitional six month

period during which reporting will be required no later than 30 days

after the end of the calendar month. Banking entities subject to

quarterly reporting will be required to report quantitative

measurements within 30 days of the end of the quarter, unless another

time is requested by the primary supervisory Agency for the entity in

writing.\68\

---------------------------------------------------------------------------

\68\ See final rule Sec. 75.20(d)(3). The final rule includes a

shorter period of time for reporting quantitative measurements than

was proposed for the largest banking entities. Like the monthly

reporting requirement for these firms, this is intended to allow for

more effective supervision of their large-scale trading operations.

---------------------------------------------------------------------------

E. Compliance Program Requirement

Subpart D of the final 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 final rule.\69\ To reduce the overall

burden of the rule, the final rule provides that a banking entity that

does not engage in covered trading activities (other than trading in

U.S. government or agency obligations, obligations of specified

government sponsored entities, and state and municipal obligations) or

covered fund activities and investments need only establish a

compliance program prior to becoming engaged in such activities or

making such investments.\70\ In addition, to reduce the burden on

smaller banking entities, a banking entity with total consolidated

assets of $10 billion or less that engages in covered trading

activities and/or covered fund activities or investments may satisfy

the requirements of the final rule by including in its existing

compliance policies and procedures appropriate references to the

requirements of section 13 and the final rule and adjustments as

appropriate given the activities, size, scope and complexity of the

banking entity.\71\

---------------------------------------------------------------------------

\69\ See final rule Sec. 75.20.

\70\ See final rule Sec. 75.20(f)(1).

\71\ See final rule Sec. 75.20(f)(2).

---------------------------------------------------------------------------

For banking entities with total assets greater than $10 billion and

less than $50 billion, the final rule specifies six elements that each

compliance program established under subpart D must, at a minimum,

include. These requirements focus on written policies and procedures

reasonably designed to ensure compliance with the final rules,

including limits on underwriting and market-making; a system of

internal controls; clear accountability for compliance and review of

limits, hedging, incentive compensation, and other matters; independent

testing and audits; additional documentation for covered funds;

training; and recordkeeping requirements.

A banking entity with $50 billion or more total consolidated assets

(or a foreign banking entity that has total U.S. assets of $50 billion

or more) or that is required to report metrics under Appendix A is

required to adopt an enhanced compliance program with more detailed

policies, limits, governance processes, independent testing and

reporting. In addition, the Chief Executive Officer of these larger

banking entities must attest that the banking entity has in place a

program reasonably designed to achieve compliance with the requirements

of section 13 of the BHC Act and the final rule.

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 final rule.

VI. Final Rule

A. Subpart B--Proprietary Trading Restrictions

1. Section 75.3: Prohibition on Proprietary Trading and Related

Definitions

Section 13(a)(1)(A) of the BHC Act prohibits a banking entity from

engaging in proprietary trading unless otherwise permitted in section

13.\72\ Section 13(h)(4) of the BHC Act defines proprietary trading, in

relevant part, as engaging as principal for the trading account of the

banking entity in any transaction to purchase or sell, or otherwise

acquire or dispose of, a security, derivative, contract of sale of a

commodity for future delivery, or other financial instrument that the

Agencies include by rule.\73\

---------------------------------------------------------------------------

\72\ 12 U.S.C. 1851(a)(1)(A).

\73\ 12 U.S.C. 1851(h)(4).

---------------------------------------------------------------------------

Section 75.3(a) of the proposed rule implemented section

13(a)(1)(A) of the BHC Act by prohibiting a banking entity from

engaging in proprietary trading unless otherwise permitted under

Sec. Sec. 75.4 through 75.6 of the proposed rule. Section 75.3(b)(1)

of the proposed rule defined proprietary trading in accordance with

section 13(h)(4) of the BHC Act and clarified that proprietary trading

does not include acting solely as agent, broker, or custodian for an

unaffiliated third party. The preamble to the proposed rule explained

that acting in these types of capacities does not involve trading as

principal.\74\

---------------------------------------------------------------------------

\74\ See Joint Proposal, 76 FR at 68857.

---------------------------------------------------------------------------

Several commenters expressed concern about the breadth of the ban

on proprietary trading.\75\ Some of these commenters stated that

proprietary trading must be carefully and narrowly defined to avoid

prohibiting activities that Congress did not intend to limit and to

preclude significant, unintended consequences for capital markets,

capital formation, and the broader economy.\76\ Some commenters

asserted that the proposed definition could result in banking entities

being unwilling to take principal risk to provide liquidity for

institutional investors; could unnecessarily constrain liquidity in

secondary markets, forcing asset managers to service client needs

through alternative non-U.S. markets; could impose substantial costs

for all institutions, especially smaller and mid-size institutions; and

could drive risk-

[[Page 5818]]

taking to the shadow banking system.\77\ Others urged the Agencies to

determine that trading as agent, broker, or custodian for an affiliate

was not proprietary trading.\78\

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\75\ See, e.g., Ass'n. of Institutional Investors (Feb. 2012);

Capital Group; Comm. on Capital Markets Regulation; IAA; SIFMA et

al. (Prop. Trading) (Feb. 2012); SVB; Chamber (Feb. 2012);

Wellington.

\76\ See Ass'n. of Institutional Investors (Feb. 2012); GE (Feb.

2012); Invesco; Sen. Corker; Chamber (Feb. 2012).

\77\ See Chamber (Feb. 2012).

\78\ See Japanese Bankers Ass'n.

---------------------------------------------------------------------------

Commenters also suggested alternative approaches for defining

proprietary trading. In general, these approaches sought to provide a

bright-line definition to provide increased certainty to banking

entities \79\ or make the prohibition easier to apply in practice.\80\

One commenter stated the Agencies should focus on the economics of

banking entities' transactions and ban trading if the banking entity is

exposed to market risk for a significant period of time or is profiting

from changes in the value of the asset.\81\ Several commenters,

including individual members of the public, urged the Agencies to

prohibit banking entities from engaging in any kind of proprietary

trading and require separation of trading from traditional banking

activities.\82\ After carefully considering comments, the Agencies are

defining proprietary trading as engaging as principal for the trading

account of the banking entity in any purchase or sale of one or more

financial instruments.\83\ The Agencies believe this effectively

restates the statutory definition. The Agencies are not adopting

commenters' suggested modifications to the proposed definition of

proprietary trading or the general prohibition on proprietary trading

because they generally appear to be inconsistent with Congressional

intent. For instance, some commenters appeared to suggest an approach

to defining proprietary trading that would capture only bright-line,

speculative proprietary trading and treat the activities covered by the

statutory exemptions as completely outside the rule.\84\ However, such

an approach would appear to be inconsistent with Congressional intent

because, for instance, it would not give effect to the limitations on

permitted activities in section 13(d) of the BHC Act.\85\ For similar

reasons, the Agencies are not adopting a bright-line definition of

proprietary trading.\86\

---------------------------------------------------------------------------

\79\ See, e.g., ABA (Keating); Ass'n. of Institutional Investors

(Feb. 2012); BOK; George Bollenbacher; Credit Suisse (Seidel); NAIB

et al.; SSgA (Feb. 2012); JPMC.

\80\ See Public Citizen.

\81\ See Sens. Merkley & Levin (Feb. 2012).

\82\ See generally Occupy; Public Citizen; AFR et al. (Feb.

2012). The Agencies received over fifteen thousand form letters in

support of a rule with few exemptions, many of which expressed a

desire to return to the regulatory scheme as governed by the Glass-

Steagall affiliation provisions of the U.S. Banking Act of 1933, as

repealed through the Graham-Leach-Bliley Act of 1999. See generally

Sarah McGee; Christopher Wilson; Michael Itlis; Barry Rein; Edward

Bright. Congress rejected such an approach, however, opting instead

for the more narrowly tailored regulatory approach embodied in

section 13 of the BHC Act.

\83\ See final rule Sec. 75.3(a). The final rule also replaces

all references to the proposed term ``covered financial position''

with the term ``financial instrument.'' This change has no

substantive impact because the definition of ``financial

instrument'' is substantially identical to the proposed definition

of ``covered financial position.'' Consistent with this change, the

final rule replaces the undefined verbs ``acquire'' or ``take'' with

the defined terms ``purchase'' or ``sale'' and ``sell.'' See final

rule Sec. Sec. 75.3(c), 75.2(u), (x).

\84\ See, e.g., Ass'n. of Institutional Investors (Feb. 2012);

GE (Feb. 2012); Invesco; Sen. Corker; Chamber (Feb. 2012); JPMC.

\85\ See 156 Cong. Rec. S5895-96 (daily ed. July 15, 2010)

(statement of Sen. Merkley) (stating the statute ``permits

underwriting and market-making-related transactions that are

technically trading for the account of the firm but, in fact,

facilitate the provision of near-term client-oriented financial

services.'').

\86\ See ABA (Keating); Ass'n. of Institutional Investors (Feb.

2012); BOK; George Bollenbacher; Credit Suisse (Seidel); NAIB et

al.; SSgA (Feb. 2012); JPMC.

---------------------------------------------------------------------------

A number of commenters expressed concern that, as a whole, the

proposed rule may result in certain negative economic impacts,

including: (i) Reduced market liquidity; \87\ (ii) wider spreads or

otherwise increased trading costs; \88\ (iii) higher borrowing costs

for businesses or increased cost of capital; \89\ and/or (iv) greater

market volatility.\90\ The Agencies have carefully considered

commenters' concerns about the proposed rule's potential impact on

overall market liquidity and quality. As discussed in more detail in

Parts VI.A.2. and VI.A.3., the final rule will permit banking entities

to continue to provide beneficial market-making and underwriting

services to customers, and therefore provide liquidity to customers and

facilitate capital-raising. However, the statute upon which the final

rule is based prohibits proprietary trading activity that is not

exempted. As such, the termination of non-exempt proprietary trading

activities of banking entities may lead to some general reductions in

liquidity of certain asset classes. Although the Agencies cannot say

with any certainty, there is good reason to believe that to a

significant extent the liquidity reductions of this type may be

temporary since the statute does not restrict proprietary trading

activities of other market participants.\91\ Thus, over time, non-

banking entities may provide much of the liquidity that is lost by

restrictions on banking entities' trading activities. If so,

eventually, the detrimental effects of increased trading costs, higher

costs of capital, and greater market volatility should be mitigated.

---------------------------------------------------------------------------

\87\ See, e.g., AllianceBernstein; Obaid Syed; Rep. Bachus et

al.; EMTA; NASP; Sen. Hagan; Investure; Lord Abbett; Sumitomo Trust;

EFAMA; Morgan Stanley; Barclays; BoA; Citigroup (Feb. 2012); STANY;

ABA (Keating); ICE; ICSA; SIFMA (Asset Mgmt.) (Feb. 2012); Putnam;

ACLI (Feb. 2012); Wells Fargo (Prop. Trading); Capital Group; RBC;

Columbia Mgmt.; SSgA (Feb. 2012); Fidelity; ICI (Feb. 2012); ISDA

(Feb. 2012); Comm. on Capital Markets Regulation; Clearing House

Ass'n.; Thakor Study. See also CalPERS (acknowledging that the

systemic protections afforded by the Volcker Rule come at a price,

including reduced liquidity to all markets).

\88\ See, e.g., AllianceBernstein; Obaid Syed; NASP; Investure;

Lord Abbett; CalPERS; Credit Suisse (Seidel); Citigroup (Feb. 2012);

ABA (Keating); SIFMA (Asset Mgmt.) (Feb. 2012); Putnam; Wells Fargo

(Prop. Trading); Comm. on Capital Markets Regulation.

\89\ See, e.g., Rep. Bachus et al.; Members of Congress (Dec.

2011); Lord Abbett; Morgan Stanley; Barclays; BoA; Citigroup (Feb.

2012); ABA (Abernathy); ICSA; SIFMA (Asset Mgmt.) (Feb. 2012);

Chamber (Feb. 2012); Putnam; ACLI (Feb. 2012); UBS; Wells Fargo

(Prop. Trading); Capital Group; Sen. Carper et al.; Fidelity;

Invesco; Clearing House Ass'n.; Thakor Study.

\90\ See, e.g., CalPERS (expressing the belief that a decline in

banking entity proprietary trading will increase the volatility of

the corporate bond market, especially during times of economic

weakness or periods where risk taking declines, but noting that

portfolio managers have experienced many different periods of market

illiquidity and stating that the market will adapt post-

implementation (e.g., portfolio managers will increase their use of

CDS to reduce economic risk to specific bond positions as the

liquidation process of cash bonds takes more time, alternative

market matching networks will be developed)); Morgan Stanley;

Capital Group; Fidelity; British Bankers' Ass'n.; Invesco.

\91\ See David McClean; Public Citizen; Occupy. In response to

commenters who expressed concern about risks associated with

proprietary trading activities moving to non-banking entities, the

Agencies note that section 13's prohibition on proprietary trading

and related exemptions apply only to banking entities. See, e.g.,

Chamber (Feb. 2012).

---------------------------------------------------------------------------

To respond to concerns raised by commenters while remaining

consistent with Congressional intent, the final rule has been modified

to provide that certain purchases and sales are not proprietary trading

as described in more detail below.\92\

---------------------------------------------------------------------------

\92\ See final rule Sec. 75.3(d).

---------------------------------------------------------------------------

a. Definition of ``Trading Account''

As explained above, section 13 defines proprietary trading as

engaging as principal ``for the trading account of the banking entity''

in certain types of transactions. Section 13(h)(6) of the BHC Act

defines trading account as any account used for acquiring or taking

positions in financial 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), and any such other

accounts as the Agencies may, by rule, determine.\93\

---------------------------------------------------------------------------

\93\ See 12 U.S.C. 1851(h)(6).

---------------------------------------------------------------------------

The proposed rule defined trading account to include three separate

accounts. First, the proposed definition

[[Page 5819]]

of trading account included, consistent with the statute, any account

that is used by a banking entity to acquire or take one or more covered

financial positions for short-term trading purposes (the ``short-term

trading account'').\94\ The proposed rule identified four purposes that

would indicate short-term trading intent: (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

positions described in (i), (ii) or (iii). The proposed rule presumed

that an account is a trading account if it is used to acquire or take a

covered financial position (other than a position in the market risk

rule trading account or the dealer trading account) that the banking

entity holds for 60 days or less.\95\

---------------------------------------------------------------------------

\94\ See proposed rule Sec. 75.3(b)(2)(i)(A).

\95\ See proposed rule Sec. 75.3(b)(2)(ii).

---------------------------------------------------------------------------

Second, the proposed definition of trading account included, for

certain entities, any account that contains positions that qualify for

trading book capital treatment under the banking agencies' market risk

capital rules other than positions that are foreign exchange

derivatives, commodity derivatives or contracts of sale of a commodity

for delivery (the ``market risk rule trading account'').\96\ ``Covered

positions'' under the banking agencies' market-risk capital rules are

positions that are generally held with the intent of sale in the short-

term.

---------------------------------------------------------------------------

\96\ See proposed rule Sec. Sec. 75.3(b)(2)(i)(B); 75.3(b)(3).

---------------------------------------------------------------------------

Third, the proposed definition of trading account included 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 (the ``dealer trading

account'').\97\ The proposed rule also included as a trading account

any account used to acquire or take any covered financial position by a

banking entity in connection with the activities of a dealer, swap

dealer, or security-based swap dealer outside of the United States.\98\

Covered financial positions held by banking entities that register or

file notice as securities or derivatives dealers as part of their

dealing activity were included because such positions are generally

held for sale to customers upon request or otherwise support the firm's

trading activities (e.g., by hedging its dealing positions).\99\

---------------------------------------------------------------------------

\97\ See proposed rule Sec. 75.3(b)(2)(i)(C).

\98\ See proposed rule Sec. 75.3(b)(2)(i)(C)(5).

\99\ See Joint Proposal, 76 FR 68860.

---------------------------------------------------------------------------

The proposed rule also set forth four clarifying exclusions from

the definition of trading account. The proposed rule provided that no

account is a trading account to the extent that it is used to acquire

or take certain positions under repurchase or reverse repurchase

arrangements, positions under securities lending transactions,

positions for bona fide liquidity management purposes, or positions

held by derivatives clearing organizations or clearing agencies.\100\

---------------------------------------------------------------------------

\100\ See proposed rule Sec. 75.3(b)(2)(iii).

---------------------------------------------------------------------------

Overall, commenters did not raise significant concerns with or

objections to the short-term trading account. Several commenters argued

that the definition of trading account should be limited to only this

portion of the proposed definition of trading account.\101\ However, a

few commenters raised concerns regarding the treatment of arbitrage

trading under the proposed rule.\102\ Several commenters asserted that

the proposed definition of trading account was too broad and covered

trading not intended to be covered by the statute.\103\ Some of these

commenters maintained that the Agencies exceeded their statutory

authority under section 13 of the BHC Act in defining trading account

to include the market risk rule trading account and dealer trading

account, and argued that the definition should be limited to the short-

term trading account definition.\104\ Commenters argued, for example,

that an overly broad definition of trading account may cause

traditional bank activities important to safety and soundness of a

banking entity to fall within the prohibition on proprietary trading to

the detriment of banking organizations, customers, and financial

markets.\105\ A number of commenters suggested modifying and narrowing

the trading account definition to remove the implicit negative

presumption that any position creates a trading account, or that all

principal trading constitutes prohibited proprietary trading unless it

qualifies for a narrowly tailored exemption, and to clearly exempt

activities important to safety and soundness.\106\ For example, one

commenter recommended that a covered financial position be considered a

trading account position only if it qualifies as a GAAP trading

position.\107\ A few commenters requested the Agencies define the

phrase ``short term'' in the rule.\108\

---------------------------------------------------------------------------

\101\ See ABA (Keating); JPMC.

\102\ See AFR et al. (Feb. 2012); Paul Volcker; Credit Suisse

(Seidel); ISDA (Feb. 2012); Japanese Bankers Ass'n.

\103\ See ABA (Keating); Allen & Overy (on behalf of Large Int'l

Banks with U.S. Operations); Am. Express; BoA; Goldman (Prop.

Trading); ISDA (Feb. 2012); Japanese Bankers Ass'n.; JPMC; SIFMA et

al. (Prop. Trading) (Feb. 2012); State Street (Feb. 2012).

\104\ See ABA (Keating); JPMC; SIFMA et al. (Prop. Trading)

(Feb. 2012); State Street (Feb. 2012).

\105\ See ABA (Keating); Credit Suisse (Seidel).

\106\ See ABA (Keating); Ass'n. of Institutional Investors (Feb.

2012); BoA; Capital Group; IAA; Credit Suisse (Seidel); ICI (Feb.

2012); ISDA (Feb. 2012); NAIB et al.; SIFMA et al. (Prop. Trading)

(Feb. 2012); SVB; Wellington.

\107\ See ABA (Keating).

\108\ See NAIB et al.; Occupy; but see Alfred Brock.

---------------------------------------------------------------------------

Several commenters argued that the market risk rule should not be

referenced as part of the definition of trading account.\109\ A few of

these commenters argued instead that the capital treatment of a

position be used only as an indicative factor rather than a dispositive

test.\110\ One commenter thought that the market risk rule trading

account was redundant because it includes only positions that have

short-term trading intent.\111\ Commenters also contended that it was

difficult to consider and comment on this aspect of the proposal

because the market risk capital rules had not been finalized.\112\

---------------------------------------------------------------------------

\109\ See ABA; BoA; Goldman (Prop. Trading); ISDA (Feb. 2012);

JPMC; SIFMA et al. (Prop. Trading) (Feb. 2012).

\110\ See BoA; SIFMA et al. (Prop. Trading) (Feb. 2012).

\111\ See ISDA (Feb. 2012).

\112\ See ABA (Keating); BoA; Goldman (Prop. Trading); ISDA

(Feb. 2012); JPMC. The banking agencies adopted a final rule that

amends their respective market risk capital rules on August 30,

2012. See 77 FR 53060 (Aug. 30, 2012). The Agencies continued to

receive and consider comments on the proposed rule to implement

section 13 of the BHC Act after that time.

---------------------------------------------------------------------------

A number of commenters objected to the dealer trading account prong

of the definition.\113\ Commenters asserted that this prong was an

unnecessary and unhelpful addition that went beyond the requirements of

section 13 of the BHC Act, and that it made the trading account

determination more complex and difficult.\114\ In particular,

commenters argued that the dealer trading account was too broad and

introduced uncertainty because it presumed that dealers always enter

into positions with short-term intent.\115\ Commenters also expressed

concern about the difficulty of applying this test outside the United

States and requested that, if this account is retained, the final rule

be explicit about how it applies to a swap dealer outside the United

States

[[Page 5820]]

and treat U.S. swap dealers consistently.\116\

---------------------------------------------------------------------------

\113\ See ABA (Keating); Allen & Overy (on behalf of Large Int'l

Banks with U.S. Operations); Am. Express; Goldman (Prop. Trading);

ISDA (Feb. 2012); Japanese Bankers Ass'n.; JPMC; SIFMA et al. (Prop.

Trading) (Feb. 2012).

\114\ See ABA (Keating); Allen & Overy (on behalf of Large Int'l

Banks with U.S. Operations); JPMC; State Street (Feb. 2012); ISDA

(Feb. 2012); SIFMA et al. (Prop. Trading) (Feb. 2012).

\115\ See ABA (Keating); Am. Express; Goldman (Prop. Trading);

ISDA (Feb. 2012); JPMC.

\116\ See Allen & Overy (on behalf of Large Int'l Banks with

U.S. Operations); Am. Express; JPMC.

---------------------------------------------------------------------------

In contrast, other commenters contended that the proposed rule's

definition of trading account was too narrow, particularly in its focus

on short-term positions,\117\ or should be simplified.\118\ One

commenter argued that the breadth of the trading account definition was

critical because positions excluded from the trading account definition

would not be subject to the proposed rule.\119\ One commenter supported

the proposed definition of trading account.\120\ Other commenters

believed that reference to the market-risk rule was an important

addition to the definition of trading account. Some expressed the view

that it should include all market risk capital rule covered positions

and not just those requiring short-term trading intent.\121\

---------------------------------------------------------------------------

\117\ See Sens. Merkley & Levin (Feb. 2012); Occupy.

\118\ See, e.g., Public Citizen.

\119\ See AFR et al. (Feb. 2012).

\120\ See Alfred Brock.

\121\ See AFR et al. (Feb. 2012).

---------------------------------------------------------------------------

Certain commenters proposed alternate definitions. Several

commenters argued against using the term ``account'' and instead

advocated applying the prohibition on proprietary trading to trading

positions.\122\ Foreign banks recommended applying the definition of

trading account applicable to such banks in their home country, if the

home country provided a clear definition of this term.\123\ These

commenters argued that new definitions in the proposed rule, like

trading account, would require foreign banking entities to develop new

and complex procedures and expensive systems.\124\

---------------------------------------------------------------------------

\122\ See ABA (Keating); Goldman (Prop. Trading); NAIB et al.

\123\ See Japanese Bankers Ass'n.; Norinchukin.

\124\ See Japanese Bankers Ass'n.

---------------------------------------------------------------------------

Commenters also argued that various types of trading activities

should be excluded from the trading account definition. For example,

one commenter asserted that arbitrage trading should not be considered

trading account activity,\125\ while other commenters argued that

arbitrage positions and strategies are proprietary trading and should

be included in the definition of trading account and prohibited by the

final rule.\126\ Another commenter argued that the trading account

should include only positions primarily intended, when the position is

entered into, to profit from short-term changes in the value of the

assets, and that liquidity investments that do not have price changes

and that can be sold whenever the banking entity needs cash should be

excluded from the trading account definition.\127\

---------------------------------------------------------------------------

\125\ See Alfred Brock.

\126\ See AFR et al. (Feb. 2012); Paul Volcker.

\127\ See NAIB et al. See infra Part VI.A.1.d.2. (discussing the

liquidity management exclusion).

---------------------------------------------------------------------------

After carefully reviewing the comments, the Agencies have

determined to retain in the final rule the proposed approach for

defining trading account that includes the short-term, market risk

rule, and dealer trading accounts with modifications to address issues

raised by commenters. The Agencies believe that this multi-prong

approach is consistent with both the language and intent of section 13

of the BHC Act, including the express statutory authority to include

``any such other account'' as determined by the Agencies.\128\ The

final definition effectuates Congress's purpose to generally focus on

short-term trading while addressing commenters' desire for greater

certainty regarding the definition of the trading account.\129\ In

addition, the Agencies believe commenters' concerns about the scope of

the proposed definition of trading account are substantially addressed

by the refined exemptions in the final rule for customer-oriented

activities, such as market making-related activities, and the

exclusions from proprietary trading.\130\ Moreover, the Agencies

believe that it is appropriate to focus on the economics of a banking

entity's trading activity to help determine whether it is engaged in

proprietary trading, as discussed further below.\131\

---------------------------------------------------------------------------

\128\ 12 U.S.C. 1851(h)(6).

\129\ In response to commenters' concerns about the meaning of

account, the Agencies note the term ``trading account'' is a

statutory concept and does not necessarily refer to an actual

account. Trading account is simply nomenclature for the set of

transactions that are subject to the final rule's restrictions on

proprietary trading. See ABA (Keating); Goldman (Prop. Trading);

NAIB et al.

\130\ For example, several commenters' concerns about the

potential impact of the proposed definition of trading account were

tied to the perceived narrowness of the proposed exemptions. See ABA

(Keating); Ass'n. of Institutional Investors (Feb. 2012); BoA;

Capital Group; IAA; Credit Suisse (Seidel); ICI (Feb. 2012); ISDA

(Feb. 2012); NAIB et al.; SIFMA et al. (Prop. Trading) (Feb. 2012);

SVB; Wellington.

\131\ See Sens. Merkley & Levin (Feb. 2012). However, as

discussed in this SUPPLEMENTARY INFORMATION, the Agencies are not

prohibiting any trading that involves profiting from changes in the

value of the asset, as suggested by this commenter, because

permitted activities, such as market making, can involve price

appreciation-related revenues. See infra Part VI.A.3. (discussing

the final market-making exemption).

---------------------------------------------------------------------------

As explained above, the short-term trading prong of the definition

largely incorporates the statutory provisions. This prong covers

trading involving short-term resale, price movements, and arbitrage

profits, and hedging positions that result from these activities.

Specifically, the reference to short-term resale is taken from the

statute's definition of trading account. The Agencies continue to

believe it is also appropriate to include in the short-term trading

prong an account that is used by a banking entity to purchase or sell

one or more financial instruments principally for the purpose of

benefitting from actual or expected short-term price movements,

realizing short-term arbitrage profits, or hedging one or more

positions captured by the short-term trading prong. The provisions

regarding price movements and arbitrage focus on the intent to engage

in transactions to benefit from short-term price movements (e.g.,

entering into a subsequent transaction in the near term to offset or

close out, rather than sell, the risks of a position held by the

banking entity to benefit from a price movement occurring between the

acquisition of the underlying position and the subsequent offsetting

transaction) or to benefit from differences in multiple market prices,

including scenarios where movement in those prices is not necessary to

realize the intended profit.\132\ These types of transactions are

economically equivalent to transactions that are principally for the

purpose of selling in the near term or with the intent to resell to

profit from short-term price movements, which are expressly covered by

the statute's definition of trading account. Thus, the Agencies believe

it is necessary to include these provisions in the final rule's short-

term trading prong to provide clarity about the scope of the definition

and to prevent evasion of the statute and final rule.\133\ In addition,

like the proposed rule, the final rule's short-term trading prong

includes hedging one or more of the positions captured by this prong

because the Agencies assume that a banking entity generally intends to

hold the hedging position for only so long as the underlying position

is held.

---------------------------------------------------------------------------

\132\ See Joint Proposal, 76 FR at 68857-68858.

\133\ As a result, the Agencies are not excluding arbitrage

trading from the trading account definition, as suggested by at

least one commenter. See, e.g., Alfred Brock.

---------------------------------------------------------------------------

The remaining two prongs to the trading account definition apply to

types of entities that engage actively in trading activities. Each

prong focuses on analogous or parallel short-term trading activities. A

few commenters stated these prongs were duplicative of the short-term

trading prong, and argued the Agencies should not include these prongs

in the definition of trading

[[Page 5821]]

account, or should only consider them as non-determinative

factors.\134\ To the extent that an overlap exists between the prongs

of this definition, the Agencies believe they are mutually reinforcing,

strengthen the rule's effectiveness, and may help simplify the analysis

of whether a purchase or sale is conducted for the trading

account.\135\

---------------------------------------------------------------------------

\134\ See ISDA (Feb. 2012); JPMC; ABA (Keating); BoA; SIFMA et

al. (Prop. Trading) (Feb. 2012).

\135\ See Occupy.

---------------------------------------------------------------------------

The market risk capital prong covers trading positions that are

covered positions for purposes of the banking agency market-risk

capital rules, as well as hedges of those positions. Trading positions

under those rules are positions held by the covered entity ``for the

purpose of short-term resale or with the intent of benefitting from

actual or expected short-term price movements, or to lock-in arbitrage

profits.'' \136\ This definition largely parallels the provisions of

section 13(h)(4) of the BHC Act and mirrors the short-term trading

account prong of both the proposed and final rules. Covered positions

are trading positions under the rule that subject the covered entity to

risks and exposures that must be actively managed and limited--a

requirement consistent with the purposes of the section 13 of the BHC

Act.

---------------------------------------------------------------------------

\136\ 12 CFR 225, Appendix E.

---------------------------------------------------------------------------

Incorporating this prong into the trading account definition

reinforces the consistency between governance of the types of positions

that banking entities identify as ``trading'' for purposes of the

market risk capital rules and those that are trading for purposes of

the final rule under section 13 of the BHC Act. Moreover, this aspect

of the final rule reduces the compliance burden on banking entities

with substantial trading activities by establishing a clear, bright-

line rule for determining that a trade is within the trading

account.\137\

---------------------------------------------------------------------------

\137\ Accordingly, the Agencies are not using a position's

capital treatment as merely an indicative factor, as suggested by a

few commenters.

---------------------------------------------------------------------------

After reviewing comments, the Agencies also continue to believe

that financial instruments purchased or sold by registered dealers in

connection with their dealing activity are generally held with short-

term intent and should be captured within the trading account. The

Agencies believe the scope of the dealer prong is appropriate because,

as noted in the proposal, positions held by a registered dealer in

connection with its 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), which is

indicative of short-term intent.\138\ Moreover, the final rule includes

a number of exemptions for the activities in which securities dealers,

swap dealers, and security-based swap dealers typically engage, such as

market making, hedging, and underwriting. Thus, the Agencies believe

the broad scope of the dealer trading account is balanced by the

exemptions that are designed to permit dealer entities to continue to

engage in customer-oriented trading activities, consistent with the

statute. This approach is designed to ensure that registered dealer

entities are engaged in permitted trading activities, rather than

prohibited proprietary trading.

---------------------------------------------------------------------------

\138\ See Joint Proposal, 76 FR at 68860.

---------------------------------------------------------------------------

The final rule adopts the dealer trading account substantially as

proposed,\139\ with streamlining that eliminates the specific

references to different types of securities and derivatives dealers.

The final rule adopts the proposed approach to covering trading

accounts of banking entities that regularly engage in the business of a

dealer, swap dealer, or security-based swap dealer outside of the

United States. In the case of both domestic and foreign entities, this

provision applies only to financial instruments purchased or sold in

connection with the activities that require the banking entity to be

licensed or registered to engage in the business of dealing, which is

not necessarily all of the activities of that banking entity.\140\

Activities of a banking entity that are not covered by the dealer prong

may, however, be covered by the short-term or market risk rule trading

accounts if the purchase or sale satisfies the requirements of

Sec. Sec. 75.3(b)(1)(i) or (ii).\141\

---------------------------------------------------------------------------

\139\ See final rule Sec. 75.3(b)(1)(iii).

\140\ An insured depository institution may be registered as a

swap dealer, but only the swap dealing activities that require it to

be so registered are covered by the dealer trading account. If an

insured depository institution purchases or sells a financial

instrument in connection with 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, the financial instrument is included in the

trading account only if the instrument falls within the statutory

trading account under Sec. 75.3(b)(1)(i) or the market risk rule

trading account under Sec. 75.3(b)(1)(ii) of the final rule.

\141\ See final rule Sec. Sec. 75.3(b)(1)(i) and (ii).

---------------------------------------------------------------------------

A few commenters stated that they do not currently analyze whether

a particular activity would require dealer registration, so the dealer

prong of the trading account definition would require banking entities

to engage in a new type of analysis.\142\ The Agencies recognize that

banking entities that are registered dealers may not currently engage

in such an analysis with respect to their current trading activities

and, thus, this may represent a new regulatory requirement for these

entities. If the regulatory analysis otherwise engaged in by banking

entities is substantially similar to the dealer prong analysis required

under the trading account definition, then any increased compliance

burden could be small or insubstantial.\143\

---------------------------------------------------------------------------

\142\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Goldman (Prop. Trading).

\143\ See, e.g., Goldman (Prop. Trading) (``For instance, a

banking entity's market making-related activities with respect to

credit trading may involve making a market in bonds (traded in a

broker-dealer), single-name CDSs (in a security-based swap dealer)

and CDS indexes (in a swap dealer). For regulatory or other reasons,

these transactions could take place in different legal entities . .

.'').

---------------------------------------------------------------------------

In response to commenters' concerns regarding the application of

this prong to banking entities acting as dealers in jurisdictions

outside the United States,\144\ the Agencies continue to believe

including the activities of a banking entity engaged in the business of

a dealer, swap dealer, or security-based swap dealer outside of the

United States, to the extent the instrument is purchased or sold in

connection with the activities of such business, is appropriate. As

noted above, dealer activity generally involves short-term trading.

Further, the Agencies are concerned that differing requirements for

U.S. and foreign dealers may lead to regulatory arbitrage. For foreign

banking entities acting as dealers outside of the United States that

are eligible for the exemption for trading conducted by foreign banking

entities, the Agencies believe the risk-based approach to this

exemption in the final rule should help address the concerns about the

scope of this prong of the definition.\145\

---------------------------------------------------------------------------

\144\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; Allen

& Overy (on behalf of Large Int'l Banks with U.S. Operations).

\145\ See final rule Sec. 75.6(e).

---------------------------------------------------------------------------

In response to one commenter's suggestion that the Agencies define

the term trading account to allow a foreign banking entity to use of

the relevant foreign regulator's definition of this term, where

available, the Agencies are concerned such an approach could lead to

regulatory arbitrage and otherwise inconsistent applications of the

rule.\146\ The Agencies believe this commenter's general concern about

the impact of the statute and rule on foreign banking entities'

activities outside the United States should be substantially addressed

by the exemption for trading conducted by foreign banking entities

under Sec. 75.6(e) of the final rule.

---------------------------------------------------------------------------

\146\ See Japanese Bankers Ass'n.

---------------------------------------------------------------------------

[[Page 5822]]

Finally, the Agencies have declined to adopt one commenter's

recommendation that a position in a financial instrument be considered

a trading account position only if it qualifies as a GAAP trading

position.\147\ The Agencies continue to believe that formally

incorporating accounting standards governing trading securities is not

appropriate because: (i) The statutory proprietary trading provisions

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

securities; and (iii) these accounting standards could change in the

future without consideration of the potential impact on section 13 of

the BHC Act and these rules.\148\

---------------------------------------------------------------------------

\147\ See ABA (Keating).

\148\ See Joint Proposal, 76 FR at 68859.

---------------------------------------------------------------------------

b. Rebuttable Presumption for the Short-Term Trading Account

The proposed rule included a rebuttable presumption clarifying when

a covered financial position, by reason of its holding period, is

traded with short-term intent for purposes of the short-term trading

account. The Agencies proposed this presumption primarily to provide

guidance to banking entities that are not subject to the market risk

capital rules or are not covered dealers or swap entities and

accordingly may not have experience evaluating short-term trading

intent. In particular, Sec. 75.3(b)(2)(ii) of the proposed rule

provided that an account would be presumed to be a short-term trading

account if it was used to acquire or take a covered financial position

that the banking entity held for a period of 60 days or less.

Several commenters supported the rebuttable presumption, but

suggested either shortening the holding period to 30 days or less,\149\

or extending the period to 90 days,\150\ to several months,\151\ or to

one year.\152\ Some of these commenters argued that specifying an

overly short holding period would be contrary to the statute, invite

gamesmanship,\153\ and miss speculative positions held for longer than

the specified period.\154\ Commenters also suggested turning the

presumption into a safe harbor \155\ or into guidance.\156\

---------------------------------------------------------------------------

\149\ See Japanese Bankers Ass'n.

\150\ See Capital Group.

\151\ See AFR et al. (Feb. 2012).

\152\ See Sens. Merkley & Levin (Feb. 2012); Public Citizen

(arguing that one-year demarks tax law covering short term capital

gains).

\153\ See Sens. Merkley & Levin (Feb. 2012).

\154\ See Occupy.

\155\ See Capital Group.

\156\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

---------------------------------------------------------------------------

Other commenters opposed the inclusion of the rebuttable

presumption for a number of reasons and requested that it be

removed.\157\ For example, these commenters argued that the presumption

had no statutory basis; \158\ was arbitrary; \159\ was not supported by

data, facts, or analysis; \160\ would dampen market-making and

underwriting activity; \161\ or did not take into account the nature of

trading in different types of securities.\162\ Some commenters also

questioned whether the Agencies would interpret rebuttals of the

presumption consistently,\163\ and stressed the difficulty and

costliness of rebutting the presumption,\164\ such as enhanced

documentation or other administrative burdens.\165\ One foreign banking

association also argued that requiring foreign banking entities to

rebut a U.S. regulatory requirement would be costly and inappropriate

given that the trading activities of the banking entity are already

reviewed by home country supervisors.\166\ This commenter also

contended that the presumption could be problematic for financial

instruments purchased for long-term investment purposes that are closed

within 60 days due to market fluctuations or other changed

circumstances.\167\

---------------------------------------------------------------------------

\157\ See ABA (Keating); Am. Express; Business Roundtable;

Capital Group; ICI (Feb. 2012); Investure; JPMC; Liberty Global;

STANY; Chamber (Feb. 2012).

\158\ See ABA (Keating); JPMC; Chamber (Feb. 2012).

\159\ See Am. Express; ICI (Feb. 2012).

\160\ See ABA (Keating); Chamber (Feb. 2012).

\161\ See AllianceBernstein; Business Roundtable; ICI (Feb.

2012); Investure; Liberty Global; STANY. Because the rebuttable

presumption does not impact the availability of the exemptions for

underwriting, market making, and other permitted activities, the

Agencies do not believe this provision creates any additional

burdens on permissible activities.

\162\ See Am. Express (noting that most foreign exchange forward

transactions settle in less than one week and are used as commercial

payment instruments, and not speculative trades); Capital Group.

\163\ See ABA (Keating). As discussed below in Part VI.C., the

Agencies expect to continue to coordinate their supervisory efforts

related to section 13 of the BHC Act and to share information as

appropriate in order to effectively implement the requirements of

that section and the final rule.

\164\ See ABA (Keating); AllianceBernstein; Capital Group;

Japanese Bankers Ass'n.; Liberty Global; JPMC.

\165\ See NAIB et al.; Capital Group.

\166\ See Japanese Bankers Ass'n. As noted above, the Agencies

believe concerns about the impacts of the definition of trading

account on foreign banking entity trading activity outside of the

United States are substantially addressed by the final rule's

exemption for proprietary trading conducted by foreign banking

entities in final rule Sec. 75.6(e).

\167\ Id.

---------------------------------------------------------------------------

After carefully considering the comments received, the Agencies

continue to believe the rebuttable presumption is appropriate to

generally define the meaning of ``short-term'' for purposes of the

short-term trading account, especially for small and regional banking

entities that are not subject to the market risk capital rules and are

not registered dealers or swap entities. The range of comments the

Agencies received on what ``short-term'' should mean--from 30 days to

one year--suggests that a clear presumption would ensure consistency in

interpretation and create a level playing field for all banking

entities with covered trading activities subject to the short-term

trading account. Based on their supervisory experience, the Agencies

find that 60 days is an appropriate cut off for a regulatory

presumption.\168\ Further, because the purpose of the rebuttable

presumption is to simplify the process of evaluating whether individual

positions are included in the trading account, the Agencies believe

that implementing different holding periods based on the type of

financial instrument would insert unnecessary complexity into the

presumption.\169\ The Agencies are not providing a safe harbor or a

reverse presumption (i.e., a presumption for positions that are outside

of the trading account), as suggested by some commenters, in

recognition that some proprietary trading could occur outside of the 60

day period.\170\

---------------------------------------------------------------------------

\168\ See final rule Sec. 75.3(b)(2). Commenters did not

provide persuasive evidence of the benefits associated with a

rebuttable presumption for positions held for greater or fewer than

60 days.

\169\ See, e.g., Am. Express; Capital Group; Sens. Merkley &

Levin (Feb. 2012).

\170\ See Capital Group; AFR et al. (Feb. 2012); Sens. Merkley &

Levin (Feb. 2012); Public Citizen; Occupy.

---------------------------------------------------------------------------

Adopting a presumption allows the Agencies and affected banking

entities to evaluate all the facts and circumstances surrounding

trading activity in determining whether the activity implicates the

purpose of the statute. For example, trading in a financial instrument

for long-term investment that is disposed of within 60 days because of

unexpected developments (e.g., an unexpected increase in the financial

instrument's volatility or a need to liquidate the instrument to meet

unexpected liquidity demands) may not be trading activity covered by

the statute. To reduce the costs and burdens of rebutting the

[[Page 5823]]

presumption, the Agencies will allow a banking entity to rebut the

presumption for a group of related positions.\171\

---------------------------------------------------------------------------

\171\ The Agencies believe this should help address commenters'

concerns about the burdens associated with rebutting the

presumption. See ABA (Keating); AllianceBernstein; Capital Group;

Japanese Bankers Ass'n.; Liberty Global; JPMC; NAIB et al.; Capital

Group.

---------------------------------------------------------------------------

The final rule provides three clarifying changes to the proposed

rebuttable presumption. First, in response to comments, the final rule

replaces the reference to an ``account'' that is presumed to be a

trading account with the purchase or sale of a ``financial

instrument.'' \172\ This change clarifies that the presumption only

applies to the purchase or sale of a financial instrument that is held

for fewer than 60 days, and not the entire account that is used to make

the purchase or sale. Second, the final rule clarifies that basis

trades, in which a banking entity buys one instrument and sells a

substantially similar instrument (or otherwise transfers the first

instrument's risk), are subject to the rebuttable presumption.\173\

Third, in order to maintain consistency with definitions used

throughout the final rule, the references to ``acquire'' or ``take'' a

financial position have been replaced with references to ``purchase''

or ``sell'' a financial instrument.\174\

---------------------------------------------------------------------------

\172\ See, e.g., ABA (Keating); Clearing House Ass'n.; JPMC.

\173\ The rebuttable presumption covered these trades in the

proposal, but the final rule's use of ``financial instrument''

rather than ``covered financial position'' necessitated clarifying

this point in the rule text. See final rule Sec. 75.3(b)(2). See

also Public Citizen.

\174\ The Agencies do not believe these revisions have a

substantive effect on the operation or scope of the final rule in

comparison to the statute or proposed rule.

---------------------------------------------------------------------------

c. Definition of ``Financial Instrument''

Section 13 of the BHC Act generally prohibits proprietary trading,

which is defined in section 13(h)(4) to mean engaging as principal for

the trading account in any purchase or sale of any security, any

derivative, any contract of sale of a commodity for future delivery,

any option on any such security, derivative, or contract, or any other

security or financial instruments that the Agencies may, by rule,

determine.\175\ The proposed rule defined the term ``covered financial

position'' to reference the instruments listed in section 13(h)(4),

including: (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.\176\ To provide additional clarity, the proposed rule also

provided that, consistent with the statute, any position that is itself

a loan, a commodity, or foreign exchange or currency was not a covered

financial position.\177\

---------------------------------------------------------------------------

\175\ See 12 U.S.C. 1851(h)(4).

\176\ See proposed rule Sec. 75.3(c)(3)(i).

\177\ See proposed rule Sec. 75.3(c)(3)(ii).

---------------------------------------------------------------------------

The proposal also defined a number of other terms used in the

definition of covered financial position, including commodity,

derivative, loan, and security.\178\ These terms were generally defined

by reference to the Federal securities laws or the Commodity Exchange

Act because these existing definitions are generally well-understood by

market participants and have been subject to extensive interpretation

in the context of securities, commodities, and derivatives trading.

---------------------------------------------------------------------------

\178\ See proposed rule Sec. 75.2(l), (q), (w); Sec.

75.3(c)(1) and (2).

---------------------------------------------------------------------------

As noted above, the proposed rule included derivatives within the

definition of covered financial position. Derivative was defined to

include any swap (as that term is defined in the Commodity Exchange

Act) and 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.\179\

The proposed rule also included 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 purpose of section 13 of the BHC Act.

Specifically, the proposed definition also included: (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); \180\ (iii) any agreement, contract, or

transaction in foreign currency described in section 2(c)(2)(C)(i) of

the Commodity Exchange Act; \181\ (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; \182\ and (v) any

transactions authorized under section 19 of the Commodity Exchange

Act.\183\ In addition, the proposed rule excluded from the definition

of derivative (i) 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 or security-based swap, and (ii) 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)).

---------------------------------------------------------------------------

\179\ See 7 U.S.C. 1a(47) (defining ``swap''); 15 U.S.C.

78c(a)(68) (defining ``security-based swap'').

\180\ 7 U.S.C. 1a(24), (25).

\181\ 7 U.S.C. 2(c)(2)(C)(i).

\182\ 7 U.S.C. 2(c)(2)(D)(i).

\183\ 7 U.S.C. 23.

---------------------------------------------------------------------------

Commenters expressed a variety of views regarding the definition of

covered financial position, as well as other defined terms used in that

definition. For instance, some commenters argued that the definition

should be expanded to include transactions in spot commodities or

foreign currency, even though those instruments are not included by the

statute.\184\ Other commenters strongly supported the exclusion of spot

commodity and foreign currency transactions as consistent with the

statute, arguing that these instruments are part of the traditional

business of banking and do not represent the types of instruments that

Congress designed section 13 to address. These commenters argued that

including spot commodities and foreign exchange within the definition

of covered financial position in the final rule would put U.S. banking

entities at a competitive disadvantage and prevent them from conducting

routine banking operations.\185\ One commenter argued that the proposed

definition of covered financial position was effective and recommended

that the definition should not be expanded.\186\ Another commenter

argued that an instrument be considered to be a spot foreign exchange

transaction, and thus not a covered financial position, if it settles

within 5 days of purchase.\187\ Another commenter argued that covered

financial positions used in interaffiliate transactions should

expressly be excluded because they are used for

[[Page 5824]]

internal risk management purposes and not for proprietary trading.\188\

---------------------------------------------------------------------------

\184\ See Sens. Merkley & Levin (Feb. 2012); Public Citizen;

Occupy.

\185\ See Northern Trust; Morgan Stanley; JPMC; Credit Suisse

(Seidel); Am. Express; see also AFR et al. (Feb. 2012) (arguing that

the final rule should explicitly exclude ``spot'' commodities and

foreign exchange).

\186\ See Alfred Brock.

\187\ See Credit Suisse (Seidel).

\188\ See GE (Feb. 2012).

---------------------------------------------------------------------------

Some commenters requested that the final rule exclude additional

instruments from the definition of covered financial position. For

instance, some commenters requested that the Agencies exclude commodity

and foreign exchange futures, forwards, and swaps, arguing that these

instruments typically have a commercial and not financial purpose and

that making them subject to the prohibitions of section 13 would

negatively affect the spot market for these instruments.\189\ A few

commenters also argued that foreign exchange swaps and forwards are

used in many jurisdictions to provide U.S. dollar-funding for foreign

banking entities and that these instruments should be excluded since

they contribute to the stability and liquidity of the market for spot

foreign exchange.\190\ Other commenters contended that foreign exchange

swaps and forwards should be excluded because they are an integral part

of banking entities' ability to provide trust and custody services to

customers and are necessary to enable banking entities to deal in the

exchange of currencies for customers.\191\

---------------------------------------------------------------------------

\189\ See JPMC; BoA; Citigroup (Feb. 2012).

\190\ See Govt. of Japan/Bank of Japan; Japanese Bankers Ass'n.;

see also Norinchukin.

\191\ See Northern Trust; Citigroup (Feb. 2012).

---------------------------------------------------------------------------

One commenter argued that the inclusion of certain instruments

within the definition of derivative, such as purchases or sales of

nonfinancial commodities for deferred shipment or delivery that are

intended to be physically settled, was inappropriate.\192\ This

commenter alleged that these instruments are not derivatives but should

instead be viewed as contracts for purchase of specific commodities to

be delivered at a future date. This commenter also argued that the

Agencies do not have authority under section 13 to include these

instruments as ``other securities or financial instruments'' subject to

the prohibition on proprietary trading.\193\

---------------------------------------------------------------------------

\192\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\193\ See id.

---------------------------------------------------------------------------

Some commenters also argued that, because the CFTC and SEC had not

yet finalized their definitions of swap and security-based swap, it was

inappropriate to use those definitions as part of the proposed

definition of derivative.\194\ One commenter argued that the definition

of derivative was effective, although this commenter argued that the

final rule should not cross-reference the definition of swap and

security-based swap under the Federal commodities and securities

laws.\195\

---------------------------------------------------------------------------

\194\ See SIFMA et al. (Prop. Trading) (Feb. 2012); ISDA (Feb.

2012).

\195\ See Alfred Brock.

---------------------------------------------------------------------------

After carefully considering the comments received on the proposal,

the final rule continues to apply the prohibition on proprietary

trading to the same types of instruments as listed in the statute and

the proposal, which the final rule defines as ``financial instrument.''

Under the final rule, a financial instrument is defined as: (i) A

security, including an option on a security; \196\ (ii) a derivative,

including an option on a derivative; or (iii) a contract of sale of a

commodity for future delivery, or option on a contract of sale of a

commodity for future delivery.\197\ The final rule excludes from the

definition of financial instrument: (i) A loan; \198\ (ii) a commodity

that is not an excluded commodity (other than foreign exchange or

currency), a derivative, a contract of sale of a commodity for future

delivery, or an option on a contract of sale of a commodity for future

delivery; or (iii) foreign exchange or currency.\199\ An excluded

commodity is defined to have the same meaning as in section 1a(19) of

the Commodity Exchange Act.

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\196\ The definition of security under the final rule is the

same as under the proposal. See final rule Sec. 75.2(y).

\197\ See final rule Sec. 75.3(c)(1).

\198\ The definition of loan, as well as comments received

regarding that definition, is discussed in detail below in Part

VI.B.1.c.8.a.

\199\ See final rule Sec. 75.3(c)(2).

---------------------------------------------------------------------------

The Agencies continue to believe that these instruments and

transactions, which are consistent with those referenced in section

13(h)(4) of the BHC Act as part of the statutory definition of

proprietary trading, represent the type of financial instruments which

the proprietary trading prohibition of section 13 was designed to

cover. While some commenters requested that this definition be expanded

to include spot transactions \200\ or loans,\201\ the Agencies do not

believe that it is appropriate at this time to expand the scope of

instruments subject to the ban on proprietary trading.\202\ Similarly,

while some commenters requested that certain other instruments, such as

foreign exchange swaps and forwards, be excluded from the definition of

financial instrument,\203\ the Agencies believe that these instruments

appear to be, or operate in economic substance as, derivatives (which

are by statute included within the scope of instruments subject to the

prohibitions of section 13). If these instruments were not included

within the definition of financial instrument, banking entities could

use them to engage in proprietary trading that is inconsistent with the

purpose and design of section 13 of the BHC Act.

---------------------------------------------------------------------------

\200\ See Sens. Merkley & Levin (Feb. 2012); Public Citizen;

Occupy.

\201\ See Occupy.

\202\ Several commenters supported the exclusion of spot

commodity and foreign currency transactions as consistent with the

statute. See Northern Trust; Morgan Stanley; State Street (Feb.

2012); JPMC; Credit Suisse (Seidel); Am. Express; see also AFR et

al. (Feb. 2012) (arguing that the final rule should explicitly

exclude ``spot'' commodities and foreign exchange). One commenter

stated that the proposed definition should not be expanded. See

Alfred Brock. With respect to the exclusion for loans, the Agencies

note this is generally consistent with the rule of statutory

construction regarding the sale and securitization of loans. See 12

U.S.C. 1851(g)(2).

\203\ See JPMC; BAC; Citigroup (Feb. 2012); Govt. of Japan/Bank

of Japan; Japanese Bankers Ass'n.; Northern Trust; see also

Norinchukin.

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As under the proposal, loans, commodities, and foreign exchange or

currency are not included within the scope of instruments subject to

section 13. The exclusion of these types of instruments is intended to

eliminate potential confusion by making clear that the purchase and

sale of loans, commodities, and foreign exchange or currency--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. 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 qualify for the exclusion.

The final rule also adopts the definitions of security and

derivative as proposed.\204\ These definitions, which reference

existing definitions under the Federal securities and commodities laws,

are generally well-understood by market participants and have been

subject to extensive interpretation in the context of securities and

commodities trading activities. While some commenters argued that it

would be inappropriate to use the definition of swap and security-based

swap because those terms had not yet been finalized pursuant to public

notice and comment,\205\ the CFTC and SEC have subsequently finalized

those definitions after receiving extensive public comment on the

rulemakings.\206\ The

[[Page 5825]]

Agencies believe that this notice and comment process provided adequate

opportunity for market participants to comment on and understand those

terms, and as such they are incorporated in the definition of

derivative under this final rule.

---------------------------------------------------------------------------

\204\ See final rule Sec. 75.2(h), (y).

\205\ See SIFMA et al. (Prop. Trading) (Feb. 2012); ISDA (Feb.

2012).

\206\ See CFTC and SEC, Further Definition of ``Swap,''

``Security-Based Swap,'' and ``Security-Based Swap Agreement'';

Mixed swaps; Security Based Swap Agreement Recordkeeping, 78 FR

48208 (Aug. 13, 2012).

---------------------------------------------------------------------------

While some commenters requested that foreign exchange swaps and

forwards be excluded from the definition of derivative or financial

instrument, the Agencies have not done so for the reasons discussed

above. However, as explained below in Part VI.A.1.d., the Agencies note

that to the extent a banking entity purchases or sells a foreign

exchange forward or swap, or any other financial instrument, in a

manner that meets an exclusion from proprietary trading, that

transaction would not be considered to be proprietary trading and thus

would not be subject to the requirements of section 13 of the BHC Act

and the final rule. This includes, for instance, the purchase or sale

of a financial instrument by a banking entity acting solely as agent,

broker, or custodian, or the purchase or sale of a security as part of

a bona fide liquidity management plan.

d. Proprietary Trading Exclusions

The proposed rule contained four exclusions from the definition of

trading account for categories of transactions that do not fall within

the scope of section 13 of the BHC Act because they do not involve

short-term trading activities subject to the statutory prohibition on

proprietary trading. These exclusions covered the purchase or sale of a

financial instrument under certain repurchase and reverse repurchase

agreements and securities lending arrangements, for bona fide liquidity

management purposes, and by a clearing agency or derivatives clearing

organization in connection with clearing activities.

As discussed below, the final rule provides exclusions for the

purchase or sale of a financial instrument under certain repurchase and

reverse repurchase agreements and securities lending agreements; for

bona fide liquidity management purposes; by certain clearing agencies,

derivatives clearing organizations in connection with clearing

activities; by a member of a clearing agency, derivatives clearing

organization, or designated financial market utility engaged in

excluded clearing activities; to satisfy existing delivery obligations;

to satisfy an obligation of the banking entity in connection with a

judicial, administrative, self-regulatory organization, or arbitration

proceeding; solely as broker, agent, or custodian; through a deferred

compensation or similar plan; and to satisfy a debt previously

contracted. After considering comments on these issues, which are

discussed in more detail below, the Agencies believe that providing

clarifying exclusions for these non-proprietary activities will likely

promote more cost-effective financial intermediation and robust capital

formation. Overly narrow exclusions for these activities would

potentially increase the cost of core banking services, while overly

broad exclusions would increase the risk of allowing the types of

trades the statute was designed to prohibit. The Agencies considered

these issues in determining the appropriate scope of these exclusions.

Because the Agencies do not believe these excluded activities involve

proprietary trading, as defined by the statute and the final rule, the

Agencies do not believe it is necessary to use our exemptive authority

in section 13(d)(1)(J) of the BHC Act to deem these activities a form

of permitted proprietary trading.

1. Repurchase and Reverse Repurchase Arrangements and Securities

Lending

The proposed rule's definition of trading account excluded an

account used to acquire or take one or more covered financial positions

that arise under (i) a repurchase or reverse repurchase agreement

pursuant to which the banking entity had 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,\207\ or (ii) 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.\208\ Positions held under

these agreements operate in economic substance as a secured loan and

are not based on expected or anticipated movements in asset prices.

Accordingly, these types of transactions do not appear to be of the

type the statutory definition of trading account was designed to

cover.\209\

---------------------------------------------------------------------------

\207\ See proposed rule Sec. 75.3(b)(2)(iii)(A).

\208\ See proposed rule Sec. 75.3(b)(2)(iii)(B). The language

that described securities lending transactions in the proposed rule

generally mirrored that contained in Rule 3a5-3 under the Exchange

Act. See 17 CFR 240.3a5-3.

\209\ See Joint Proposal, 76 FR at 68862.

---------------------------------------------------------------------------

Several commenters expressed support for these exclusions and

requested that the Agencies expand them.\210\ For example, one

commenter requested clarification that all types of repurchase

transactions qualify for the exclusion.\211\ Some commenters requested

expanding this exclusion to cover all positions financed by, or

transactions related to, repurchase and reverse repurchase

agreements.\212\ Other commenters requested that the exclusion apply to

all transactions that are analogous to extensions of credit and are not

based on expected or anticipated movements in asset prices, arguing

that the exclusion would be too limited in scope to achieve its

objective if it is based on the legal form of the underlying

contract.\213\ Additionally, some commenters suggested expanding the

exclusion to cover transactions that are for funding purposes,

including prime brokerage transactions, or for the purpose of asset-

liability management.\214\ Commenters also recommended expanding the

exclusion to include re-hypothecation of customer securities, which can

produce financing structures that, like a repurchase agreement, are

functionally loans.\215\

---------------------------------------------------------------------------

\210\ See generally ABA (Keating); Alfred Brock; Citigroup (Feb.

2012); GE (Feb. 2012); Goldman (Prop. Trading); ICBA; Japanese

Bankers Ass'n.; JPMC; Norinchukin; RBC; RMA; SIFMA et al. (Prop.

Trading) (Feb. 2012); State Street (Feb. 2012); T. Rowe Price; UBS;

Wells Fargo (Prop. Trading). See infra Part VI.A.d.10. for the

discussion of commenters' requests for additional exclusions from

the trading account.

\211\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\212\ See FIA; SIFMA et al. (Prop. Trading) (Feb. 2012).

\213\ See Goldman (Prop. Trading); JPMC; UBS.

\214\ See Goldman (Prop. Trading); UBS. For example, one

commenter suggested that fully collateralized swap transactions

should be exempted from the definition of trading account because

they serve as funding transactions and are economically similar to

repurchase agreements. See SIFMA et al. (Prop. Trading) (Feb. 2012).

\215\ See Goldman (Prop. Trading).

---------------------------------------------------------------------------

In contrast, other commenters argued that there was no statutory or

policy justification for excluding repurchase and reverse repurchase

agreements from the trading account, and requested that this exclusion

be removed from the final rule.\216\ Some of these commenters argued

that repurchase agreements could be used for prohibited proprietary

trading \217\ and suggested that, if repurchase agreements are excluded

from the trading account, documentation detailing the use of liquidity

derived from repurchase agreements should be required.\218\ These

[[Page 5826]]

commenters suggested that unless the liquidity is used to secure a

position for a willing customer, repurchase agreements should be

regarded as a strong indicator of proprietary trading.\219\ As an

alternative, commenters suggested that the Agencies instead use their

exemptive authority pursuant to section 13(d)(1)(J) of the BHC Act to

permit repurchase and reverse repurchase transactions so that such

transactions must comply with the statutory limits on material

conflicts of interests and high-risks assets and trading strategies,

and compliance requirements under the final rule.\220\ These commenters

urged the Agencies to specify permissible collateral types, haircuts,

and contract terms for securities lending agreements and require that

the investment of proceeds from securities lending transactions be

limited to high-quality liquid assets in order to limit potential risks

of these activities.\221\

---------------------------------------------------------------------------

\216\ See AFR et al. (Feb. 2012); Occupy; Public Citizen; Sens.

Merkley & Levin (Feb. 2012).

\217\ See AFR et al. (Feb. 2012).

\218\ See Public Citizen.

\219\ See Public Citizen.

\220\ See AFR et al. (Feb. 2012); Occupy.

\221\ See AFR et al. (Feb. 2012); Occupy.

---------------------------------------------------------------------------

After considering the comments received, the Agencies have

determined to exclude repurchase and reverse repurchase agreements and

securities lending agreements from the definition of proprietary

trading under the final rule. The final rule defines these terms

subject to the same conditions as were in the proposal. This

determination recognizes that repurchase and reverse repurchase

agreements and securities lending agreements excluded from the

definition operate in economic substance as secured loans and do not in

normal practice represent proprietary trading.\222\ The Agencies will,

however, monitor these transactions to ensure this exclusion is not

used to engage in prohibited proprietary trading activities.

---------------------------------------------------------------------------

\222\ Congress recognized that repurchase agreements and

securities lending agreements are loans or extensions of credit by

including them in the legal lending limit. See Dodd-Frank Act

section 610 (amending 12 U.S.C. 84b). The Agencies believe the

conditions of the final rule's exclusions for repurchase agreements

and securities lending agreements identify those activities that do

not in normal practice represent proprietary trading and, thus, the

Agencies decline to provide additional requirements for these

activities, as suggested by some commenters. See Public Citizen; AFR

et al. (Feb. 2012); Occupy.

---------------------------------------------------------------------------

To avoid evasion of the rule, the Agencies note that, in contrast

to certain commenters' requests,\223\ only the transactions pursuant to

the repurchase agreement, reverse repurchase agreement, or securities

lending agreement are excluded. For example, the collateral or position

that is being financed by the repurchase or reverse repurchase

agreement is not excluded and may involve proprietary trading. The

Agencies further note that if a banking entity uses a repurchase or

reverse repurchase agreement to finance a purchase of a financial

instrument, other transactions involving that financial instrument may

not qualify for this exclusion.\224\ Similarly, short positions

resulting from securities lending agreements cannot rely upon this

exclusion and may involve proprietary trading.

---------------------------------------------------------------------------

\223\ See Goldman (Prop. Trading); JPMC; UBS.

\224\ See CFTC Proposal, 77 FR at 8348.

---------------------------------------------------------------------------

Additionally, the Agencies have determined not to exclude all

transactions, in whatever legal form that may be construed to be an

extension of credit, as suggested by commenters, because such a broad

exclusion would be too difficult to assess for compliance and would

provide significant opportunity for evasion of the prohibitions in

section 13 of the BHC Act.

2. Liquidity Management Activities

The proposed definition of trading account excluded an account used

to acquire or take a position for the purpose of bona fide liquidity

management, subject to certain requirements.\225\ The preamble to the

proposed rule explained that bona fide liquidity management seeks to

ensure that the banking entity has sufficient, readily-marketable

assets available to meet its expected near-term liquidity needs, not to

realize short-term profit or benefit from short-term price

movements.\226\

---------------------------------------------------------------------------

\225\ See proposed rule Sec. 75.3(b)(2)(iii)(C).

\226\ Id.

---------------------------------------------------------------------------

To curb abuse, the proposed rule required that a banking entity

acquire or take a position for liquidity management in accordance with

a documented liquidity management plan that meets five criteria.\227\

Moreover, the Agencies stated in the preamble that liquidity management

positions that give rise to appreciable profits or losses as a result

of short-term price movements would be subject to significant Agency

scrutiny and, absent compelling explanatory facts and circumstances,

would be considered proprietary trading.\228\

---------------------------------------------------------------------------

\227\ See proposed rule Sec. 75.3(b)(2)(iii)(C)(1)-(5).

\228\ See Joint Proposal, 76 FR at 68862.

---------------------------------------------------------------------------

The Agencies received a number of comments regarding the exclusion.

Many commenters supported the exclusion of liquidity management

activities from the definition of trading account as appropriate and

necessary. At the same time, some commenters expressed the view that

the exclusion was too narrow and should be replaced with a broader

exclusion permitting trading activity for asset-liability management

(``ALM''). Commenters argued that two aspects of the proposed rule's

definition of ``trading account'' would cause ALM transactions to fall

within the prohibition on proprietary trading--the 60-day rebuttable

presumption and the reference to the market risk rule trading

account.\229\ For example, commenters expressed concern that hedging

transactions associated with a banking entity's residential mortgage

pipeline and mortgage servicing rights, and managing credit risk,

earnings at risk, capital, asset-liability mismatches, and foreign

exchange risks would be among positions that may be held for 60 days or

less.\230\ These commenters contended that the exclusion for liquidity

management and the activity exemptions for risk-mitigating hedging and

trading in U.S. government obligations would not be sufficient to

permit a wide variety of ALM activities.\231\ These commenters

contended that prohibiting trading for ALM purposes would be contrary

to the goals of enhancing sound risk management, the safety and

soundness of banking entities, and U.S. financial stability,\232\ and

would limit banking entities' ability to manage liquidity.\233\

---------------------------------------------------------------------------

\229\ See ABA (Keating); BoA; CH/ABASA; JPMC. See supra Part

VI.A.1.b. (discussing the rebuttable presumption under Sec.

75.3(b)(2) of the final rule); see also supra Part VI.A.1.a.

(discussing the market risk rule trading account under Sec.

75.3(b)(1)(ii) of the final rule).

\230\ See CH/ABASA; Wells Fargo (Prop. Trading).

\231\ See CH/ABASA; JPMC; State Street (Feb. 2012); Wells Fargo

(Prop. Trading). See also BaFin/Deutsche Bundesbank.

\232\ See BoA; JPMC; RBC.

\233\ See ABA (Keating); Allen & Overy (on behalf of Canadian

Banks); JPMC; NAIB et al.; State Street (Feb. 2012); T. Rowe Price.

---------------------------------------------------------------------------

Some commenters argued that the requirements of the exclusion would

not provide a banking entity with sufficient flexibility to respond to

liquidity needs arising from changing economic conditions.\234\ Some

commenters argued the requirement that any position taken for liquidity

management purposes be limited to the banking entity's near-term

funding needs failed to account for longer-term liquidity management

requirements.\235\ These commenters further argued that the

requirements of the liquidity management exclusion might not be

synchronized with the Basel III framework, particularly with respect to

the liquidity coverage ratio if ``near-term'' is considered less than

30 days.\236\

---------------------------------------------------------------------------

\234\ See ABA (Keating); CH/ABASA; JPMC.

\235\ See ABA (Keating); BoA; CH/ABASA; JPMC.

\236\ See ABA (Keating); Allen & Overy (on behalf of Canadian

Banks); BoA; CH/ABASA.

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[[Page 5827]]

Commenters also requested clarification on a number of other issues

regarding the exclusion. For example, one commenter requested

clarification that purchases and sales of U.S. registered mutual funds

sponsored by a banking entity would be permissible.\237\ Another

commenter requested clarification that the deposits resulting from

providing custodial services that are invested largely in high-quality

securities in conformance with the banking entity's ALM policy would

not be presumed to be ``short-term trading'' under the final rule.\238\

Commenters also urged that the final rule not prohibit interaffiliate

transactions essential to the ALM function.\239\

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\237\ See T. Rowe Price.

\238\ See State Street (Feb. 2012).

\239\ See State Street (Feb. 2012); JPMC. See also Part

VI.A.1.d.10. (discussing commenter requests to exclude inter-

affiliate transactions).

---------------------------------------------------------------------------

In contrast, other commenters supported the liquidity management

exclusion criteria \240\ and suggested tightening these requirements.

For example, one commenter recommended that the rule require that

investments made under the liquidity management exclusion consist only

of high-quality liquid assets.\241\ Other commenters argued that the

exclusion for liquidity management should be eliminated.\242\ One

commenter argued that there was no need to provide a special exemption

for liquidity management or ALM activities given the exemptions for

trading in government obligations and risk-mitigating hedging

activities.\243\

---------------------------------------------------------------------------

\240\ See AFR et al. (Feb. 2012); Occupy.

\241\ See Occupy.

\242\ See Sens. Merkley & Levin (Feb. 2012).

\243\ See Sens. Merkley & Levin (Feb. 2012).

---------------------------------------------------------------------------

After carefully reviewing the comments received, the Agencies have

adopted the proposed exclusion for liquidity management with several

important modifications. As limited below, liquidity management

activity serves the important prudential purpose, recognized in other

provisions of the Dodd-Frank Act and in rules and guidance of the

Agencies, of ensuring banking entities have sufficient liquidity to

manage their short-term liquidity needs.\244\

---------------------------------------------------------------------------

\244\ See section 165(b)(1)(A)(ii) of the Dodd-Frank Act;

Enhanced Prudential Standards, 77 FR 644 at 645 (Jan. 5, 2012),

available at http://www.gpo.gov/fdsys/pkg/FR-2012-01-05/pdf/2011-33364.pdf; see also Enhanced Prudential Standards, 77 FR 76678 at

76682 (Dec. 28, 2012), available at http://www.gpo.gov/fdsys/pkg/FR-2012-12-28/pdf/2012-30734.pdf.

---------------------------------------------------------------------------

To ensure that this exclusion is not misused for the purpose of

proprietary trading, the final rule imposes a number of requirements.

First, the liquidity management plan of the banking entity must be

limited to securities (in keeping with the liquidity management

requirements proposed by the Federal banking agencies) and specifically

contemplate and authorize the particular securities to be used for

liquidity management purposes; describe the amount, types, and risks of

securities that are consistent with the entity's liquidity management;

and the liquidity circumstances in which the particular securities may

or must be used.\245\ Second, any purchase or sale of securities

contemplated and authorized by the plan must 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 taken for such short-term purposes. Third, the plan

must require that any securities purchased or sold for liquidity

management purposes be highly liquid and limited to instruments the

market, credit and other risks of which the banking entity does not

reasonably expect to give rise to appreciable profits or losses as a

result of short-term price movements.\246\ Fourth, the plan must limit

any securities purchased or sold for liquidity management purposes to

an amount that is consistent with the banking entity's near-term

funding needs, including deviations from normal operations of the

banking entity or any affiliate thereof, as estimated and documented

pursuant to methods specified in the plan.\247\ Fifth, the banking

entity must incorporate into its compliance program internal controls,

analysis and independent testing designed to ensure that activities

undertaken for liquidity management purposes are conducted in

accordance with the requirements of the final rule and the entity's

liquidity management plan. Finally, the plan must be consistent with

the supervisory requirements, guidance and expectations regarding

liquidity management of the Agency responsible for regulating the

banking entity.

---------------------------------------------------------------------------

\245\ To ensure sufficient flexibility to respond to liquidity

needs arising from changing economic times, a banking entity should

envision and address a range of liquidity circumstances in its

liquidity management plan, and provide a mechanism for periodically

reviewing and revising the liquidity management plan.

\246\ The requirement to use highly liquid instruments is

consistent with the focus of the clarifying exclusion on a banking

entity's near-term liquidity needs. Thus, the final rules do not

include commenters' suggested revisions to this requirement. See

Clearing House Ass'n.; see also Occupy; Sens. Merkley & Levin (Feb.

2012). The Agencies decline to identify particular types of

securities that will be considered highly liquid for purposes of the

exclusion, as requested by some commenters, in recognition that such

a determination will depend on the facts and circumstances. See T.

Rowe Price; State Street (Feb. 2012).

\247\ The Agencies plan to construe ``near-term funding needs''

in a manner that is consistent with the laws, regulations, and

issuances related to liquidity risk management. See, e.g., Liquidity

Coverage Ratio: Liquidity Risk Measurement, Standards, and

Monitoring, 78 FR 71818 (Nov. 29, 2013); Basel Committee on Bank

Supervision, Basel III: The Liquidity Coverage Ratio and Liquidity

Risk Management Tools (January 2013) available at http://www.bis.org/publ/bcbs238.htm. The Agencies believe this should help

address commenters' concerns about the proposed requirement. See,

e.g., ABA (Keating); Allen & Overy (on behalf of Canadian Banks);

CH/ABASA; BoA; JPMC.

---------------------------------------------------------------------------

The final rule retains the provision that the financial instruments

purchased and sold as part of a liquidity management plan be highly

liquid and not reasonably expected to give rise to appreciable profits

or losses as a result of short-term price movements. This requirement

is consistent with the Agencies' expectation for liquidity management

plans in the supervisory context. It is not intended to prevent firms

from recognizing profits (or losses) on instruments purchased and sold

for liquidity management purposes. Instead, this requirement is

intended to underscore that the purpose of these transactions must be

liquidity management. Thus, the timing of purchases and sales, the

types and duration of positions taken and the incentives provided to

managers of these purchases and sales must all indicate that managing

liquidity, and not taking short-term profits (or limiting short-term

losses), is the purpose of these activities.

The exclusion as adopted does not apply to activities undertaken

with the stated purpose or effect of hedging aggregate risks incurred

by the banking entity or its affiliates related to asset-liability

mismatches or other general market risks to which the entity or

affiliates may be exposed. Further, the exclusion does not apply to any

trading activities that expose banking entities to substantial risk

from fluctuations in market values, unrelated to the management of

near-term funding needs, regardless of the stated purpose of the

activities.\248\

---------------------------------------------------------------------------

\248\ See, e.g., Staff of S. Comm. on Homeland Sec. &

Governmental Affairs Permanent Subcomm. on Investigations, 113th

Cong., Report: JPMorgan Chase Whale Trades: A Case History of

Derivatives Risks and Abuses (Apr. 11, 2013), available at http://www.hsgac.senate.gov/download/report-jpmorgan-chase-whale-trades-a-case-history-of-derivatives-risks-and-abuses-march-15-2013.

---------------------------------------------------------------------------

Overall, the Agencies do not believe that the final rule will stand

as an obstacle to or otherwise impair the ability of banking entities

to manage the

[[Page 5828]]

risks of their businesses and operate in a safe and sound manner.

Banking entities engaging in bona fide liquidity management activities

generally do not purchase or sell financial instruments for the purpose

of short-term resale or to benefit from actual or expected short-term

price movements. The Agencies have determined, in contrast to certain

commenters' requests, not to expand this liquidity management provision

to broadly allow asset-liability management, earnings management, or

scenario hedging.\249\ To the extent these activities are for the

purpose of profiting from short-term price movements or to hedge risks

not related to short-term funding needs, they represent proprietary

trading subject to section 13 of the BHC Act and the final rule; the

activity would then be permissible only if it meets all of the

requirements for an exemption, such as the risk-mitigating hedging

exemption, the exemption for trading in U.S. government securities, or

another exemption.

---------------------------------------------------------------------------

\249\ See, e.g., ABA (Keating); BoA; CH/ABASA; JPMC.

---------------------------------------------------------------------------

3. Transactions of Derivatives Clearing Organizations and Clearing

Agencies

A banking entity that is a central counterparty for clearing and

settlement activities engages in the purchase and sale of financial

instruments as an integral part of clearing and settling those

instruments. The proposed definition of trading account excluded an

account used to acquire or take one or more covered financial positions

by a derivatives clearing organization registered under the Commodity

Exchange Act or a clearing agency registered under the Securities

Exchange Act of 1934 in connection with clearing derivatives or

securities transactions.\250\ The preamble to the proposed rule noted

that the purpose of these transactions is to provide a clearing service

to third parties, not to profit from short-term resale or short-term

price movements.\251\

---------------------------------------------------------------------------

\250\ See proposed rule Sec. 75.3(b)(2)(iii)(D).

\251\ See Joint Proposal, 76 FR at 68863.

---------------------------------------------------------------------------

Several commenters supported the proposed exclusion for derivatives

clearing organizations and urged the Agencies to expand the exclusion

to cover a banking entity's clearing-related activities, such as

clearing a trade for a customer, trading with a clearinghouse, or

accepting positions of a defaulting member, on grounds that these

activities are not proprietary trades and reduce systemic risk.\252\

One commenter recommended expanding the exclusion to non-U.S. central

counterparties \253\ In contrast, one commenter argued that the

exclusion for derivatives clearing organizations and clearing agencies

had no statutory basis and should instead be a permitted activity under

section 13(d)(1)(J).\254\

---------------------------------------------------------------------------

\252\ See Allen & Overy (Clearing); Goldman (Prop. Trading);

SIFMA et al. (Prop. Trading) (Feb. 2012); State Street (Feb. 2012).

\253\ See IIB/EBF.

\254\ See Sens. Merkley & Levin (Feb. 2012).

---------------------------------------------------------------------------

After considering the comments received, the final rule retains the

exclusion for purchases and sales of financial instruments by a banking

entity that is a clearing agency or derivatives clearing organization

in connection with its clearing activities.\255\ In response to

comments,\256\ the Agencies have also incorporated two changes to the

rule. First, the final rule applies the exclusion to the purchase and

sale of financial instruments by a banking entity that is a clearing

agency or derivatives clearing organization in connection with clearing

financial instrument transactions. Second, in response to

comments,\257\ the exclusion in the final rule is not limited to

clearing agencies or derivatives clearing organizations that are

subject to SEC or CFTC registration requirements and, instead, certain

foreign clearing agencies and foreign derivatives clearing

organizations will be permitted to rely on the exclusion if they are

banking entities.

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\255\ ``Clearing agency'' is defined in the final rule with

reference to the definition of this term in the Exchange Act. See

final rule Sec. 75.3(e)(2). ``Derivatives clearing organization''

is defined in the final rule as (i) a derivatives clearing

organization registered under section 5b of the Commodity Exchange

Act; (ii) a derivatives clearing organization that, pursuant to CFTC

regulation, is exempt from the registration requirements under

section 5b of the Commodity Exchange Act; or (iii) a foreign

derivatives clearing organization that, pursuant to CFTC regulation,

is permitted to clear for a foreign board of trade that is

registered with the CFTC.

\256\ See IIB/EBF; BNY Mellon et al.; SIFMA et al. (Prop.

Trading) (Feb. 2012); Allen & Overy (Clearing); Goldman (Prop.

Trading).

\257\ See IIB/EBF; Allen & Overy (Clearing).

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The Agencies believe that clearing and settlement activity is not

designed to create short-term trading profits. Moreover, excluding

clearing and settlement activities prevents the final rule from

inadvertently hindering the Dodd-Frank Act's goal of promoting central

clearing of financial transactions. The Agencies have narrowly tailored

this exclusion by allowing only central counterparties to use it and

only with respect to their clearing and settlement activity.

4. Excluded Clearing-Related Activities of Clearinghouse Members

In addition to the exclusion for trading activities of a

derivatives clearing organization or clearing agency, some commenters

requested an additional exclusion from the definition of ``trading

account'' for clearing-related activities of members of these

entities.\258\ These commenters noted that the proposed definition of

``trading account'' provides an exclusion for positions taken by

registered derivatives clearing organizations and registered clearing

agencie s\259\ and requested a corresponding exclusion for certain

clearing-related activities of banking entities that are members of a

clearing agency or members of a derivatives clearing organization

(collectively, ``clearing members'').\260\

---------------------------------------------------------------------------

\258\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Allen &

Overy (Clearing); Goldman (Prop. Trading); State Street (Feb. 2012).

\259\ See proposed rule Sec. 75.3(b)(2)(iii)(D).

\260\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Allen &

Overy (Clearing); Goldman (Prop. Trading); State Street (Feb. 2012).

---------------------------------------------------------------------------

Several commenters argued that certain aspects of the clearing

process may require a clearing member to engage in principal

transactions. For example, some commenters argued that a

clearinghouse's default management process may require clearing members

to take positions in financial instruments upon default of another

clearing member.\261\ According to commenters, default management

processes can involve: (i) Collection of initial and variation margin

from customers under an ``agency model'' of clearing; (ii) porting,

where a defaulting clearing member's customer positions and margin are

transferred to another non-defaulting clearing member; \262\ (iii)

hedging, where the clearing house looks to clearing members and third

parties to enter into risk-reducing transactions and to flatten the

market risk associated with the defaulting clearing member's house

positions and non-ported customer positions; (iv) unwinding, where the

defaulting member's open positions may be allocated to other clearing

members, affiliates, or third parties pursuant to a mandatory auction

process or forced allocation; \263\ and (v) imposing certain

obligations on clearing members upon exhaustion of a guaranty

fund.\264\

---------------------------------------------------------------------------

\261\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Allen &

Overy (Clearing); State Street (Feb. 2012). See also ISDA (Feb.

2012).

\262\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Allen &

Overy (Clearing).

\263\ See Allen & Overy (Clearing).

\264\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

---------------------------------------------------------------------------

Commenters argued that, absent an exclusion from the definition of

``trading account,'' some of these clearing-related activities could be

considered prohibited proprietary trading under the proposal. Two

commenters specifically contended that

[[Page 5829]]

the dealer prong of the definition of ``trading account'' may cause

certain of these activities to be considered proprietary trading.\265\

Some commenters suggested alternative avenues for permitting such

clearing-related activity under the rules.\266\ Commenters argued that

such clearing-related activities of banking entities should not be

subject to the rule because they are risk-reducing, beneficial for the

financial system, required by law under certain circumstances (e.g.,

central clearing requirements for swaps and security-based swaps under

Title VII of the Dodd-Frank Act), and not used by banking entities to

engage in proprietary trading.\267\

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\265\ See SIFMA et al. (Prop. Trading) (Feb. 2012) (arguing that

the SEC has suggested that entities that collect margins from

customers for cleared swaps may be required to be registered as

broker-dealers); State Street (Feb. 2012).

\266\ See Goldman (Prop. Trading); SIFMA et al. (Prop. Trading)

(Feb. 2012); ISDA (Feb. 2012).

\267\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading); State Street (Feb. 2012); Allen & Overy (Clearing).

---------------------------------------------------------------------------

Commenters further argued that certain activities undertaken as

part of a clearing house's daily risk management process may be

impacted by the rule, including unwinding self-referencing transactions

through a mandatory auction (e.g., where a firm acquired credit default

swap (``CDS'') protection on itself as a result of a merger with

another firm) \268\ and trade crossing, a mechanism employed by certain

clearing houses to ensure the accuracy of the price discovery process

in the course of, among other things, calculating settlement prices and

margin requirements.\269\

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\268\ See Allen & Overy (Clearing).

\269\ See Allen & Overy (Clearing); SIFMA et al. (Prop. Trading)

(Feb. 2012). These commenters stated that, in order to ensure that a

clearing member is providing accurate end-of-day prices for its open

positions, a clearing house may require the member to provide firm

bids for such positions, which may be tested through a ``forced

trade'' with another member. See id.; see also ISDA (Feb. 2012).

---------------------------------------------------------------------------

The Agencies do not believe that certain core clearing-related

activities conducted by a clearing member, often as required by

regulation or the rules and procedures of a clearing agency,

derivatives clearing organization, or designated financial market

utility, represent proprietary trading as contemplated by the statute.

For example, the clearing and settlement activities discussed above are

not conducted for the purpose of profiting from short-term price

movements. The Agencies believe that these clearing-related activities

provide important benefits to the financial system.\270\ In particular,

central clearing reduces counterparty credit risk,\271\ which can lead

to a host of other benefits, including lower hedging costs, increased

market participation, greater liquidity, more efficient risk sharing

that promotes capital formation, and reduced operational risk.\272\

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\270\ For example, Title VII of the Dodd-Frank Act mandates the

central clearing of swaps and security-based swaps, and requires

that banking entities that are swap dealers, security-based swap

dealers, major swap participants or major security-based swap

participants collect variation margin from many counterparties on a

daily basis for their swap or security-based swap activity. See 7

U.S.C. 2(h); 15 U.S.C. 78c-3; 7 U.S.C. 6s(e); 15 U.S.C. 78o-10(e);

Margin Requirements for Uncleared Swaps for Swap Dealers and Major

Swap Participants, 76 FR 23732 (Apr. 28, 2011). Additionally, the

SEC's Rule 17Ad-22(d)(11) requires that each registered clearing

agency establish, implement, maintain and enforce policies and

procedures that set forth the clearing agency's default management

procedures. See 17 CFR 240.17Ad-22(d)(11). See also Exchange Act

Release No. 68,080 (Oct. 12, 2012), 77 FR 66220, 66,283 (Nov. 2,

2012).

\271\ Centralized clearing affects counterparty risk in three

basic ways. First, it redistributes counterparty risk among members

through mutualization of losses, reducing the likelihood of

sequential counterparty failure and contagion. Second, margin

requirements and monitoring reduce moral hazard, reducing

counterparty risk. Finally, clearing may reallocate counterparty

risk outside of the clearing agency because netting may implicitly

subordinate outside creditors' claims relative to other clearing

member claims.

\272\ See Proposed Rule, Cross-Border Security-Based Swap

Activities, Exchange Act Release No. 69490 (May 1, 2013), 78 FR

30968, 31,162-31,163 (May 23, 2013).

---------------------------------------------------------------------------

Accordingly, in response to comments, the final rule provides that

proprietary trading does not include specified excluded clearing

activities by a banking entity that is a member of a clearing agency, a

member of a derivatives clearing organization, or a member of a

designated financial market utility.\273\ ``Excluded clearing

activities'' is defined in the rule to identify particular core

clearing-related activities, many of which were raised by

commenters.\274\ Specifically, the final rule will exclude the

following activities by clearing members: (i) Any purchase or sale

necessary to correct error trades made by or on behalf of customers

with respect to customer transactions that are cleared, provided the

purchase or sale is conducted in accordance with certain regulations,

rules, or procedures; (ii) any purchase or sale related to the

management of a default or threatened imminent default of a customer,

subject to certain conditions, another clearing member, or the clearing

agency, derivatives clearing organization, or designated financial

market utility itself; \275\ and (iii) any purchase or sale required by

the rules or procedures of a clearing agency, derivatives clearing

organization, or designated financial market utility that mitigates

risk to such agency, organization, or utility that would result from

the clearing by a clearing member of security-based swaps that

references the member or an affiliate of the member.\276\

---------------------------------------------------------------------------

\273\ See final rule Sec. 75.3(d)(5).

\274\ See final rule Sec. 75.3(e)(7).

\275\ A number of commenters discussed the default management

process and requested an exclusion for such activities. See SIFMA et

al. (Prop. Trading) (Feb. 2012); Allen & Overy (Clearing); State

Street (Feb. 2012). See also ISDA (Feb. 2012).

\276\ See Allen & Overy (Clearing) (discussing rules that

require unwinding self-referencing transactions through a mandatory

auction (e.g., where a firm acquired CDS protection on itself as a

result of a merger with another firm)).

---------------------------------------------------------------------------

The Agencies are identifying specific activities in the rule to

limit the potential for evasion that may arise from a more generalized

approach. However, the relevant supervisory Agencies will be prepared

to provide further guidance or relief, if appropriate, to ensure that

the terms of the exclusion do not limit the ability of clearing

agencies, derivatives clearing organizations, or designated financial

market utilities to effectively manage their risks in accordance with

their rules and procedures. In response to commenters requesting that

the exclusion be available when a clearing member is required by rules

of a clearing agency, derivatives clearing organization, or designated

financial market utility to purchase or sell a financial instrument as

part of establishing accurate prices to be used by the clearing agency,

derivatives clearing organization, or designated financial market

utility in its end of day settlement process,\277\ the Agencies note

that whether this is an excluded clearing activity depends on the facts

and circumstances. Similarly, the availability of other exemptions to

the rule, such as the market-making exemption, depend on the facts and

circumstances. This exclusion applies only to excluded clearing

activities of clearing members. It does not permit a banking entity to

engage in proprietary trading and claim protection for that activity

because trades are cleared or settled through a central counterparty.

---------------------------------------------------------------------------

\277\ See Allen & Overy (Clearing); SIFMA et al. (Prop. Trading)

(Feb. 2012); see also ISDA (Feb. 2012).

---------------------------------------------------------------------------

5. Satisfying an Existing Delivery Obligation

A few commenters requested additional or expanded exclusions from

the definition of ``trading account'' for covering short sales or

failures to deliver.\278\ These commenters alleged that a banking

entity engages in this activity for purposes other than to

[[Page 5830]]

benefit from short term price movements and that it is not proprietary

trading as defined in the statute. In response to these comments, the

final rule provides that a purchase or sale by a banking entity that

satisfies an existing delivery obligation of the banking entity or its

customers, including to prevent or close out a failure to deliver, in

connection with delivery, clearing, or settlement activity is not

proprietary trading.

---------------------------------------------------------------------------

\278\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading).

---------------------------------------------------------------------------

Among other things, this exclusion will allow a banking entity that

is an SEC-registered broker-dealer to take action to address failures

to deliver arising from its own trading activity or the trading

activity of its customers.\279\ In certain circumstances, SEC-

registered broker-dealers are required to take such action under SEC

rules.\280\ In addition, buy-in procedures of a clearing agency,

securities exchange, or national securities association may require a

banking entity to deliver securities if a party with a fail to receive

position takes certain action.\281\ When a banking entity purchases

securities to meet an existing delivery obligation, it is engaging in

activity that facilitates timely settlement of securities transactions

and helps provide a purchaser of the securities with the benefits of

ownership (e.g., voting and lending rights). In addition, a banking

entity has limited discretion to determine when and how to take action

to meet an existing delivery obligation.\282\ Providing a limited

exclusion for this activity will avoid the potential for SEC-registered

broker-dealers being subject to conflicting or inconsistent regulatory

requirements with respect to activity required to meet the broker-

dealer's existing delivery obligations.

---------------------------------------------------------------------------

\279\ In order to qualify for this exclusion, a banking entity's

principal trading activity that results in its own failure to

deliver must have been conducted in compliance with these rules.

\280\ See, e.g., 17 CFR 242.204 (requiring, among other things,

that a participant of a registered clearing agency or, upon

reasonable allocation, a broker-dealer for which the participant

clears trades or from which the participant receives trades for

settlement, take action to close out a fail to deliver position in

any equity security by borrowing or purchasing securities of like

kind and quantity); 17 CFR 240.15c3-3(m) (providing that, if a

broker-dealer executes a sell order of a customer and does not

obtain possession of the securities from the customer within 10

business days after settlement, the broker-dealer must immediately

close the transaction with the customer by purchasing securities of

like kind and quantity).

\281\ See, e.g., NSCC Rule 11, NASDAQ Rule 11810, FINRA Rule

11810.

\282\ See, e.g., 17 CFR 242.204 (requiring action to close out a

fail to deliver position in an equity security within certain

specified timeframes); 17 CFR 240.15c3-3(m) (requiring a broker-

dealer to ``immediately'' close a transaction under certain

circumstances).

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6. Satisfying an Obligation in Connection With a Judicial,

Administrative, Self-Regulatory Organization, or Arbitration Proceeding

The Agencies recognize that, under certain circumstances, a banking

entity may be required to purchase or sell a financial instrument at

the direction of a judicial or regulatory body. For example, an

administrative agency or self-regulatory organization (``SRO'') may

require a banking entity to purchase or sell a financial instrument in

the course of disciplinary proceedings against that banking

entity.\283\ A banking entity may also be obligated to purchase or sell

a financial instrument in connection with a judicial or arbitration

proceeding.\284\ Such transactions do not represent trading for short-

term profit or gain and do not constitute proprietary trading under the

statute.

---------------------------------------------------------------------------

\283\ For example, an administrative agency or SRO may require a

broker-dealer to offer to buy securities back from customers where

the agency or SRO finds the broker-dealer fraudulently sold

securities to those customers. See, e.g., In re Raymond James &

Assocs., Exchange Act Release No. 64767, 101 S.E.C. Docket 1749

(June 29, 2011); FINRA Dep't of Enforcement v. Pinnacle Partners

Fin. Corp., Disciplinary Proceeding No. 2010021324501 (Apr. 25,

2012); FINRA Dep't of Enforcement v. Fifth Third Sec., Inc., No.

2005002244101 (Press Rel. Apr. 14, 2009).

\284\ For instance, section 29 of the Exchange Act may require a

broker-dealer to rescind a contract with a customer that was made in

violation of the Exchange Act. Such rescission relief may involve

the broker-dealer's repurchase of a financial instrument from a

customer. See 15 U.S.C. 78cc; Reg'l Props., Inc. v. Fin. & Real

Estate Consulting Co., 678 F.2d 552 (5th Cir. 1982); Freeman v.

Marine Midland Bank N.Y., 419 F.Supp. 440 (E.D.N.Y. 1976).

---------------------------------------------------------------------------

Accordingly, the Agencies have determined to adopt a provision

clarifying that a purchase or sale of one or more financial instruments

that satisfies an obligation of the banking entity in connection with a

judicial, administrative, self-regulatory organization, or arbitration

proceeding is not proprietary trading for purposes of these rules. This

clarification will avoid the potential for conflicting or inconsistent

legal requirements for banking entities.

7. Acting Solely as Agent, Broker, or Custodian

The proposal clarified that proprietary trading did not include

acting solely as agent, broker, or custodian for an unaffiliated third

party.\285\ Commenters generally supported this aspect of the proposal.

One commenter suggested that acting as agent, broker, or custodian for

affiliates should be explicitly excluded from the definition of

proprietary trading in the same manner as acting as agent, broker, or

custodian for unaffiliated third parties.\286\

---------------------------------------------------------------------------

\285\ See proposed rule Sec. 75.3(b)(1).

\286\ See Japanese Bankers Ass'n.

---------------------------------------------------------------------------

Like the proposal, the final rule expressly provides that the

purchase or sale of one or more financial instruments by a banking

entity acting solely as agent, broker, or custodian is not proprietary

trading because acting in these types of capacities does not involve

trading as principal, which is one of the requisite aspects of the

statutory definition of proprietary trading.\287\ The final rule has

been modified to include acting solely as agent, broker, or custodian

on behalf of an affiliate. However, the affiliate must comply with

section 13 of the BHC Act and the final implementing rule; and may not

itself engage in prohibited proprietary trading. To the extent a

banking entity acts in both a principal and agency capacity for a

purchase or sale, it may only use this exclusion for the portion of the

purchase or sale for which it is acting as agent. The banking entity

must use a separate exemption or exclusion, if applicable, to the

extent it is acting in a principal capacity.

---------------------------------------------------------------------------

\287\ See 12 U.S.C. 1851(h)(4). A common or collective

investment fund that is an investment company under section 3(c)(3)

or 3(c)(11) will not be deemed to be acting as principal within the

meaning of Sec. 75.3(a) because the fund is performing a

traditional trust activity and purchases and sells financial

instruments solely on behalf of customers as trustee or in a similar

fiduciary capacity, as evidenced by its regulation under 12 CFR part

9 (Fiduciary Activities of National Banks) or similar state laws.

---------------------------------------------------------------------------

8. Purchases or Sales Through a Deferred Compensation or Similar Plan

While the proposed rule provided that the prohibition on covered

fund activities and investments did not apply to certain instances

where the banking entity acted through or on behalf of a pension or

similar deferred compensation plan, no such similar treatment was given

for proprietary trading. One commenter argued that the proposal

restricted a banking entity's ability to engage in principal-based

trading as an asset manager that serves the needs of the institutional

investors, such as through ERISA pension and 401(k) plans.\288\

---------------------------------------------------------------------------

\288\ See Ass'n. of Institutional Investors (Nov. 2012).

---------------------------------------------------------------------------

To address these concerns, the final rule provides that proprietary

trading does not include the purchase or sale of one or more financial

instruments through a deferred compensation, stock-bonus, profit-

sharing, or pension plan of the banking entity that is established

[[Page 5831]]

and administered in accordance with the laws of the United States or a

foreign sovereign, if the purchase or sale is made directly or

indirectly by the banking entity as trustee for the benefit of the

employees of the banking entity or members of their immediate family.

Banking entities often establish and act as trustee to pension or

similar deferred compensation plans for their employees and, as part of

managing these plans, may engage in trading activity. The Agencies

believe that purchases or sales by a banking entity when acting through

pension and similar deferred compensation plans generally occur on

behalf of beneficiaries of the plan and consequently do not constitute

the type of principal trading that is covered by the statute.

The Agencies note that if a banking entity engages in trading

activity for an unaffiliated pension or similar deferred compensation

plan, the trading activity of the banking entity would not be

proprietary trading under the final rule to the extent the banking

entity was acting solely as agent, broker, or custodian.

9. Collecting a Debt Previously Contracted

Several commenters argued that the final rule should exclude

collecting and disposing of collateral in satisfaction of debts

previously contracted from the definition of proprietary trading.\289\

Commenters argued that acquiring and disposing of collateral in

satisfaction of debt previously contracted does not involve trading

with the intent of profiting from short-term price movements and, thus,

should not be proprietary trading for purposes of this rule. Rather,

this activity is a prudent and desirable part of lending and debt

collection activities.

---------------------------------------------------------------------------

\289\ See LSTA (Feb. 2012); JPMC; Goldman (Prop. Trading); SIFMA

et al. (Prop. Trading) (Feb. 2012).

---------------------------------------------------------------------------

The Agencies believe that the purchase and sale of a financial

instrument in satisfaction of a debt previously contracted does not

constitute proprietary trading. The Agencies believe an exclusion for

purchases and sales in satisfaction of debts previously contracted is

necessary for banking entities to continue to lend to customers,

because it allows banking entities to continue lending activity with

the knowledge that they will not be penalized for recouping losses

should a customer default. Accordingly, the final rule provides that

proprietary trading does not include the purchase or sale of one or

more financial instruments in the ordinary course of collecting a debt

previously contracted in good faith, provided that the banking entity

divests the financial instrument as soon as practicable within the time

period permitted or required by the appropriate financial supervisory

agency.\290\

---------------------------------------------------------------------------

\290\ See final rule Sec. 75.3(d)(9).

---------------------------------------------------------------------------

As a result of this exclusion, banking entities, including SEC-

registered broker-dealers, will be able to continue providing margin

loans to their customers and may take possession of margined collateral

following a customer's default or failure to meet a margin call under

applicable regulatory requirements.\291\ Similarly, a banking entity

that is a CFTC-registered swap dealer or SEC-registered security-based

swap dealer may take, hold, and exchange any margin collateral as

counterparty to a cleared or uncleared swap or security-based swap

transaction, in accordance with the rules of the Agencies.\292\ This

exclusion will allow banking entities to comply with existing

regulatory requirements regarding the divestiture of collateral taken

in satisfaction of a debt.

---------------------------------------------------------------------------

\291\ For example, if any margin call is not met in full within

the time required by Regulation T, then Regulation T requires a

broker-dealer to liquidate securities sufficient to meet the margin

call or to eliminate any margin deficiency existing on the day such

liquidation is required, whichever is less. See 12 CFR 220.4(d).

\292\ See SEC Proposed Rule, Capital, Margin, Segregation,

Reporting and Recordkeeping Requirements for Security-Based Swap

Dealers, Exchange Act Release No. 68071, 77 FR 70214 (Nov. 23,

2012); CFTC Proposed Rule, Margin Requirements for Uncleared Swaps

for Swap Dealers and Major Swap Participants, 76 FR 23732 (Apr. 28,

2011); Banking Agencies' Proposed Rule, Margin and Capital

Requirements for Covered Swap Entities, 76 FR 27564 (May 11, 2011).

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10. Other Requested Exclusions

Commenters requested a number of additional exclusions from the

trading account and, in turn, the prohibition on proprietary trading.

In order to avoid potential evasion of the final rule, the Agencies

decline to adopt any exclusions from the trading account other than the

exclusions described above.\293\ The Agencies believe that various

modifications to the final rule, including in particular to the

exemption for market-making related activities, address many of

commenters' concerns regarding unintended consequences of the

prohibition on proprietary trading.

---------------------------------------------------------------------------

\293\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012)

(transactions that are not based on expected or anticipated

movements in asset prices, such as fully collateralized swap

transactions that serve funding purposes); Norinchukin and Wells

Fargo (Prop. Trading) (derivatives that qualify for hedge

accounting); GE (Feb. 2012) (transactions related to commercial

contracts); Citigroup (Feb. 2012) (FX swaps and FX forwards); SIFMA

et al. (Prop. Trading) (Feb. 2012) (interaffiliate transactions); T.

Rowe Price (purchase and sale of shares in sponsored mutual funds);

RMA (cash collateral pools); Alfred Brock (arbitrage trading); ICBA

(securities traded pursuant to 12 U.S.C. 1831a(f)). The Agencies are

concerned that these exclusions could be used to conduct

impermissible proprietary trading, and the Agencies believe some of

these exclusions are more appropriately addressed by other

provisions of the rule. For example, derivatives qualifying for

hedge accounting may be permitted under the hedging exemption.

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2. Section 75.4(a): Underwriting Exemption

a. Introduction

After carefully considering comments on the proposed underwriting

exemption, the Agencies are adopting the proposed underwriting

exemption substantially as proposed, but with certain refinements and

clarifications to the proposed approach to better reflect the range of

securities offerings that an underwriter may help facilitate on behalf

of an issuer or selling security holder and the types of activities an

underwriter may undertake in connection with a distribution of

securities to facilitate the distribution process and provide important

benefits to issuers, selling security holders, or purchasers in the

distribution. The Agencies are adopting such an approach because the

statute specifically permits banking entities to continue providing

these beneficial services to clients, customers, and counterparties. At

the same time, to reduce the potential for evasion of the general

prohibition on proprietary trading, the Agencies are requiring, among

other things, that the trading desk make reasonable efforts to sell or

otherwise reduce its underwriting position (accounting for the

liquidity, maturity, and depth of the market for the relevant type of

security) and be subject to a robust risk limit structure that is

designed to prevent a trading desk from having an underwriting position

that exceeds the reasonably expected near term demands of clients,

customers, or counterparties.

b. Overview

1. Proposed Underwriting Exemption

Section 13(d)(1)(B) of the BHC Act provides an exemption from the

prohibition on proprietary trading for the purchase, sale, acquisition,

or disposition of securities and certain other instruments in

connection with underwriting activities, to the extent that such

activities are designed not to exceed the reasonably expected near term

demands of clients, customers, or counterparties.\294\

---------------------------------------------------------------------------

\294\ 12 U.S.C. 1851(d)(1)(B).

---------------------------------------------------------------------------

Section 75.4(a) of the proposed rule would have implemented this

exemption by requiring that a banking entity's underwriting activities

comply with seven requirements. As discussed

[[Page 5832]]

in more detail below, the proposed underwriting exemption required

that: (i) A banking entity establish a compliance program under Sec.

75.20; (ii) the covered financial position be a security; (iii) the

purchase or sale be effected solely in connection with a distribution

of securities for which the banking entity is acting as underwriter;

(iv) the banking entity meet certain dealer registration requirements,

where applicable; (v) the underwriting activities be designed not to

exceed the reasonably expected near term demands of clients, customers,

or counterparties; (vi) the underwriting activities be designed to

generate revenues primarily from fees, commissions, underwriting

spreads, or other income not attributable to appreciation in the value

of covered financial positions or to hedging of covered financial

positions; and (vii) the compensation arrangements of persons

performing underwriting activities be designed not to reward

proprietary risk-taking.\295\ The proposal explained that these seven

criteria were proposed so that any banking entity relying on the

underwriting exemption would be engaged in bona fide underwriting

activities and would conduct those activities in a way that would not

be susceptible to abuse through the taking of speculative, proprietary

positions as part of, or mischaracterized as, underwriting

activity.\296\

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\295\ See proposed rule Sec. 75.4(a).

\296\ See Joint Proposal, 76 FR at 68866; CFTC Proposal, 77 FR

at 8352.

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2. Comments on Proposed Underwriting Exemption

As a general matter, a few commenters expressed overall support for

the proposed underwriting exemption.\297\ Some commenters indicated

that the proposed exemption is too narrow and may negatively impact

capital markets.\298\ As discussed in more detail below, many

commenters expressed views on the effectiveness of specific

requirements of the proposed exemption. Further, some commenters

requested clarification or expansion of the proposed exemption for

certain activities that may be conducted in the course of underwriting.

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\297\ See Barclays (stating that the proposed exemption

generally effectuates the aims of the statute while largely avoiding

undue interference, although the commenter also requested certain

technical changes to the rule text); Alfred Brock.

\298\ See, e.g., Lord Abbett; BoA; Fidelity; Chamber (Feb.

2012).

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Several commenters suggested alternative approaches to implementing

the statutory exemption for underwriting activities.\299\ More

specifically, commenters recommended that the Agencies: (i) Provide a

safe harbor for low risk, standard underwritings; \300\ (ii) better

incorporate the statutory limitations on high-risk activity or

conflicts of interest; \301\ (iii) prohibit banking entities from

underwriting illiquid securities; \302\ (iv) prohibit banking entities

from participating in private placements; \303\ (v) place greater

emphasis on adequate internal compliance and risk management

procedures; \304\ or (vi) make the exemption as broad as possible.\305\

---------------------------------------------------------------------------

\299\ See Sens. Merkley & Levin (Feb. 2012); BoA; Fidelity;

Occupy; AFR et al. (Feb. 2012).

\300\ See Sens. Merkley & Levin (Feb. 2012) (suggesting a safe

harbor for underwriting efforts that meet certain low-risk criteria,

including that: The underwriting be in plain vanilla stock or bond

offerings, including commercial paper, for established business and

governments; and the distribution be completed within relevant time

periods, as determined by asset classes, with relevant factors being

the size of the issuer and the market served); Johnson & Prof.

Stiglitz (expressing support for a narrow safe harbor for

underwriting of basic stocks and bonds that raise capital for real

economy firms).

\301\ See Sens. Merkley & Levin (Feb. 2012) (suggesting that,

for example, the exemption plainly prevent high-risk, conflict

ridden underwritings of securitizations and structured products and

cross-reference Section 621 of the Dodd-Frank Act, which prohibits

certain material conflicts of interest in connection with asset-

backed securities).

\302\ See AFR et al. (Feb. 2012) (recommending that the Agencies

prohibit banking entities from acting as underwriter for assets

classified as Level 3 under FAS 157, which would prohibit

underwriting of illiquid and opaque securities without a genuine

external market, and representing that such a restriction would be

consistent with the statutory limitation on exposures to high-risk

assets).

\303\ See Occupy.

\304\ See BoA (recommending that the Agencies establish a strong

presumption that all of a banking entity's activities related to

underwriting are permitted under the rules as long as the banking

entity has adequate compliance and risk management procedures).

\305\ See Fidelity (suggested that the rules be revised to

``provide the broadest exemptions possible under the statute'' for

underwriting and certain other permitted activities).

---------------------------------------------------------------------------

3. Final Underwriting Exemption

After considering the comments received, the Agencies are adopting

the underwriting exemption substantially as proposed, but with

important modifications to clarify provisions or to address commenters'

concerns. As discussed above, some commenters were generally supportive

of the proposed approach to implementing the underwriting exemption,

but noted certain areas of concern or uncertainty. The underwriting

exemption the Agencies are adopting addresses these issues by further

clarifying the scope of activities that qualify for the exemption. In

particular, the Agencies are refining the proposed exemption to better

capture the broad range of capital-raising activities facilitated by

banking entities acting as underwriters on behalf of issuers and

selling security holders.

The final underwriting exemption includes the following components:

A framework that recognizes the differences in

underwriting activities across markets and asset classes by

establishing criteria that will be applied flexibly based on the

liquidity, maturity, and depth of the market for the particular type of

security.

A general focus on the ``underwriting position'' held by a

banking entity or its affiliate, and managed by a particular trading

desk, in connection with the distribution of securities for which such

banking entity or affiliate is acting as an underwriter.\306\

---------------------------------------------------------------------------

\306\ See infra Part VI.A.2.c.1.c.

---------------------------------------------------------------------------

A definition of the term ``trading desk'' that focuses on

the functionality of the desk rather than its legal status, and

requirements that apply at the trading desk level of organization

within a banking entity or across two or more affiliates.\307\

---------------------------------------------------------------------------

\307\ See infra Part VI.A.2.c.1.c. The term ``trading desk'' is

defined in final rule Sec. 75.3(e)(13) as ``the smallest discrete

unit of organization of a banking entity that purchases or sells

financial instruments for the trading account of the banking entity

or an affiliate thereof.''

---------------------------------------------------------------------------

Five standards for determining whether a banking entity is

engaged in permitted underwriting activities. Many of these criteria

have similarities to those included in the proposed rule, but with

important modifications in response to comments. These standards

require that:

[cir] The banking entity act as an ``underwriter'' for a

``distribution'' of securities and the trading desk's underwriting

position be related to such distribution. The final rule includes

refined definitions of ``distribution'' and ``underwriter'' to better

capture the broad scope of securities offerings used by issuers and

selling security holders and the range of roles that a banking entity

may play as intermediary in such offerings.\308\

---------------------------------------------------------------------------

\308\ See final rule Sec. Sec. 75.4(a)(2)(i), 75.4(a)(3),

75.4(a)(4); see also infra Part VI.A.2.c.1.c.

---------------------------------------------------------------------------

[cir] The amount and types of securities in the trading desk's

underwriting position be designed not to exceed the reasonably expected

near term demands of clients, customers, or counterparties, and

reasonable efforts be made to sell or otherwise reduce the underwriting

position within a reasonable period, taking into account the liquidity,

maturity, and depth of the market for the relevant type of

security.\309\

---------------------------------------------------------------------------

\309\ See final rule Sec. 75.4(a)(2)(ii); see also infra Part

VI.A.2.c.2.c.

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[[Page 5833]]

[cir] The banking entity establish, implement, maintain, and

enforce an internal compliance program that is reasonably designed to

ensure the banking entity's compliance with the requirements of the

underwriting exemption, including reasonably designed written policies

and procedures, internal controls, analysis, and independent testing

identifying and addressing:

[ssquf] The products, instruments, or exposures each trading desk

may purchase, sell, or manage as part of its underwriting activities;

[ssquf] Limits for each trading desk, based on the nature and

amount of the trading desk's underwriting activities, including the

reasonably expected near term demands of clients, customers, or

counterparties, on the amount, types, and risk of the trading desk's

underwriting position, level of exposures to relevant risk factors

arising from the trading desk's underwriting position, and period of

time a security may be held;

[ssquf] Internal controls and ongoing monitoring and analysis of

each trading desk's compliance with its limits; and

[ssquf] Authorization procedures, including escalation procedures

that require review and approval of any trade that would exceed a

trading desk's limit(s), demonstrable analysis of the basis for any

temporary or permanent increase to a trading desk's limit(s), and

independent review of such demonstrable analysis and approval.\310\

---------------------------------------------------------------------------

\310\ See final rule Sec. 75.4(a)(2)(iii); see also infra Part

VI.A.2.c.3.c.

---------------------------------------------------------------------------

[cir] The compensation arrangements of persons performing the

banking entity's underwriting activities are designed not to reward or

incentivize prohibited proprietary trading.\311\

---------------------------------------------------------------------------

\311\ See final rule Sec. 75.4(a)(2)(iv); see also infra Part

VI.A.2.c.4.c.

---------------------------------------------------------------------------

[cir] The banking entity is licensed or registered to engage in the

activity described in the underwriting exemption in accordance with

applicable law.\312\

---------------------------------------------------------------------------

\312\ See final rule Sec. 75.4(a)(2)(v); see also infra Part

VI.A.2.c.5.c.

---------------------------------------------------------------------------

After considering commenters' suggested alternative approaches to

implementing the statute's underwriting exemption, the Agencies have

determined to retain the general structure of the proposed underwriting

exemption. For instance, two commenters suggested providing a safe

harbor for ``plain vanilla'' or ``basic'' underwritings of stocks and

bonds.\313\ The Agencies do not believe that a safe harbor is necessary

to provide certainty that a banking entity may act as an underwriter in

these particular types of offerings. This is because ``plain vanilla''

or ``basic'' underwriting activity should be able to meet the

requirements of the final rule. For example, the final definition of

``distribution'' includes any offering of securities made pursuant to

an effective registration statement under the Securities Act.\314\

---------------------------------------------------------------------------

\313\ See Sens. Merkley & Levin (Feb. 2012); Johnson & Prof.

Stiglitz. One of these commenters also suggested that the Agencies

better incorporate the statutory limitations on material conflicts

of interest and high-risk activities in the underwriting exemption

by including additional provisions in the exemption to refer to

these limitations. See Sens. Merkley & Levin (Feb. 2012). The

Agencies note that these limitations are adopted in Sec. 75.7 of

the final rules, and this provision will apply to underwriting

activities, as well as all other exempted activities.

\314\ See final rule Sec. 75.4(a)(3).

---------------------------------------------------------------------------

Further, in response to one commenter's request that the final rule

prohibit a banking entity from acting as an underwriter in illiquid

assets that are determined to not have observable price inputs under

accounting standards,\315\ the Agencies continue to believe that it

would be inappropriate to incorporate accounting standards in the rule

because accounting standards could change in the future without

consideration of the potential impact on the final rule.\316\ Moreover,

the Agencies do not believe it is necessary to differentiate between

liquid and less liquid securities for purposes of determining whether a

banking entity may underwrite a distribution of securities because, in

either case, a banking entity must have a reasonable expectation of

purchaser demand for the securities and must make reasonable efforts to

sell or otherwise reduce its underwriting position within a reasonable

period under the final rule.\317\

---------------------------------------------------------------------------

\315\ See AFR et al. (Feb. 2012).

\316\ See Joint Proposal, 76 FR at 68859 n.101 (explaining why

the Agencies declined to incorporate certain accounting standards in

the proposed rule); CFTC Proposal, 77 FR at 8344 n.107.

\317\ See infra Part VI.A.2.c.2.c.

---------------------------------------------------------------------------

Another commenter suggested that the Agencies establish a strong

presumption that all of a banking entity's activities related to

underwriting are permitted under the rule as long as the banking entity

has adequate compliance and risk management procedures.\318\ While

strong compliance and risk management procedures are important for

banking entities' permitted activities, the Agencies believe that an

approach focused solely on the establishment of a compliance program

would likely increase the potential for evasion of the general

prohibition on proprietary trading. Similarly, the Agencies are not

adopting an exemption that is unlimited, as requested by one commenter,

because the Agencies believe controls are necessary to prevent

potential evasion of the statute through, among other things, retaining

an unsold allotment when there is sufficient customer interest for the

securities and to limit the risks associated with these

activities.\319\

---------------------------------------------------------------------------

\318\ See BoA.

\319\ See Fidelity.

---------------------------------------------------------------------------

Underwriters play an important role in facilitating issuers' access

to funding, and thus underwriters are important to the capital

formation process and economic growth.\320\ Obtaining new financing can

be expensive for an issuer because of the natural information advantage

that less well-known issuers have over investors about the quality of

their future investment opportunities. An underwriter can help reduce

these costs by mitigating the information asymmetry between an issuer

and its potential investors. The underwriter does this based in part on

its familiarity with the issuer and other similar issuers as well as by

collecting information about the issuer. This allows investors to look

to the reputation and experience of the underwriter as well as its

ability to provide information about the issuer and the underwriting.

For these and other reasons, most U.S. issuers rely on the services of

an underwriter when raising funds through public offerings. As

recognized in the statute, the exemption is intended to permit banking

entities to continue to perform the underwriting function, which

contributes to capital formation and its positive economic effects.

---------------------------------------------------------------------------

\320\ See, e.g., BoA (``The underwriting activities of U.S.

banking entities are essential to capital formation and, therefore,

economic growth and job creation.''); Goldman (Prop. Trading); Sens.

Merkley & Levin (Feb. 2012).

---------------------------------------------------------------------------

c. Detailed Explanation of the Underwriting Exemption

1. Acting as an Underwriter for a Distribution of Securities

a. Proposed Requirements That the Purchase or Sale Be Effected Solely

in Connection With a Distribution of Securities for Which the Banking

Entity Acts as an Underwriter and That the Covered Financial Position

Be a Security

Section 75.4(a)(2)(iii) of the proposed rule required that the

purchase or sale be effected solely in connection with a distribution

of securities for which a banking entity is acting as

[[Page 5834]]

underwriter.\321\ As discussed below, the Agencies proposed to define

the terms ``distribution'' and ``underwriter'' in the proposed rule.

The proposed rule also required that the covered financial position

being purchased or sold by the banking entity be a security.\322\

---------------------------------------------------------------------------

\321\ See proposed rule Sec. 75.4(a)(2)(iii).

\322\ See proposed rule Sec. 75.4(a)(2)(ii).

---------------------------------------------------------------------------

i. Proposed Definition of ``Distribution''

The proposed definition of ``distribution'' mirrored the definition

of this term used in the SEC's Regulation M under the Exchange

Act.\323\ More specifically, the proposed rule defined ``distribution''

as ``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.'' \324\ The Agencies did

not propose to define the terms ``magnitude'' and ``special selling

efforts and selling methods,'' but stated that the Agencies would

expect to rely on the same factors considered in Regulation M for

assessing these elements.\325\ The Agencies noted that ``magnitude''

does not imply that a distribution must be large and, therefore, this

factor would not preclude small offerings or private placements from

qualifying for the proposed underwriting exemption.\326\

---------------------------------------------------------------------------

\323\ See Joint Proposal, 76 FR at 68866-68867; CFTC Proposal,

77 FR at 8352; 17 CFR 242.101; proposed rule Sec. 75.4(a)(3).

\324\ See proposed rule Sec. 75.4(a)(3).

\325\ See Joint Proposal, 76 FR at 68867 (``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. In addition,

delivering a sales document, such as a prospectus, and conducting

road shows are generally indicative of special selling efforts and

selling methods. 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.''); CFTC Proposal, 77 FR at 8352; Review of

Antimanipulation Regulation of Securities Offering, Exchange Act

Release No. 33924 (Apr. 19, 1994), 59 FR 21681, 21684-21685 (Apr.

26, 1994).

\326\ See Joint Proposal, 76 FR at 68867; CFTC Proposal, 77 FR

at 8352.

---------------------------------------------------------------------------

ii. Proposed Definition of ``Underwriter''

Like the proposed definition of ``distribution,'' the Agencies

proposed to define ``underwriter'' in a manner similar to the

definition of this term in the SEC's Regulation M.\327\ The definition

of ``underwriter'' in the proposed rule was: (i) Any person who has

agreed with an issuer or selling security holder to: (a) Purchase

securities for distribution; (b) engage in a distribution of securities

for or on behalf of such issuer or selling security holder; or (c)

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 the preceding provisions to engage in a

distribution of such securities for or on behalf of the issuer or

selling security holder.\328\

---------------------------------------------------------------------------

\327\ See Joint Proposal, 76 FR at 68866-68867; CFTC Proposal,

77 FR at 8352; 17 CFR 242.101; proposed rule Sec. 75.4(a)(4).

\328\ See proposed rule Sec. 75.4(a)(4). As noted in the

proposal, the proposed rule's definition differed from the

definition in Regulation M because the proposed rule's definition

would also include 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. See Joint Proposal,

76 FR at 68867; CFTC Proposal, 77 FR at 8352.

---------------------------------------------------------------------------

In connection with this proposed requirement, the Agencies noted

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. To determine whether a banking

entity is acting as an underwriter as part of a distribution of

securities, the Agencies proposed to take into consideration the extent

to which a banking entity is engaged in the following activities:

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 document;

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.\329\

---------------------------------------------------------------------------

\329\ See Joint Proposal, 76 FR at 68867; CFTC Proposal, 77 FR

at 8352.

The proposal recognized that there may be circumstances in which an

underwriter would hold securities that it could not sell in the

distribution for investment purposes. The Agencies stated that if the

unsold securities were acquired in connection with underwriting under

the proposed exemption, then the underwriter would be able to dispose

of such securities at a later time.\330\

---------------------------------------------------------------------------

\330\ See id.

---------------------------------------------------------------------------

iii. Proposed Requirement That the Covered Financial Position Be a

Security

Pursuant to Sec. 75.4(a)(2)(ii) of the proposed exemption, a

banking entity would be permitted to purchase or sell a covered

financial position that is a security only in connection with its

underwriting activities.\331\ The proposal stated that this requirement

was meant to reflect the common usage and understanding of the term

``underwriting.'' \332\ It was noted, 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).\333\

---------------------------------------------------------------------------

\331\ See proposed rule Sec. 75.4(a)(2)(ii).

\332\ See Joint Proposal, 76 FR at 68866; CFTC Proposal, 77 FR

at 8352.

\333\ See Joint Proposal, 76 FR at 68866 n.132; CFTC Proposal,

77 FR at 8352 n.138.

---------------------------------------------------------------------------

b. Comments on the Proposed Requirements That the Trade Be Effected

Solely in Connection With a Distribution for Which the Banking Entity

Is Acting as an Underwriter and That the Covered Financial Position Be

a Security

In response to the proposed requirement that a purchase or sale be

``effected solely in connection with a distribution of securities'' for

which the ``banking entity is acting as underwriter,'' commenters

generally focused on the proposed definitions of ``distribution'' and

``underwriter'' and the types of activities that should be permitted

under the ``in connection with'' standard. Commenters did not directly

address the requirement in Sec. 75.4(a)(2)(ii) of the proposed rule,

which provided that the covered financial position purchased or sold

under the exemption must be a security. A number of commenters

expressed general concern that the proposed underwriting exemption's

references to a ``purchase or sale of a covered financial position''

could be interpreted to require compliance with the proposed rule on a

transaction-by-transaction basis. These commenters indicated that such

an approach would be overly burdensome.\334\

---------------------------------------------------------------------------

\334\ See, e.g., Goldman (Prop. Trading); SIFMA et al. (Prop.

Trading) (Feb. 2012).

---------------------------------------------------------------------------

i. Definition of ``Distribution''

Several commenters stated that the proposed definition of

``distribution'' is too narrow,\335\ while one commenter stated that

the proposed definition is too broad.\336\ Commenters who viewed the

proposed definition as too narrow stated that it may exclude important

capital-raising and financing transactions that do not appear to

involve ``special selling

[[Page 5835]]

efforts and selling methods'' or ``magnitude.''\337\ In particular,

these commenters stated that the proposed definition of

``distribution'' may preclude a banking entity from participating in

commercial paper issuances,\338\ bridge loans,\339\ ``at-the-market''

offerings or ``dribble out'' programs conducted off issuer shelf

registrations,\340\ offerings in response to reverse inquiries,\341\

offerings through an automated execution system,\342\ small private

offerings,\343\ or selling security holders' sales of securities of

issuers with large market capitalizations that are executed as

underwriting transactions in the normal course.\344\

---------------------------------------------------------------------------

\335\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading); Wells Fargo (Prop. Trading); RBC.

\336\ See Occupy.

\337\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading); Wells Fargo (Prop. Trading); RBC.

\338\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading); Wells Fargo (Prop. Trading). In addition, one

commenter expressed general concern that the proposed rule would

cause a reduction in underwriting services with respect to

commercial paper, which would reduce liquidity in commercial paper

markets and raise the costs of capital in already tight credit

markets. See Chamber (Feb. 2012).

\339\ See Goldman (Prop. Trading); Wells Fargo (Prop. Trading);

RBC; LSTA (Feb. 2012).

\340\ See Goldman (Prop. Trading).

\341\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\342\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\343\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading); Wells Fargo (Prop. Trading).

\344\ See RBC.

---------------------------------------------------------------------------

Several commenters suggested that the proposed definition be

modified to include some or all of these types of offerings.\345\ For

example, two commenters requested that the definition explicitly

include all offerings of securities by an issuer.\346\ One of these

commenters further requested a broader definition that would include

any offering by a selling security holder that is registered under the

Securities Act or that involves an offering document prepared by the

issuer.\347\ Another commenter suggested that the rule explicitly

authorize certain forms of offerings, such as offerings under Rule

144A, Regulation S, Rule 101(b)(10) of Regulation M, or the so-called

``section 4(1\1/2\)'' of the Securities Act, as well as transactions on

behalf of selling security holders.\348\ Two commenters proposed

approaches that would include the resale of notes or other debt

securities received by a banking entity from a borrower to replace or

refinance a bridge loan.\349\ One of these commenters stated that

permitting a banking entity to receive and resell notes or other debt

securities from a borrower to replace or refinance a bridge loan would

preserve the ability of a banking entity to extend credit and offer

customers a range of financing options. This commenter further

represented that such an approach would be consistent with the

exclusion of loans from the proposed definition of ``covered financial

position'' and the commenter's recommended exclusion from the

definition of ``trading account'' for collecting debts previously

contracted.\350\

---------------------------------------------------------------------------

\345\ See Goldman (Prop. Trading); SIFMA et al. (Prop. Trading)

(Feb. 2012); RBC.

\346\ See Goldman (Prop. Trading) (stating that this would

capture, among other things, commercial paper issuances, issuer

``dribble out'' programs, and small private offerings, which involve

the purchase of securities directly from an issuer with a view

toward resale, but may not always be clearly distinguished by

``special selling efforts and selling methods'' or by

``magnitude''); SIFMA et al. (Prop. Trading) (Feb. 2012).

\347\ See SIFMA et al. (Prop. Trading) (Feb. 2012). This

commenter indicated that expanding the definition of

``distribution'' to include both offerings of securities by an

issuer and offerings by a selling security holder that are

registered under the Securities Act or that involve an offering

document prepared by the issuer would ``include, for example, an

offering of securities by an issuer or a selling security holder

where securities are sold through an automated order execution

system, offerings in response to reverse inquiries and commercial

paper issuances.'' Id.

\348\ See RBC.

\349\ See Goldman (Prop. Trading); RBC. In addition, one

commenter requested the Agencies clarify that permitted underwriting

activities include the acquisition and resale of securities issued

in lieu of or to refinance bridge loan facilities, irrespective of

whether such activities qualify as ``distributions'' under the

proposal. See LSTA (Feb. 2012).

\350\ See Goldman (Prop. Trading).

---------------------------------------------------------------------------

One commenter, however, stated that the proposed definition of

``distribution'' is too broad. This commenter suggested that the

underwriting exemption should only be available for registered

offerings, and the rule should preclude a banking entity from

participating in a private placement. According to the commenter,

permitting a banking entity to participate in a private placement may

facilitate evasion of the prohibition on proprietary trading.\351\

---------------------------------------------------------------------------

\351\ See Occupy.

---------------------------------------------------------------------------

ii. Definition of ``Underwriter''

Several commenters stated that the proposed definition of

``underwriter'' is too narrow.\352\ Other commenters, however, stated

that the proposed definition is too broad, particularly due to the

proposed inclusion of selling group members.\353\

---------------------------------------------------------------------------

\352\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading); Wells Fargo (Prop. Trading).

\353\ See AFR et al. (Feb. 2012); Public Citizen; Occupy

(suggesting that the Agencies exceeded their statutory authority by

incorporating the Regulation M definition of ``underwriter,'' rather

than the Securities Act definition of ``underwriter'').

---------------------------------------------------------------------------

Commenters requesting a broader definition generally stated that

the Agencies should instead use the Regulation M definition of

``distribution participant'' or otherwise revise the definition of

``underwriter'' to incorporate the concept of a ``distribution

participant,'' as defined under Regulation M.\354\ According to these

commenters, using the term ``distribution participant'' would better

reflect current market practice and would include dealers that

participate in an offering but that do not deal directly with the

issuer or selling security holder and do not have a written agreement

with the underwriter.\355\ One commenter further represented that the

proposed provision for selling group members may be less inclusive than

the Agencies intended because individual selling dealers or dealer

groups may or may not have written agreements with an underwriter in

privity of contract with the issuer.\356\ Another commenter requested

that, if the ``distribution participant'' concept is not incorporated

into the rule, the proposed definition of ``underwriter'' be modified

to include a person who has an agreement with an affiliate of an issuer

or selling security holder (e.g., an agreement with a parent company to

distribute the issuer's securities).\357\

---------------------------------------------------------------------------

\354\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading); Wells Fargo (Prop. Trading). The term

``distribution participant'' is defined in Rule 100 of Regulation M

as ``an underwriter, prospective underwriter, broker, dealer, or

other person who has agreed to participate or is participating in a

distribution.'' 17 CFR 242.100.

\355\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading); Wells Fargo (Prop. Trading).

\356\ See Goldman (Prop. Trading).

\357\ See SIFMA et al. (Prop. Trading) (Feb. 2012). This

commenter also requested a technical amendment to proposed rule

Sec. 75.4(a)(4)(ii) to clarify that the person is ``participating''

in a distribution, not ``engaging'' in a distribution. See id.

---------------------------------------------------------------------------

Other commenters opposed the inclusion of selling group members in

the proposed definition of ``underwriter.'' These commenters stated

that because selling group members do not provide a price guarantee to

an issuer, they do not provide services to a customer and their

activities should not qualify for the underwriting exemption.\358\

---------------------------------------------------------------------------

\358\ See AFR et al. (Feb. 2012); Public Citizen.

---------------------------------------------------------------------------

A number of commenters stated that it is unclear whether the

proposed underwriting exemption would permit a banking entity to act as

an authorized participant (``AP'') to an ETF issuer, particularly with

respect to the creation and redemption of ETF shares or ``seeding'' an

ETF for a short period of

[[Page 5836]]

time when it is initially launched.\359\ For example, a few commenters

noted that APs typically do not perform some or all of the activities

that the Agencies proposed to consider to help determine whether a

banking entity is acting as an underwriter in connection with a

distribution of securities, including due diligence, advising an issuer

on market conditions and assisting in preparation of a registration

statement or offering documents, and participating in or organizing a

syndicate of investment banks.\360\

---------------------------------------------------------------------------

\359\ See BoA; ICI Global; Vanguard; ICI (Feb. 2012); SSgA (Feb.

2012). As one commenter explained, an AP may ``seed'' an ETF for a

short period of time at its inception by entering into several

initial creation transactions with the ETF issuer and refraining

from selling those shares to investors or redeeming them for a

period of time to facilitate the ETF achieving its liquidity launch

goals. See BoA.

\360\ See ICI Global; ICI (Feb. 2012); Vanguard.

---------------------------------------------------------------------------

However, one commenter appeared to oppose applying the underwriting

exemption to certain AP activities. According to this commenter, APs

are generally reluctant to concede that they are statutory underwriters

because they do not perform all the activities associated with the

underwriting of an operating company's securities. Further, this

commenter expressed concern that, if an AP had to rely on the proposed

underwriting exemption, the AP could be subject to heightened risk of

incurring underwriting liability on the issuance of ETF shares traded

by the AP. As a result of these considerations, the commenter believed

that a banking entity may be less willing to act as an AP for an ETF

issuer if it were required to rely on the underwriting exemption.\361\

---------------------------------------------------------------------------

\361\ See SSgA (Feb. 2012).

---------------------------------------------------------------------------

iii. ``Solely in Connection With'' Standard

To qualify for the underwriting exemption, the proposed rule

required a purchase or sale of a covered financial position to be

effected ``solely in connection with'' a distribution of securities for

which the banking entity is acting as underwriter. Several commenters

expressed concern that the word ``solely'' in this provision may result

in an overly narrow interpretation of permissible activities. In

particular, these commenters indicated that the ``solely in connection

with'' standard creates uncertainty about certain activities that are

currently conducted in the course of an underwriting, such as customary

underwriting syndicate activities.\362\ One commenter represented that

such activities are traditionally undertaken to: Support the success of

a distribution; mitigate risk to issuers, investors, and underwriters;

and facilitate an orderly aftermarket.\363\ A few commenters further

stated that requiring a trade to be ``solely'' in connection with a

distribution by an underwriter would be inconsistent with the

statute,\364\ may reduce future innovation in the capital-raising

process,\365\ and could create market disruptions.\366\

---------------------------------------------------------------------------

\362\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading); BoA; Wells Fargo (Prop. Trading); Comm. on Capital

Markets Regulation.

\363\ See Goldman (Prop. Trading).

\364\ See Goldman (Prop. Trading); Wells Fargo (Prop. Trading);

SIFMA et al. (Prop. Trading) (Feb. 2012).

\365\ See Goldman (Prop. Trading).

\366\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

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A number of commenters stated that it is unclear whether certain

activities would qualify for the proposed underwriting exemption and

requested that the Agencies adopt an exemption that is broad enough to

permit such activities.\367\ Commenters stated that there are a number

of activities that should be permitted under the underwriting

exemption, including: (i) Creating a naked or covered syndicate short

position in connection with an offering;\368\ (ii) creating a

stabilizing bid;\369\ (iii) acquiring positions via overallotments\370\

or trading in the market to close out short positions in connection

with an overallotment option or in connection with other stabilization

activities;\371\ (iv) using call spread options in a convertible debt

offering to mitigate dilution of existing shareholders;\372\ (v)

repurchasing existing debt securities of an issuer in the course of

underwriting a new series of debt securities in order to stimulate

demand for the new issuance;\373\ (vi) purchasing debt securities of

comparable issuers as a price discovery mechanism in connection with

underwriting a new debt security;\374\ (vii) hedging the underwriter's

exposure to a derivative strategy engaged in with an issuer;\375\

(viii) organizing and assembling a resecuritized product, including,

for example, sourcing bond collateral over a period of time in

anticipation of issuing new securities;\376\ and (ix) selling a

security to an intermediate entity as part of the creation of certain

structured products.\377\

---------------------------------------------------------------------------

\367\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading); Wells Fargo (Prop. Trading); RBC.

\368\ See SIFMA et al. (Prop. Trading) (Feb. 2012) (``The reason

for creating the short positions (covered and naked) is to

facilitate an orderly aftermarket and to reduce price volatility of

newly offered securities. This provides significant value to issuers

and selling security holders, as well as to investors, by giving the

syndicate buying power that helps protect against immediate

volatility in the aftermarket.''); RBC; Goldman (Prop. Trading).

\369\ See SIFMA et al. (Prop. Trading) (Feb. 2012)

(``Underwriters may also engage in stabilization activities under

Regulation M by creating a stabilizing bid to prevent or slow a

decline in the market price of a security. These activities should

be encouraged rather than restricted by the Volcker Rule because

they reduce price volatility and facilitate the orderly pricing and

aftermarket trading of underwritten securities, thereby contributing

to capital formation.'').

\370\ See RBC.

\371\ See Goldman (Prop. Trading).

\372\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading) (stating that the call spread arrangement ``may make

a wider range of financing options feasible for the issuer of the

convertible debt'' and ``can help it to raise more capital at more

attractive prices'').

\373\ See Wells Fargo (Prop. Trading). The commenter further

stated that the need to purchase the issuer's other debt securities

from investors may arise if an investor has limited risk tolerance

to the issuer's credit or has portfolio restrictions. According to

the commenter, the underwriter would typically sell the debt

securities it purchased from existing investors to new investors.

See id.

\374\ See Wells Fargo (Prop. Trading).

\375\ See Goldman (Prop. Trading).

\376\ See ASF (Feb. 2012) (stating that, for example, a banking

entity may respond to customer or general market demand for highly-

rated mortgage paper by accumulating residential mortgage-backed

securities over time and holding such securities in inventory until

the transaction can be organized and assembled).

\377\ See ICI (Feb. 2012) (stating that the sale of assets to an

intermediate asset-backed commercial paper or tender option bond

program should be permitted under the underwriting exemption if the

sale is part of the creation of a structured security). See also AFR

et al. (Feb. 2012) (stating that the treatment of a sale to an

intermediate entity should depend on whether the banking entity or

an external client is the driver of the demand and, if the banking

entity is the driver of the demand, then the near term demand

requirement should not be met). Two commenters stated that the

underwriting exemption should not permit a banking entity to sell a

security to an intermediate entity in the course of creating a

structured product. See Occupy; Alfred Brock. These commenters were

generally responding to a question on this issue in the proposal.

See Joint Proposal, 76 FR at 68868-68869 (question 78); CFTC

Proposal, 77 FR at 8354 (question 78).

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c. Final Requirement That the Banking Entity Act as an Underwriter for

a Distribution of Securities and the Trading Desk's Underwriting

Position Be Related to Such Distribution

The final rule requires that the banking entity act as an

underwriter for a distribution of securities and the trading desk's

underwriting position be related to such distribution.\378\ This

requirement is substantially similar to the proposed rule,\379\ but

with five key refinements. First, to address commenters' confusion

about whether

[[Page 5837]]

the underwriting exemption applies on a transaction-by-transaction

basis, the phrase ``purchase or sale'' has been modified to instead

refer to the trading desk's ``underwriting position.'' Second, to

balance this more aggregated position-based approach, the final rule

specifies that the trading desk is the organizational level of a

banking entity (or across one or more affiliated banking entities) at

which the requirements of the underwriting exemption will be assessed.

Third, the Agencies have made important modifications to the definition

of ``distribution'' to better capture the various types of private and

registered offerings a banking entity may be asked to underwrite by an

issuer or selling security holder. Fourth, the definition of

``underwriter'' has been refined to clarify that both members of the

underwriting syndicate and selling group members may qualify as

underwriters for purposes of this exemption. Finally, the word

``solely'' has been removed to clarify that a broader scope of

activities conducted in connection with underwriting (e.g.,

stabilization activities) are permitted under this exemption. These

issues are discussed in turn below.

---------------------------------------------------------------------------

\378\ Final rule Sec. 75.4(a)(2)(i). The terms ``distribution''

and ``underwriter'' are defined in final rule Sec. 75.4(a)(3) and

Sec. 75.4(a)(4), respectively.

\379\ Proposed rule Sec. 75.4(a)(2)(iii) required that ``[t]he

purchase or sale is effected solely in connection with a

distribution of securities for which the covered banking entity is

acting as underwriter.''

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i. Definition of ``Underwriting Position''

In response to commenters' concerns about transaction-by-

transaction analyses,\380\ the Agencies are modifying the exemption to

clarify the level at which compliance with certain provisions will be

assessed. The proposal was not intended to impose a transaction-by-

transaction approach, and the final rule's requirements generally focus

on the long or short positions in one or more securities held by a

banking entity or its affiliate, and managed by a particular trading

desk, in connection with a particular distribution of securities for

which such banking entity or its affiliate is acting as an underwriter.

Like Sec. 75.4(a)(2)(ii) of the proposed rule, the definition of

``underwriting position'' is limited to positions in securities because

the common usage and understanding of the term ``underwriting'' is

limited to activities in securities.

---------------------------------------------------------------------------

\380\ See, e.g., Goldman (Prop. Trading); SIFMA et al. (Prop.

Trading) (Feb. 2012).

---------------------------------------------------------------------------

A trading desk's underwriting position constitutes the securities

positions that are acquired in connection with a single distribution

for which the relevant banking entity is acting as an underwriter. A

trading desk may not aggregate securities positions acquired in

connection with two or more distributions to determine its

``underwriting position.'' A trading desk may, however, have more than

one ``underwriting position'' at a particular point in time if the

banking entity is acting as an underwriter for more than one

distribution. As a result, the underwriting exemption's requirements

pertaining to a trading desk's underwriting position will apply on a

distribution-by-distribution basis.

A trading desk's underwriting position can include positions in

securities held at different affiliated legal entities, provided the

banking entity is able to provide supervisors or examiners of any

Agency that has regulatory authority over the banking entity pursuant

to section 13(b)(2)(B) of the BHC Act with records, promptly upon

request, that identify any related positions held at an affiliated

entity that are being included in the trading desk's underwriting

position for purposes of the underwriting exemption. Banking entities

should be prepared to provide all records that identify all of the

positions included in a trading desk's underwriting position and where

such positions are held.

The Agencies believe that a distribution-by-distribution approach

is appropriate due to the relatively distinct nature of underwriting

activities for a single distribution on behalf of an issuer or selling

security holder. The Agencies do not believe that a narrower

transaction-by-transaction analysis is necessary to determine whether a

banking entity is engaged in permitted underwriting activities. The

Agencies also decline to take a broader approach, which would allow a

banking entity to aggregate positions from multiple distributions for

which it is acting as an underwriter, because it would be more

difficult for the banking entity's internal compliance personnel and

Agency supervisors and examiners to review the trading desk's positions

to assess the desk's compliance with the underwriting exemption. A more

aggregated approach would increase the number of positions in different

types of securities that could be included in the underwriting

position, which would make it more difficult to determine that an

individual position is related to a particular distribution of

securities for which the banking entity is acting as an underwriter

and, in turn, increase the potential for evasion of the general

prohibition on proprietary trading.

ii. Definition of ``Trading Desk''

The proposed underwriting exemption would have applied certain

requirements across an entire banking entity. To promote consistency

with the market-making exemption and address potential evasion

concerns, the final rule applies the requirements of the underwriting

exemption at the trading desk level of organization.\381\ This approach

will result in the requirements of the underwriting exemption applying

to the aggregate trading activities of a relatively limited group of

employees on a single desk. Applying requirements at the trading desk

level should facilitate banking entity and Agency monitoring and review

of compliance with the exemption by limiting the location where

underwriting activity may occur and allowing better identification of

the aggregate trading volume that must be reviewed to determine whether

the desk's activities are being conducted in a manner that is

consistent with the underwriting exemption, while also allowing

adequate consideration of the particular facts and circumstances of the

desk's trading activities.

---------------------------------------------------------------------------

\381\ See infra Part VI.A.3.c. (discussing the final market-

making exemption).

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The trading desk should be managed and operated as an individual

unit and should reflect the level at which the profit and loss of

employees engaged in underwriting activities is attributed. The term

``trading desk'' in the underwriting context is intended to encompass

what is commonly thought of as an underwriting desk. A trading desk

engaged in underwriting activities would not necessarily be an active

market participant that engages in frequent trading activities.

A trading desk may manage an underwriting position that includes

positions held by different affiliated legal entities.\382\ Similarly,

a trading desk may include employees working on behalf of multiple

affiliated legal entities or booking trades in multiple affiliated

entities. The geographic location of individual traders is not

dispositive for purposes of determining whether the employees are

engaged in activities for a single trading desk.

---------------------------------------------------------------------------

\382\ See supra note 307 and accompanying text.

---------------------------------------------------------------------------

iii. Definition of ``Distribution''

The term ``distribution'' is defined in the final rule as: (i) An

offering of securities, whether or not subject to registration under

the Securities Act, that is distinguished from ordinary trading

transactions by the presence of special selling efforts and selling

methods; or (ii) an offering of securities made pursuant to an

effective registration statement under the Securities Act.\383\ In

response to comments, the proposed definition has been revised to

eliminate the need to consider the ``magnitude'' of an offering and

instead supplements the definition

[[Page 5838]]

with an alternative prong for registered offerings under the Securities

Act.\384\

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\383\ Final rule Sec. 75.4(a)(3).

\384\ Proposed rule Sec. 75.4(a)(3) defined ``distribution'' as

``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.''

---------------------------------------------------------------------------

The proposed definition's reference to magnitude caused some

commenter concern with respect to whether it could be interpreted to

preclude a banking entity from intermediating a small private

placement. After considering comments, the Agencies have determined

that the requirement to have special selling efforts and selling

methods is sufficient to distinguish between permissible securities

offerings and prohibited proprietary trading, and the additional

magnitude factor is not needed to further this objective.\385\ As

proposed, the Agencies will rely on the same factors considered under

Regulation M to analyze the presence of special selling efforts and

selling methods.\386\ Indicators of special selling efforts and selling

methods include delivering a sales document (e.g., a prospectus),

conducting road shows, and receiving compensation that is greater than

that for secondary trades but consistent with underwriting

compensation.\387\ For purposes of the final rule, each of these

factors need not be present under all circumstances. Offerings that

qualify as distributions under this prong of the definition include,

among others, private placements in which resales may be made in

reliance on the SEC's Rule 144A or other available exemptions \388\

and, to the extent the commercial paper being offered is a security,

commercial paper offerings that involve the underwriter receiving

special compensation.\389\

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\385\ The policy goals of this rule differ from those of the

SEC's Regulation M, which is an anti-manipulation rule. The focus on

magnitude is appropriate for that regulation because it helps

identify offerings that can give rise to an incentive to condition

the market for the offered security. To the contrary, this rule is

intended to allow banking entities to continue to provide client-

oriented financial services, including underwriting services. The

SEC emphasizes that this rule does not have any impact on Regulation

M.

\386\ See Joint Proposal, 76 FR at 68867; CFTC Proposal, 77 FR

at 8352.

\387\ See Joint Proposal, 76 FR at 68867; CFTC Proposal, 77 FR

at 8352; Review of Antimanipulation Regulation of Securities

Offering, Exchange Act Release No. 33924 (Apr. 19, 1994), 59 FR

21681, 21684-21685 (Apr. 26, 1994).

\388\ The final rule does not provide safe harbors for

particular distribution techniques. A safe harbor-based approach

would provide certainty for specific types of offerings, but may not

account for evolving market practices and distribution techniques

that could technically satisfy a safe harbor but that might

implicate the concerns that led Congress to enact section 13 of the

BHC Act. See RBC.

\389\ This clarification is intended to address commenters'

concern regarding potential limitations on banking entities' ability

to facilitate commercial paper offerings under the proposed

underwriting exemption. See supra Part VI.A.2.c.1.b.i.

---------------------------------------------------------------------------

The Agencies are also adopting a second prong to this definition,

which will independently capture all offerings of securities that are

made pursuant to an effective registration statement under the

Securities Act.\390\ The registration prong of the definition is

intended to provide another avenue by which an offering of securities

may be conducted under the exemption, absent other special selling

efforts and selling methods or a determination of whether such efforts

and methods are being conducted. The Agencies believe this prong

reduces potential administrative burdens by providing a bright-line

test for what constitutes a distribution for purposes of the final

rule. In addition, this prong is consistent with the purpose and goals

of the statute because it reflects a common type of securities offering

and does not raise evasion concerns as it is unlikely that an entity

would go through the registration process solely to facilitate or

engage in speculative proprietary trading.\391\ This prong would

include, among other things, the following types of registered

securities offerings: Offerings made pursuant to a shelf registration

statement (whether on a continuous or delayed basis),\392\ bought

deals,\393\ at the market offerings,\394\ debt offerings, asset-backed

security offerings, initial public offerings, and other registered

offerings. An offering can be a distribution for purposes of either

Sec. 75.4(a)(3)(i) or Sec. 75.4(a)(3)(ii) of the final rule

regardless of whether the offering is issuer driven, selling security

holder driven, or arises as a result of a reverse inquiry.\395\

Provided the definition of distribution is met, an offering can be a

distribution for purposes of this rule regardless of how it is

conducted, whether by direct communication, exchange transactions, or

automated execution system.\396\

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\390\ See, e.g., Form S-1 (17 CFR 239.11); Form S-3 (17 CFR

239.13); Form S-8 (17 CFR 239.16b); Form F-1 (17 CFR 239.31); Form

F-3 (17 CFR 239.33).

\391\ Although the Agencies are providing an additional prong to

the definition of ``distribution'' for registered offerings, the

final rule does not limit the availability of the underwriting

exemption to registered offerings, as suggested by one commenter.

The statute does not include such an express limitation, and the

Agencies decline to construe the statute to require such an

approach. In response to the commenter stating that permitting a

banking entity to participate in a private placement may facilitate

evasion of the prohibition on proprietary trading, the Agencies

believe this concern is addressed by the provision in the final rule

requiring that a trading desk have a reasonable expectation of

demand from other market participants for the amount and type of

securities to be acquired from an issuer or selling security holder

for distribution and make reasonable efforts to sell its

underwriting position within a reasonable period. As discussed

below, the Agencies believe this requirement in the final rule

appropriately addresses evasion concerns that a banking entity may

retain an unsold allotment for purely speculative purposes. Further,

the Agencies believe that preventing a banking entity from

facilitating a private offering could unnecessarily hinder capital-

raising without providing commensurate benefits because issuers use

private offerings to raise capital in a variety of situations and

the underwriting exemption's requirements limit the potential for

evasion for both registered and private offerings, as noted above.

\392\ See Securities Offering Reform, Securities Act Release No.

8591 (July 19, 2005), 70 FR 44722 (Aug. 3, 2005); 17 CFR 230.405

(defining ``automatic shelf registration statement'' as a

registration statement filed on Form S-3 (17 CFR 239.13) or Form F-3

(17 CFR 239.33) by a well-known seasoned issuer pursuant to General

Instruction I.D. or I.C. of such forms, respectively); 17 CFR

230.415.

\393\ A bought deal is a distribution technique whereby an

underwriter makes a bid for securities without engaging in a

preselling effort, such as book building or distribution of a

preliminary prospectus. See, e.g., Delayed or Continuous Offering

and Sale of Securities, Securities Act Release No. 6470 (June 9,

1983), n.5.

\394\ See, e.g., 17 CFR 230.415(a)(4) (defining ``at the market

offering'' as ``an offering of equity securities into an existing

trading market for outstanding shares of the same class at other

than a fixed price''). At the market offerings may also be referred

to as ``dribble out'' programs.

\395\ Under the ``reverse inquiry'' process, an investor may be

allowed to purchase securities from the issuer through an

underwriter that is not designated in the prospectus as the issuer's

agent by having such underwriter approach the issuer with an

interest from the investor. See Joseph McLaughlin and Charles J.

Johnson, Jr., ``Corporate Finance and the Securities Laws'' (4th ed.

2006, supplemented 2012).

\396\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

---------------------------------------------------------------------------

As discussed above, some commenters expressed concern that the

proposed definition of ``distribution'' would prevent a banking entity

from acquiring and reselling securities issued in lieu of or to

refinance bridge loan facilities in reliance on the underwriting

exemption. Bridge financing arrangements can be structured in many

different ways, depending on the context and the specific objectives of

the parties involved. As a result, the treatment of securities acquired

in lieu of or to refinance a bridge loan and the subsequent sale of

such securities under the final rule depends on the facts and

circumstances. A banking entity may meet the terms of the underwriting

exemption for its bridge loan activity, or it may be able to rely on

the market-making exemption. If the banking entity's bridge loan

activity does not qualify for an exemption under the rule, then it

would not be permitted to engage in such activity.

[[Page 5839]]

iv. Definition of ``Underwriter''

In response to comments, the Agencies are adopting certain

modifications to the proposed definition of ``underwriter'' to better

capture selling group members and to more closely resemble the

definition of ``distribution participant'' in Regulation M. In

particular, the Agencies are defining ``underwriter'' as: (i) A person

who has agreed with an issuer or selling security holder to: (A)

Purchase Securities from the issuer or selling security holder for

distribution; (B) engage in a distribution of securities for or on

behalf of the issuer or selling security holder; or (C) manage a

distribution of securities for or on behalf of the issuer or selling

security holder; or (ii) a person who has agreed to participate or is

participating in a distribution of such securities for or on behalf of

the issuer or selling security holder.\397\

---------------------------------------------------------------------------

\397\ See final rule Sec. 75.4(a)(4).

---------------------------------------------------------------------------

A number of commenters requested that the Agencies broaden the

underwriting exemption to permit activities in connection with a

distribution of securities by any distribution participant. A few of

these commenters interpreted the proposed definition of ``underwriter''

as requiring a selling group member to have a written agreement with

the underwriter to participate in the distribution.\398\ These

commenters noted that such a written agreement may not exist under all

circumstances. The Agencies did not intend to require that members of

the underwriting syndicate or the lead underwriter have a written

agreement with all selling group members for each offering or that they

be in privity of contract with the issuer or selling security holder.

To provide clarity on this issue, the Agencies have modified the

language of subparagraph (ii) of the definition to include firms that,

while not members of the underwriting syndicate, have agreed to

participate or are participating in a distribution of securities for or

on behalf of the issuer or selling security holder.

---------------------------------------------------------------------------

\398\ The basic documents in firm commitment underwritten

securities offerings generally are: (i) The agreement among

underwriters, which establishes the relationship among the managing

underwriter, any co-managers, and the other members of the

underwriting syndicate; (ii) the underwriting (or ``purchase'')

agreement, in which the underwriters commit to purchase the

securities from the issuer or selling security holder; and (iii) the

selected dealers agreement, in which selling group members agree to

certain provisions relating to the distribution. See Joseph

McLaughlin and Charles J. Johnson, Jr., ``Corporate Finance and the

Securities Laws'' (4th ed. 2006, supplemented 2012), Ch. 2. The

Agencies understand that two firms may enter into a master agreement

that governs all offerings in which both firms participate as

members of the underwriting syndicate or as a member of the

syndicate and a selling group member. See, e.g., SIFMA Master

Selected Dealers Agreement (June 10, 2011), available at

www.sifma.org.

---------------------------------------------------------------------------

The final rule does not adopt a narrower definition of

``underwriter,'' as suggested by two commenters.\399\ Although selling

group members do not have a direct relationship with the issuer or

selling security holder, they do help facilitate the successful

distribution of securities to a wider variety of purchasers, such as

regional or retail purchasers that members of the underwriting

syndicate may not be able to access as easily. Thus, the Agencies

believe it is consistent with the purpose of the statutory underwriting

exemption and beneficial to recognize and allow the current market

practice of an underwriting syndicate and selling group members

collectively facilitating a distribution of securities. The Agencies

note that because banking entities that are selling group members will

be underwriters under the final rule, they will be subject to all the

requirements of the underwriting exemption.

---------------------------------------------------------------------------

\399\ See AFR et al. (Feb. 2012); Public Citizen.

---------------------------------------------------------------------------

As provided in the preamble to the proposed rule, engaging in the

following activities may indicate that a banking entity is acting as an

underwriter under Sec. 75.4(a)(4) as part of a distribution of

securities:

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 document;

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.\400\

\400\ See Joint Proposal, 76 FR at 68867; CFTC Proposal, 77 FR

at 8352. Post-issuance secondary market activity is expected to be

conducted in accordance with the market-making exemption.

---------------------------------------------------------------------------

The Agencies continue to take the view that the precise activities

performed by an underwriter will vary depending on the liquidity of the

securities being underwritten and the type of distribution being

conducted. A banking entity is not required to engage in each of the

above-noted activities to be considered an underwriter for purposes of

this rule. In addition, the Agencies note that, to the extent a banking

entity does not meet the definition of ``underwriter'' in the final

rule, it may be able to rely on the market-making exemption in the

final rule for its trading activity. In response to comments noting

that APs for ETFs do not engage in certain of these activities and

inquiring whether an AP would be able to qualify for the underwriting

exemption for certain of its activities, the Agencies believe that many

AP activities, such as conducting general creations and redemptions of

ETF shares, are better suited for analysis under the market-making

exemption because they are driven by the demands of other market

participants rather than the issuer, the ETF.\401\ Whether an AP may

rely on the underwriting exemption for its activities in an ETF will

depend on the facts and circumstances, including, among other things,

whether the AP meets the definition of ``underwriter'' and the offering

of ETF shares qualifies as a ``distribution.''

---------------------------------------------------------------------------

\401\ See infra Part VI.A.3.

---------------------------------------------------------------------------

To provide further clarity about the scope of the definition of

``underwriter,'' the Agencies are defining the terms ``selling security

holder'' and ``issuer'' in the final rule. The Agencies are using the

definition of ``issuer'' from the Securities Act because this

definition is commonly used in the context of securities offerings and

is well understood by market participants.\402\ A ``selling security

holder'' is defined as ``any person, other than an issuer, on whose

behalf a distribution is made.''\403\ This definition is consistent

with the

[[Page 5840]]

definition of ``selling security holder'' found in the SEC's Regulation

M.\404\

---------------------------------------------------------------------------

\402\ See final rule Sec. 75.3(e)(9) (defining the term

``issuer'' for purposes of the proprietary trading provisions in

subpart B of the final rule). Under section 2(a)(4) of the

Securities Act, ``issuer'' is defined as ``every person who issues

or proposes to issue any security; except that with respect to

certificates of deposit, voting-trust certificates, or collateral-

trust certificates, or with respect to certificates of interest or

shares in an unincorporated investment trust not having a board of

directors (or persons performing similar functions) or of the fixed,

restricted management, or unit type, the term `issuer' means the

person or persons performing the acts and assuming the duties of

depositor or manager pursuant to the provisions of the trust or

other agreement or instrument under which such securities are

issued; except that in the case of an unincorporated association

which provides by its articles for limited liability of any or all

of its members, or in the case of a trust, committee, or other legal

entity, the trustees or members thereof shall not be individually

liable as issuers of any security issued by the association, trust,

committee, or other legal entity; except that with respect to

equipment-trust certificates or like securities, the term `issuer'

means the person by whom the equipment or property is or is to be

used; and except that with respect to fractional undivided interests

in oil, gas, or other mineral rights, the term `issuer' means the

owner of any such right or of any interest in such right (whether

whole or fractional) who creates fractional interests therein for

the purpose of public offering.'' 15 U.S.C. 77b(a)(4).

\403\ Final rule Sec. 75.4(a)(5).

\404\ See 17 CFR 242.100(b).

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v. Activities Conducted ``in Connection With'' a Distribution

As discussed above, several commenters expressed concern that the

proposed underwriting exemption would not allow a banking entity to

engage in certain auxiliary activities that may be conducted in

connection with acting as an underwriter for a distribution of

securities in the normal course. These commenters' concerns generally

arose from the use of the word ``solely'' in Sec. 75.4(a)(2)(iii) of

the proposed rule, which commenters noted was not included in the

statute's underwriting exemption.\405\ In addition, a number of

commenters discussed particular activities they believed should be

permitted under the underwriting exemption and indicated the term

``solely'' created uncertainty about whether such activities would be

permitted.\406\

---------------------------------------------------------------------------

\405\ See supra Part VI.A.2.c.1.b.iii.

\406\ See supra notes 362, 363, 368-77 and accompanying text.

---------------------------------------------------------------------------

To reduce uncertainty in response to comments, the final rule

requires a trading desk's underwriting position to be ``held . . . and

managed . . . in connection with'' a single distribution for which the

relevant banking entity is acting as an underwriter, rather than

requiring that a purchase or sale be ``effected solely in connection

with'' such a distribution. Importantly, for purposes of establishing

an underwriting position in reliance on the underwriting exemption, a

trading desk may only engage in activities that are related to a

particular distribution of securities for which the banking entity is

acting as an underwriter. Activities that may be permitted under the

underwriting exemption include stabilization activities,\407\ syndicate

shorting and aftermarket short covering,\408\ holding an unsold

allotment when market conditions may make it impracticable to sell the

entire allotment at a reasonable price at the time of the distribution

and selling such position when it is reasonable to do so,\409\ and

helping the issuer mitigate its risk exposure arising from the

distribution of its securities (e.g., entering into a call-spread

option with an issuer as part of a convertible debt offering to

mitigate dilution to existing shareholders).\410\ Such activities

should be intended to effectuate the distribution process and provide

benefits to issuers, selling security holders, or purchasers in the

distribution. Existing laws, regulations, and self-regulatory

organization rules limit or place certain requirements around many of

these activities. For example, an underwriter's subsequent sale of an

unsold allotment must comply with applicable provisions of the Federal

securities laws and the rules thereunder. Moreover, any position

resulting from these activities must be included in the trading desk's

underwriting position, which is subject to a number of restrictions in

the final rule. Specifically, as discussed in more detail below, the

trading desk must make reasonable efforts to sell or otherwise reduce

its underwriting position within a reasonable period,\411\ and each

trading desk must have robust limits on, among other things, the

amount, types, and risks of its underwriting position and the period of

time a security may be held.\412\ Thus, in general, the underwriting

exemption would not permit a trading desk, for example, to acquire a

position as part of its stabilization activities and hold that position

for an extended period.

---------------------------------------------------------------------------

\407\ See SIFMA et al. (Prop. Trading) (Feb. 2012). See Anti-

Manipulation Rules Concerning Securities Offerings, Exchange Act

Release No. 38067 (Dec. 20, 1996), 62 FR 520, 535 (Jan. 3, 1997)

(``Although stabilization is price-influencing activity intended to

induce others to purchase the offered security, when appropriately

regulated it is an effective mechanism for fostering an orderly

distribution of securities and promotes the interests of

shareholders, underwriters, and issuers.'').

\408\ See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; Goldman

(Prop. Trading). See Proposed Amendments to Regulation M: Anti-

Manipulation Rules Concerning Securities Offerings, Exchange Act

Release No. 50831 (Dec. 9, 2004), 69 FR 75774, 75780 (Dec. 17, 2004)

(``In the typical offering, the syndicate agreement allows the

managing underwriter to `oversell' the offering, i.e., establish a

short position beyond the number of shares to which the underwriting

commitment relates. The underwriting agreement with the issuer often

provides for an `overallotment option' whereby the syndicate can

purchase additional shares from the issuer or selling shareholders

in order to cover its short position. To the extent that the

syndicate short position is in excess of the overallotment option,

the syndicate is said to have taken an `uncovered' short position.

The syndicate short position, up to the amount of the overallotment

option, may be covered by exercising the option or by purchasing

shares in the market once secondary trading begins.'').

\409\ See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; BoA;

BDA (Feb. 2012).

\410\ See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; Goldman

(Prop. Trading).

\411\ See final rule Sec. 75.4(a)(2)(ii); infra Part

VI.A.2.c.2.c. (discussing the requirement to make reasonable efforts

to sell or otherwise reduce the underwriting position).

\412\ See final rule Sec. 75.4(a)(2)(iii)(B); infra Part

VI.A.2.c.3.c. (discussing the required limits for trading desks

engaged in underwriting activity).

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This approach does not mean that any activity that is arguably

connected to a distribution of securities is permitted under the

underwriting exemption. Certain activities noted by commenters are not

core to the underwriting function and, thus, are not permitted under

the final underwriting exemption. However, a banking entity may be able

to rely on another exemption for such activities (e.g., the market-

making or hedging exemptions), if applicable. For example, a trading

desk would not be able to use the underwriting exemption to purchase a

financial instrument from a customer to facilitate the customer's

ability to buy securities in the distribution.\413\ Further, purchasing

another financial instrument to help determine how to price the

securities that are subject to a distribution would not be permitted

under the underwriting exemption.\414\ These two activities may be

permitted under the market-making exemption, depending on the facts and

circumstances. In response to one commenter's suggestion that hedging

the underwriter's risk exposure be permissible under this exemption,

the Agencies emphasize that hedging the underwriter's risk exposure is

not permitted under the underwriting exemption.\415\ A banking entity

must comply with the hedging exemption for such activity.

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\413\ See Wells Fargo (Prop. Trading). The Agencies do not

believe this activity is consistent with underwriting activity

because it could result in an underwriting desk holding a variety of

positions over time that are not directly related to a distribution

of securities the desk is conducting on behalf of an issuer or

selling security holder. Further, the Agencies believe this activity

may be more appropriately analyzed under the market-making exemption

because market makers generally purchase or sell a financial

instrument at the request of customers and otherwise routinely stand

ready to purchase and sell a variety of related financial

instruments.

\414\ See id. The Agencies view this activity as inconsistent

with underwriting because underwriters typically engage in other

activities, such as book-building and other marketing efforts, to

determine the appropriate price for a security and these activities

do not involve taking positions that are unrelated to the securities

subject to distribution. See infra VI.A.2.c.2.

\415\ Although one commenter suggested that an underwriter's

hedging activity be permitted under the underwriting exemption, we

do not believe the requirements in the proposed hedging exemption

would be unworkable or overly burdensome in the context of an

underwriter's hedging activity. See Goldman (Prop. Trading). As

noted above, underwriting activity is of a relatively distinct

nature, which is substantially different from market-making

activity, which is more dynamic and involves more frequent trading

activity giving rise to a variety of positions that may naturally

hedge the risks of certain other positions. The Agencies believe it

is appropriate to require that a trading desk comply with the

requirements of the hedging exemption when it is hedging the risks

of its underwriting position, while allowing a trading desk's market

making-related hedging under the market-making exemption.

---------------------------------------------------------------------------

In response to comments about the sale of a security to an

intermediate entity in connection with a structured

[[Page 5841]]

finance product,\416\ the Agencies have not modified the underwriting

exemption. Underwriting is distinct from product development. Thus,

parties must adjust activities associated with developing structured

finance products or meet the terms of other available exemptions.

Similarly, the accumulation of securities or other assets in

anticipation of a securitization or resecuritization is not an activity

conducted ``in connection with'' underwriting for purposes of the

exemption.\417\ This activity is typically engaged in by an issuer or

sponsor of a securitized product in that capacity, rather than in the

capacity of an underwriter. The underwriting exemption only permits a

banking entity's activities when it is acting as an underwriter.

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\416\ See ICI (Feb. 2012); AFR et al. (Feb. 2012); Occupy;

Alfred Brock.

\417\ A banking entity may accumulate loans in anticipation of

securitization because loans are not financial instruments under the

final rule. See supra Part VI.A.1.c.

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2. Near Term Customer Demand Requirement

a. Proposed Near Term Customer Demand Requirement

Like the statute, Sec. 75.4(a)(2)(v) of the proposed rule required

that the underwriting activities of the banking entity with respect to

the covered financial position be designed not to exceed the reasonably

expected near term demands of clients, customers, or

counterparties.\418\

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\418\ See proposed rule Sec. 75.4(a)(2)(v); Joint Proposal, 76

FR at 68867; CFTC Proposal, 77 FR at 8353.

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b. Comments Regarding the Proposed Near Term Customer Demand

Requirement

Both the statute and the proposed rule require a banking entity's

underwriting activity to be ``designed not to exceed the reasonably

expected near term demands of clients, customers, or counterparties.''

\419\ Several commenters requested that this standard be interpreted in

a flexible manner to allow a banking entity to participate in an

offering that may require it to retain an unsold allotment for a period

of time.\420\ In addition, one commenter stated that the final rule

should provide flexibility in this standard by recognizing that the

concept of ``near term'' differs between asset classes and depends on

the liquidity of the market.\421\ Two commenters expressed views on how

the near term customer demand requirement should work in the context of

a securitization or creating what the commenters characterized as

``structured products'' or ``structured instruments.''\422\

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\419\ See supra Part VI.A.2.c.2.a.

\420\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; BDA

(Feb. 2012); RBC. Another commenter requested that this requirement

be eliminated or changed to ``underwriting activities of the banking

entity with respect to the covered financial position must be

designed to meet the near-term demands of clients, customers, or

counterparties.'' See Japanese Bankers Ass'n.

\421\ See RBC (stating that the Board has found acceptable the

retention of assets acquired in connection with underwriting

activities for a period of 90 to 180 days and has further permitted

holding periods of up to a year in certain circumstances, such as

for less liquid securities).

\422\ See AFR et al. (Feb. 2012); Sens. Merkley & Levin (Feb.

2012).

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Many commenters expressed concern that the proposed requirement, if

narrowly interpreted, could prevent an underwriter from holding a

residual position for which there is no immediate demand from clients,

customers, or counterparties.\423\ Commenters noted that there are a

variety of offerings that present some risk of an underwriter having to

hold a residual position that cannot be sold in the initial

distribution, including ``bought deals,'' \424\ rights offerings,\425\

and fixed-income offerings.\426\ A few commenters noted that similar

scenarios can arise in the case of an AP creating more shares of an ETF

than it can sell\427\ and bridge loans.\428\ Two commenters indicated

that if the rule does not provide greater clarity and flexibility with

respect to the near term customer demand requirement, a banking entity

may be less inclined to participate in a distribution where there is

the potential risk of an unsold allotment, may price such risk into the

fees charged to underwriting clients, or may be forced into a ``fire

sale'' of the unsold allotment.\429\

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\423\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; BDA

(Feb. 2012); RBC.

\424\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; RBC.

These commenters generally stated that an underwriter for a ``bought

deal'' may end up with an unsold allotment because, pursuant to this

type of offering, an underwriter makes a commitment to purchase

securities from an issuer or selling security holder, without pre-

commitment marketing to gauge customer interest, in order to provide

greater speed and certainty of execution. See SIFMA et al. (Prop.

Trading) (Feb. 2012); RBC.

\425\ See SIFMA et al. (Prop. Trading) (Feb. 2012) (representing

that because an underwriter generally backstops a rights offering by

committing to exercise any rights not exercised by shareholders, the

underwriter may end up holding a residual portion of the offering if

investors do not exercise all of the rights).

\426\ See BDA (Feb. 2012). This commenter stated that

underwriters frequently underwrite bonds in the fixed-income market

knowing that they may need to retain unsold allotments in their

inventory. The commenter indicated that this scenario arises because

the fixed-income market is not as deep as other markets, so

underwriters frequently cannot sell bonds when they go to market;

instead, the underwriters will retain the bonds until a sufficient

amount of liquidity is available in the market. See id.

\427\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA.

\428\ See BoA; RBC; LSTA (Feb. 2012). One of these commenters

stated that, in the case of securities issued in lieu of or to

refinance bridge loan facilities, market conditions or investor

demand may change during the period of time between extension of the

bridge commitment and when the bridge loan is required to be funded

or such securities are required to be issued. As a result, this

commenter requested that the near term demands of clients,

customers, or counterparties be measured at the time of the initial

extension of the bridge commitment. See LSTA (Feb. 2012).

\429\ See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC.

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Several other commenters provided views on whether a banking entity

should be able to hold a residual position from an offering pursuant to

the underwriting exemption, although they did not generally link their

comments to the proposed near term demand requirement.\430\ Many of

these commenters expressed concern about permitting a banking entity to

retain a portion of an underwriting and noted potential risks that may

arise from such activity.\431\ For example, some of these commenters

stated that retention or warehousing of underwritten securities can be

an indication of impermissible proprietary trading intent (particularly

if systematic), or may otherwise result in high-risk exposures or

conflicts of interests.\432\ One of these commenters recommended the

Agencies use a metric to monitor the size of residual positions

retained by an underwriter,\433\ while another commenter suggested

adding a requirement to the proposed exemption to provide that a

``substantial'' unsold or retained allotment would be an indication of

prohibited proprietary trading.\434\ Similarly, one commenter

recommended that the Agencies consider whether there are sufficient

provisions in the proposed rule to reduce the risks posed by banking

entities retaining or warehousing underwritten instruments, such as

subprime mortgages, collateralized debt obligation tranches, and high

yield debt of leveraged buyout issuers, which

[[Page 5842]]

poses heightened financial risk at the top of economic cycles.\435\

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\430\ See AFR et al. (Feb. 2012); CalPERS; Occupy; Public

Citizen; Goldman (Prop. Trading); Fidelity; Japanese Bankers Ass'n.;

Sens. Merkley & Levin (Feb. 2012); Alfred Brock.

\431\ See AFR et al. (Feb. 2012); CalPERS; Occupy; Public

Citizen; Alfred Brock.

\432\ See AFR et al. (Feb. 2012) (recognizing, however, that a

small portion of an underwriting may occasionally be ``hung'');

CalPERS; Occupy (stating that a banking entity's retention of unsold

allotments may result in potential conflicts of interest).

\433\ See AFR et al. (Feb. 2012).

\434\ See Occupy (stating that the meaning of the term

``substantial'' would depend on the circumstances of the particular

offering).

\435\ See CalPERS.

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Other commenters indicated that undue restrictions on an

underwriter's ability to retain a portion of an offering may result in

certain harms to the capital-raising process. These commenters

represented that unclear or negative treatment of residual positions

will make banking entities averse to the risk of an unsold allotment,

which may result in banking entities underwriting smaller offerings,

less capital generation for issuers, or higher underwriting discounts,

which would increase the cost of raising capital for businesses.\436\

One of these commenters suggested that a banking entity be permitted to

hold a residual position under the underwriting exemption as long as it

continues to take reasonable steps to attempt to dispose of the

residual position in light of existing market conditions.\437\

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\436\ See Goldman (Prop. Trading); Fidelity (expressing concern

that this may result in a more concentrated supply of securities

and, thus, decrease the opportunity for diversification in the

portfolios of shareholders' funds).

\437\ See Goldman (Prop. Trading).

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In addition, in response to a question in the proposal, one

commenter expressed the view that the rule should not require

documentation with respect to residual positions held by an

underwriter.\438\ In the case of securitizations, one commenter stated

that if the underwriter wishes to retain some of the securities or

bonds in its longer-term investment book, such decisions should be made

by a separate officer, subject to different standards and

compensation.\439\

---------------------------------------------------------------------------

\438\ See Japanese Bankers Ass'n.

\439\ See Sens. Merkley & Levin (Feb. 2012).

---------------------------------------------------------------------------

Two commenters discussed how the near term customer demand

requirement should apply in the context of a banking entity acting as

an underwriter for a securitization or structured product.\440\ One of

these commenters indicated that the near term demand requirement should

be interpreted to require that a distribution of securities facilitate

pre-existing client demand. This commenter stated that a banking entity

should not be considered to meet the terms of the proposed requirement

if, on the firm's own initiative, it designs and structures a complex,

novel instrument and then seeks customers for the instrument, while

retaining part of the issuance on its own book. The commenter further

emphasized that underwriting should involve two-way demand--clients who

want assistance in marketing their securities and customers who may

wish to purchase the securities--with the banking entity serving as an

intermediary.\441\ Another commenter indicated that an underwriting

should likely be seen as a distribution of all, or nearly all, of the

securities related to a securitization (excluding any amount required

for credit risk retention purposes) along a time line designed not to

exceed reasonably expected near term demands of clients, customers, or

counterparties. According to the commenter, this approach would serve

to minimize the arbitrage and risk concentration possibilities that can

arise through the securitization and sale of some tranches and the

retention of other tranches.\442\

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\440\ See AFR et al. (Feb. 2012); Sens. Merkley & Levin (Feb.

2012).

\441\ See AFR et al. (Feb. 2012).

\442\ See Sens. Merkley & Levin (Feb. 2012).

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One commenter expressed concern that the proposed near term

customer demand requirement may impact a banking entity's ability to

act as primary dealer because some primary dealers are obligated to bid

on each issuance of a government's sovereign debt, without regard to

expected customer demand.\443\ Two other commenters expressed general

concern that the proposed underwriting exemption may be too narrow to

permit banking entities that act as primary dealers in or for foreign

jurisdictions to continue to meet the relevant jurisdiction's primary

dealer requirements.\444\

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\443\ See Banco de M[eacute]xico.

\444\ See SIFMA et al. (Prop. Trading) (Feb. 2012); IIB/EBF. One

of these commenters represented that many banking entities serve as

primary dealers in jurisdictions in which they operate, and primary

dealers often: (i) Are subject to minimum purchase and other

obligations in the jurisdiction's foreign sovereign debt; (ii) play

important roles in underwriting and market making in State,

provincial, and municipal debt issuances; and (iii) act as

intermediaries through which a government's financial and monetary

policies operate. This commenter stated that, due to these

considerations, restrictions on the ability of banking entities to

act as primary dealer are likely to harm the governments they serve.

See IIB/EBF.

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c. Final Near Term Customer Demand Requirement

The final rule requires that the amount and types of the securities

in the trading desk's underwriting position be designed not to exceed

the reasonably expected near term demands of clients, customers, or

counterparties, and reasonable efforts be made to sell or otherwise

reduce the underwriting position within a reasonable period, taking

into account the liquidity, maturity, and depth of the market for the

relevant type of security.\445\ As noted above, the near term demand

standard originates from section 13(d)(1)(B) of the BHC Act, and a

similar requirement was included in the proposed rule.\446\ The

Agencies are making certain modifications to the proposed approach in

response to comments.

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\445\ Final rule Sec. 75.4(a)(2)(ii).

\446\ The proposed rule required the underwriting activities of

the banking entity with respect to the covered financial position to

be designed not to exceed the reasonably expected near term demands

of clients, customers, or counterparties. See proposed rule Sec.

75.4(a)(2)(v).

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In particular, the Agencies are clarifying the operation of this

requirement, particularly with respect to unsold allotments.\447\ Under

this requirement, a trading desk must have a reasonable expectation of

demand from other market participants for the amount and type of

securities to be acquired from an issuer or selling security holder for

distribution.\448\ Such reasonable expectation may be based on factors

such as current market conditions and prior experience with similar

offerings of securities. A banking entity is not required to engage in

book-building or similar marketing efforts to determine investor demand

for the securities pursuant to this requirement, although such efforts

may form the basis for the trading desk's reasonable expectation of

demand. While an issuer or selling security holder can be considered to

be a client, customer, or counterparty of a banking entity acting as an

underwriter for its distribution of securities, this requirement cannot

be met by accounting solely for the issuer's or selling security

holder's desire to sell the securities.\449\ However, the

[[Page 5843]]

expectation of demand does not require a belief that the securities

will be placed immediately. The time it takes to carry out a

distribution may differ based on the liquidity, maturity, and depth of

the market for the type of security.\450\

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\447\ See supra Part VI.A.2.c.2.b. (discussing commenters'

concerns that the proposed near term customer demand requirement may

limit a banking entity's ability to retain an unsold allotment).

\448\ A banking entity may not structure a complex instrument on

its own initiative using the underwriting exemption. It may use the

underwriting exemption only with respect to distributions of

securities that comply with the final rule. The Agencies believe

this requirement addresses one commenter's concern that a banking

entity could rely on the underwriting exemption without regard to

anticipated customer demand. See AFR et al. (Feb. 2012) In addition,

a trading desk hedging the risks of an underwriting position in a

complex, novel instrument must comply with the hedging exemption in

the final rule.

\449\ An issuer or selling security holder for purposes of this

rule may include, among others, corporate issuers, sovereign issuers

for which the banking entity acts as primary dealer (or functional

equivalent), or any other person that is an issuer, as defined in

final rule Sec. 75.3(e)(9), or a selling security holder, as

defined in final rule Sec. 75.4(a)(5). The Agencies believe that

the underwriting exemption in the final rule should generally allow

a primary dealer (or functional equivalent) to act as an underwriter

for a sovereign government's issuance of its debt because, similar

to other underwriting activities, this involves a banking entity

agreeing to distribute securities for an issuer (in this case, the

foreign sovereign) and engaging in a distribution of such

securities. See SIFMA et al. (Prop. Trading) (Feb. 2012); IIB/EBF;

Banco de M[eacute]xico. A banking entity acting as primary dealer

(or functional equivalent) may also be able to rely on the market-

making exemption or other exemptions for some of its activities. See

infra Part VI.A.3.c.2.c. The final rule defines ``client, customer,

or counterparty'' for purposes of the underwriting exemption as

``market participants that may transact with the banking entity in

connection with a particular distribution for which the banking

entity is acting as underwriter.'' Final rule Sec. 75.4(a)(7).

\450\ One commenter stated that, in the case of a

securitization, an underwriting should be seen as a distribution of

all, or nearly all, of the securities related to a securitization

(excluding the amount required for credit risk retention purposes)

along a time line designed not to exceed the reasonably expected

near term demands of clients, customers, or counterparties. See

Sens. Merkley & Levin (Feb. 2012). The final rule's near term

customer demand requirement considers the liquidity, maturity, and

depth of the market for the type of security and recognizes that the

amount of time a trading desk may need to hold an underwriting

position may vary based on these factors. The final rule does not,

however, adopt a standard that applies differently based solely on

the particular type of security being distributed (e.g., an asset-

backed security versus an equity security) or that precludes certain

types of securities from being distributed by a banking entity

acting as an underwriter in accordance with the requirements of this

exemption because the Agencies believe the statute is best read to

permit a banking entity to engage in underwriting activity to

facilitate distributions of securities by issuers and selling

security holders, regardless of type, to provide client-oriented

financial services. That reading is consistent with the statute's

language and finds support in the legislative history. See 156 Cong.

Rec. S5895-S5896 (daily ed. July 15, 2010) (statement of Sen.

Merkley) (stating that the underwriting exemption permits

``transactions that are technically trading for the account of the

firm but, in fact, facilitate the provision of near-term client-

oriented financial services''). In addition, with respect to this

commenter's statement regarding credit risk retention requirements,

the Agencies note that compliance with the credit risk retention

requirements of Section 15G of the Exchange Act would not impact the

availability of the underwriting exemption in the final rule.

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This requirement is not intended to prevent a trading desk from

distributing an offering over a reasonable time consistent with market

conditions or from retaining an unsold allotment of the securities

acquired from an issuer or selling security holder where holding such

securities is necessary due to circumstances such as less-than-expected

purchaser demand at a given price.\451\ An unsold allotment is,

however, subject to the requirement to make reasonable efforts to sell

or otherwise reduce the underwriting position.\452\ The definition of

``underwriting position'' includes, among other things, any residual

position from the distribution that is managed by the trading desk. The

final rule includes the requirement to make reasonable efforts to sell

or otherwise reduce the trading desk's underwriting position in order

to respond to comments on the issue of when a banking entity may retain

an unsold allotment when it is acting as an underwriter, as discussed

in more detail below, and ensure that the exemption is available only

for activities that involve underwriting activities, and not prohibited

proprietary trading.\453\

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\451\ This approach should help address commenters' concerns

that an inflexible interpretation of the near term demand

requirement could result in fire sales, higher fees for underwriting

services, or reluctance to act as an underwriter for certain types

of distributions that present a greater risk of unsold allotments.

See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC. Further, the

Agencies believe this should reduce commenters' concerns that, to

the extent a delayed distribution of securities, which are acquired

as a result of an outstanding bridge loan, is able to qualify for

the underwriting exemption, a stringent interpretation of the near

term demand requirement could prevent a banking entity from

retaining such securities if market conditions are suboptimal or

marketing efforts are not entirely successful. See RBC; BoA; LSTA

(Feb. 2012). In response to one commenter's request that the

Agencies allow a banking entity to assess near term demand at the

time of the initial extension of the bridge commitment, the Agencies

believe it could be appropriate to determine whether the banking

entity has a reasonable expectation of demand from other market

participants for the amount and type of securities to be acquired at

that time, but note that the trading desk would continue to be

subject to the requirement to make reasonable efforts to sell the

resulting underwriting position at the time of the initial

distribution and for the remaining time the securities are in its

inventory. See LSTA (Feb. 2012).

\452\ The Agencies believe that requiring a trading desk to make

reasonable efforts to sell or otherwise reduce its underwriting

position addresses commenters' concerns about the risks associated

with unsold allotments or the retention of underwritten instruments

because this requirement is designed to prevent a trading desk from

retaining an unsold allotment for speculative purposes when there is

customer buying interest for the relevant security at commercially

reasonable prices. Thus, the Agencies believe this obviates the need

for certain additional requirements suggested by commenters. See,

e.g., Occupy; AFR et al. (Feb. 2012); CalPERS. The final rule

strikes an appropriate balance between the concerns raised by these

commenters and those noted by other commenters regarding the

potential market impacts of strict requirements against holding an

unsold allotment, such as higher fees to underwriting clients, fire

sales of unsold allotments, or general reluctance to participate in

any distribution that presents a risk of an unsold allotment. The

requirement to make reasonable efforts to sell or otherwise reduce

the underwriting position should not cause the market impacts

predicted by these commenters because it does not prevent an

underwriter from retaining an unsold allotment for a reasonable

period or impose strict holding period limits on unsold allotments.

See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; Goldman (Prop.

Trading); Fidelity.

\453\ This approach is generally consistent with one commenter's

suggested approach to addressing the issue of unsold allotments.

See, e.g., Goldman (Prop. Trading) (suggesting that a banking entity

be permitted to hold a residual position under the underwriting

exemption as long as it continues to take reasonable steps to

attempt to dispose of the residual position in light of existing

market conditions). In addition, allowing an underwriter to retain

an unsold allotment under certain circumstances is consistent with

the proposal. See Joint Proposal, 76 FR at 68867 (``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.''); CFTC Proposal, 77 FR at 8352. A

number of commenters raised questions about whether the rule would

permit retaining an unsold allotment. See Goldman (Prop. Trading);

Fidelity; SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; RBC; AFR et

al. (Feb. 2012); CalPERS; Occupy; Public Citizen; Alfred Brock.

---------------------------------------------------------------------------

As a general matter, commenters expressed differing views on

whether an underwriter should be permitted to hold an unsold allotment

for a certain period of time after the initial distribution. For

example, a few commenters suggested that limitations on retaining an

unsold allotment would increase the cost of raising capital \454\ or

would negatively impact certain types of securities offerings (e.g.,

bought deals, rights offerings, and fixed-income offerings).\455\ Other

commenters, however, expressed concern that the proposed exemption

would allow a banking entity to retain a portion of a distribution for

speculative purposes.\456\

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\454\ See Goldman (Prop. Trading); Fidelity.

\455\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; RBC.

\456\ See AFR et al. (Feb. 2012); CalPERS; Occupy; Public

Citizen; Alfred Brock.

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The Agencies believe the requirement to make reasonable efforts to

sell or otherwise reduce the underwriting position appropriately

addresses both sets of comments. More specifically, this standard

clarifies that an underwriter generally may retain an unsold allotment

that it was unable to sell to purchasers as part of the initial

distribution of securities, provided it had a reasonable expectation of

buying interest and engaged in reasonable selling efforts.\457\ This

should reduce the potential for the negative impacts of a more

stringent approach predicted by commenters, such as increased fees for

underwriting, greater costs to businesses for raising capital, and

potential fire sales of unsold allotments.\458\ However, to address

concerns that a banking entity may retain an unsold allotment for

purely speculative purposes, the Agencies are requiring that reasonable

efforts be made to sell or otherwise

[[Page 5844]]

reduce the underwriting position, which includes any unsold allotment,

within a reasonable period. The Agencies agree with these commenters

that systematic retention of an underwriting position, without engaging

in efforts to sell the position and without regard to whether the

trading desk is able to sell the securities at a commercially

reasonable price, would be indicative of impermissible proprietary

trading intent.\459\ The Agencies recognize that the meaning of

``reasonable period'' may differ based on the liquidity, maturity, and

depth of the market for the relevant type of securities. For example,

an underwriter may be more likely to retain an unsold allotment in a

bond offering because liquidity in the fixed-income market is generally

not as deep as that in the equity market. If a trading desk retains an

underwriting position for a period of time after the distribution, the

trading desk must manage the risk of its underwriting position in

accordance with its inventory and risk limits and authorization

procedures. As discussed above, hedging transactions undertaken in

connection with such risk management activities must be conducted in

compliance with the hedging exemption in Sec. 75.5 of the final rule.

---------------------------------------------------------------------------

\457\ To the extent that an AP for an ETF is able to meet the

terms of the underwriting exemption for its activity, it may be able

to retain ETF shares that it created if it had a reasonable

expectation of buying interest in the ETF shares and engages in

reasonable efforts to sell the ETF shares. See SIFMA et al. (Prop.

Trading) (Feb. 2012); BoA.

\458\ See Goldman (Prop. Trading); Fidelity; SIFMA et al. (Prop.

Trading) (Feb. 2012); RBC.

\459\ See AFR et al. (Feb. 2012); CalPERS; Occupy.

---------------------------------------------------------------------------

The Agencies emphasize that the requirement to make reasonable

efforts to sell or otherwise reduce the underwriting position applies

to the entirety of the trading desk's underwriting position. As a

result, this requirement applies to a number of different scenarios in

which an underwriter may hold a long or short position in the

securities that are the subject of a distribution for a period of time.

For example, if an underwriter is facilitating a distribution of

securities for which there is sufficient investor demand to purchase

the securities at the offering price, this requirement would prevent

the underwriter from retaining a portion of the allotment for its own

account instead of selling the securities to interested investors. If

instead there was insufficient investor demand at the time of the

initial offering, this requirement would recognize that it may be

appropriate for the underwriter to hold an unsold allotment for a

reasonable period of time. Under these circumstances, the underwriter

would need to make reasonable efforts to sell the unsold allotment when

there is sufficient market demand for the securities.\460\ This

requirement would also apply in situations where the underwriters sell

securities in excess of the number of securities to which the

underwriting commitment relates, resulting in a syndicate short

position in the same class of securities that were the subject of the

distribution.\461\ This provision of the final exemption would require

reasonable efforts to reduce any portion of the syndicate short

position attributable to the banking entity that is acting as an

underwriter. Such reduction could be accomplished if, for example, the

managing underwriter exercises an overallotment option or shares are

purchased in the secondary market to cover the short position.

---------------------------------------------------------------------------

\460\ The trading desk's retention and sale of the unsold

allotment must comply with the Federal securities laws and

regulations, but is otherwise permitted under the underwriting

exemption.

\461\ See supra note 408.

---------------------------------------------------------------------------

The near term demand requirement, including the requirement to make

reasonable efforts to reduce the underwriting position, represents a

new regulatory requirement for banking entities engaged in

underwriting. At the margins, this requirement could alter the

participation decision for some banking entities with respect to

certain types of distributions, such as distributions that are more

likely to result in the banking entity retaining an underwriting

position for a period of time.\462\ However, the Agencies recognize

that liquidity, maturity, and depth of the market vary across types of

securities, and the Agencies expect that the express recognition of

these differences in the rule should help mitigate any incentive to

exit the underwriting business for certain types of securities or types

of distributions.

---------------------------------------------------------------------------

\462\ For example, some commenters suggested that the proposed

underwriting exemption could have a chilling effect on banking

entities' willingness to engage in underwriting activities. See,

e.g., Lord Abbett; Fidelity. Further, some commenters expressed

concern that the proposed near term customer demand requirement

might negatively impact certain forms of capital-raising if the

requirement is interpreted narrowly or inflexibly. See SIFMA et al.

(Prop. Trading) (Feb. 2012); BoA; BDA (Feb. 2012); RBC.

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3. Compliance Program Requirement

a. Proposed Compliance Program Requirement

Section 75.4(a)(2)(i) of the proposed exemption required a banking

entity to establish an internal compliance program, as required by

Sec. 75.20 of the proposed rule, that is designed to ensure the

banking entity's compliance with the requirements of the underwriting

exemption, including reasonably designed written policies and

procedures, internal controls, and independent testing.\463\ This

requirement was proposed so that any banking entity relying on the

underwriting exemption would have reasonably designed written policies

and procedures, internal controls, and independent testing in place to

support its compliance with the terms of the exemption.\464\

---------------------------------------------------------------------------

\463\ See proposed rule Sec. 75.4(a)(2)(i).

\464\ See Joint Proposal, 76 FR at 68866; CFTC Proposal, 77 FR

at 8352.

---------------------------------------------------------------------------

b. Comments on the Proposed Compliance Program Requirement

Commenters did not directly address the proposed compliance program

requirement in the underwriting exemption. Comments on the proposed

compliance program requirement of Sec. 75.20 of the proposed rule are

discussed in Part VI.C., below.

c. Final Compliance Program Requirement

The final rule includes a compliance program requirement that is

similar to the proposed requirement, but the Agencies are making

certain enhancements to emphasize the importance of a strong internal

compliance program. More specifically, the final rule requires that a

banking entity's compliance program specifically include reasonably

designed written policies and procedures, internal controls, analysis

and independent testing \465\ identifying and addressing: (i) The

products, instruments or exposures each trading desk may purchase,

sell, or manage as part of its underwriting activities; \466\ (ii)

limits for each trading desk, based on the nature and amount of the

trading desk's underwriting activities, including the reasonably

expected near term demands of clients, customers, or counterparties;

\467\ (iii) internal controls and ongoing monitoring and analysis of

each trading desk's compliance with its limits; \468\ and (iv)

authorization procedures, including escalation procedures that require

review and approval of any trade that would exceed one or more of a

trading desk's limits, demonstrable analysis of the basis for any

temporary or permanent increase to one or more of a trading desk's

limits, and independent review (i.e., by risk managers and compliance

officers at the appropriate level independent of the trading desk) of

[[Page 5845]]

such demonstrable analysis and approval.\469\

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\465\ The independent testing standard is discussed in more

detail in Part VI.C., which discusses the compliance program

requirement in Sec. 75.20 of the final rule.

\466\ See final rule Sec. 75.4(a)(2)(iii)(A).

\467\ See final rule Sec. 75.4(a)(2)(iii)(B). A trading desk

must have limits on the amount, types, and risk of the securities in

its underwriting position, level of exposures to relevant risk

factors arising from its underwriting position, and period of time a

security may be held. See id.

\468\ See final rule Sec. 75.4(a)(2)(iii)(C).

\469\ See final rule Sec. 75.4(a)(2)(iii)(D).

---------------------------------------------------------------------------

As noted above, the proposed compliance program requirement did not

include the four specific elements listed above in the proposed

underwriting exemption, although each of these provisions was included

in some form in the detailed compliance program requirement under

Appendix C of the proposed rule.\470\ The Agencies are moving these

particular requirements, with certain enhancements, into the

underwriting exemption because the Agencies believe these are core

elements of a program to ensure compliance with the underwriting

exemption. These compliance procedures must be established,

implemented, maintained, and enforced for each trading desk engaged in

underwriting activity under Sec. 75.4(a) of the final rule. Each of

the requirements in paragraphs (a)(2)(iii)(A) through (D) must be

appropriately tailored to the individual trading activities and

strategies of each trading desk.

---------------------------------------------------------------------------

\470\ See Joint Proposal, 76 FR at 68963-68967 (requiring

certain banking entities to establish, maintain, and enforce

compliance programs with, among other things: (i) Written policies

and procedures that describe a trading unit's authorized instruments

and products; (ii) internal controls for each trading unit,

including risk limits for each trading unit and surveillance

procedures; and (iii) a management framework, including management

procedures for overseeing compliance with the proposed rule).

---------------------------------------------------------------------------

The compliance program requirement in the underwriting exemption is

substantially similar to the compliance program requirement in the

market-making exemption, except that the Agencies are requiring more

detailed risk management procedures in the market-making exemption due

to the nature of that activity.\471\ The Agencies believe including

similar compliance program requirements in the underwriting and market-

making exemptions may reduce burdens associated with building and

maintaining compliance programs for each trading desk.

---------------------------------------------------------------------------

\471\ See final rule Sec. Sec. 75.4(a)(2)(iii),

75.4(b)(2)(iii).

---------------------------------------------------------------------------

Identifying in the compliance program the relevant products,

instruments, and exposures in which a trading desk is permitted to

trade will facilitate monitoring and oversight of compliance with the

underwriting exemption. For example, this requirement should prevent an

individual trader on an underwriting desk from establishing positions

in instruments that are unrelated to the desk's underwriting function.

Further, the identification of permissible products, instruments, and

exposures will help form the basis for the specific types of position

and risk limits that the banking entity must establish and is relevant

to considerations throughout the exemption regarding the liquidity,

maturity, and depth of the market for the relevant type of security.

A trading desk must have limits on the amount, types, and risk of

the securities in its underwriting position, level of exposures to

relevant risk factors arising from its underwriting position, and

period of time a security may be held. Limits established under this

provision, and any modifications to these limits made through the

required escalation procedures, must account for the nature and amount

of the trading desk's underwriting activities, including the reasonably

expected near term demands of clients, customers, or counterparties.

Among other things, these limits should be designed to prevent a

trading desk from systematically retaining unsold allotments even when

there is customer demand for the positions that remain in the trading

desk's inventory. The Agencies recognize that trading desks' limits may

differ across types of securities and acknowledge that trading desks

engaged in underwriting activities in less liquid securities, such as

corporate bonds, may require different inventory, risk exposure, and

holding period limits than trading desks engaged in underwriting

activities in more liquid securities, such as certain equity

securities. A trading desk hedging the risks of an underwriting

position must comply with the hedging exemption, which provides for

compliance procedures regarding risk management.\472\

---------------------------------------------------------------------------

\472\ See final rule Sec. 75.5.

---------------------------------------------------------------------------

Furthermore, a banking entity must establish internal controls and

ongoing monitoring and analysis of each trading desk's compliance with

its limits, including the frequency, nature, and extent of a trading

desk exceeding its limits.\473\ This may include the use of management

and exception reports. Moreover, the compliance program must set forth

a process for determining the circumstances under which a trading

desk's limits may be modified on a temporary or permanent basis (e.g.,

due to market changes).

---------------------------------------------------------------------------

\473\ See final rule Sec. 75.4(a)(2)(iii)(C).

---------------------------------------------------------------------------

As noted above, a banking entity's compliance program for trading

desks engaged in underwriting activity must also include escalation

procedures that require review and approval of any trade that would

exceed one or more of a trading desk's limits, demonstrable analysis

that the basis for any temporary or permanent increase to one or more

of a trading desk's limits is consistent with the near term customer

demand requirement, and independent review of such demonstrable

analysis and approval.\474\ Thus, to increase a limit of a trading

desk, there must be an analysis of why such increase would be

appropriate based on the reasonably expected near term demands of

clients, customers, or counterparties, which must be independently

reviewed. A banking entity also must maintain documentation and records

with respect to these elements, consistent with the requirement of

Sec. 75.20(b)(6).

---------------------------------------------------------------------------

\474\ See final rule Sec. 75.4(a)(2)(iii)(D).

---------------------------------------------------------------------------

As discussed in more detail in Part VI.C., the Agencies recognize

that the compliance program requirements in the final rule will impose

certain costs on banking entities but, on balance, the Agencies believe

such requirements are necessary to facilitate compliance with the

statute and the final rule and to reduce the risk of evasion.\475\

---------------------------------------------------------------------------

\475\ See Part VI.C. (discussing the compliance program

requirement in Sec. 75.20 of the final rule).

---------------------------------------------------------------------------

4. Compensation Requirement

a. Proposed Compensation Requirement

Another provision of the proposed underwriting exemption required

that the compensation arrangements of persons performing underwriting

activities at the banking entity must be designed not to encourage

proprietary risk-taking.\476\ In connection with this requirement, the

proposal clarified that 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.\477\

---------------------------------------------------------------------------

\476\ See proposed rule Sec. 75.4(a)(2)(vii); Joint Proposal,

76 FR at 68868; CFTC Proposal, 77 FR at 8353.

\477\ See id.

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b. Comments on the Proposed Compensation Requirement

A few commenters expressed general support for the proposed

requirement, but suggested certain modifications that they believed

would enhance the requirement and make it more effective.\478\

Specifically, one

[[Page 5846]]

commenter suggested tailoring the requirement to underwriting activity

by, for example, ensuring that personnel involved in underwriting are

given compensation incentives for the successful distribution of

securities off the firm's balance sheet and are not rewarded for

profits associated with securities that are not successfully

distributed (although losses from such positions should be taken into

consideration in determining the employee's compensation). This

commenter further recommended that bonus compensation for a deal be

withheld until all or a high percentage of the relevant securities are

distributed.\479\ Finally, one commenter suggested that the term

``designed'' should be removed from this provision.\480\

---------------------------------------------------------------------------

\478\ See Occupy; AFR et al. (Feb. 2012); Better Markets (Feb.

2012).

\479\ See AFR et al. (Feb. 2012).

\480\ See Occupy.

---------------------------------------------------------------------------

c. Final Compensation Requirement

Similar to the proposed rule, the underwriting exemption in the

final rule requires that the compensation arrangements of persons

performing the banking entity's underwriting activities, as described

in the exemption, be designed not to reward or incentivize prohibited

proprietary trading.\481\ The Agencies do not intend to preclude an

employee of an underwriting desk from being compensated for successful

underwriting, which involves some risk-taking.

---------------------------------------------------------------------------

\481\ See final rule Sec. 75.4(a)(2)(iv); proposed rule Sec.

75.4(a)(2)(vii). This is consistent with the final compensation

requirements in the market-making and hedging exemptions. See final

rule Sec. 75.4(b)(2)(v); final rule Sec. 75.5(b)(3).

---------------------------------------------------------------------------

Consistent with the proposal, 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 by the banking entity are inconsistent with the

underwriting exemption. A banking entity may, however, 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

services, not prohibited proprietary trading. For example, a

compensation plan based purely on net profit and loss with no

consideration for inventory control or risk undertaken to achieve those

profits would not be consistent with the underwriting exemption.

The Agencies are not adopting an approach that prevents an employee

from receiving any compensation related to profits arising from an

unsold allotment, as suggested by one commenter, because the Agencies

believe the final rule already includes sufficient controls to prevent

a trading desk from intentionally retaining an unsold allotment to make

a speculative profit when such allotment could be sold to

customers.\482\ The Agencies also are not requiring compensation to be

vested for a period of time, as recommended by one commenter to reduce

traders' incentives for undue risk-taking. The Agencies believe the

final rule includes sufficient controls around risk-taking activity

without a compensation vesting requirement because a banking entity

must establish limits for a trading desk's underwriting position and

the trading desk must make reasonable efforts to sell or otherwise

reduce the underwriting position within a reasonable period.\483\ The

Agencies continue to believe it is appropriate to focus on the design

of a banking entity's compensation structure, so the Agencies are not

removing the term ``designed'' from this provision.\484\ This retains

an objective focus on actions that the banking entity can control--the

design of its incentive compensation program--and avoids a subjective

focus on whether an employee feels incentivized by compensation, which

may be more difficult to assess. In addition, the framework of the

final compensation requirement will allow banking entities to better

plan and control the design of their compensation arrangements, which

should reduce costs and uncertainty and enhance monitoring, than an

approach focused solely on individual outcomes.

---------------------------------------------------------------------------

\482\ See AFR et al. (Feb. 2012); supra Part VI.A.2.c.2.c.

(discussing the requirement to make reasonable efforts to sell or

otherwise reduce the underwriting position).

\483\ See AFR et al. (Feb. 2012).

\484\ See Occupy.

---------------------------------------------------------------------------

5. Registration Requirement

a. Proposed Registration Requirement

Section 75.4(a)(2)(iv) of the proposed rule would have required

that a banking entity have the appropriate dealer registration or be

exempt from registration or excluded from regulation as a dealer to the

extent that, in order to underwrite the security at issue, a person

must generally be a registered securities dealer, municipal securities

dealer, or government securities dealer.\485\ Further, if the banking

entity was engaged in the business of a dealer outside the United

States in a manner for which no U.S. registration is required, the

proposed rule would have required the banking entity to be subject to

substantive regulation of its dealing business in the jurisdiction in

which the business is located.

---------------------------------------------------------------------------

\485\ See proposed rule Sec. 75.4(a)(2)(iv); Joint Proposal, 76

FR at 68867; CFTC Proposal, 77 FR at 8353. The proposal clarified

that, in the case of a financial institution that is a government

securities dealer, such institution must have filed notice of that

status as required by section 15C(a)(1)(B) of the Exchange Act. See

Joint Proposal, 76 FR at 68867; CFTC Proposal, 77 FR at 8353.

---------------------------------------------------------------------------

b. Comments on Proposed Registration Requirement

Commenters generally did not address the proposed dealer

requirement in the underwriting exemption. However, as discussed below

in Part VI.A.3.c.2.b., a number of commenters addressed a similar

requirement in the proposed market-making exemption.

c. Final Registration Requirement

The requirement in Sec. 75.4(a)(2)(vi) of the underwriting

exemption, which provides that the banking entity must be licensed or

registered to engage in underwriting activity in accordance with

applicable law, is substantively similar to the proposed dealer

registration requirement in Sec. 75.4(a)(2)(iv) of the proposed rule.

The primary difference between the proposed requirement and the final

requirement is that the Agencies have simplified the language of the

rule. The Agencies have also made conforming changes to the

corresponding requirement in the market-making exemption to promote

consistency across the exemptions, where appropriate.\486\

---------------------------------------------------------------------------

\486\ See Part VI.A.3.c.6. (discussing the registration

requirement in the market-making exemption).

---------------------------------------------------------------------------

As was proposed, this provision will require a U.S. banking entity

to be an SEC-registered dealer in order to rely on the underwriting

exemption in connection with a distribution of securities--other than

exempted securities, security-based swaps, commercial paper, bankers

acceptances or commercial bills--unless the banking entity is exempt

from registration or excluded from regulation as a dealer.\487\ To the

extent that a banking entity relies on the underwriting exemption in

[[Page 5847]]

connection with a distribution of municipal securities or government

securities, rather than the exemption in Sec. 75.6(a) of the final

rule, this provision may require the banking entity to be registered or

licensed as a municipal securities dealer or government securities

dealer, if required by applicable law. However, this provision does not

require a banking entity to register in order to qualify for the

underwriting exemption if the banking entity is not otherwise required

to register by applicable law.

---------------------------------------------------------------------------

\487\ 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 final rule would

not require the banking entity to be a registered securities dealer

to underwrite the asset-backed securities. See 15 U.S.C.

78c(a)(5)(C)(iii).

---------------------------------------------------------------------------

The Agencies have determined that, for purposes of the underwriting

exemption, rather than require a banking entity engaged in the business

of a securities dealer outside the United States to be subject to

substantive regulation of its dealing business in the jurisdiction in

which the business is located, a banking entity's dealing activity

outside the U.S. should only be subject to licensing or registration

provisions if required under applicable foreign law (provided no U.S.

registration or licensing requirements apply to the banking entity's

activities). In response to comments, the final rule recognizes that

certain foreign jurisdictions may not provide for substantive

regulation of dealing businesses.\488\ The Agencies do not believe it

is necessary to preclude banking entities from engaging in underwriting

activities in such foreign jurisdictions to achieve the goals of

section 13 of the BHC Act because these banking entities would continue

to be subject to the other requirements of the underwriting exemption.

---------------------------------------------------------------------------

\488\ See infra Part VI.A.3.c.6.c. (discussing comments on this

issue with respect to the proposed dealer registration requirement

in the market-making exemption).

---------------------------------------------------------------------------

6. Source of Revenue Requirement

a. Proposed Source of Revenue Requirement

Under Sec. 75.4(a)(2)(vi) of the proposed rule, the underwriting

activities of a banking entity would have been required to be designed

to generate revenues primarily from fees, commissions, underwriting

spreads, or other income not attributable to appreciation in the value

of covered financial positions or hedging of covered financial

positions.\489\ The proposal clarified that 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.\490\ This requirement provided that activities conducted in

reliance on the underwriting exemption should 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

underwritten securities.\491\

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\489\ See proposed rule Sec. 75.4(a)(2)(vi); Joint Proposal, 76

FR at 68867-68868; CFTC Proposal, 77 FR at 8353.

\490\ See Joint Proposal, 76 FR at 68867-68868 n.142; CFTC

Proposal, 77 FR at 8353 n.148.

\491\ See Joint Proposal, 76 FR at 68867-68868; CFTC Proposal,

77 FR at 8353.

---------------------------------------------------------------------------

b. Comments on the Proposed Source of Revenue Requirement

A few commenters requested certain modifications to the proposed

source of revenue requirement. These commenters' suggested revisions

were generally intended either to refine the standard to better account

for certain activities or to make it more stringent.\492\ Three

commenters expressed concern that the proposed source of revenue

requirement would negatively impact a banking entity's ability to act

as a primary dealer or in a similar capacity.\493\

---------------------------------------------------------------------------

\492\ See Goldman (Prop. Trading); Occupy; Sens. Merkley & Levin

(Feb. 2012).

\493\ See Banco de M[eacute]xico (stating that primary dealers

need to profit from resulting proprietary positions in foreign

sovereign debt, including by holding significant positions in

anticipation of future price movements, in order to make the primary

dealer business financially attractive); IIB/EBF (noting that

primary dealers may actively seek to profit from price and interest

rate movements of their holdings, which the relevant sovereign

entity supports because such activity provides much-needed liquidity

for securities that are otherwise largely purchased pursuant to buy-

and-hold strategies by institutional investors and other entities

seeking safe returns and liquidity buffers); Japanese Bankers Ass'n.

---------------------------------------------------------------------------

With respect to suggested modifications, one commenter recommended

that ``customer revenue'' include revenues attributable to syndicate

activities, hedging activities, and profits and losses from sales of

residual positions, as long as the underwriter makes a reasonable

effort to dispose of any residual position in light of existing market

conditions.\494\ Another commenter indicated that the rule would better

address securitization if it required compensation to be linked in part

to risk minimization for the securitizer and in part to serving

customers. This commenter suggested that such a framework would be

preferable because, in the context of securitizations, fee-based

compensation structures did not previously prevent banking entities

from accumulating large and risky positions with significant market

exposure.\495\

---------------------------------------------------------------------------

\494\ See Goldman (Prop. Trading).

\495\ See Sens. Merkley & Levin (Feb. 2012).

---------------------------------------------------------------------------

To strengthen the proposed requirement, one commenter requested

that the terms ``designed'' and ``primarily'' be removed and replaced

by the word ``solely.'' \496\ Two other commenters requested that this

requirement be interpreted to prevent a banking entity from acting as

an underwriter for a distribution of securities if such securities lack

a discernible and sufficiently liquid pre-existing market and a

foreseeable market price.\497\

---------------------------------------------------------------------------

\496\ See Occupy (requesting that the rule require automatic

disgorgement of any profits arising from appreciation in the value

of positions in connection with underwriting activities).

\497\ See AFR et al. (Feb. 2012); Public Citizen.

---------------------------------------------------------------------------

c. Final Rule's Approach To Assessing Source of Revenue

The Agencies believe the final rule includes sufficient controls

around an underwriter's source of revenue and have determined not to

adopt the additional requirement included in proposed rule Sec.

75.4(a)(2)(vi). The Agencies believe that removing this requirement

addresses commenters' concerns that the proposed requirement did not

appropriately reflect certain revenue sources from underwriting

activity \498\ or may impact primary dealer activities.\499\ At the

same time, the final rule continues to include provisions that focus on

whether an underwriter is generating underwriting-related revenue and

that should limit an underwriter's ability to generate revenues purely

from price appreciation. In particular, the requirement to make

reasonable efforts to sell or otherwise reduce the underwriting

position within a reasonable period, which was not included in the

proposed rule, should limit an underwriter's ability to gain revenues

purely from price appreciation related to its underwriter position.

Similarly, the determination of whether an underwriter receives special

compensation for purposes of the definition of ``distribution'' takes

into account whether a banking entity is generating underwriting-

related revenue.

---------------------------------------------------------------------------

\498\ See Goldman (Prop. Trading).

\499\ See Banco de M[eacute]xico; IIB/EBF; Japanese Bankers

Ass'n.

---------------------------------------------------------------------------

The final rule does not adopt a requirement that prevents an

underwriter from generating any revenue from price appreciation out of

concern that such a requirement could prevent an underwriter from

retaining an unsold allotment under any

[[Page 5848]]

circumstances, which would be inconsistent with other provisions of the

exemption.\500\ Similarly, the Agencies are not adopting a source of

revenue requirement that would prevent a banking entity from acting as

underwriter for a distribution of securities if such securities lack a

discernible and sufficiently liquid pre-existing market and a

foreseeable market price, as suggested by two commenters.\501\ The

Agencies believe these commenters' concern is mitigated by the near

term demand requirement, which requires a trading desk to have a

reasonable expectation of demand from other market participants for the

amount and type of securities to be acquired from an issuer or selling

security holder for distribution.\502\ Further, one commenter

recommended a revenue requirement directed at securitization activities

to prevent banking entities from accumulating large and risky positions

with significant market exposure.\503\ The Agencies believe the

requirement to make reasonable efforts to sell or otherwise reduce the

underwriting position should achieve this stated goal and, thus, the

Agencies do not believe an additional revenue requirement for

securitization activity is needed.\504\

---------------------------------------------------------------------------

\500\ See Occupy; supra Part VI.A.2.c.2. (discussing comments on

unsold allotments and the requirement in the final rule to make

reasonable efforts to sell or otherwise reduce the underwriting

position).

\501\ See AFR et al. (Feb. 2012); Public Citizen.

\502\ See supra Part VI.A.2.c.2.

\503\ See Sens. Merkley & Levin (Feb. 2012).

\504\ See final rule Sec. 75.4(a)(2)(ii). Further, as noted

above, this exemption does not permit the accumulation of assets for

securitization. See supra Part VI.A.2.c.1.c.v.

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3. Section 75.4(b): Market-Making Exemption

a. Introduction

In adopting the final rule, the Agencies are striving to balance

two goals of section 13 of the BHC Act: To allow market making, which

is important to well-functioning markets as well as to the economy, and

simultaneously to prohibit proprietary trading, unrelated to market

making or other permitted activities, that poses significant risks to

banking entities and the financial system. In response to comments on

the proposed market-making exemption, the Agencies are adopting certain

modifications to the proposed exemption to better account for the

varying characteristics of market making-related activities across

markets and asset classes, while requiring that banking entities

maintain a robust set of risk controls for their market making-related

activities. A flexible approach to this exemption is appropriate

because the activities a market maker undertakes to provide important

intermediation and liquidity services will differ based on the

liquidity, maturity, and depth of the market for a given type of

financial instrument. The statute specifically permits banking entities

to continue to provide these beneficial services to their clients,

customers, and counterparties.\505\ Thus, the Agencies are adopting an

approach that recognizes the full scope of market making-related

activities banking entities currently undertake and requires that these

activities be subject to clearly defined, verifiable, and monitored

risk parameters.

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\505\ As discussed in Part VI.A.3.c.2.c.i., infra, the terms

``client,'' ``customer,'' and ``counterparty'' are defined in the

same manner in the final rule. Thus, the Agencies use these terms

synonymously throughout this discussion and sometimes use the term

``customer'' to refer to all entities that meet the definition of

``client, customer, and counterparty'' in the final rule's market-

making exemption.

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b. Overview

1. Proposed Market-Making Exemption

Section 13(d)(1)(B) of the BHC Act provides an exemption from the

prohibition on proprietary trading for the purchase, sale, acquisition,

or disposition of securities, derivatives, contracts of sale of a

commodity for future delivery, and options on any of the foregoing 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.\506\

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\506\ 12 U.S.C. 1851(d)(1)(B).

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Section 75.4(b) of the proposed rule would have implemented this

statutory exemption by requiring that a banking entity's market making-

related activities comply with seven standards. As discussed in the

proposal, these standards were designed to ensure that any banking

entity relying on the exemption would be engaged in bona fide market

making-related activities and, further, would conduct such activities

in a way that was not susceptible to abuse through the taking of

speculative, proprietary positions as a part of, or mischaracterized

as, market making-related activities. The Agencies proposed to use

additional regulatory and supervisory tools in conjunction with the

proposed market-making exemption, including quantitative measurements

for banking entities engaged in significant covered trading activity in

proposed Appendix A, commentary on how the Agencies proposed to

distinguish between permitted market making-related activity and

prohibited proprietary trading in proposed Appendix B, and a compliance

regime in proposed Sec. 75.20 and, where applicable, Appendix C of the

proposal. This multi-faceted approach was intended to address the

complexities of differentiating permitted market making-related

activities from prohibited proprietary trading.\507\

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\507\ See Joint Proposal, 76 FR at 68869; CFTC Proposal, 77 FR

at 8354-8355.

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2. Comments on the Proposed Market-Making Exemption

The Agencies received significant comment regarding the proposed

market-making exemption. In this Part, the Agencies highlight the main

issues, concerns, and suggestions raised by commenters with respect to

the proposed market-making exemption. As discussed in greater detail

below, commenters' views on the effectiveness of the proposed exemption

varied. Commenters discussed a broad range of topics related to the

proposed market-making exemption including, among others: The overall

scope of the proposed exemption and potential restrictions on market

making in certain markets or asset classes; the potential market impact

of the proposed market-making exemption; the appropriate level of

analysis for compliance with the proposed exemption; the effectiveness

of the individual requirements of the proposed exemption; and specific

activities that should or should not be considered permitted market

making-related activity under the rule.

a. Comments on the Overall Scope of the Proposed Exemption

With respect to the general scope of the exemption, a number of

commenters expressed concern that the proposed approach to implementing

the market-making exemption is too narrow or restrictive, particularly

with respect to less liquid markets. These commenters expressed concern

that the proposed exemption would not be workable in many markets and

asset classes and does not take into account how market-making services

are provided in those markets and asset classes.\508\ Some

[[Page 5849]]

commenters expressed particular concern that the proposed exemption may

restrict or limit certain activities currently conducted by market

makers (e.g., holding inventory or interdealer trading).\509\ Several

commenters stated that the proposed exemption would create too much

uncertainty regarding compliance \510\ and, further, may have a

chilling effect on banking entities' market making-related

activities.\511\ Due to the perceived restrictions and burdens of the

proposed exemption, many commenters indicated that the rule may change

the way in which market-making services are provided.\512\ A number of

commenters expressed the view that the proposed exemption is

inconsistent with Congressional intent because it would restrict and

reduce banking entities' current market making-related activities.\513\

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\508\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012)

(stating that the proposed exemption ``seems to view market making

based on a liquid, exchange-traded equity model in which market

makers are simple intermediaries akin to agents'' and that ``[t]his

view does not fit market making even in equity markets and widely

misses the mark for the vast majority of markets and asset

classes''); SIFMA (Asset Mgmt.) (Feb. 2012); Credit Suisse (Seidel);

ICI (Feb. 2012); BoA; Columbia Mgmt.; Comm. on Capital Markets

Regulation; Invesco; ASF (Feb. 2012) (``The seven criteria in the

proposed rule, and the related criterion for identifying permitted

hedging, are overly restrictive and will make it impractical for

dealers to continue making markets in most securitized products.'');

Chamber (Feb. 2012) (expressing particular concern about the

commercial paper market).

\509\ Several commenters stated that the proposed rule would

limit a market maker's ability to maintain inventory. See, e.g.,

NASP; Oliver Wyman (Dec. 2011); Wellington; Prof. Duffie; Standish

Mellon; MetLife; Lord Abbett; NYSE Euronext; CIEBA; British

Columbia; SIFMA et al. (Prop. Trading) (Feb. 2012); Shadow Fin.

Regulatory Comm.; Credit Suisse (Seidel); Morgan Stanley; Goldman

(Prop. Trading); BoA; STANY; SIFMA (Asset Mgmt.) (Feb. 2012);

Chamber (Feb. 2012); IRSG; Abbott Labs et al. (Feb. 14, 2012);

Abbott Labs et al. (Feb. 21, 2012); Australian Bankers Ass'n. (Feb.

2012); FEI; ASF (Feb. 2012); RBC; PUC Texas; Columbia Mgmt.; SSgA

(Feb. 2012); PNC et al.; Fidelity; ICI (Feb. 2012); British Bankers'

Ass'n.; Comm. on Capital Markets Regulation; IHS; Oliver Wyman (Feb.

2012); Thakor Study (stating that by artificially constraining the

security holdings that a banking entity can have in its inventory

for market making or proprietary trading purposes, section 13 of the

BHC Act will make bank risk management less efficient and may

adversely impact the diversified financial services business model

of banks). However, some commenters stated that market makers should

seek to minimize their inventory or should not need large

inventories. See, e.g., AFR et al. (Feb. 2012); Public Citizen;

Johnson & Prof. Stiglitz. Other commenters expressed concern that

the proposed rule could limit interdealer trading. See, e.g., Prof.

Duffie; Credit Suisse (Seidel); JPMC; Morgan Stanley; Goldman (Prop.

Trading); Chamber (Feb. 2012); Oliver Wyman (Dec. 2011).

\510\ See, e.g., BlackRock; Putnam; Fixed Income Forum/Credit

Roundtable; ACLI (Feb. 2012); MetLife; IAA; Wells Fargo (Prop.

Trading); T. Rowe Price; Sen. Bennet; Sen. Corker; PUC Texas;

Fidelity; ICI (Feb. 2012); Invesco.

\511\ See, e.g., Wellington; Prof. Duffie; Standish Mellon;

Commissioner Barnier; NYSE Euronext; BoA; Citigroup (Feb. 2012);

STANY; ICE; Chamber (Feb. 2012); BDA (Feb. 2012); Putnam; FTN; Fixed

Income Forum/Credit Roundtable; ACLI (Feb. 2012); IAA; CME Group;

Capital Group; PUC Texas; Columbia Mgmt.; SSgA (Feb. 2012); Eaton

Vance; ICI (Feb. 2012); Invesco; Comm. on Capital Markets

Regulation; Oliver Wyman (Feb. 2012); SIFMA (Asset Mgmt.) (Feb.

2012); Thakor Study.

\512\ For example, some commenters stated that market makers may

revert to an agency or ``special order'' model. See, e.g., Barclays;

Goldman (Prop. Trading); ACLI (Feb. 2012); Vanguard; RBC. In

addition, some commenters stated that new systems will be developed,

such as alternative market matching networks, but these commenters

disagreed about whether such changes would happen in the near term.

See, e.g., CalPERS; BlackRock; Stuyvesant; Comm. on Capital Markets

Regulation. Other commenters stated that it is unlikely that new

systems will be developed. See, e.g., SIFMA et al. (Prop. Trading)

(Feb. 2012); Oliver Wyman (Feb. 2012). One commenter stated that the

proposed rule may cause a banking organization that engages in

significant market-making activity to give up its banking charter or

spin off its market-making operations to avoid compliance with the

proposed exemption. See Prof. Duffie.

\513\ See, e.g., NASP; Wellington; JPMC; Morgan Stanley; Credit

Suisse (Seidel); BoA; Goldman (Prop. Trading); Citigroup (Feb.

2012); STANY; SIFMA (Asset Mgmt.) (Feb. 2012); Chamber (Feb. 2012);

Putnam; ICI (Feb. 2012); Wells Fargo (Prop. Trading); NYSE Euronext;

Sen. Corker; Invesco.

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Other commenters, however, stated that the proposed exemption was

too broad and recommended that the rule place greater restrictions on

market making, particularly in illiquid, nontransparent markets.\514\

Many of these commenters suggested that the exemption should only be

available for traditional market-making activity in relatively safe,

``plain vanilla'' instruments.\515\ Two commenters represented that the

proposed exemption would have little to no impact on banking entities'

current market making-related services.\516\

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\514\ See, e.g., Better Markets (Feb. 2012); Sens. Merkley &

Levin (Feb. 2012); Occupy; AFR et al. (Feb. 2012); Public Citizen;

Johnson & Prof. Stiglitz.

\515\ See, e.g., Johnson & Prof. Stiglitz; Sens. Merkley & Levin

(Feb. 2012); Occupy; AFR et al. (Feb. 2012); Public Citizen.

\516\ See Occupy (``[I]t is unclear that this rule, as written,

will markedly alter the current customer-serving business. Indeed,

this rule has gone to excessive lengths to protect the covered

banking entities' ability to maintain responsible customer-facing

business.''); Alfred Brock.

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Commenters expressed differing views regarding the ease or

difficulty of distinguishing permitted market making-related activity

from prohibited proprietary trading. A number of commenters represented

that it is difficult or impossible to distinguish prohibited

proprietary trading from permitted market making-related activity.\517\

With regard to this issue, several commenters recommended that the

Agencies not try to remove all aspects of proprietary trading from

market making-related activity because doing so would likely restrict

certain legitimate market-making activity.\518\

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\517\ See, e.g., Rep. Bachus et al.; IIF; Morgan Stanley

(stating that beyond walled-off proprietary trading, the line is

hard to draw, particularly because both require principal risk-

taking and the features of market making vary across markets and

asset classes and become more pronounced in times of market stress);

CFA Inst. (representing that the distinction is particularly

difficult in the fixed-income market); ICFR; Prof. Duffie; WR

Hambrecht.

\518\ See, e.g., Chamber (Feb. 2012) (citing an article by

Stephen Breyer stating that society should not expend

disproportionate resources trying to reduce or eliminate ``the last

10 percent'' of the risks of a certain problem); JPMC; RBC; ICFR;

Sen. Hagan. One of these commenters indicated that any concerns that

banking entities would engage in speculative trading as a result of

an expansive market-making exemption would be addressed by other

reform initiatives (e.g., Basel III implementation will provide

laddered disincentives to holding positions as principal as a result

of capital and liquidity requirements). See RBC.

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Other commenters were of the view that it is possible to

differentiate between prohibited proprietary trading and permitted

market making-related activity.\519\ For example, one commenter stated

that, while the analysis may involve subtle distinctions, the

fundamental difference between a banking entity's market-making

activities and proprietary trading activities is the emphasis in market

making on seeking to meet customer needs on a consistent and reliable

basis throughout a market cycle.\520\ According to another commenter,

holding substantial securities in a trading book for an extended period

of time assumes the character of a proprietary position and, while

there may be occasions when a customer-oriented purchase and subsequent

sale extend over days and cannot be more quickly executed or hedged,

substantial holdings of this character should be relatively rare and

limited to less liquid markets.\521\

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\519\ See Wellington; Paul Volcker; Better Markets (Feb. 2012);

Occupy.

\520\ See Wellington.

\521\ See Paul Volcker.

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Several commenters expressed general concern that the proposed

exemption may be applied on a transaction-by-transaction basis and

explained the burdens that may result from such an approach.\522\

Commenters appeared to attribute these concerns to language in the

proposed exemption referring to a ``purchase or sale of a [financial

instrument]'' \523\ or to language in Appendix B indicating that the

Agencies may assess certain factors and criteria at different levels,

including a ``single significant transaction.'' \524\ With respect to

the burdens of a transaction-by-transaction analysis,

[[Page 5850]]

some commenters noted that banking entities can engage in a large

volume of market-making transactions daily, which would make it

burdensome to apply the exemption to each trade.\525\ A few commenters

indicated that, even if the Agencies did not intend to require

transaction-by-transaction analysis, the proposed rule's language can

be read to imply such a requirement. These commenters indicated that

ambiguity on this issue could have a chilling effect on market making

or could allow some examiners to rigidly apply the requirements of the

exemption on a trade-by-trade basis.\526\ Other commenters indicated

that it would be difficult to determine whether a particular trade was

or was not a market-making trade without consideration of the relevant

unit's overall activities.\527\ One commenter elaborated on this point

by stating that ``an analysis that seeks to characterize specific

transactions as either market making . . . or prohibited activity does

not accord with the way in which modern trading units operate, which

generally view individual positions as a bundle of characteristics that

contribute to their complete portfolio.'' \528\ This commenter noted

that a position entered into as part of market making-related

activities may serve multiple functions at one time, such as responding

to customer demand, hedging a risk, and building inventory. The

commenter also expressed concern that individual transactions or

positions may not be severable or separately identifiable as serving a

market-making purpose.\529\ Two commenters suggested that the

requirements in the market-making exemption be applied at the portfolio

level rather than the trade level.\530\

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\522\ See Wellington; SIFMA et al. (Prop. Trading) (Feb. 2012);

Barclays; Goldman (Prop. Trading); HSBC; Fixed Income Forum/Credit

Roundtable; ACLI (Feb. 2012); PUC Texas; ERCOT; Invesco. See also

IAA (stating that it is unclear whether the requirements must be

applied on a transaction-by-transaction basis or if compliance with

the requirements is based on overall activities). This issue is

addressed in Part VI.A.3.c.1.c., infra.

\523\ See, e.g., Barclays; SIFMA et al. (Prop. Trading) (Feb.

2012). As explained above, the term ``covered financial position''

from the proposal has been replaced by the term ``financial

instrument'' in the final rule. Because the types of instruments

included in both definitions are identical, the term ``financial

instrument'' is used throughout this Part.

\524\ See, e.g., Goldman (Prop. Trading); Wellington.

\525\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Barclays (stating that ``hundreds or thousands of trades can occur

in a single day in a single trading unit'').

\526\ See, e.g., ICI (Feb. 2012); Barclays; Goldman (Prop.

Trading).

\527\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Goldman (Prop. Trading).

\528\ SIFMA et al. (Prop. Trading) (Feb. 2012).

\529\ See id. (suggesting that the Agencies ``give full effect

to the statutory intent to allow market making by viewing the

permitted activity on a holistic basis'').

\530\ See ACLI (Feb. 2012); Fixed Income Forum/Credit

Roundtable.

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Moreover, commenters also set forth their views on the

organizational level at which the requirements of the proposed market-

making exemption should apply.\531\ The proposed exemption generally

applied requirements to a ``trading desk or other organizational unit''

of a banking entity. In response to this proposed approach, commenters

stated that compliance should be assessed at each trading desk or

aggregation unit\532\ or at each trading unit.\533\

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\531\ See Wellington; Morgan Stanley; SIFMA et al. (Prop.

Trading) (Feb. 2012); ACLI (Feb. 2012); Fixed Income Forum/Credit

Roundtable. The Agencies address this topic in Part VI.A.3.c.1.c.,

infra.

\532\ See Wellington. This commenter did not provide greater

specificity about how it would define ``trading desk'' or

``aggregation unit.'' See id.

\533\ See Morgan Stanley (stating that ``trading unit'' should

be defined as ``each organizational unit that is used to structure

and control the aggregate risk-taking activities and employees that

are engaged in the coordinated implementation of a customer-facing

revenue generation strategy and that participate in the execution of

any covered trading activity''); SIFMA et al. (Prop. Trading) (Feb.

2012). One of these commenters discussed its suggested definition of

``trading unit'' in the context of the proposed requirement to

record and report certain quantitative measurements, but it is

unclear that the commenter was also suggesting that this definition

be used for purposes of the market-making exemption. For example,

this commenter expressed support for a multi-level approach to

defining ``trading unit,'' and it is not clear how a definition that

captures multiple organizational levels across a banking

organization would work in the context of the market-making

exemption. See SIFMA et al. (Prop. Trading) (Feb. 2012) (suggested

that ``trading unit'' be defined ``at a level that presents its

activities in the context of the whole'' and noting that the

appropriate level may differ depending on the structure of the

banking entity).

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Several commenters suggested alternative or additive means of

implementing the statutory exemption for market making-related

activity.\534\ Commenters' recommended approaches varied, but a number

of commenters requested approaches involving one or more of the

following elements: (i) Safe harbors,\535\ bright lines,\536\ or

presumptions of compliance with the exemption based on the existence of

certain factors (e.g., compliance program, metrics, general customer

focus or orientation, providing liquidity, and/or exchange registration

as a market maker); \537\ (ii) a focus on metrics or other objective

factors; \538\ (iii) guidance on permitted market making-related

activity, rather than rule requirements; \539\ (iv) risk management

structures and/or risk limits; \540\ (v) adding a new customer-facing

criterion or focusing on client-related activities; \541\ (vi) capital

and liquidity requirements; \542\ (vii) development of individualized

plans for each banking entity, in coordination with regulators; \543\

(viii) ring fencing affiliates engaged in market making-related

activity; \544\ (ix) margin requirements; \545\ (x) a compensation-

focused approach; \546\ (xi) permitting all swap dealing activity;

\547\ (xii) additional provisions regarding material conflicts of

interest and high-risk assets and trading strategies; \548\ and/or

(xiii) making the exemption as broad as possible under the

statute.\549\

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\534\ See, e.g., Wellington; Japanese Bankers Ass'n.; Prof.

Duffie; IR&M; G2 FinTech; MetLife; NYSE Euronext; Anthony Flynn and

Koral Fusselman; IIF; CalPERS; SIFMA et al. (Prop. Trading) (Feb.

2012); Sens. Merkley & Levin (Feb. 2012); Shadow Fin. Regulatory

Comm.; John Reed; Prof. Richardson; Credit Suisse (Seidel); JPMC;

Morgan Stanley; Barclays; Goldman (Prop. Trading); BoA; Citigroup

(Feb. 2012); STANY; ICE; BlackRock; Johnson & Prof. Stiglitz; Fixed

Income Forum/Credit Roundtable; ACLI (Feb. 2012); Wells Fargo (Prop.

Trading); WR Hambrecht; Vanguard; Capital Group; PUC Texas; SSgA

(Feb. 2012); PNC et al.; Fidelity; Occupy; AFR et al. (Feb. 2012);

Invesco; ISDA (Feb. 2012); Stephen Roach; Oliver Wyman (Feb. 2012).

The Agencies respond to these comments in Part VI.A.3.b.3., infra.

\535\ See, e.g., Sens. Merkley & Levin (Feb. 2012); John Reed;

Prof. Richardson; Johnson & Prof. Stiglitz; Capital Group; Invesco;

BDA (Feb. 2012) (Oct. 2012) (suggesting a safe harbor for any

trading desk that effects more than 50 percent of its transactions

through sales representatives).

\536\ See, e.g., Flynn & Fusselman; Prof. Colesanti et al.

\537\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); IIF;

NYSE Euronext; Credit Suisse (Seidel); JPMC; Barclays; BoA; Wells

Fargo (Prop. Trading) (suggesting that the rule: (i) Provide a

general grant of authority to engage in any transactions entered

into as part of a banking entity's market-making business, where

``market making'' is defined as ``the business of being willing to

facilitate customer purchases and sales of [financial instruments]

as an intermediary over time and in size, including by holding

positions in inventory;'' and (ii) allow banking entities to monitor

compliance with this exemption internally through their compliance

and risk management infrastructure); PNC et al.; Oliver Wyman (Feb.

2012).

\538\ See, e.g., Goldman (Prop. Trading); Morgan Stanley;

Barclays; Wellington; CalPERS; BlackRock; SSgA (Feb. 2012); Invesco.

\539\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012)

(suggesting that this guidance could be incorporated in banking

entities' policies and procedures for purposes of complying with the

rule, in addition to the establishment of risk limits, controls, and

metrics); JPMC; BoA; PUC Texas; SSgA (Feb. 2012); PNC et al.; Wells

Fargo (Prop. Trading).

\540\ See, e.g., Japanese Bankers Ass'n.; Citigroup (Feb. 2012).

\541\ See, e.g., Morgan Stanley; Stephen Roach.

\542\ See, e.g., Prof. Duffie; CalPERS; STANY; ICE; Vanguard;

Capital Group.

\543\ See MetLife; Fixed Income Forum/Credit Roundtable; ACLI

(Feb. 2012).

\544\ See, e.g., Prof. Duffie; Shadow Fin. Regulatory Comm. See

also Wedbush.

\545\ See WR Hambrecht.

\546\ See G2 FinTech.

\547\ See ISDA (Feb. 2012); ISDA (Apr. 2012).

\548\ See Sens. Merkley & Levin (Feb. 2012) (stating that the

exemption should expressly mention the conflicts provision and

provide examples to warn against particular conflicts, such as

recommending clients buy poorly performing assets in order to remove

them from the banking entity's book or attempting to move market

prices in favor of trading positions a banking entity has built up

in order to make a profit); Stephen Roach (suggesting that the

exemption integrate the limitations on permitted activities).

\549\ See Fidelity (stating that the exemption needs to be as

broad as possible to account for customer-facing principal trades,

block trades, and market making in OTC derivatives). See also STANY

(stating that it is better to make the exemption too broad than too

narrow).

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[[Page 5851]]

b. Comments Regarding the Potential Market Impact of the Proposed

Exemption

As discussed above, several commenters stated that the proposed

rule would impact a banking entity's ability to engage in market

making-related activity. Many of these commenters represented that, as

a result, the proposed exemption would likely result in reduced

liquidity,\550\ wider bid-ask spreads,\551\ increased market

volatility,\552\ reduced price discovery or price transparency,\553\

increased costs of raising capital or higher financing costs,\554\

greater costs for investors or consumers,\555\ and slower execution

times.\556\ Some commenters expressed particular concern about

potential impacts on institutional investors (e.g., mutual funds and

pension funds) \557\ or on small or midsized companies.\558\ A number

of commenters discussed the interrelationship between primary and

secondary market activity and indicated that restrictions on market

making would impact the underwriting process.\559\

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\550\ See, e.g., AllianceBernstein; Rep. Bachus et al. (Dec.

2011); EMTA; NASP; Wellington; Japanese Bankers Ass'n.; Sen. Hagan;

Prof. Duffie; Investure; Standish Mellon; IR&M; MetLife; Lord

Abbett; Commissioner Barnier; Quebec; IIF; Sumitomo Trust; Liberty

Global; NYSE Euronext; CIEBA; EFAMA; SIFMA et al. (Prop. Trading)

(Feb. 2012); Credit Suisse (Seidel); JPMC; Morgan Stanley; Barclays;

Goldman (Prop. Trading); BoA; Citigroup (Feb. 2012); STANY; ICE;

BlackRock; SIFMA (Asset Mgmt.) (Feb. 2012); BDA (Feb. 2012); Putnam;

Fixed Income Forum/Credit Roundtable; Western Asset Mgmt.; ACLI

(Feb. 2012); IAA; CME Group; Wells Fargo (Prop. Trading); Abbott

Labs et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012); T.

Rowe Price; Australian Bankers Ass'n. (Feb. 2012); FEI; AFMA; Sen.

Carper et al.; PUC Texas; ERCOT; IHS; Columbia Mgmt.; SSgA (Feb.

2012); PNC et al.; Eaton Vance; Fidelity; ICI (Feb. 2012); British

Bankers' Ass'n.; Comm. on Capital Markets Regulation; Union Asset;

Sen. Casey; Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012)

(providing estimated impacts on asset valuation, borrowing costs,

and transaction costs in the corporate bond market based on

hypothetical liquidity reduction scenarios); Thakor Study. The

Agencies respond to comments regarding the potential market impact

of the rule in Part VI.A.3.b.3., infra.

\551\ See, e.g., AllianceBernstein; Wellington; Investure;

Standish Mellon; MetLife; Lord Abbett; Barclays; Goldman (Prop.

Trading); Citigroup (Feb. 2012); BlackRock; Putnam; ACLI (Feb.

2012); Abbott Labs et al. (Feb. 14, 2012); Abbott Labs et al. (Feb.

21, 2012); T. Rowe Price; Sen. Carper et al.; IHS; Columbia Mgmt.;

ICI (Feb. 2012) British Bankers' Ass'n.; Comm. on Capital Markets

Regulation; Thakor Study (stating that section 13 of the BHC Act

will likely result in higher bid-ask spreads by causing at least

some retrenchment of banks from market making, resulting in fewer

market makers and less competition).

\552\ See, e.g., Wellington; Prof. Duffie; Standish Mellon; Lord

Abbett; IIF; SIFMA et al. (Prop. Trading) (Feb. 2012); Barclays;

Goldman (Prop. Trading); BDA (Feb. 2012); IHS; FTN; IAA; Wells Fargo

(Prop. Trading); T. Rowe Price; Columbia Mgmt.; SSgA (Feb. 2012);

Eaton Vance; British Bankers' Ass'n.; Comm. on Capital Markets

Regulation.

\553\ See, e.g., Prof. Duffie (arguing that, for example,

``during the financial crisis of 2007-2009, the reduced market

making capacity of major dealer banks caused by their insufficient

capital levels resulted in dramatic downward distortions in

corporate bond prices''); IIF; Barclays; IAA; Vanguard; Wellington;

FTN.

\554\ See, e.g., AllianceBernstein; Chamber (Dec. 2011); Members

of Congress (Dec. 2011); Wellington; Sen. Hagan; Prof. Duffie; IR&M;

MetLife; Lord Abbett; Liberty Global; NYSE Euronext; SIFMA et al.

(Prop. Trading) (Feb. 2012); NCSHA; ASF (Feb. 2012) (stating that

``[f]ailure to permit the activities necessary for banking entities

to act in [a] market-making capacity [in asset-backed securities]

would have a dramatic adverse effect on the ability of securitizers

to access the asset-backed securities markets and thus to obtain the

debt financing necessary to ensure a vibrant U.S. economy''); Credit

Suisse (Seidel); JPMC; Morgan Stanley; Barclays; Goldman (Prop.

Trading); BoA; Citigroup (Feb. 2012); STANY; BlackRock; Chamber

(Feb. 2012); IHS; BDA (Feb. 2012); Fixed Income Forum/Credit

Roundtable; ACLI (Feb. 2012); Wells Fargo (Prop. Trading); Abbott

Labs et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012); T.

Rowe Price; FEI; AFMA; SSgA (Feb. 2012); PNC et al.; ICI (Feb.

2012); British Bankers' Ass'n.; Oliver Wyman (Dec. 2011); Oliver

Wyman (Feb. 2012); GE (Feb. 2012); Thakor Study (stating that when a

firm's cost of capital goes up, it invests less--resulting in lower

economic growth and lower employment--and citing supporting data

indicating that a 1 percent increase in the cost of capital would

lead to a $55 to $82.5 billion decline in aggregate annual capital

spending by U.S. nonfarm firms and job losses between 550,000 and

1.1 million per year in the nonfarm sector). One commenter further

noted that a higher cost of capital can lead a firm to make riskier,

short-term investments. See Thakor Study.

\555\ See, e.g., Wellington; Standish Mellon; IR&M; MetLife;

Lord Abbett; NYSE Euronext; CIEBA; Barclays; Goldman (Prop.

Trading); BoA; Citigroup (Feb. 2012); STANY; ICE; BlackRock; Fixed

Income Forum/Credit Roundtable; ACLI (Feb. 2012); IAA; Abbott Labs

et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012); T. Rowe

Price; Vanguard; Australian Bankers Ass'n. (Feb. 2012); FEI; Sen.

Carper et al.; Columbia Mgmt.; SSgA (Feb. 2012); ICI (Feb. 2012);

Comm. on Capital Markets Regulation; TMA Hong Kong; Sen. Casey; IHS;

Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012); Thakor Study.

\556\ See, e.g., Barclays; FTN; Abbott Labs et al. (Feb. 14,

2012); Abbott Labs et al. (Feb. 21, 2012).

\557\ See, e.g., AllianceBernstein (stating that, to the extent

the rule reduces liquidity provided by market makers, open end

mutual funds that are largely driven by the need to respond to both

redemptions and subscriptions will be immediately impacted in terms

of higher trading costs); Wellington (indicating that periods of

extreme market stress are likely to exacerbate costs and challenges,

which could force investors such as mutual funds and pension funds

to accept distressed prices to fund redemptions or pay current

benefits); Lord Abbett (stating that certain factors, such as

reduced bank capital to support market-making businesses and

economic uncertainty, have already reduced liquidity and caused

asset managers to have an increased preference for highly liquid

credits and expressing concern that, if section 13 of the BHC Act

further reduces liquidity, then: (i) asset managers' increased

preference for highly liquid credit could lead to unhealthy

portfolio concentrations, and (ii) asset managers will maintain a

larger cash cushion in portfolios that may be subject to redemption,

which will likely result in investors getting poorer returns);

EFAMA; BlackRock (stating that investment decisions are heavily

dependent on a liquidity factor input, so as liquidity dissipates,

investment strategies become more limited and returns to investors

are diminished by wider spreads and higher transaction costs); CFA

Inst. (noting that a mutual fund that tries to liquidate holdings to

meet redemptions may have difficulty selling at acceptable prices,

thus impairing the fund's NAV for both redeeming investors and for

those that remain in the fund); Putnam; Fixed Income Forum/Credit

Roundtable; ACLI; T. Rowe Price; Vanguard; IAA; FEI; Sen. Carper et

al.; Columbia Mgmt.; ICI (Feb. 2012); Invesco; Union Asset; Standish

Mellon; Morgan Stanley; SIFMA (Asset Mgmt.) (Feb. 2012).

\558\ See, e.g., CIEBA (stating that for smaller issuers in

particular, market makers need to have incentives to make markets,

and the proposal removes important incentives); ACLI (indicating

that lower liquidity will most likely result in higher costs for

issuers of debt and, for lesser known or lower quality issuers, this

cost may be significant and in some cases prohibitive because the

cost will vary depending on the credit quality of the issuer, the

amount of debt it has in the market, and the maturity of the

security); PNC et al. (expressing concern that a regional bank's

market-making activity for small and middle market customers is more

likely to be inappropriately characterized as impermissible

proprietary trading due to lower trading volume involving less

liquid securities); Morgan Stanley; Chamber (Feb. 2012); Abbott Labs

et al. (Feb. 14, 2012); Abbott Labs et al. (Feb. 21, 2012); FEI; ICI

(Feb. 2012); TMA Hong Kong; Sen. Casey.

\559\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; RBC;

NYSE Euronext; Credit Suisse (Seidel).

---------------------------------------------------------------------------

A few commenters expressed the view that reduced liquidity would

not necessarily be a negative result.\560\ For example, two commenters

noted that liquidity is vulnerable to liquidity spirals, in which a

high level of market liquidity during one period feeds a sharp decline

in liquidity during the next period by initially driving asset prices

upward and supporting increased leverage. The commenters explained that

liquidity spirals lead to ``fire sales'' by market speculators when

events reveal that assets are overpriced and speculators must sell

their assets to reduce their leverage.\561\ According to another

commenter, banking entities' access to the safety net allows them to

distort market prices and, arguably, produce excess liquidity. The

commenter further represented that it would be preferable to allow the

discipline of the market to choose the pricing of securities and the

amount of liquidity.\562\ Some commenters cited an economic study

indicating that the U.S. financial system has become less efficient in

generating economic growth

[[Page 5852]]

in recent years, despite increased trading volumes.\563\

---------------------------------------------------------------------------

\560\ See, e.g., Paul Volcker; AFR et al. (Feb. 2012); Public

Citizen; Prof. Richardson; Johnson & Prof. Stiglitz; Better Markets

(Feb. 2012); Prof. Johnson.

\561\ See AFR et al. (Feb. 2012); Public Citizen. See also Paul

Volcker (stating that at some point, greater liquidity, or the

perception of greater liquidity, may encourage more speculative

trading).

\562\ See Prof. Richardson.

\563\ See, e.g., Johnson & Prof. Stiglitz (citing Thomas

Phillippon, ``Has the U.S. Finance Industry Become Less

Efficient?,'' NYU Working Paper, Nov. 2011); AFR et al. (Feb. 2012);

Public Citizen; Better Markets (Feb. 2012); Prof. Johnson.

---------------------------------------------------------------------------

Some commenters stated that it is unlikely the proposed rule would

result in the negative market impacts identified above, such as reduced

market liquidity.\564\ For example, a few commenters stated that other

market participants, who are not subject to section 13 of the BHC Act,

may enter the market or increase their trading activities to make up

for any reduction in banking entities' market-making activity or other

trading activity.\565\ For instance, one of these commenters suggested

that the revenue and profits from market making will be sufficient to

attract capital and competition to that activity.\566\ In addition, one

commenter expressed the view that prohibiting proprietary trading may

support more liquid markets by ensuring that banking entities focus on

providing liquidity as market makers, rather than taking liquidity from

the market in the course of ``trading to beat'' institutional buyers

like pension funds, university endowments, and mutual funds.\567\

Another commenter stated that, while section 13 of the BHC Act may

temporarily reduce trading volume and excessive liquidity at the peak

of market bubbles, it should increase the long-run stability of the

financial system and render genuine liquidity and credit availability

more reliable over the long term.\568\

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\564\ See, e.g., Sens. Merkley & Levin (Feb. 2012) (stating that

there is no convincing, independent evidence that the rule would

increase trading costs or reduce liquidity, and the best evidence

available suggests that the buy-side firms would greatly benefit

from the competitive pressures that transparency can bring); Better

Markets (Feb. 2012) (``Industry's claim that [section 13 of the BHC

Act] will `reduce market liquidity, capital formation, and credit

availability, and thereby hamper economic growth and job creation'

disregard the fact that the financial crisis did more damage to

those concerns than any rule or reform possibly could.''); Profs.

Stout & Hastings; Prof. Johnson; Occupy; Public Citizen; Profs.

Admati & Pfleiderer; Better Markets (June 2012); AFR et al. (Feb.

2012). One commenter stated that the proposed rule would improve

market liquidity, efficiency, and price transparency. See Alfred

Brock.

\565\ See, e.g., Sens. Merkley & Levin (Feb. 2012); Prof.

Richardson; Better Markets (Feb. 2012); Profs. Stout & Hastings;

Prof. Johnson; Occupy; Public Citizen; Profs. Admati & Pfleiderer;

Better Markets (June 2012). Similarly, one commenter indicated that

non-banking entity market participants could fill the current role

of banking entities in the market if implementation of the rule is

phased in. See ACLI (Feb. 2012).

\566\ See Better Markets (Feb. 2012).

\567\ See Prof. Johnson.

\568\ See AFR et al. (Feb. 2012).

---------------------------------------------------------------------------

Other commenters, however, indicated that it is uncertain or

unlikely that non-banking entities will enter the market or increase

their trading activities, particularly in the short term.\569\ For

example, one commenter noted the investment that banking entities have

made in infrastructure for trading and compliance would take smaller or

new firms years and billions of dollars to replicate.\570\ Another

commenter questioned whether other market participants, such as hedge

funds, would be willing to dedicate capital to fully serving customer

needs, which is required to provide ongoing liquidity.\571\ One

commenter stated that even if non-banking entities move in to replace

lost trading activity from banking entities, the value of the current

interdealer network among market makers will be reduced due to the exit

of banking entities.\572\ Several commenters expressed the view that

migration of market making-related activities to firms outside the

banking system would be inconsistent with Congressional intent and

would have potentially adverse consequences for the safety and

soundness of the U.S. financial system.\573\

---------------------------------------------------------------------------

\569\ See, e.g., Wellington; Prof. Duffie; Investure; IIF;

Liberty Global; SIFMA et al. (Prop. Trading) (Feb. 2012); Credit

Suisse (Seidel); JPMC; Morgan Stanley; Barclays; BoA; STANY; SIFMA

(Asset Mgmt.) (Feb. 2012); FTN; Western Asset Mgmt.; IAA; PUC Texas;

ICI (Feb. 2012); IIB/EBF; Invesco. In addition, some commenters

recognized that other market participants are likely to fill banking

entities' roles in the long term, but not in the short term. See,

e.g., ICFR; Comm. on Capital Markets Regulation; Oliver Wyman (Feb.

2012).

\570\ See Oliver Wyman (Feb. 2012) (``Major bank-affiliated

market makers have large capital bases, balance sheets, technology

platforms, global operations, relationships with clients, sales

forces, risk infrastructure, and management processes that would

take smaller or new dealers years and billions of dollars to

replicate.'').

\571\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\572\ See Thakor Study.

\573\ See, e.g., Prof. Duffie; Oliver Wyman (Feb. 2012).

---------------------------------------------------------------------------

Many commenters requested additional clarification on how the

proposed market-making exemption would apply to certain asset classes

and markets or to particular types of market making-related activities.

In particular, commenters requested greater clarity regarding the

permissibility of: (i) Interdealer trading,\574\ including trading for

price discovery purposes or to test market depth; \575\ (ii) inventory

management; \576\ (iii) block positioning activity; \577\ (iv) acting

as an authorized participant or market maker in ETFs; \578\ (v)

arbitrage or other activities that promote price transparency and

liquidity; \579\ (vi) primary dealer activity; \580\ (vii) market

making in futures and options; \581\ (viii) market making in new or

bespoke products or customized hedging contracts; \582\ and (ix) inter-

affiliate transactions.\583\ As discussed in more detail in Part

VI.B.2.c., a number of commenters requested that the market-making

exemption apply to the restrictions on acquiring or retaining an

ownership

[[Page 5853]]

interest in a covered fund.\584\ Some commenters stated that no other

activities should be considered permitted market making-related

activity under the rule.\585\ In addition, a few commenters requested

clarification that high-frequency trading would not qualify for the

market-making exemption.\586\

---------------------------------------------------------------------------

\574\ See, e.g., MetLife; SIFMA et al. (Prop. Trading) (Feb.

2012); RBC; Credit Suisse (Seidel); JPMC; BoA; ACLI (Feb. 2012); AFR

et al. (Feb. 2012); ISDA (Feb. 2012); Goldman (Prop. Trading);

Oliver Wyman (Feb. 2012).

\575\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Chamber

(Feb. 2012); Goldman (Prop. Trading).

\576\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Credit Suisse (Seidel); Goldman (Prop. Trading); MFA; RBC.

\577\ See infra Part VI.A.3.c.1.b.ii. (discussing commenters'

requests for greater clarity regarding the permissibility of block

positioning activity).

\578\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); BoA; ICI

(Feb. 2012); ICI Global; Vanguard; SSgA (Feb. 2012).

\579\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit

Suisse (Seidel); JPMC; Goldman (Prop. Trading); FTN; RBC; ISDA (Feb.

2012).

\580\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC;

Goldman (Prop. Trading); Banco de M[eacute]xico; IIB/EBF.

\581\ See CME Group (requesting clarification that the market-

making exemption permits a banking entity to engage in market making

in exchange-traded futures and options because the dealer

registration requirement in Sec. 75.4(b)(2)(iv) of the proposed

rule did not refer to such instruments and stating that lack of an

explicit exemption would reduce market-making activities in these

instruments, which would decrease liquidity). But see Johnson &

Prof. Stiglitz (stating that the Agencies should pay special

attention to options trading and other derivatives because they are

highly volatile assets that are difficult if not impossible to

effectively hedge, except through a completely matched position, and

suggesting that options and similar derivatives may need to be

required to be sold only as riskless principal under Sec.

75.6(b)(1)(ii) of the proposed rule or significantly limited through

capital charges); Sens. Merkley & Levin (Feb. 2012) (stating that

asset classes that are particularly hard to hedge, such as options,

should be given special attention under the hedging exemption).

\582\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); SIFMA (Asset

Mgmt.) (Feb. 2012). Other commenters, however, stated that banking

entities should be limited in their ability to rely on the market-

making exemption to conduct transactions in bespoke or customized

derivatives. See, e.g., AFR et al. (Feb. 2012); Public Citizen.

\583\ See, e.g., Japanese Bankers Ass'n. (stating that

transactions with affiliates and subsidiaries and related to hedging

activities are a type of market making-related activity or risk-

mitigating hedging activity that should be exempted by the rule);

SIFMA et al. (Prop. Trading) (Feb. 2012). According to one of these

commenters, inter-affiliate transactions should be viewed as part of

a coordinated activity for purposes of determining whether a banking

entity qualifies for an exemption. This commenter stated that, for

example, if a market maker shifts positions held in inventory to an

affiliate that is better able to manage the risk of such positions,

both the market maker and its affiliate would be engaged in

permitted market making-related activity. This commenter further

represented that fitting the inter-affiliate swap into the exemption

may be difficult (e.g., one of the affiliates entering into the swap

may not be holding itself out as a willing counterparty). See SIFMA

et al. (Prop. Trading) (Feb. 2012).

\584\ See, e.g., Cleary Gottlieb; JPMC; BoA; Credit Suisse

(Williams).

\585\ See, e.g., Occupy; Alfred Brock.

\586\ See, e.g., Occupy; AFR et al. (Feb. 2012); Public Citizen;

Johnson & Prof. Stiglitz; Sens. Merkley & Levin (Feb. 2012); John

Reed.

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3. Final Market-Making Exemption

After carefully considering comment letters, the Agencies are

adopting certain refinements to the proposed market-making exemption.

The Agencies are adopting a market-making exemption that is consistent

with the statutory exemption for this activity and designed to permit

banking entities to continue providing intermediation and liquidity

services. The Agencies note that, while all market-making activity

should ultimately be related to the intermediation of trading, whether

directly to individual customers through bilateral transactions or more

broadly to a given marketplace, certain characteristics of a market-

making business may differ among markets and asset classes.\587\ The

final rule is intended to account for these differences to allow

banking entities to continue to engage in market making-related

activities by providing customer intermediation and liquidity services

across markets and asset classes, if such activities do not violate the

statutory limitations on permitted activities (e.g., by involving or

resulting in a material conflict of interest with a client, customer,

or counterparty) and are conducted in conformance with the exemption.

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\587\ Consistent with the FSOC study and the proposal, the final

rule recognizes that 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 type of financial

instrument. See Joint Proposal, 76 FR at 68870; CFTC Proposal, 77 FR

at 8356; FSOC study (stating that ``characteristics of permitted

activities in one market or asset class may not be the same in

another market (e.g., permitted activities in a liquid equity

securities market may vary significantly from an illiquid over-the-

counter derivatives market)'').

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At the same time, the final rule requires development and

implementation of trading, risk and inventory limits, risk management

strategies, analyses of how the specific market making-related

activities are designed not to exceed the reasonably expected near term

demands of customers, compensation standards, and monitoring and review

requirements that are consistent with market-making activities.\588\

These requirements are designed to distinguish exempt market making-

related activities from impermissible proprietary trading. In addition,

these requirements are designed to ensure that a banking entity is

aware of, monitors, and limits the risks of its exempt activities

consistent with the prudent conduct of market making-related

activities.

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\588\ Certain of these requirements, like the requirements to

have risk and inventory limits, risk management strategies, and

monitoring and review requirements were included in the enhanced

compliance program requirement in proposed Appendix C, but were not

separately included in the proposed market-making exemption. Like

the statute, the proposed rule would have required that market

making-related activities be designed not to exceed the reasonably

expected near term demand of clients, customers, or counterparties.

The Agencies are adding an explicit requirement in the final rule

that a trading desk conduct analyses of customer demand for purposes

of complying with this statutory requirement.

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As described in detail below, the final market-making exemption

consists of the following elements:

A framework that recognizes the differences in market

making-related activities across markets and asset classes by

establishing criteria that can be applied based on the liquidity,

maturity, and depth of the market for the particular type of financial

instrument.

A general focus on analyzing the overall ``financial

exposure'' and ``market-maker inventory'' held by any given trading

desk rather than a transaction-by-transaction analysis. The ``financial

exposure'' reflects the aggregate risks of the financial instruments,

and any associated loans, commodities, or foreign exchange or currency,

held by a banking entity or its affiliate and managed by a particular

trading desk as part of its market making-related activities. The

``market-maker inventory'' means all of the positions, in the financial

instruments for which the trading desk stands ready to make a market

that are managed by the trading desk, including the trading desk's open

positions or exposures arising from open transactions.\589\

---------------------------------------------------------------------------

\589\ See infra Part VI.A.3.c.1.c.ii. See also final rule

Sec. Sec. 75.4(b)(4), (5).

---------------------------------------------------------------------------

A definition of the term ``trading desk'' that focuses on

the operational functionality of the desk rather than its legal status,

and requirements that apply at the trading desk level of organization

within a single banking entity or across two or more affiliates.\590\

---------------------------------------------------------------------------

\590\ See infra Part VI.A.3.c.1.c.i. The term ``trading desk''

is defined as ``the smallest discrete unit of organization of a

banking entity that buys or sells financial instruments for the

trading account of the banking entity or an affiliate thereof.''

Final rule Sec. 75.3(e)(13).

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Five requirements for determining whether a banking entity

is engaged in permitted market making-related activities. Many of these

criteria have similarities to the factors included in the proposed

rule, but with important modifications in response to comments. These

standards require that:

[cir] The trading desk that establishes and manages a financial

exposure routinely stands ready to purchase and sell one or more types

of financial instruments related to its financial exposure and is

willing and available to quote, buy and sell, or otherwise enter into

long and short positions in those types of financial instruments for

its own account, in commercially reasonable amounts and throughout

market cycles, on a basis appropriate for the liquidity, maturity, and

depth of the market for the relevant types of financial instruments;

\591\

---------------------------------------------------------------------------

\591\ See final rule Sec. 75.4(b)(2)(i); infra Part

VI.A.3.c.1.c.iii.

---------------------------------------------------------------------------

[cir] The amount, types, and risks of the financial instruments in

the trading desk's market-maker inventory are designed not to exceed,

on an ongoing basis, the reasonably expected near term demands of

clients, customers, or counterparties, as required by the statute and

based on certain factors and analysis; \592\

---------------------------------------------------------------------------

\592\ See final rule Sec. 75.4(b)(2)(ii); infra Part

VI.A.3.c.2.c. In addition, the Agencies are adopting a definition of

the terms ``client,'' ``customer,'' and ``counterparty'' in Sec.

75.4(b)(3) of the final rule.

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[cir] The banking entity has established and implements, maintains,

and enforces an internal compliance program that is reasonably designed

to ensure its compliance with the market-making exemption, including

reasonably designed written policies and procedures, internal controls,

analysis, and independent testing identifying and addressing:

[ssquf] The financial instruments each trading desk stands ready to

purchase and sell in accordance with Sec. 75.4(b)(2)(i) of the final

rule;

[ssquf] The actions the trading desk will take to demonstrably

reduce or otherwise significantly mitigate promptly the risks of its

financial exposure consistent with its established limits; the

products, instruments, and exposures each trading desk may use for risk

management purposes; the techniques and strategies each trading desk

may use to manage the risks of its market making-related activities and

inventory; and the process, strategies, and personnel responsible for

ensuring that the actions taken by the trading

[[Page 5854]]

desk to mitigate these risks are and continue to be effective; \593\

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\593\ Routine market making-related risk management activity by

a trading desk is permitted under the market-making exemption and,

provided the standards of the exemption are met, is not required to

separately meet the requirements of the hedging exemption. The

circumstances under which risk management activity relating to the

trading desk's financial exposure is permitted under the market-

making exemption or must separately comply with the hedging

exemption are discussed in more detail in Parts VI.A.3.c.1.c.ii. and

VI.A.3.c.4., infra.

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[ssquf] Limits for each trading desk, based on the nature and

amount of the trading desk's market making-related activities,

including factors used to determine the reasonably expected near term

demands of clients, customers, or counterparties, on: the amount,

types, and risks of its market-maker inventory; the amount, types, and

risks of the products, instruments, and exposures the trading desk uses

for risk management purposes; the level of exposures to relevant risk

factors arising from its financial exposure; and the period of time a

financial instrument may be held;

[ssquf] Internal controls and ongoing monitoring and analysis of

each trading desk's compliance with its limits; and

[ssquf] Authorization procedures, including escalation procedures

that require review and approval of any trade that would exceed a

trading desk's limit(s), demonstrable analysis that the basis for any

temporary or permanent increase to a trading desk's limit(s) is

consistent with the requirements of the market-making exemption, and

independent review of such demonstrable analysis and approval; \594\

---------------------------------------------------------------------------

\594\ See final rule Sec. 75.4(b)(2)(iii); infra Part

VI.A.3.c.3.

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[cir] To the extent that any limit identified above is exceeded,

the trading desk takes action to bring the trading desk into compliance

with the limits as promptly as possible after the limit is exceeded;

\595\

---------------------------------------------------------------------------

\595\ See final rule Sec. 75.4(b)(2)(iv).

---------------------------------------------------------------------------

[cir] The compensation arrangements of persons performing market

making-related activities are designed not to reward or incentivize

prohibited proprietary trading; \596\ and

---------------------------------------------------------------------------

\596\ See final rule Sec. 75.4(b)(2)(v); infra Part VI.A.3.c.5.

---------------------------------------------------------------------------

The banking entity is licensed or registered to engage in

market making-related activities in accordance with applicable

law.\597\

---------------------------------------------------------------------------

\597\ See final rule Sec. 75.4(b)(2)(vi); infra Part

VI.A.3.c.6. As discussed further below, this provision pertains to

legal registration or licensing requirements that may apply to an

entity engaged in market making-related activities, depending on the

facts and circumstances. This provision would not require a banking

entity to comply with registration requirements that are not

required by law, such as discretionary registration with a national

securities exchange as a market maker on that exchange.

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The use of quantitative measurements to highlight

activities that warrant further review for compliance with the

exemption.\598\ As discussed further in Part VI.C.3., the Agencies have

reduced some of the compliance burdens by adopting a more tailored

subset of metrics than was proposed to better focus on those metrics

that the Agencies believe are most germane to the evaluation of the

activities that firms conduct under the market-making exemption.

---------------------------------------------------------------------------

\598\ See infra Part VI.C.3.

---------------------------------------------------------------------------

In refining the proposed approach to implementing the statute's

market-making exemption, the Agencies closely considered the various

alternative approaches suggested by commenters.\599\ However, like the

proposed approach, the final market-making exemption continues to

adhere to the statutory mandate that provides for an exemption to the

prohibition on proprietary trading for market making-related

activities. Therefore, the final rule focuses on providing a framework

for assessing whether trading activities are consistent with market

making. The Agencies believe this approach is consistent with the

statute \600\ and strikes an appropriate balance between commenters'

desire for both clarity and flexibility. For example, while a bright-

line or safe harbor based approach would generally provide a high

degree of certainty about whether an activity qualifies for the market-

making exemption, it would also provide less flexibility to recognize

the differences in market-making activities across markets and asset

classes.\601\ In addition, any bright-line approach would be more

likely to be subject to gaming and avoidance as new products and types

of trading activities are developed than other approaches to

implementing the market-making exemption.\602\ Although a purely

guidance-based approach would provide greater flexibility, it would

also provide less clarity, which could make it difficult for trading

personnel, internal compliance personnel, and Agency supervisors and

examiners to determine whether an activity complies with the rule and

would lead to an increased risk of evasion of the statutory

requirements.\603\

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\599\ See supra Part VI.A.3.b.2.

\600\ Certain approaches suggested by commenters, such as

relying solely on capital requirements, requiring ring fencing,

permitting all swap dealing activity, or focusing solely on how

traders are compensated do not appear to be consistent with the

statutory language because they do not appear to limit market

making-related activity to that which is designed not to exceed the

reasonably expected near term demands of clients, customers, or

counterparties, as required by the statute. See Prof. Duffie; STANY;

ICE; Shadow Fin. Regulatory Comm.; ISDA (Feb. 2012); ISDA (Apr.

2012); G2 FinTech.

\601\ While an approach establishing a number of safe harbors

that are each tailored to a specific asset class would address the

need to recognize differences across asset classes, such an approach

may also increase the complexity of the final rule. Further,

commenters did not provide sufficient information to determine the

appropriate parameters of a safe harbor-based approach.

\602\ As noted above, a number of commenters suggested the

Agencies adopt a bright-line rule, provide a safe harbor for certain

types of activities, or establish a presumption of compliance based

on certain factors. See, e.g., Sens. Merkley & Levin (Feb. 2012);

John Reed; Prof. Richardson; Johnson & Prof. Stiglitz; Capital

Group; Invesco; BDA (Oct. 2012); Flynn & Fusselman; Prof. Colesanti

et al.; SIFMA et al. (Prop. Trading) (Feb. 2012); IIF; NYSE

Euronext; Credit Suisse (Seidel); JPMC; Barclays; BoA; Wells Fargo

(Prop. Trading); PNC et al.; Oliver Wyman (Feb. 2012). Many of these

commenters expressed general concern that the proposed market-making

exemption may create uncertainty for individual traders engaged in

market making-related activity and suggested that their proposed

approach would alleviate such concern. The Agencies believe that the

enhanced focus on risk and inventory limits for each trading desk

(which must be tied to the near term customer demand requirement)

and the clarification that the final market-making exemption does

not require a trade-by-trade analysis should address concerns about

individual traders having to assess whether they are complying with

the market-making exemption on a trade-by-trade basis.

\603\ Several commenters suggested a guidance-based approach,

rather than requirements in the final rule. See, e.g., SIFMA et al.

(Prop. Trading) (Feb. 2012) (suggesting that this guidance could

then be incorporated in banking entities' policies and procedures

for purposes of complying with the rule, in addition to the

establishment of risk limits, controls, and metrics); JPMC; BoA; PUC

Texas; SSgA (Feb. 2012); PNC et al.; Wells Fargo (Prop. Trading).

---------------------------------------------------------------------------

Some commenters suggested an approach to implementing the market-

making exemption that would focus on metrics or other objective

factors.\604\ As discussed below, a number of commenters expressed

support for using the metrics as a tool to monitor trading activity and

not to determine compliance with the rule.\605\ While the Agencies

agree that quantitative measurements are useful for purposes of

monitoring a trading desk's activities and are requiring certain

banking entities to calculate, record, and report quantitative

measurements to the Agencies in the final rule, the Agencies do not

believe that quantitative measurements should be used as a dispositive

tool for determining

[[Page 5855]]

compliance with the market-making exemption.\606\

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\604\ See, e.g., Goldman (Prop. Trading); Morgan Stanley;

Barclays; Wellington; CalPERS; BlackRock; SSgA (Feb. 2012); Invesco.

\605\ See infra Part VI.C.3. (discussing the final rule's

metrics requirement). See SIFMA et al. (Prop. Trading) (Feb. 2012);

Wells Fargo (Prop. Trading); RBC; ICI (Feb. 2012); Occupy (stating

that there are serious limits to the capabilities of the metrics and

the potential for abuse and manipulation of the input data is

significant); Alfred Brock.

\606\ See infra Part VI.C.3. (discussing the final metrics

requirement).

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In response to two commenters' request that the final rule focus on

a banking entity's risk management structures or risk limits and not on

attempting to define market-making activities,\607\ the Agencies do not

believe that management of risk, on its own, is sufficient to

differentiate permitted market making-related activities from

impermissible proprietary trading. For example, the existence of a risk

management framework or risk limits, while important, would not ensure

that a trading desk is acting as a market maker by engaging in

customer-facing activity and providing intermediation and liquidity

services.\608\ The Agencies also decline to take an approach to

implementing the market-making exemption that would require the

development of individualized plans for each banking entity in

coordination with the Agencies, as suggested by a few commenters.\609\

The Agencies believe it is useful to establish a consistent framework

that will apply to all banking entities to reduce the potential for

unintended competitive impacts that could arise if each banking entity

is subject to an individualized plan that is tailored to its specific

organizational structure and trading activities and strategies.

---------------------------------------------------------------------------

\607\ See, e.g., Japanese Bankers Ass'n.; Citigroup (Feb. 2012).

\608\ However, as discussed below, the Agencies believe risk

limits can be a useful tool when they must account for the nature

and amount of a particular trading desk's market making-related

activities, including the reasonably expected near term demands of

clients, customers, or counterparties.

\609\ See MetLife; Fixed Income Forum/Credit Roundtable; ACLI

(Feb. 2012).

---------------------------------------------------------------------------

Although the Agencies are not in the final rule modifying the basic

structure of the proposed market-making exemption, certain general

items suggested by commenters, such as enhanced compliance program

elements and risk limits, have been incorporated in the final rule text

for the market-making exemption, instead of a separate appendix.\610\

Moreover, as described below, the final market-making exemption

includes specific substantive changes in response to a wide variety of

commenter concerns.

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\610\ The Agencies are not, however, adding certain additional

requirements suggested by commenters, such as a new customer-facing

criterion, margin requirements, or additional provisions regarding

material conflicts of interest or high-risk assets or trading

strategies. See, e.g., Morgan Stanley; Stephen Roach; WR Hambrecht;

Sens. Merkley & Levin (Feb. 2012). The Agencies believe that the

final rule includes sufficient requirements to ensure that a trading

desk relying on the market-making exemption is engaged in customer-

facing activity (for example, the final rule requires the trading

desk to stand ready to buy and sell a type of financial instrument

as market maker and that the trading desk's market-maker inventory

is designed not to exceed the reasonably expected near term demands

of clients, customers, or counterparties). The Agencies decline to

include margin requirements in the final exemption because banking

entities are currently subject to a number of different margin

requirements, including those applicable to, among others: SEC-

registered broker-dealers; CFTC-registered swap dealers; SEC-

registered security-based swap dealers: and foreign dealer entities.

Further, the Agencies are not providing new requirements regarding

material conflicts of interest and high-risk assets and trading

strategies in the market-making exemption because the Agencies

believe these issues are adequately addressed in Sec. 75.7 of the

final rule. The limitations in Sec. 75.7 will apply to market

making-related activities and all other exempted activities.

---------------------------------------------------------------------------

The Agencies understand that the economics of market making--and

financial intermediation in general--require a market maker to be

active in markets. In determining the appropriate scope of the market-

making exemption, the Agencies have been mindful of commenters' views

on market making and liquidity. Several commenters stated that the

proposed rule would impact a banking entity's ability to engage in

market making-related activity, with corresponding reductions in market

liquidity.\611\ However, commenters disagreed about whether reduced

liquidity would be beneficial or detrimental to the market, or if any

such reductions would even materialize.\612\ Many commenters stated

that reduced liquidity could lead to other negative market impacts,

such as wider spreads, higher transaction costs, greater market

volatility, diminished price discovery, and increased cost of capital.

---------------------------------------------------------------------------

\611\ See supra note 550 and accompanying text. The Agencies

acknowledge that reduced liquidity can be costly. One commenter

provided estimated impacts on asset valuation, borrowing costs, and

transaction costs in the corporate bond market based on certain

hypothetical scenarios of reduced market liquidity. This commenter

noted that its hypothetical liquidity shifts of 5, 10, and 15

percentile points were ``necessarily arbitrary'' but judged ``to be

realistic potential outcomes of the proposed rule.'' Oliver Wyman

(Feb. 2012). Because the Agencies have made significant

modifications to the proposed rule in response to comments, the

Agencies believe this commenter's concerns about the market impacts

of the proposed rule have been substantially addressed.

\612\ As noted above, a few commenters stated that reduced

liquidity may provide certain benefits. See, e.g., Paul Volcker; AFR

et al. (Feb. 2012); Public Citizen; Prof. Richardson; Johnson &

Prof. Stiglitz; Better Markets (Feb. 2012); Prof. Johnson. However,

a number of commenters stated that reduced liquidity would have

negative market impacts. See supra note 550 and accompanying text.

---------------------------------------------------------------------------

The Agencies understand that market makers play an important role

in providing and maintaining liquidity throughout market cycles and

that restricting market-making activity may result in reduced

liquidity, with corresponding negative market impacts. For instance,

absent a market maker who stands ready to buy and sell, investors may

have to make large price concessions or otherwise expend resources

searching for counterparties. By stepping in to intermediate trades and

provide liquidity, market makers thus add value to the financial system

by, for example, absorbing supply and demand imbalances. This often

means taking on financial exposures, in a principal capacity, to

satisfy reasonably expected near term customer demand, as well as to

manage the risks associated with meeting such demand.

The Agencies recognize that, as noted by commenters, liquidity can

be associated with narrower spreads, lower transaction costs, reduced

volatility, greater price discovery, and lower costs of capital.\613\

The Agencies agree with these commenters that liquidity provides

important benefits to the financial system, as more liquid markets are

characterized by competitive market makers, narrow bid-ask spreads, and

frequent trading, and that a narrowly tailored market-making exemption

could negatively impact the market by, as described above, forcing

investors to make price concessions or unnecessarily expend resources

searching for counterparties.\614\ For example, while bid-ask spreads

compensate market makers for providing liquidity when asset values are

uncertain, under competitive forces, dealers compete with respect to

spreads, thus lowering their profit margins on a per trade basis and

benefitting investors.\615\ Volatility is

[[Page 5856]]

driven by both uncertainty about fundamental value and the liquidity

needs of investors. When markets are illiquid, participants may have to

make large price concessions to find a counterparty willing to trade,

increasing the importance of the liquidity channel for addressing

volatility. If liquidity-based volatility is not diversifiable,

investors will require a risk premium for holding liquidity risk,

increasing the cost of capital.\616\ Commenters additionally suggested

that the effects of diminished liquidity could be concentrated in

securities markets for small or midsize companies or for lesser-known

issuers, where trading is already infrequent.\617\ Volume in these

markets can be low, increasing the inventory risk of market makers. The

Agencies recognize that, if the final rule creates disincentives for

banking entities to provide liquidity, these low volume markets may be

impacted first.

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\613\ See supra Part VI.A.3.b.2.b.

\614\ See supra Part VI.A.3.b.2.b. As discussed above, a few

other commenters suggested that to the extent liquidity is

vulnerable to destabilizing liquidity spirals, any reduced liquidity

stemming from section 13 of the BHC Act and its implementing rules

would not necessarily be a negative result. See AFR et al. (Feb.

2012); Public Citizen. See also Paul Volcker. These commenters also

suggested that the Agencies adopt stricter conditions in the market-

making exemption, as discussed throughout this Part VI.A.3. However,

liquidity--essentially, the ease with which assets can be converted

into cash--is not destabilizing in and of itself. Rather, liquidity

spirals are a function of how firms are funded. During market

downturns, when margin requirements tend to increase, firms that

fund their operations with leverage face higher costs of providing

liquidity; firms that run up against their maximum leverage ratios

may be forced to retreat from market making, contributing to the

liquidity spiral. Viewed in this light, it is institutional features

of financial markets--in particular, leverage--rather than liquidity

itself that contributes to liquidity spirals.

\615\ Wider spreads can be costly for investors. For example,

one commenter estimated that a 10 basis point increase in spreads in

the corporate bond market would cost investors $29 billion per year.

See Wellington. Wider spreads can also be particularly costly for

open-end mutual funds, which must trade in and out of the fund's

portfolio holdings on a daily basis in order to satisfy redemptions

and subscriptions. See Wellington; AllianceBernstein.

\616\ A higher cost of capital increases financing costs and

translates into reduced capital investment. While one commenter

estimated that a one percent increase in the cost of capital would

lead to a $55 to $82.5 billion decline in capital investments by

U.S. nonfarm firms, the Agencies cannot independently verify these

potential costs. Further, this commenter did not indicate what

aspect of the proposed rule could cause a one percent increase in

the cost of capital. See Thakor Study. In any event, the Agencies

have made significant changes to the proposed approach to

implementing the market-making exemption that should help address

this commenter's concern.

\617\ See, e.g., CIEBA; ACLI; PNC et al.; Morgan Stanley;

Chamber (Feb. 2012); Abbott Labs et al. (Feb. 14, 2012); FEI; ICI

(Feb. 2012); TMA Hong Kong; Sen. Casey.

---------------------------------------------------------------------------

As discussed above, the Agencies received several comments

suggesting that the negative consequences associated with reduced

liquidity would be unlikely to materialize under the proposed rule. For

example, a few commenters stated that non-bank financial

intermediaries, who are not subject to section 13 of the BHC Act, may

increase their market-making activities in response to any reduction in

market making by banking entities, a topic the Agencies discuss in more

detail below.\618\ In addition, some commenters suggested that the

restrictions on proprietary trading would support liquid markets by

encouraging banking entities to focus on financial intermediation

activities that supply liquidity, rather than proprietary trades that

demand liquidity, such as speculative trades or trades that front-run

institutional investors.\619\ The statute prohibits proprietary trading

activity that is not exempted. As such, the termination of nonexempt

proprietary trading activities of banking entities may lead to some

general reductions in liquidity of certain asset classes. Although the

Agencies cannot say with any certainty, there is good reason to believe

that to a significant extent the liquidity reductions of this type may

be temporary since the statute does not restrict proprietary trading

activities of other market participants. Thus, over time, non-banking

entities may provide much of the liquidity that is lost by restrictions

on banking entities' trading activities. If so, eventually, the

detrimental effects of increased trading costs, higher costs of

capital, and greater market volatility should be mitigated.

---------------------------------------------------------------------------

\618\ See, e.g., Sens. Merkley & Levin (Feb. 2012); Prof.

Richardson; Better Markets (Feb. 2012); Profs. Stout & Hastings;

Prof. Johnson; Occupy; Public Citizen; Profs. Admati & Pfleiderer;

Better Markets (June 2012).

\619\ See, e.g., Prof. Johnson.

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Based on the many detailed comments provided, the Agencies have

made substantive refinements to the market-making exemption that the

Agencies believe will reduce the likelihood that the rule, as

implemented, will negatively impact the ability of banking entities to

engage in the types of market making-related activities permitted under

the statute and, therefore, will continue to promote the benefits to

investors and other market participants described above, including

greater market liquidity, narrower bid-ask spreads, reduced price

concessions and price impact, lower volatility, and reduced

counterparty search costs, thus reducing the cost of capital. For

instance, the final market-making exemption does not require a trade-

by-trade analysis, which was a significant source of concern from

commenters who represented, among other things, that a trade-by-trade

analysis could have a chilling effect on individual traders'

willingness to engage in market-making activities.\620\ Rather, the

final rule has been crafted around the overall market making-related

activities of individual trading desks, with various requirements that

these activities be demonstrably related to satisfying reasonably

expected near term customer demands and other market-making activities.

The Agencies believe that applying certain requirements to the

aggregate risk exposure of a trading desk, along with the requirement

to establish risk and inventory limits to routinize a trading desk's

compliance with the near term customer demand requirement, will reduce

negative potential impacts on individual traders' decision-making

process in the normal course of market making.\621\ In addition, in

response to a large number of comments expressing concern that the

proposed market-making exemption would restrict or prohibit market

making-related activities in less liquid markets, the Agencies are

clarifying that the application of certain requirements in the final

rule, such as the frequency of required quoting and the near term

demand requirement, will account for the liquidity, maturity, and depth

of the market for a given type of financial instrument. Thus, banking

entities will be able to continue to engage in market making-related

activities across markets and asset classes.

---------------------------------------------------------------------------

\620\ See supra note 522 (discussing commenters' concerns

regarding a trade-by-trade analysis).

\621\ For example, by clarifying that individual trades will not

be viewed in isolation and requiring strong compliance procedures,

this approach will generally allow an individual trader to operate

within the compliance framework established for his or her trading

desk without having to assess whether each individual transaction

complies with all requirements of the market-making exemption.

---------------------------------------------------------------------------

At the same time, the Agencies recognize that an overly broad

market-making exemption may allow banking entities to mask speculative

positions as liquidity provision or related hedges. The Agencies

believe the requirements included in the final rule are necessary to

prevent such evasion of the market-making exemption, ensure compliance

with the statute, and facilitate internal banking entity and external

Agency reviews of compliance with the final rule. Nevertheless, the

Agencies acknowledge that these additional costs may have an impact on

banking entities' willingness to engage in market making-related

activities. Banking entities will incur certain compliance costs in

connection with their market making-related activities under the final

rule. For example, banking entities may not currently limit their

trading desks' market-maker inventory to that which is designed not to

exceed reasonably expected near term customer demand, as required by

the statute.

As discussed above, commenters presented diverging views on whether

non-banking entities are likely to enter the market or increase their

market-making activities if the final rule should cause banking

entities to reduce their market-making activities.\622\ The

[[Page 5857]]

Agencies note that prior to the Gramm-Leach-Bliley Act of 1999, market-

making services were more commonly provided by non-bank-affiliated

broker-dealers than by banking entities. As discussed above, by

intermediating and facilitating trading, market makers provide value to

the markets and profit from providing liquidity. Should banking

entities retreat from making markets, the profit opportunities

available from providing liquidity will provide an incentive for non-

bank-affiliated broker-dealers to enter the market and intermediate

trades. The Agencies are unable to assess the likely effect with any

certainty, but the Agencies recognize that a market-making operation

requires certain infrastructure and capital, which will impact the

ability of non-banking entities to enter the market-making business or

to increase their presence. Therefore, should banking entities retreat

from making markets, there could be a transition period with reduced

liquidity as non-banking entities build up the needed infrastructure

and obtain capital. However, because the Agencies have substantially

modified this exemption in response to comments to ensure that market

making related to near-term customer demand is permitted as

contemplated by the statute, the Agencies do not believe the final rule

should significantly impact currently-available market-making

services.\623\

---------------------------------------------------------------------------

\622\ See supra notes 565 and 569 and accompanying text

(discussing comments on the issue of whether non-banking entities

are likely to enter the market or increase their trading activities

in response to reduced trading activity by banking entities). For

example, one commenter stated that broker-dealers that are not

affiliated with a bank would have reduced access to lender-of-last

resort liquidity from the central bank, which could limit their

ability to make markets during times of market stress or when

capital buffers are small. See Prof. Duffie. However, another

commenter noted that the presence and evolution of market making

after the enactment of the Glass-Steagall Act mutes this particular

concern. See Prof. Richardson.

\623\ Certain non-banking entities, such as some SEC-registered

broker-dealers that are not banking entities subject to the final

rule, currently engage in market-making activities and, thus, should

have the needed infrastructure and may attract additional capital.

If the final rule has a marginal impact on banking entities'

willingness to engage in market making-related activities, these

non-banking entities should be able to respond by increasing their

market making-related activities. The Agencies recognize, however,

that firms that do not have existing infrastructure or sufficient

capital are unlikely to be able to act as market makers shortly

after the final rule is implemented. Nevertheless, because some non-

bank-affiliated broker-dealers currently operate market-making

desks, and because it was the dominant model prior to the Gramm-

Leach-Bliley Act, the Agencies believe that non-bank-affiliated

financial intermediaries will be able to provide market-making

services longer term.

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c. Detailed Explanation of the Market-Making Exemption

1. Requirement to Routinely Stand Ready To Purchase and Sell

a. Proposed Requirement To Hold Self Out

Section 75.4(b)(2)(ii) of the proposed rule would have required the

trading desk or other organizational unit that conducts the purchase or

sale in reliance on the market-making exemption to hold itself out as

being willing to buy and sell, including through entering into long and

short positions in, the financial instrument for its own account on a

regular or continuous basis.\624\ The proposal stated that a banking

entity could rely on the proposed exemption only for the type of

financial instrument that the entity actually made a market in.\625\

---------------------------------------------------------------------------

\624\ See proposed rule Sec. 75.4(b)(2)(ii).

\625\ See Joint Proposal, 76 FR at 68870 (``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 [financial instrument] involved; simply because a banking

entity makes a market in one type of [financial instrument] does not

permit it to rely on the market-making exemption for another type of

[financial instrument].''); CFTC Proposal, 77 FR at 8355-8356.

---------------------------------------------------------------------------

The proposal recognized that 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 financial instrument.\626\ To account

for these variations, the Agencies proposed indicia for assessing

compliance with this requirement that differed between relatively

liquid markets and less liquid markets. Further, the Agencies

recognized that the proposed indicia could not 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-related

activity is conducted.

---------------------------------------------------------------------------

\626\ See Joint Proposal, 76 FR at 68870; CFTC Proposal, 77 FR

at 8356.

---------------------------------------------------------------------------

In particular, the proposal stated that a trading desk or other

organizational unit's market making-related activities in relatively

liquid markets, such as equity securities or other exchange-traded

instruments, should generally include: (i) Making continuous, two-sided

quotes and holding oneself out as willing to buy and sell on a

continuous basis; (ii) a pattern of trading that includes both

purchases and sales in roughly comparable amounts to provide liquidity;

(iii) making continuous quotations that are at or near the market on

both sides; and (iv) providing widely accessible and broadly

disseminated quotes.\627\ With respect to market making in less liquid

markets, the proposal noted that the appropriate indicia of market

making-related activities will vary, but should generally include: (i)

Holding oneself out as willing and available to provide liquidity by

providing quotes on a regular (but not necessarily continuous) basis;

\628\ (ii) with respect to securities, regularly purchasing securities

from, or selling securities to, clients, customers, or counterparties

in the secondary market; and (iii) transaction volumes and risk

proportionate to historical customer liquidity and investments

needs.\629\

---------------------------------------------------------------------------

\627\ See Joint Proposal, 76 FR at 68870-68871; CFTC Proposal,

77 FR at 8356. These proposed factors are generally consistent with

the indicia used by the SEC to assess whether a broker-dealer is

engaged in bona fide market making for purposes of Regulation SHO

under the Exchange Act. See Joint Proposal, 76 FR at 68871 n.148;

CFTC Proposal, 77 FR at 8356 n.155.

\628\ The Agencies noted that, with respect to this factor, the

frequency of regular quotations will vary, as moderately illiquid

markets may involve quotations on a daily or more frequent basis,

while highly illiquid markets may trade only by appointment. See

Joint Proposal, 76 FR at 68871 n.149; CFTC Proposal, 77 FR at 8356

n.156.

\629\ See Joint Proposal, 76 FR at 68871; CFTC Proposal, 77 FR

at 8356.

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In discussing this proposed requirement, the Agencies stated that

bona fide market making-related activity may include certain block

positioning and anticipatory position-taking. More specifically, the

proposal indicated that the bona fide market making-related activity

described in Sec. 75.4(b)(2)(ii) of the proposed rule would include:

(i) Block positioning if undertaken by a trading desk or other

organizational unit of a banking entity for the purpose of

intermediating customer trading; \630\ and (ii) 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.\631\

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\630\ In the preamble to the proposed rule, the Agencies stated

that the SEC's definition of ``qualified block positioner'' may

serve as guidance in determining whether a block positioner engaged

in block positioning is engaged in bona fide market making for

purposes of Sec. 75.4(b)(2)(ii) of the proposed rule. See Joint

Proposal, 76 FR at 68871 n.151; CFTC Proposal, 77 FR at 8356 n.157.

\631\ See Joint Proposal, 76 FR at 68871; CFTC Proposal, 77 FR

at 8356-8357.

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b. Comments on the Proposed Requirement To Hold Self Out

Commenters raised many issues regarding Sec. 75.4(b)(2)(ii) of the

proposed exemption, which would require a trading desk or other

organizational unit to hold itself out as willing to buy and sell the

financial instrument for its own account on a regular or continuous

basis. As discussed below, some commenters viewed the proposed

requirement as too restrictive, while other commenters stated that the

requirement was too permissive. Two commenters expressed support for

the proposed requirement.\632\ A number of

[[Page 5858]]

commenters provided views on statements in the proposal regarding

indicia of bona fide market making in more and less liquid markets and

the permissibility of block positioning and anticipatory position-

taking.

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\632\ See Sens. Merkley & Levin (Feb. 2012); Alfred Brock.

---------------------------------------------------------------------------

Several commenters represented that the proposed requirement was

too restrictive.\633\ For example, a number of these commenters

expressed concern that the proposed requirement may limit a banking

entity's ability to act as a market maker under certain circumstances,

including in less liquid markets, for instruments lacking a two-sided

market, or in customer-driven, structured transactions.\634\ In

addition, a few commenters expressed specific concern about how this

requirement would impact more limited market-making activity conducted

by banks.\635\

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\633\ See infra Part VI.A.3.c.1.c.iii. (addressing these

concerns).

\634\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Morgan Stanley; Barclays; Goldman (Prop. Trading); ABA; Chamber

(Feb. 2012); BDA (Feb. 2012); Fixed Income Forum/Credit Roundtable;

ACLI (Feb. 2012); T. Rowe Price; PUC Texas; PNC; MetLife; RBC; IHS;

SSgA (Feb. 2012).

\635\ See, e.g., PNC (stating that the proposed rule needs to

account for market making by regional banks on behalf of small and

middle-market customers whose securities are less liquid); ABA

(stating that the rule should continue to permit banks to provide

limited liquidity by buying securities that they feel are suitable

for their retail and institutional customer base by stating that a

bank is ``holding itself out'' when it buys and sells securities

that are suitable for its customers).

---------------------------------------------------------------------------

Many commenters indicated that it was unclear whether this

provision would require a trading desk or other organizational unit to

regularly or continuously quote every financial instrument in which a

market is made, but expressed concern that the proposed language could

be interpreted in this manner.\636\ These commenters noted that there

are thousands of individual instruments within a given asset class,

such as corporate bonds, and that it would be burdensome for a market

maker to provide quotes in such a large number of instruments on a

regular or continuous basis.\637\ One of these commenters represented

that, because customer demand may be infrequent in a particular

instrument, requiring a banking entity to provide regular or continuous

quotes in the instrument may not provide a benefit to its

customers.\638\ A few commenters requested that the Agencies provide

further guidance on this issue or modify the proposed standard to state

that holding oneself out in a range of similar instruments will be

considered to be within the scope of permitted market making-related

activities.\639\

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\636\ This issue is further discussed in Part VI.A.3.c.1.c.iii.,

infra.

\637\ See, e.g., Goldman (Prop. Trading) (stating that it would

be burdensome for a U.S. credit market-making business to be

required to produce and disseminate quotes for thousands of

individual bond CUSIPs that trade infrequently and noting that a

market maker in credit markets will typically disseminate indicative

prices for the most liquid instruments but, for the thousands of

other instruments that trade infrequently, the market maker will

generally provide a price for a trade upon request from another

market participant); Morgan Stanley; SIFMA et al. (Prop. Trading)

(Feb. 2012); RBC. See also BDA (Feb. 2012); FTN (stating that in

some markets, such as the markets for residential mortgage-backed

securities and investment grade corporate debt, a market maker will

hold itself out in a subset of instruments (e.g., particular issues

in the investment grade corporate debt market with heavy trading

volume or that are in the midst of particular credit developments),

but will trade in other instruments within the group or sector upon

inquiry from customers and other dealers); Oliver Wyman (Feb. 2012)

(discussing data regarding the number of U.S. corporate bonds and

frequency of trading in such bonds in 2009).

\638\ See Goldman (Prop. Trading).

\639\ See, e.g., RBC (recommending that the Agencies clarify

that a trading desk is required to hold itself out as willing to buy

and sell a particular type of ``product''); SIFMA et al. (Prop.

Trading) (Feb. 2012) (suggesting that the Agencies use the term

``instrument,'' rather than ``covered financial position,'' to

provide greater clarity); CIEBA (supporting alternative criteria

that would require a banking entity to hold itself out generally as

a market maker for the relevant asset class, but not for every

instrument it purchases and sells); Goldman (Prop. Trading). One of

these commenters recommended that the Agencies recognize and permit

the following kinds of activity in related financial instruments:

(i) Options market makers should be deemed to be engaged in market

making in all put and call series related to a particular underlying

security and should be permitted to trade the underlying security

regardless of whether such trade qualifies for the hedging

exemption; (ii) convertible bond traders should be permitted to

trade in the associated equity security; (iii) a market maker in one

issuer's bonds should be considered a market maker in similar bonds

of other issuers; and (iv) a market maker in standardized interest

rate swaps should be considered to be engaged in market making-

related activity if it engages in a customized interest rate swap

with a customer upon request. See RBC.

---------------------------------------------------------------------------

To address concerns about the restrictiveness of this requirement,

commenters suggested certain modifications. For example, some

commenters suggested adding language to the requirement to account for

market making in markets that do not typically involve regular or

continuous, or two-sided, quoting.\640\ In addition, a few commenters

requested that the requirement expressly include transactions in new

instruments or transactions in instruments that occur infrequently to

address situations where a banking entity may not have previously had

the opportunity to hold itself out as willing to buy and sell the

applicable instrument.\641\ Other commenters supported alternative

criteria for assessing whether a banking entity is acting as a market

maker, such as: (i) A willingness to respond to customer demand by

providing prices upon request; \642\ (ii) being in the business of

providing prices upon request for that financial instrument or other

financial instruments in the same or similar asset class or product

class; \643\ or (iii) a historical test of market-making activity, with

compliance judged on the basis of actual trades.\644\ Finally, two

commenters stated that this requirement should be moved to Appendix B

of the rule,\645\ which, according to one of these commenters, would

provide the Agencies greater flexibility to consider the facts and

circumstances of a particular activity.\646\

---------------------------------------------------------------------------

\640\ See, e.g., Morgan Stanley (suggesting that the Agencies

add the phrase ``or, in markets where regular or continuous quotes

are not typically provided, the trading unit stands ready to provide

quotes upon request''); Barclays (suggesting addition of the phrase

``to the extent that two-sided markets are typically made by market

makers in a given product,'' as well as changing the reference to

``purchase or sale'' to ``market making-related activity'' to avoid

any inference of a trade-by-trade analysis). See also Fixed Income

Forum/Credit Roundtable. To address concerns about the requirement's

application to bespoke products, one commenter suggested that the

rule clearly state that a banking entity fulfills this requirement

if it markets structured transactions to its client base and stands

ready to enter into such transactions with customers, even though

transactions may occur on a relatively infrequent basis. See JPMC.

\641\ See Wells Fargo (Prop. Trading); RBC (supporting this

approach as an alternative to removing the requirement from the

rule, but primarily supporting its removal). See also ISDA (Feb.

2012) (stating that the analysis of compliance with the proposed

requirement must carefully consider the degree of presence a market

maker wishes to have in a given market, which may include being a

leader in certain types of instruments, having a secondary presence

in others, and potentially leaving or entering other submarkets).

\642\ See SIFMA et al. (Prop. Trading) (Feb. 2012). This

commenter also suggested that such test be assessed at the ``trading

unit'' level. See id.

\643\ See Goldman (Prop. Trading).

\644\ See FTN.

\645\ See Flynn & Fusselman; JPMorgan.

\646\ See JPMC.

---------------------------------------------------------------------------

Other commenters took the view that the proposed requirement was

too permissive.\647\ For example, one commenter stated that the

proposed standard provided too much room for interpretation and would

be difficult to measure and monitor. This commenter expressed

particular concern that a trading desk or other organizational unit

could meet this requirement by regularly or continuously making wide,

out of context quotes that do not present any real risk of execution

and do not contribute to market liquidity.\648\ Some commenters

suggested the Agencies place greater restrictions on a banking entity's

ability to rely on the market-making exemption in certain illiquid

[[Page 5859]]

markets, such as assets that cannot be reliably valued, products that

do not have a genuine external market, or instruments for which a

banking entity does not expect to have customers wishing to both buy

and sell.\649\ In support of these requests, commenters stated that

trading in illiquid products raises certain concerns under the rule,

including: A lack of reliable data for purposes of using metrics to

monitor a banking entity's market making-related activity (e.g.,

products whose valuations are determined by an internal model that can

be manipulated, rather than an observable market price); \650\ relation

to the last financial crisis; \651\ lack of important benefits to the

real economy; \652\ similarity to prohibited proprietary trading; \653\

and inconsistency with the statute's requirements that market making-

related activity must be ``designed not to exceed the reasonably

expected near term demands of clients, customers, or counterparties''

and must not result in a material exposure to high-risk assets or high-

risk trading strategies.\654\

---------------------------------------------------------------------------

\647\ See, e.g., Occupy; AFR et al. (Feb. 2012); Public Citizen;

Johnson & Prof. Stiglitz; John Reed. See infra note 751 and

accompanying text (responding to these comments).

\648\ See Occupy.

\649\ See Occupy; AFR et al. (Feb. 2012); Public Citizen;

Johnson & Prof. Stiglitz; Sens. Merkley & Levin (Feb. 2012); John

Reed.

\650\ See AFR et al. (Feb. 2012); Occupy.

\651\ See Occupy.

\652\ See John Reed.

\653\ See Johnson & Prof. Stiglitz.

\654\ See Sens. Merkley & Levin (Feb. 2012) (stating that a

banking entity must have or reasonably expect at least two

customers--one for each side of the trade--and must have a

reasonable expectation of the second customer coming to take the

position or risk off its books in the ``near term''); AFR et al.

(Feb. 2012); Public Citizen.

---------------------------------------------------------------------------

These commenters also requested that the proposed requirement be

modified in certain ways. In particular, several commenters stated that

the proposed exemption should only permit market making in assets that

can be reliably valued through external market transactions.\655\ In

order to implement such a limitation, three commenters suggested that

the Agencies prohibit banking entities from market making in assets

classified as Level 3 under FAS 157.\656\ One of these commenters

explained that Level 3 assets are generally highly illiquid assets

whose fair value cannot be determined using either market prices or

models.\657\ In addition, a few commenters suggested that banking

entities be subject to additional capital charges for market making in

illiquid products.\658\ Another commenter stated that the Agencies

should require all market making-related activity to be conducted on a

multilateral organized electronic trading platform or exchange to make

it possible to monitor and confirm certain trading data.\659\ Two

commenters emphasized that their recommended restrictions on market

making in illiquid markets should not prohibit banking entities from

making markets in corporate bonds.\660\

---------------------------------------------------------------------------

\655\ See AFR et al. (Feb. 2012) (stating that the rule should

ban market making in illiquid and opaque securities with no genuine

external market, but permit market making in somewhat illiquid

securities, such as certain corporate bonds, as long as the

securities can be reliably valued with reference to other extremely

similar securities that are regularly traded in liquid markets and

the financial outcome of the transaction is reasonably predictable);

Johnson & Prof. Stiglitz (recommending that permitted market making

be limited to assets that can be reliably valued in, at a minimum, a

moderately liquid market evidenced by trading within a reasonable

period, such as a week, through a real transaction and not simply

with interdealer trades); Public Citizen (stating that market making

should be limited to assets that can be reliably valued in a market

where transactions take place on a weekly basis).

\656\ See AFR et al. (Feb. 2012) (stating that such a limitation

would be consistent with the proposed limitation on ``high-risk

assets'' and the discussion of this limitation in proposed Appendix

C); Public Citizen; Prof. Richardson.

\657\ See Prof. Richardson.

\658\ Two commenters recommended that banking entities be

required to treat trading in assets that cannot be reliably valued

and that trade only by appointment, such as bespoke derivatives and

structured products, as providing an illiquid bespoke loan, which

are subject to higher capital charges under the Federal banking

agencies' capital rules. See Johnson & Prof. Stiglitz; John Reed.

Another commenter suggested that, if not directly prohibited,

trading in bespoke instruments that cannot be reliably valued should

be assessed an appropriate capital charge. See Public Citizen.

\659\ See Occupy. This commenter further suggested that the

exemption exclude all activities that include: (i) Assets whose

changes in value cannot be mitigated by effective hedges; (ii) new

products with rapid growth, including those that do not have a

market history; (iii) assets or strategies that include significant

imbedded leverage; (iv) assets or strategies that have demonstrated

significant historical volatility; (v) assets or strategies for

which the application of capital and liquidity standards would not

adequately account for the risk; and (vi) assets or strategies that

result in large and significant concentrations to sectors, risk

factors, or counterparties. See id.

\660\ See AFR et al. (Feb. 2012); Johnson & Prof. Stiglitz.

---------------------------------------------------------------------------

i. The Proposed Indicia

As noted above, the proposal set forth certain indicia of bona fide

market making-related activity in liquid and less liquid markets that

the Agencies proposed to apply when evaluating whether a banking entity

was eligible for the proposed exemption.\661\ Several commenters

provided their views regarding the effectiveness of the proposed

indicia.

---------------------------------------------------------------------------

\661\ See supra Part VI.A.3.c.1.a.

---------------------------------------------------------------------------

With respect to the proposed indicia for liquid markets, a few

commenters expressed support for the proposed indicia.\662\ One of

these commenters stated that while the proposed factors are reasonably

consistent with bona fide market making, the Agencies should add two

other factors: (i) A willingness to transact in reasonable quantities

at quoted prices, and (ii) inventory turnover.\663\

---------------------------------------------------------------------------

\662\ See Occupy; AFR et al. (Feb. 2012); NYSE Euronext

(expressing support for the indicia set forth in the FSOC study,

which are substantially the same as the indicia in the proposal);

Alfred Brock.

\663\ See AFR et al. (Feb. 2012).

---------------------------------------------------------------------------

Other commenters, however, stated that the proposed use of factors

from the SEC's analysis of bona fide market making under Regulation SHO

was inappropriate in this context. In particular, these commenters

represented that bona fide market making for purposes of Regulation SHO

is a purposefully narrow concept that permits a subset of market makers

to qualify for an exception from the ``locate'' requirement in Rule 203

of Regulation SHO. The commenters further expressed the belief that the

policy goals of section 13 of the BHC Act do not necessitate a

similarly narrow interpretation of market making.\664\

---------------------------------------------------------------------------

\664\ See Goldman (Prop. Trading); SIFMA et al. (Prop. Trading)

(Feb. 2012).

---------------------------------------------------------------------------

A few commenters expressed particular concern about how the factor

regarding patterns of purchases and sales in roughly comparable amounts

would apply to market making in exchange-traded funds (``ETFs'').

According to these commenters, demonstrating this factor could be

difficult because ETF market making involves a pattern of purchases and

sales of groups of equivalent securities (i.e., the ETF shares and the

basket of securities and cash that is exchanged for them), not a single

security. In addition, the commenters were unsure whether this factor

could be demonstrated in times of limited trading in ETF shares.\665\

---------------------------------------------------------------------------

\665\ See ICI (Feb. 2012); ICI Global.

---------------------------------------------------------------------------

The preamble to the proposed rule also provided certain proposed

indicia of bona fide market making-related activity in less liquid

markets.\666\ As discussed above, commenters had differing views about

whether the exemption for market making-related activity should permit

banking entities to engage in market making in some or all illiquid

markets. Thus, with respect to the proposed indicia for market making

in less liquid markets, commenters generally stated that the indicia

should be broader or narrower, depending on the commenter's overall

view on the issue of market making in illiquid markets. One commenter

stated

[[Page 5860]]

that the proposed indicia are effective.\667\

---------------------------------------------------------------------------

\666\ See supra Part VI.A.3.c.1.a.

\667\ See Alfred Brock.

---------------------------------------------------------------------------

The first proposed factor of market making-related activity in less

liquid markets was holding oneself out as willing and available to

provide liquidity by providing quotes on a regular (but not necessarily

continuous) basis. As noted above, several commenters expressed concern

about a requirement that market makers provide regular quotations in

less liquid instruments, including in fixed income markets and bespoke,

customized derivatives.\668\ With respect to the interaction between

the rule language requiring ``regular'' quoting and the proposal's

language permitting trading by appointment under certain circumstances,

some of these commenters expressed uncertainty about how a market maker

trading only by appointment would be able to satisfy the proposed

rule's regular quotation requirement.\669\ In addition, another

commenter stated that the proposal's recognition of trading by

appointment does not alleviate concerns about applying the ``regular''

quotation requirement to market making in less liquid instruments in

markets that are not, as a whole, highly illiquid, such as credit and

interest rate markets.\670\

---------------------------------------------------------------------------

\668\ See supra note 634 accompanying text. With respect to this

factor, one commenter requested that the Agencies delete the

parenthetical of ``but not necessarily continuous'' from the

proposed factor as part of a broader effort to recognize the

relative illiquidity of swap markets. See ISDA (Feb. 2012).

\669\ See SIFMA et al. (Prop. Trading) (Feb. 2012); CIEBA. These

commenters requested greater clarity or guidance on the meaning of

``regular'' in the instance of a market maker trading only by

appointment. See id.

\670\ See Goldman (Prop. Trading).

---------------------------------------------------------------------------

Other commenters expressed concern about only requiring a market

maker to provide regular quotations or permitting trading by

appointment to qualify for the market-making exemption. With respect to

regular quotations, some commenters stated that such a requirement

enables evasion of the prohibition on proprietary trading because a

proprietary trader may post a quote at a time of little interest in a

financial product or may post wide, out of context quotes on a regular

basis with no real risk of execution.\671\ Several commenters stated

that trading only by appointment should not qualify as market making

for purposes of the proposed rule.\672\ Some of these commenters stated

that there is no ``market'' for assets that trade only by appointment,

such as customized, structured products and OTC derivatives.\673\

---------------------------------------------------------------------------

\671\ See Public Citizen; Occupy. One of these commenters

further noted that most markets lack a structural framework that

would enable monitoring of compliance with this requirement. See

Occupy.

\672\ See, e.g., Sens. Merkley & Levin (Feb. 2012); Johnson &

Prof. Stiglitz; John Reed; Public Citizen.

\673\ See, e.g., John Reed; Public Citizen.

---------------------------------------------------------------------------

The second proposed criterion for market making-related activity in

less liquid markets was, with respect to securities, regularly

purchasing securities from, or selling securities to, clients,

customers, or counterparties in the secondary market. Two commenters

expressed concern about this proposed factor.\674\ In particular, one

of these commenters stated that the language is fundamentally

inconsistent with market making because it contemplates that only

taking one side of the market is sufficient, rather than both buying

and selling an instrument.\675\ The other commenter expressed concern

that banking entities would be allowed to accumulate a significant

amount of illiquid risk because the indicia for market making-related

activity in less liquid markets did not require a market maker to buy

and sell in comparable amounts (as required by the indicia for liquid

markets).\676\

---------------------------------------------------------------------------

\674\ See AFR et al. (Feb. 2012); Occupy.

\675\ See AFR et al. (Feb. 2012)

\676\ See Occupy.

---------------------------------------------------------------------------

Finally, the third proposed factor of market making in less liquid

markets would consider transaction volumes and risk proportionate to

historical customer liquidity and investment needs. A few commenters

indicated that there may not be sufficient information available for a

banking entity to conduct such an analysis.\677\ For example, one

commenter stated that historical information may not necessarily be

available for new businesses or developing markets in which a market

maker may seek to establish trading operations.\678\ Another commenter

expressed concern that this factor would not help differentiate market

making from prohibited proprietary trading because most illiquid

markets do not have a source for such historical risk and volume

data.\679\

---------------------------------------------------------------------------

\677\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading); Occupy.

\678\ See Goldman (Prop. Trading).

\679\ See Occupy.

---------------------------------------------------------------------------

ii. Treatment of Block Positioning Activity

The proposal provided that the activity described in Sec.

75.4(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.\680\

---------------------------------------------------------------------------

\680\ See Joint Proposal, 76 FR at 68871.

---------------------------------------------------------------------------

A number of commenters supported the general language in the

proposal permitting block positioning, but expressed concern about the

reference to the definition of ``qualified block positioner'' in SEC

Rule 3b-8(c).\681\ With respect to using Rule 3b-8(c) as guidance under

the proposed rule, these commenters represented that Rule 3b-8(c)'s

requirement to resell block positions ``as rapidly as possible'' would

cause negative results (e.g., fire sales) or create market uncertainty

(e.g., when, if ever, a longer unwind would be permitted).\682\

According to one of these commenters, gradually disposing of a large

long position purchased from a customer may be the best means of

reducing near term price volatility associated with the supply shock of

trying to sell the position at once.\683\ Another commenter expressed

concern about the second requirement of Rule 3b-8(c), which provides

that the dealer must determine in the exercise of reasonable diligence

that the block cannot be sold to or purchased from others on equivalent

or better terms. This commenter stated that this kind of determination

would be difficult in less liquid markets because those markets do not

have widely disseminated quotes that dealers can use for purposes of

comparison.\684\

---------------------------------------------------------------------------

\681\ See, e.g., RBC; SIFMA (Asset Mgmt.) (Feb. 2012); Goldman

(Prop. Trading). See also infra note 740 (responding to these

comments).

\682\ See RBC (expressing concern about fire sales); SIFMA

(Asset Mgmt.) (Feb. 2012) (expressing concern about fire sales,

particularly in less liquid markets where a block position would

overwhelm the market and undercut the price a market maker can

obtain); Goldman (Prop. Trading) (representing that this requirement

could create uncertainty about whether a longer unwind would be

permissible and, if so, under what circumstances).

\683\ See Goldman (Prop. Trading).

\684\ See RBC.

---------------------------------------------------------------------------

Beyond the reference to Rule 3b-8(c), a few commenters expressed

more general concern about the proposed rule's application to block

positioning activity.\685\ One commenter noted that the proposal only

discussed block positioning in the context of the proposed requirement

to hold oneself out, which implies that block positioning activity also

must meet the other requirements of the market-making exemption. This

commenter requested an explicit recognition that banking entities meet

the requirements of the market-making exemption when they enter into

block trades for customers, including related trades entered to support

the block, such as

[[Page 5861]]

hedging transactions.\686\ Finally, one commenter expressed concern

that the inventory metrics in proposed Appendix A would make dealers

reluctant to execute large, principal transactions because such trades

would have a transparent impact on inventory metrics in the relevant

asset class.\687\

---------------------------------------------------------------------------

\685\ See SIFMA (Asset Mgmt.) (Feb. 2012); Fidelity (requesting

that the Agencies explicitly recognize that block trades qualify for

the market-making exemption); Oliver Wyman (Feb. 2012).

\686\ See SIFMA (Asset Mgmt.) (Feb. 2012).

\687\ See Oliver Wyman (Feb. 2012). This commenter estimated

that investors trading out of large block positions on their own,

without a market maker directly providing liquidity, would have to

pay incremental transaction costs between $1.7 and $3.4 billion per

year. This commenter estimated a block trading size of $850 billion,

based on a haircut of total block trading volume reported for NYSE

and Nasdaq. The commenter then estimated, based on market interviews

and analysis of standard market impact models provided by dealers,

that the market impact of executing large block orders without

direct market maker liquidity provision would be the difference

between the market impact costs of executing a block trade over a 5-

day period versus a 1-day period--which would be approximately 20 to

50 basis points, depending on the size of the trade. See id.

---------------------------------------------------------------------------

iii. Treatment of Anticipatory Market Making

In the proposal, the Agencies proposed that ``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.'' \688\ Many

commenters indicated that the language in the proposal is inconsistent

with the statute's language regarding near term demands of clients,

customers, or counterparties. According to these commenters, the

statute's ``designed'' and ``reasonably expected'' language expressly

acknowledges that a market maker may need to accumulate inventory

before customer demand manifests itself. Commenters further represented

that the proposed standard may unduly limit a banking entity's ability

to accumulate inventory in anticipation of customer demand.\689\

---------------------------------------------------------------------------

\688\ Joint Proposal, 76 FR at 68871; CFTC Proposal, 77 FR at

8356-8357.

\689\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012)

(expressing concern that requiring trades to be related to clear

demonstrable trading interest could curtail the market-making

function by removing a market maker's discretion to develop

inventory to best serve its customers and adversely restrict

liquidity); Goldman (Prop. Trading); Chamber (Feb. 2012); Comm. on

Capital Markets Regulation. See also Morgan Stanley (requesting

certain revisions to more closely track the statute); SIFMA (Asset

Mgmt.) (Feb. 2012) (expressing general concern that the standard

creates limitations on a market maker's inventory). These comments

are addressed in Part VI.A.3.c.2., infra.

---------------------------------------------------------------------------

In addition, two commenters expressed concern that the proposal's

language would effectively require a banking entity to engage in

impermissible front running.\690\ One of these commenters indicated

that the Agencies should not restrict anticipatory trading to such a

short time period.\691\ To the contrary, the other commenter stated

that anticipatory accumulation of inventory should be considered to be

prohibited proprietary trading.\692\ A few commenters noted that the

standard in the proposal explicitly refers to securities and requested

that the reference be changed to encompass the full scope of financial

instruments covered by the rule to avoid ambiguity.\693\ Several

commenters recommended that the language be eliminated \694\ or

modified \695\ to address the concerns discussed above.

---------------------------------------------------------------------------

\690\ See Goldman (Prop. Trading); Occupy. See also Public

Citizen (expressing general concern that accumulating positions in

anticipation of demand opens issues of front running).

\691\ See Goldman (Prop. Trading).

\692\ See Occupy.

\693\ See Goldman (Prop. Trading); ISDA (Feb. 2012); SIFMA et

al. (Prop. Trading) (Feb. 2012).

\694\ See BoA (stating that a market maker must acquire

inventory in advance of express customer demand and customers expect

a market maker's inventory to include not only the financial

instruments in which customers have previously traded, but also

instruments that the banking entity believes they may want to

trade); Occupy.

\695\ See Morgan Stanley (suggesting a new standard providing

that a purchase or sale must be ``reasonably consistent with

observable customer demand patterns and, in the case of new asset

classes or markets, with reasonably expected future developments on

the basis of the trading unit's client relationships''); Chamber

(Feb. 2012) (requesting that the final rule permit market makers to

make individualized assessments of anticipated customer demand based

on their expertise and experience in the markets and make trades

according to those assessments); Goldman (Prop. Trading)

(recommending that the Agencies instead focus on how trading

activities are ``designed'' to meet the reasonably expected near

term demands of clients over time, rather than whether those demands

have actually manifested themselves at a given point in time); ISDA

(Feb. 2012) (stating that the Agencies should clarify this language

to recognize differences between liquid and illiquid markets and

noting that illiquid and low volume markets necessitate that swap

dealers take a longer and broader view than dealers in liquid

markets).

---------------------------------------------------------------------------

iv. High-Frequency Trading

A few commenters stated that high-frequency trading should be

considered prohibited proprietary trading under the rule, not permitted

market making-related activity.\696\ For example, one commenter stated

that the Agencies should not confuse high volume trading and market

making. This commenter emphasized that algorithmic traders in general--

and high-frequency traders in particular--do not hold themselves out in

the manner required by the proposed rule, but instead only offer to buy

and sell when they think it is profitable.\697\ Another commenter

suggested the Agencies impose a resting period on any order placed by a

banking entity in reliance on any exemption in the rule by, for

example, prohibiting a banking entity from buying and subsequently

selling a position within a span of two seconds.\698\

---------------------------------------------------------------------------

\696\ See, e.g., Better Markets (Feb. 2012); Occupy; Public

Citizen.

\697\ See Better Markets (Feb. 2012). See also infra note 747

(addressing this issue).

\698\ See Occupy.

---------------------------------------------------------------------------

c. Final Requirement To Routinely Stand Ready To Purchase and Sell

Section 75.4(b)(2)(i) of the final rule provides that the trading

desk that establishes and manages the financial exposure must routinely

stand ready to purchase and sell one or more types of financial

instruments related to its financial exposure and be willing and

available to quote, buy and sell, or otherwise enter into long and

short positions in those types of financial instruments for its own

account, in commercially reasonable amounts and throughout market

cycles, on a basis appropriate for the liquidity, maturity, and depth

of the market for the relevant types of financial instruments. As

discussed in more detail below, the standard of ``routinely'' standing

ready to purchase and sell one or more types of financial instruments

will be interpreted to account for differences across markets and asset

classes. In addition, this requirement provides that a trading desk

must be willing and available to provide quotations and transact in the

particular types of financial instruments in commercially reasonable

amounts and throughout market cycles. Thus, a trading desk's activities

would not meet the terms of the market-making exemption if, for

example, the trading desk only provides wide quotations on one or both

sides of the market relative to prevailing market conditions or is only

willing to trade on an irregular, intermittent basis.

While this provision of the market-making exemption has some

similarity to the requirement to hold oneself out in Sec.

75.4(b)(2)(ii) of the proposed rule, the Agencies have made a number of

refinements in response to comments. Specifically, a number of

commenters expressed concern that the proposed requirement did not

sufficiently account for differences between markets and asset classes

and would unduly limit certain types of market making by requiring

``regular or continuous'' quoting in a particular instrument.\699\

[[Page 5862]]

The explanation of this requirement in the proposal was intended to

address many of these concerns. For example, the Agencies stated that

the proposed ``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.''

\700\ Nonetheless, the Agencies believe that certain modifications are

warranted to clarify the rule and to prevent a potential chilling

effect on market making-related activities conducted by banking

entities.

---------------------------------------------------------------------------

\699\ See supra Part VI.A.3.c.1.b. (discussing comments on this

issue). The Agencies did not intend for the reference to ``covered

financial position'' in the proposed rule to imply a single

instrument, although commenters contended that the proposal may not

have been sufficiently clear on this point.

\700\ Joint Proposal, 76 FR at 68871; CFTC Proposal, 77 FR at

8356.

---------------------------------------------------------------------------

Commenters represented that the requirement that a trading desk

hold itself out as being willing to buy and sell ``on a regular or

continuous basis,'' as was originally proposed, was impossible to meet

or impractical in the context of many markets, especially less liquid

markets.\701\ Accordingly, the final rule requires a trading desk that

establishes and manages the financial exposure to ``routinely'' stand

ready to trade one or more types of financial instruments related to

its financial exposure. As discussed below, the meaning of

``routinely'' will account for the liquidity, maturity, and depth of

the market for a type of financial instrument, which should address

commenter concern that the proposed standard would not work in less

liquid markets and would have a chilling effect on banking entities'

ability to act as market makers in less liquid markets. A concept of

market making that is applicable across securities, commodity futures,

and derivatives markets has not previously been defined by any of the

Agencies. Thus, while this standard is based generally on concepts from

the securities laws and is consistent with the CFTC's and SEC's

description of market making in swaps,\702\ the Agencies note that it

is not directly based on an existing definition of market making.\703\

Instead, the approach taken in the final rule is intended to take into

account and accommodate the conditions in the relevant market for the

financial instrument in which the banking entity is making a market.

---------------------------------------------------------------------------

\701\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Morgan Stanley; Barclays; Goldman (Prop. Trading); ABA; Chamber

(Feb. 2012); BDA (Feb. 2012); Fixed Income Forum/Credit Roundtable;

ACLI (Feb. 2012); T. Rowe Price; PUC Texas; PNC; MetLife; RBC; SSgA

(Feb. 2012). Some commenters suggested alternative criteria, such as

providing prices upon request, using a historical test of market

making, or a purely guidance-based approach. See SIFMA et al. (Prop.

Trading) (Feb. 2012); Goldman (Prop. Trading); FTN; Flynn &

Fusselman; JPMC. The Agencies are not adopting a requirement that

the trading desk only provide prices upon request because the

Agencies believe it would be inconsistent with market making in

liquid exchange-traded instruments where market makers regularly or

continuously post quotes on an exchange. With respect to one

commenter's suggested approach of a historical test of market

making, this commenter did not provide enough information about how

such a test would work for the Agencies' consideration. Finally, the

final rule does not adopt a purely guidance-based approach because,

as discussed further above, the Agencies believe it could lead to an

increased risk of evasion.

\702\ See Further Definition of ``Swap Dealer,'' ``Security-

Based Swap Dealer,'' ``Major Swap Participant,'' ``Major Security-

Based Swap Participant'' and ``Eligible Contract Participant,'' 77

FR 30596, 30609 (May 23, 2012) (describing market making in swaps as

``routinely standing ready to enter into swaps at the request or

demand of a counterparty'').

\703\ As a result, activity that is considered market making

under this final rule may not necessarily be considered market

making for purposes of other laws or regulations, such as the U.S.

securities laws, the rules and regulations thereunder, or self-

regulatory organization rules. In addition, the Agencies note that a

banking entity acting as an underwriter would continue to be treated

as an underwriter for purposes of the securities laws and the

regulations thereunder, including any liability arising under the

securities laws as a result of acting in such capacity, regardless

of whether it is able to meet the terms of the market-making

exemption for its activities. See Sens. Merkley & Levin (Feb. 2012).

---------------------------------------------------------------------------

i. Definition of ``Trading Desk''

The Agencies are adopting a market-making exemption with

requirements that generally focus on a financial exposure managed by a

``trading desk'' of a banking entity and such trading desk's market-

maker inventory. The market-making exemption as originally proposed

would have applied to ``a trading desk or other organizational unit''

of a banking entity. In addition, for purposes of the proposed

requirement to report and record certain quantitative measurements, the

proposal defined the term ``trading unit'' as each of the following

units of organization of a 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; (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); and (iii) all trading

operations, collectively.\704\

---------------------------------------------------------------------------

\704\ See Joint Proposal, 76 FR at 68957; CFTC Proposal, 77 FR

at 8436.

---------------------------------------------------------------------------

The Agencies received few comments regarding the organizational

level at which the requirements of the market-making exemption should

apply, and many of the commenters that addressed this issue did not

describe their suggested approach in detail.\705\ One commenter

suggested that the market-making exemption apply to each ``trading

unit'' of a banking entity, defined as ``each organizational unit that

is used to structure and control the aggregate risk-taking activities

and employees that are engaged in the coordinated implementation of a

customer-facing revenue generation strategy and that participate in the

execution of any covered trading activity.'' \706\ This suggested

approach is substantially similar to the second prong of the Agencies'

proposed definition of ``trading unit'' in Appendix A of the proposal.

The Agencies described this prong as generally including management or

reporting divisions, groups, sub-groups, or other intermediate units of

organization used by the banking entity to manage one or more discrete

trading units (e.g., ``North American Credit Trading,'' ``Global Credit

Trading,'' etc.).\707\ The Agencies are concerned that this commenter's

suggested approach, or any other approach applying the exemption's

requirements to a higher level of organization than the trading desk,

would impede monitoring of market making-related activity and detection

of impermissible proprietary trading by combining a number of different

trading strategies and aggregating a larger volume of trading

activities.\708\ Further, key requirements in the market-making

exemption, such as the required limits and risk management procedures,

are generally used by banking entities for risk control and applied at

the trading desk level. Thus, applying them at a broader organizational

level than the trading desk would create a separate system for

compliance with this exemption designed to permit a banking entity to

aggregate disparate trading activities and apply limits more generally.

Applying the conditions of the exemption at a more aggregated level

would allow banking entities more flexibility in trading and could

result in a higher volume of trading that could contribute modestly to

liquidity.\709\

[[Page 5863]]

Instead of taking that approach, the Agencies have determined to permit

a broader range of market making-related activities that can be

effectively controlled by building on risk controls used by trading

desks for business purposes. This will allow an individual trader to

use instruments or strategies within limits established in the

compliance program to confidently trade in the type of financial

instruments in which his or her trading desk makes a market. The

Agencies believe this addresses concerns that uncertainty would

negatively impact liquidity. It also addresses concerns that applying

the market-making exemption at a higher level of organization would

reduce the effectiveness of the requirements in the final rule aimed at

ensuring that the quality and character of trading is consistent with

market making-related activity and would increase the risk of evasion.

Moreover, several provisions of the final rule are intended to account

for the liquidity, maturity, and depth of the market for a given type

of financial instrument in which the trading desk makes a market. The

final rule takes account of these factors to, among other things,

respond to commenters' concerns about the proposed rule's potential

impact on market making in less liquid markets. Applying these

requirements at an organizational level above the trading desk would be

more likely to result in aggregation of trading in various types of

instruments with differing levels of liquidity, which would make it

more difficult for these market factors to be taken into account for

purposes of the exemption (for example, these factors are considered

for purposes of tailoring the analysis of reasonably expected near-term

demands of customers and establishing risk, inventory, and duration

limits).

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\705\ See Wellington; SIFMA et al. (Prop. Trading) (Feb. 2012).

\706\ Morgan Stanley.

\707\ See Joint Proposal, 76 FR at 68957 n.2.

\708\ See, e.g., Occupy (expressing concern that, with respect

to the proposed definition of ``trading unit,'' an ``oversized''

unit could combine significantly unrelated trading desks, which

would impede detection of proprietary trading activity).

\709\ The Agencies recognize that the proposed rule's

application to a trading desk ``or other organizational unit'' would

have provided banking entities with this type of flexibility to

determine the level of organization at which the market-making

exemption should apply based on the entity's particular business

structure and trading strategies, which would likely reduce the

burdens of this aspect of the final rule. However, for the reasons

noted above regarding application of this exemption to a higher

organizational level than the trading desk, the Agencies are not

adopting the ``or other organizational unit'' language.

---------------------------------------------------------------------------

Thus, the Agencies continue to believe that certain requirements of

the exemption should apply to a relatively granular level of

organization within a banking entity (or across two or more affiliated

banking entities). These requirements of the final market-making

exemption have been formulated to best reflect the nature of activities

at the trading desk level of granularity.

As explained below, the Agencies are applying certain requirements

to a ``trading desk'' of a banking entity and adopting a definition of

this term in the final rule.\710\ The definition of ``trading desk'' is

similar to the first prong of the proposed definition of ``trading

unit.'' The Agencies are not adopting the proposed ``or other

organizational unit'' language because the Agencies are concerned that

approach would have provided banking entities with too much discretion

to independently determine the organizational level at which the

requirements should apply, including a more aggregated level of

organization, which could lead to evasion of the general prohibition on

proprietary trading and the other concerns noted above. The Agencies

believe that adopting an approach focused on the trading desk level

will allow banking entities and the Agencies to better distinguish

between permitted market making-related activities and trading that is

prohibited by section 13 of the BHC Act and, thus, will prevent evasion

of the statutory requirements, as discussed in more detail below.

Further, as discussed below, the Agencies believe that applying

requirements at the trading desk level is balanced by the financial

exposure-based approach, which will address commenters' concerns about

the burdens of trade-by-trade analyses.

---------------------------------------------------------------------------

\710\ See final rule Sec. 75.3(e)(13).

---------------------------------------------------------------------------

In the final rule, trading desk is defined to mean the smallest

discrete unit of organization of a banking entity that buys or sells

financial instruments for the trading account of the banking entity or

an affiliate thereof. The Agencies expect that a trading desk would be

managed and operated as an individual unit and should reflect the level

at which the profit and loss of market-making traders is

attributed.\711\ The geographic location of individual traders is not

dispositive for purposes of the analysis of whether the traders may

comprise a single trading desk. For instance, a trading desk making

markets in U.S. investment grade telecom corporate credits may use

trading personnel in both New York (to trade U.S. dollar-denominated

bonds issued by U.S.-incorporated telecom companies) and London (to

trade Euro-denominated bonds issued by the same type of companies).

This approach allows more effective management of risks of trading

activity by requiring the establishment of limits, management

oversight, and accountability at the level where trading activity

actually occurs. It also allows banking entities to tailor the limits

and procedures to the type of instruments traded and markets served by

each trading desk.

---------------------------------------------------------------------------

\711\ For example, the Agencies expect a banking entity may

determine the foreign exchange options desk to be a trading desk;

however, the Agencies do not expect a banking entity to consider an

individual Japanese Yen options trader (i.e., the trader in charge

of all Yen-based options trades) as a trading desk, unless the

banking entity manages its profit and loss, market making, and

hedging in Japanese Yen options independently of all other financial

instruments.

---------------------------------------------------------------------------

In response to comments, and as discussed below in the context of

the ``financial exposure'' definition, a trading desk may manage a

financial exposure that includes positions in different affiliated

legal entities.\712\ Similarly, a trading desk may include employees

working on behalf of multiple affiliated legal entities or booking

trades in multiple affiliated entities. Using the previous example, the

U.S. investment grade telecom corporate credit trading desk may include

traders working for or booking into a broker-dealer entity (for

corporate bond trades), a security-based swap dealer entity (for

single-name CDS trades), and/or a swap dealer entity (for index CDS or

interest rate swap hedges). To clarify this issue, the definition of

``trading desk'' specifically provides that the desk can buy or sell

financial instruments ``for the trading account of a banking entity or

an affiliate thereof.'' Thus, a trading desk need not be constrained to

a single legal entity, although it is permissible for a trading desk to

only trade for a single legal entity. A trading desk booking positions

in different affiliated legal entities must have records that identify

all positions included in the trading desk's financial exposure and

where such positions are held, as discussed below.\713\

---------------------------------------------------------------------------

\712\ See infra note 729 and accompanying text. Several

commenters noted that market-making activities may be conducted

across separate affiliated legal entities. See, e.g., SIFMA et al.

(Prop. Trading) (Feb. 2012); Goldman (Prop. Trading).

\713\ See infra note 732 and accompanying text.

---------------------------------------------------------------------------

The Agencies believe that establishing a defined organizational

level at which many of the market-making exemption's requirements apply

will address potential evasion concerns. Applying certain requirements

of the market-making exemption at the trading desk level will

strengthen their effectiveness and prevent evasion of the exemption by

ensuring that the aggregate trading activities of a relatively limited

group of traders on a single desk are conducted in a manner that is

consistent with the exemption's standards. In particular, because many

of the requirements in the market-making exemption look to the specific

type(s) of financial instruments in which a market is being made, and

such requirements are designed to take into account differences among

markets and asset classes, the Agencies believe it is important that

these requirements be applied to a discrete and identifiable unit

engaged in, and operated by personnel whose responsibilities relate to,

making a market in a specific set or

[[Page 5864]]

type of financial instruments. Further, applying requirements at the

trading desk level should facilitate banking entity monitoring and

review of compliance with the exemption by limiting the aggregate

trading volume that must be reviewed, as well as allowing consideration

of the particular facts and circumstances of the desk's trading

activities (e.g., the liquidity, maturity, and depth of the market for

the relevant types of financial instruments). As discussed above, the

Agencies believe that applying the requirements of the market-making

exemption to a higher level of organization would reduce the ability to

consider the liquidity, maturity, and depth of the market for a type of

financial instrument, would impede effective monitoring and compliance

reviews, and would increase the risk of evasion.

ii. Definitions of ``Financial Exposure'' and ``Market-Maker

Inventory''

Certain requirements of the proposed market-making exemption

referred to a ``purchase or sale of a [financial instrument].'' \714\

Even though the Agencies did not intend to require a trade-by-trade

review, a significant number of commenters expressed concern that this

language could be read to require compliance with the proposed market-

making exemption on a transaction-by-transaction basis.\715\ In

response to these concerns, the Agencies are modifying the exemption to

clarify the manner in which compliance with certain provisions will be

assessed. In particular, rather than a transaction-by-transaction

focus, the market-making exemption in the final rule focuses on two

related aspects of market-making activity: A trading desk's ``market-

maker inventory'' and its overall ``financial exposure.''\716\

---------------------------------------------------------------------------

\714\ See proposed rule Sec. 75.4(b).

\715\ Some commenters also contended that language in proposed

Appendix B raised transaction-by-transaction implications. See supra

notes 522 to 529 and accompanying text (discussing commenters'

transaction-by-transaction concerns).

\716\ The Agencies are not adopting a transaction-by-transaction

approach because the Agencies are concerned that such an approach

would be unduly burdensome or impractical and inconsistent with the

manner in which bona fide market making-related activity is

conducted. Additionally, the Agencies are concerned that the burdens

of such an approach would cause banking entities to significantly

reduce or cease market making-related activities, which would cause

negative market impacts harmful to both investors and issuers, as

well as the financial system generally.

---------------------------------------------------------------------------

The Agencies are adopting an approach that focuses on both a

trading desk's financial exposure and market-maker inventory in

recognition that market making-related activity is best viewed in a

holistic manner and that, during a single day, a trading desk may

engage in a large number of purchases and sales of financial

instruments. While all these transactions must be conducted in

compliance with the market-making exemption, the Agencies recognize

that they involve financial instruments for which the trading desk acts

as market maker (i.e., by standing ready to purchase and sell that type

of financial instrument) and instruments that are acquired to manage

the risks of positions in financial instruments for which the desk acts

as market maker, but in which the desk is not itself a market

maker.\717\

---------------------------------------------------------------------------

\717\ See Joint Proposal, 76 FR at 68870 n.146 (``The Agencies

note that a market maker may often make a market in one type of

[financial instrument] and hedge its activities using different

[financial instruments] in which it does not make a market.''); CFTC

Proposal, 77 FR at 8356 n.152.

---------------------------------------------------------------------------

The final rule requires that activity by a trading desk under the

market-making exemption be evaluated by a banking entity through

monitoring and setting limits for the trading desk's market-maker

inventory and financial exposure. The market-maker inventory of a

trading desk includes the positions in financial instruments, including

derivatives, in which the trading desk acts as market maker. The

financial exposure of the trading desk includes the aggregate risks of

financial instruments in the market-maker inventory of the trading desk

plus the financial instruments, including derivatives, that are

acquired to manage the risks of the positions in financial instruments

for which the trading desk acts as a market maker, but in which the

trading desk does not itself make a market, as well as any associated

loans, commodities, and foreign exchange that are acquired as incident

to acting as a market maker. In addition, the trading desk generally

must maintain its market-maker inventory and financial exposure within

its market-maker inventory limit and its financial exposure limit,

respectively and, to the extent that any limit of the trading desk is

exceeded, the trading desk must take action to bring the trading desk

into compliance with the limits as promptly as possible after the limit

is exceeded.\718\ Thus, if market movements cause a trading desk's

financial exposure to exceed one or more of its risk limits, the

trading desk must promptly take action to reduce its financial exposure

or obtain approval for an increase to its limits through the required

escalation procedures, detailed below. A trading desk may not, however,

enter into a trade that would cause it to exceed its limits without

first receiving approval through its escalation procedures.\719\

---------------------------------------------------------------------------

\718\ See final rule Sec. 75.4(b)(2)(iv).

\719\ See final rule Sec. 75.4(b)(2)(iii)(E).

---------------------------------------------------------------------------

Under the final rule, the term market-maker inventory is defined to

mean all of the positions, in the financial instruments for which the

trading desk stands ready to make a market in accordance with paragraph

(b)(2)(i) of this section, that are managed by the trading desk,

including the trading desk's open positions or exposures arising from

open transactions.\720\ Those financial instruments in which a trading

desk acts as market maker must be identified in the trading desk's

compliance program under Sec. 75.4(b)(2)(iii)(A) of the final rule. As

used throughout this SUPPLEMENTARY INFORMATION, the term ``inventory''

refers to both the retention of financial instruments (e.g.,

securities) and, in the context of derivatives trading, the risk

exposures arising out of market-making related activities.\721\

Consistent with the statute, the final rule requires that the market-

maker inventory of a trading desk be designed not to exceed, on an

ongoing basis, the reasonably expected near term demands of clients,

customers, or counterparties.

---------------------------------------------------------------------------

\720\ See final rule Sec. 75.4(b)(5).

\721\ As noted in the proposal, certain types of market making-

related activities, such as market making in derivatives, involves

the retention of principal exposures rather than the retention of

actual financial instruments. See Joint Proposal, 76 FR at 68869

n.143; CFTC Proposal, 77 FR at 8354 n.149. This type of activity

would be included under the concept of ``inventory'' in the final

rule.

---------------------------------------------------------------------------

The financial exposure concept is broader in scope than market-

maker inventory and reflects the aggregate risks of the financial

instruments (as well as any associated loans, spot commodities, or spot

foreign exchange or currency) the trading desk manages as part of its

market making-related activities.\722\ Thus, a trading desk's financial

exposure will take into account a trading desk's positions in

instruments for which it does not act as a market maker, but which are

[[Page 5865]]

established as part of its market making-related activities, which

includes risk mitigation and hedging. For instance, a trading desk that

acts as a market maker in Euro-denominated corporate bonds may, in

addition to Euro-denominated bonds, enter into credit default swap

transactions on individual European corporate bond issuers or an index

of European corporate bond issuers in order to hedge its exposure

arising from its corporate bond inventory, in accordance with its

documented hedging policies and procedures. Though only the corporate

bonds would be considered as part of the trading desk's market-maker

inventory, its overall financial exposure would also include the credit

default swaps used for hedging purposes.

---------------------------------------------------------------------------

\722\ The Agencies recognize that under the statute a banking

entity's positions in loans, spot commodities, and spot foreign

exchange or currency are not subject to the final rule's

restrictions on proprietary trading. Thus, a banking entity's

trading in these instruments does not need to comply with the

market-making exemption or any other exemption to the prohibition on

proprietary trading. A banking entity may, however, include

exposures in loans, spot commodities, and spot foreign exchange or

currency that are related to the desk's market-making activities in

determining the trading desk's financial exposure and in turn, the

desk' s financial exposure limits under the market-making exemption.

The Agencies believe this will provide a more accurate picture of

the trading desk's financial exposure. For example, a market maker

in foreign exchange forwards or swaps may mitigate the risks of its

market-maker inventory with spot foreign exchange.

---------------------------------------------------------------------------

As noted above, the Agencies believe the extent to which a trading

desk is engaged in permitted market making-related activities is best

determined by evaluating both the financial exposure that results from

the desk's trading activity and the amount, types, and risks of the

financial instruments in the desk's market-maker inventory. Both

concepts are independently valuable and will contribute to the

effectiveness of the market-making exemption. Specifically, a trading

desk's financial exposure will highlight the net exposure and risks of

its positions and, along with an analysis of the actions the trading

desk will take to demonstrably reduce or otherwise significantly

mitigate promptly the risks of that exposure consistent with its

limits, the extent to which it is appropriately managing the risk of

its market-maker inventory consistent with applicable limits, all of

which are significant to an analysis of whether a trading desk is

engaged in market making-related activities. An assessment of the

amount, types, and risks of the financial instruments in a trading

desk's market-maker inventory will identify the aggregate amount of the

desk's inventory in financial instruments for which it acts as market

maker, the types of these financial instruments that the desk holds at

a particular time, and the risks arising from such holdings.

Importantly, an analysis of a trading desk's market-maker inventory

will inform the extent to which this inventory is related to the

reasonably expected near term demands of clients, customers, or

counterparties.

Because the market-maker inventory concept is more directly related

to the financial instruments that a trading desk buys and sells from

customers than the financial exposure concept, the Agencies believe

that requiring review and analysis of a trading desk's market-maker

inventory, as well as its financial exposure, will enhance compliance

with the statute's near-term customer demand requirement. While the

amount, types, and risks of a trading desk's market-maker inventory are

constrained by the near-term customer demand requirement, any other

positions in financial instruments managed by the trading desk as part

of its market making-related activities (i.e., those reflected in the

trading desk's financial exposure, but not included in the trading

desk's market-maker inventory) are also constrained because they must

be consistent with the market-maker inventory or, if taken for hedging

purposes, designed to reduce the risks of the trading desk's market-

maker inventory.

The Agencies note that disaggregating the trading desk's market-

maker inventory from its other exposures also allows for better

identification of the trading desk's hedging positions in instruments

for which the trading desk does not make a market. As a result, a

banking entity's systems should be able to readily identify and monitor

the trading desk's hedging positions that are not in its market-maker

inventory. As discussed in Part VI.A.3.c.3., a trading desk must have

certain inventory and risk limits on its market-maker inventory, the

products, instruments, and exposures the trading desk may use for risk

management purposes, and its financial exposure that are designed to

facilitate the trading desk's compliance with the exemption and that

are based on the nature and amount of the trading desk's market making-

related activities, including analyses regarding the reasonably

expected near term demands of customers.\723\

---------------------------------------------------------------------------

\723\ See infra Part VI.A.3.c.2.c.; final rule Sec.

75.4(b)(2)(iii)(C).

---------------------------------------------------------------------------

The final rule also requires these policies and procedures to

contain escalation procedures if a trade would exceed the limits set

for the trading desk. However, the final rule does not permit a trading

desk to exceed the limits solely based on customer demand. Rather,

before executing a trade that would exceed the desk's limits or

changing the desk's limits, a trading desk must first follow the

relevant escalation procedures, which may require additional approval

within the banking entity and provide demonstrable analysis that the

basis for any temporary or permanent increase in limits is consistent

with the reasonably expected near term demands of customers.

Due to these considerations, the Agencies believe the final rule

should result in more efficient compliance analyses on the part of both

banking entities and Agency supervisors and examiners and should be

less costly for banking entities to implement than a transaction-by-

transaction or instrument-by-instrument approach. For example, the

Agencies believe that some banking entities already compute and monitor

most trading desks' financial exposures for risk management or other

purposes.\724\ The Agencies also believe that focusing on the financial

exposure and market-maker inventory of a trading desk, as opposed to

each separate individual transaction, is consistent with the statute's

goal of reducing proprietary trading risk in the banking system and its

exemption for market making-related activities. The Agencies recognize

that banking entities may not currently disaggregate trading desks'

market-maker inventory from their financial exposures and that, to the

extent banking entities do not currently separately identify trading

desks' market-maker inventory, requiring such disaggregation for

purposes of this rule will impose certain costs. In addition, the

Agencies understand that an approach focused solely on the aggregate of

all the unit's trading positions, as suggested by some commenters,

would present fewer burdens.\725\ However, for the reasons discussed

above, the Agencies believe such disaggregation is necessary to give

full effect to the statute's near term customer demand requirement.

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\724\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012)

(stating that modern trading units generally view individual

positions as a bundle of characteristics that contribute to their

complete portfolio). See also Federal Reserve Board, Trading and

Capital-Markets Activities Manual Sec. 2000.1 (Feb. 1998) (``The

risk-measurement system should also permit disaggregation of risk by

type and by customer, instrument, or business unit to effectively

support the management and control of risks.'').

\725\ See ACLI (Feb. 2012); Fixed Income Forum/Credit

Roundtable; SIFMA et al. (Prop. Trading) (Feb. 2012).

---------------------------------------------------------------------------

The Agencies note that whether a financial instrument or exposure

stemming from a derivative is considered to be market-maker inventory

is based only on whether the desk makes a market in the financial

instrument, regardless of the type of counterparty or the purpose of

the transaction. Thus, the Agencies believe that banking entities

should be able to develop a standardized methodology for identifying a

trading desk's positions and exposures in the financial instruments for

which it acts as a market maker. As further discussed in this Part, a

trading desk's financial exposure must reflect the aggregate risks

managed by the trading desk as part of its market

[[Page 5866]]

making-related activities,\726\ and a banking entity should be able to

demonstrate that the financial exposure of a trading desk is related to

its market-making activities.

---------------------------------------------------------------------------

\726\ See final rule Sec. 75.4(b)(4).

---------------------------------------------------------------------------

The final rule defines ``financial exposure'' to mean the

``aggregate risks of one or more financial instruments and any

associated loans, commodities, or foreign exchange or currency, held by

a banking entity or its affiliate and managed by a particular trading

desk as part of the trading desk's market making-related activities.''

\727\ In this context, the term ``aggregate'' does not imply that a

long exposure in one instrument can be combined with a short exposure

in a similar or related instrument to yield a total exposure of zero.

Instead, such a combination may reduce a trading desk's economic

exposure to certain risk factors that are common to both instruments,

but it would still retain any basis risk between those financial

instruments or potentially generate a new risk exposure in the case of

purposeful hedging.

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\727\ Final rule Sec. 75.4(b)(4). For example, in the case of

derivatives, a trading desk's financial position will be the

residual risks of the trading desk's open positions. For instance,

an options desk may have thousands of open trades at any given time,

including hedges, but the desk will manage, among other risk

factors, the trading desk's portfolio delta, gamma, rho, and

volatility.

---------------------------------------------------------------------------

With respect to the frequency with which a trading desk should

determine its financial exposure and the amount, types, and risks of

the financial instruments in its market-maker inventory, a trading

desk's financial exposure and market-maker inventory should be

evaluated and monitored at a frequency that is appropriate for the

trading desk's trading strategies and the characteristics of the

financial instruments the desk trades, including historical intraday

volatility. For example, a trading desk that repeatedly acquired and

then terminated significant financial exposures throughout the day but

that had little or no financial exposure at the end of the day should

assess its financial exposure based on its intraday activities, not

simply its end-of-day financial exposure. The frequency with which a

trading desk's financial exposure and market-maker inventory will be

monitored and analyzed should be specified in the trading desk's

compliance program.

A trading desk's financial exposure reflects its aggregate risk

exposures. The types of ``aggregate risks'' identified in the trading

desk's financial exposure should reflect consideration of all

significant market factors relevant to the financial instruments in

which the trading desk acts as market maker or that the desk uses for

risk management purposes pursuant to this exemption, including the

liquidity, maturity, and depth of the market for the relevant types of

financial instruments. Thus, market factors reflected in a trading

desk's financial exposure should include all significant and relevant

factors associated with the products and instruments in which the desk

trades as market maker or for risk management purposes, including basis

risk arising from such positions.\728\ Similarly, an assessment of the

risks of the trading desk's market-maker inventory must reflect

consideration of all significant market factors relevant to the

financial instruments in which the trading desk makes a market.

Importantly, a trading desk's financial exposure and the risks of its

market-maker inventory will change based on the desk's trading activity

(e.g., buying an instrument that it did not previously hold, increasing

its position in an instrument, or decreasing its position in an

instrument) as well as changing market conditions related to

instruments or positions managed by the trading desk.

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\728\ As discussed in Part VI.A.3.c.3., a banking entity must

establish, implement, maintain, and enforce policies and procedures,

internal controls, analysis, and independent testing regarding the

financial instruments each trading desk stands ready to purchase and

sell and the products, instruments, or exposures each trading desk

may use for risk management purposes. See final rule Sec.

75.4(b)(2)(iii).

---------------------------------------------------------------------------

Because the final rule defines ``trading desk'' based on

operational functionality rather than corporate formality, a trading

desk's financial exposure may include positions that are booked in

different affiliated legal entities.\729\ The Agencies understand that

positions may be booked in different legal entities for a variety of

reasons, including regulatory reasons. For example, a trading desk that

makes a market in corporate bonds may book its corporate bond positions

in an SEC-registered broker-dealer and may book index CDS positions

acquired for hedging purposes in a CFTC-registered swap dealer. A

financial exposure that reflects both the corporate bond position and

the index CDS position better reflects the economic reality of the

trading desk's risk exposure (i.e., by showing that the risk of the

corporate bond position has been reduced by the index CDS position).

---------------------------------------------------------------------------

\729\ Other statutory or regulatory requirements, including

those based on prudential safety and soundness concerns, may prevent

or limit a banking entity from booking hedging positions in a legal

entity other than the entity taking the underlying position.

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In addition, a trading desk engaged in market making-related

activities in compliance with the final rule may direct another

organizational unit of the banking entity or an affiliate to execute a

risk-mitigating transaction on the trading desk's behalf.\730\ The

other organizational unit may rely on the market-making exemption for

these purposes only if: (i) The other organizational unit acts in

accordance with the trading desk's risk management policies and

procedures established in accordance with Sec. 75.4(b)(2)(iii) of the

final rule; and (ii) the resulting risk-mitigating position is

attributed to the trading desk's financial exposure (and not the other

organizational unit's financial exposure) and is included in the

trading desk's daily profit and loss calculation. If another

organizational unit of the banking entity or an affiliate establishes a

risk-mitigating position for the trading desk on its own accord (i.e.,

not at the direction of the trading desk) or if the risk-mitigating

position is included in the other organizational unit's financial

exposure or daily profit and loss calculation, then the other

organizational unit must comply with the requirements of the hedging

exemption for such activity.\731\ It may not rely on the market-making

exemption under these circumstances. If a trading desk engages in a

risk-mitigating transaction with a second trading desk of the banking

entity or an affiliate that is also engaged in permissible market

making-related activities, then the risk-mitigating position would be

included in the first trading desk's financial exposure and the contra-

risk would be included in the second trading desk's market-maker

inventory and financial exposure. The Agencies believe the net effect

of the final rule is to allow individual trading desks to efficiently

manage their own hedging and risk mitigation activities on a holistic

basis, while only allowing for external hedging directed by staff

outside of the trading desk under the additional requirements of the

hedging exemption.

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\730\ See infra Part VI.A.3.c.4.

\731\ Under these circumstances, the other organizational unit

would also be required to meet the hedging exemption's documentation

requirement for the risk-mitigating transaction. See final rule

Sec. 75.5(c).

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To include in a trading desk's financial exposure either positions

held at an affiliated legal entity or positions established by another

organizational unit on the trading desk's behalf, a banking entity must

be able to provide supervisors or examiners of any Agency that has

regulatory authority over the banking entity pursuant to section

[[Page 5867]]

13(b)(2)(B) of the BHC Act with records, promptly upon request, that

identify any related positions held at an affiliated entity that are

being included in the trading desk's financial exposure for purposes of

the market-making exemption. Similarly, the supervisors and examiners

of any Agency that has supervisory authority over the banking entity

that holds financial instruments that are being included in another

trading desk's financial exposure for purposes of the market-making

exemption must have the same level of access to the records of the

trading desk.\732\ Banking entities should be prepared to provide all

records that identify all positions included in a trading desk's

financial exposure and where such positions are held.

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\732\ A banking entity must be able to provide such records when

a related position is held at an affiliate, even if the affiliate

and the banking entity are not subject to the same Agency's

regulatory jurisdiction.

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As an example of how a trading desk's market-maker inventory and

financial exposure will be analyzed under the market-making exemption,

assume a trading desk makes a market in a variety of U.S. corporate

bonds and hedges its aggregated positions with a combination of

exposures to corporate bond indexes and specific name CDS in which the

desk does not make a market. To qualify for the market-making

exemption, the trading desk would have to demonstrate, among other

things, that: (i) The desk routinely stands ready to purchase and sell

the U.S. corporate bonds, consistent with the requirement of Sec.

75.4(b)(2)(i) of the final rule, and these instruments (or category of

instruments) are identified in the trading desk's compliance program;

(ii) the trading desk's market-maker inventory in U.S. corporate bonds

is designed not to exceed, on an ongoing basis, the reasonably expected

near term demands of clients, customers, or counterparties, consistent

with the analysis and limits established by the banking entity for the

trading desk; (iii) the trading desk's exposures to corporate bond

indexes and single name CDS are designed to mitigate the risk of its

financial exposure, are consistent with the products, instruments, or

exposures and the techniques and strategies that the trading desk may

use to manage its risk effectively (and such use continues to be

effective), and do not exceed the trading desk's limits on the amount,

types, and risks of the products, instruments, and exposures the

trading desk uses for risk management purposes; and (iv) the aggregate

risks of the trading desk's exposures to U.S. corporate bonds,

corporate bond indexes, and single name CDS do not exceed the trading

desk's limits on the level of exposures to relevant risk factors

arising from its financial exposure.

Our focus on the financial exposure of a trading desk, rather than

a trade-by-trade requirement, is designed to give banking entities the

flexibility to acquire not only market-maker inventory, but positions

that facilitate market making, such as positions that hedge market-

maker inventory.\733\ As commenters pointed out, a trade-by-trade

requirement would view trades in isolation and could fail to recognize

that certain trades that are not customer-facing are nevertheless

integral to market making and financial intermediation.\734\ The

Agencies understand that the risk-reducing effects of combining large

diverse portfolios could, in certain instances, mask otherwise

prohibited proprietary trading.\735\ However, the Agencies do not

believe that taking a transaction-by-transaction approach is necessary

to address this concern. Rather, the Agencies believe that the broader

definitions of ``financial exposure'' and ``market-maker inventory''

coupled with the tailored definition of ``trading desk'' facilitates

the analysis of aggregate risk exposures and positions in a manner best

suited to apply and evaluate the market-making exemption.

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\733\ The Agencies believe it is appropriate to apply the

requirements of the exemption to the financial exposure of a

``trading desk,'' rather than the portfolio of a higher level of

organization, for the reasons discussed above, including our concern

that aggregating a large number of disparate positions and exposures

across a range of trading desks could increase the risk of evasion.

See supra Part VI.A.3.c.1.c.i. (discussing the determination to

apply requirements at the trading desk level).

\734\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012).

\735\ See, e.g., Occupy.

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In short, this approach is designed to mitigate the costs of a

trade-by-trade analysis identified by commenters. The Agencies

recognize, however, that this approach is only effective at achieving

the goals of the section 13 of the BHC Act--promoting financial

intermediation and limiting speculative risks within banking entities--

if there are limits on a trading desk's financial exposure. That is, a

permissive market-making exemption that gives banking entities maximum

discretion in acquiring positions to provide liquidity runs the risk of

also allowing banking entities to engage in speculative trades. As

discussed more fully in the following Parts of this SUPPLEMENTARY

INFORMATION, the final market-making exemption provides a number of

controls on a trading desk's financial exposure. These controls

include, among others, a provision requiring that a trading desk's

market-maker inventory be designed not to exceed, on an ongoing basis,

the reasonably expected near term demands of customers and that any

other financial instruments managed by the trading desk be designed to

mitigate the risk of such desk's market-maker inventory. In addition,

the final market-making exemption requires the trading desk's

compliance program to include appropriate risk and inventory limits

tied to the near term demand requirement, as well as escalation

procedures if a trade would exceed such limits. The compliance program,

which includes internal controls and independent testing, is designed

to prevent instances where transactions not related to providing

financial intermediation services are part of a desk's financial

exposure.

iii. Routinely Standing Ready To Buy and Sell

The requirement to routinely stand ready to buy and sell a type of

financial instrument in the final rule recognizes that market making-

related activities differ based on the liquidity, maturity, and depth

of the market for the relevant type of financial instrument. For

example, a trading desk acting as a market maker in highly liquid

markets would engage in more regular quoting activity than a market

maker in less liquid markets. Moreover, the Agencies recognize that the

maturity and depth of the market also play a role in determining the

character of a market maker's activity.

As noted above, the standard of ``routinely'' standing ready to buy

and sell will differ across markets and asset classes based on the

liquidity, maturity, and depth of the market for the type of financial

instrument. For instance, a trading desk that is a market maker in

liquid equity securities generally should engage in very regular or

continuous quoting and trading activities on both sides of the market.

In less liquid markets, a trading desk should engage in regular quoting

activity across the relevant type(s) of financial instruments, although

such quoting may be less frequent than in liquid equity markets.\736\

Consistent with the CFTC's and SEC's interpretation of market making in

swaps and security-based swaps for purposes of the definitions of

[[Page 5868]]

``swap dealer'' and ``security-based swap dealer,'' ``routinely'' in

the swap market context means that the trading desk should stand ready

to enter into swaps or security-based swaps at the request or demand of

a counterparty more frequently than occasionally.\737\ The Agencies

note that a trading desk may routinely stand ready to enter into

derivatives on both sides of the market, or it may routinely stand

ready to enter into derivatives on either side of the market and then

enter into one or more offsetting positions in the derivatives market

or another market, particularly in the case of relatively less liquid

derivatives. While a trading desk may respond to requests to trade

certain products, such as custom swaps, even if it does not normally

quote in the particular product, the trading desk should hedge against

the resulting exposure in accordance with its financial exposure and

hedging limits.\738\ Further, the Agencies continue to recognize that

market makers in highly illiquid markets may trade only intermittently

or at the request of particular customers, which is sometimes referred

to as trading by appointment.\739\ A trading desk's block positioning

activity would also meet the terms of this requirement provided that,

from time to time, the desk engages in block trades (i.e., trades of a

large quantity or with a high dollar value) with customers.\740\

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\736\ Indeed, in the most specialized situations, such

quotations may only be provided upon request. See infra note 740 and

accompanying text (discussing permissible block positioning).

\737\ The Agencies will consider factors similar to those

identified by the CFTC and SEC in connection with this standard. See

Further Definition of ``Swap Dealer,'' ``Security-Based Swap

Dealer,'' ``Major Swap Participant,'' ``Major Security-Based Swap

Participant'' and ``Eligible Contract Participant'', 77 FR 30596,

30609 (May 23, 2012)

\738\ The Agencies recognize that, as noted by commenters,

preventing a banking entity from conducting customized transactions

with customers may impact customers' risk exposures or transaction

costs. See Goldman (Prop. Trading); SIFMA (Asset Mgmt.) (Feb. 2012).

The Agencies are not prohibiting this activity under the final rule,

as discussed in this Part.

\739\ The Agencies have considered comments on the issue of

whether trading by appointment should be permitted under the final

market-making exemption. The Agencies believe it is appropriate to

permit trading by appointment to the extent that there is customer

demand for liquidity in the relevant products.

\740\ As noted in the preamble to the proposed rule, the size of

a block will vary among different asset classes. The Agencies also

stated in the proposal that the SEC's definition of ``qualified

block positioner'' in Rule 3b-8(c) under the Exchange Act may serve

as guidance for determining whether block positioning activity

qualifies for the market-making exemption. In referencing that rule

as guidance, the Agencies did not intend to imply that a banking

entity engaged in block positioning activity would be required to

meet all terms of the ``qualified block positioner'' definition at

all times. Nonetheless, a number of commenters indicated that it was

unclear when a banking entity would need to act as a qualified block

positioner in accordance with Rule 3b-8(c) and expressed concern

that uncertainty could have a chilling effect on a banking entity's

willingness to facilitate customer block trades. See, e.g., RBC;

SIFMA (Asset Mgmt.) (Feb. 2012); Goldman (Prop. Trading). For

example, a few commenters stated that certain requirements in Rule

3b-8(c) could cause fire sales or general market uncertainty. See

id. After considering comments, the Agencies have decided that the

reference to Rule 3b-8(c) is unnecessary for purposes of the final

rule. In particular, the Agencies believe that the requirements in

the market-making exemption provide sufficient safeguards, and the

additional requirements of the ``qualified block positioner''

definition may present unnecessary burdens or redundancies with the

rule, as adopted. For example, the Agencies believe that there is

some overlap between Sec. 75.4(b)(2)(ii) of the exemption, which

provides that the amount, types, and risks of the financial

instruments in the trading desk's market-maker inventory must be

designed not to exceed the reasonably expected near term demands of

clients, customers, or counterparties, and Rule 3b-8(c)(iii), which

requires the sale of the shares comprising the block as rapidly as

possible commensurate with the circumstances. In other words, the

market-making exemption would require a banking entity to

appropriately manage its inventory when engaged in block positioning

activity, but would not speak directly to the timing element given

the diversity of markets to which the exemption applies.

As noted above, one commenter analyzed the potential market

impact of a complete restriction on a market maker's ability to

provide direct liquidity to help a customer execute a large block

trade. See supra note 687 and accompanying text. Because the

Agencies are not restricting a banking entity's ability to engage in

block positioning in the manner suggested by this commenter, the

Agencies do not believe that the final rule will cause the cited

market impact of incremental transaction costs between $1.7 and $3.4

billion per year. The Agencies address this commenter's concern

about the impact of inventory metrics on a banking entity's

willingness to engage in block trading in Part VI.C.3. (discussing

the metrics requirement in the final rule and noting that metrics

will not be used to determine compliance with the rule but, rather,

will be monitored for patterns over time to identify activities that

may warrant further review).

One commenter appeared to request that block trading activity

not be subject to all requirements of the market-making exemption.

See SIFMA (Asset Mgmt.) (Feb. 2012). Any activity conducted in

reliance on the market-making exemption, including block trading

activity, must meet the requirements of the market-making exemption.

The Agencies believe the requirements in the final rule are workable

for block positioning activity and do not believe it would be

appropriate to subject block positioning to lesser requirements than

general market-making activity. For example, trading in large block

sizes can expose a trading desk to greater risk than market making

in smaller sizes, particularly absent risk management requirements.

Thus, the Agencies believe it is important for block positioning

activity to be subject to the same requirements, including the

requirements to establish risk limits and risk management

procedures, as general market-making activity.

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Regardless of the liquidity, maturity, and depth of the market for

a particular type of financial instrument, a trading desk should have a

pattern of providing price indications on either side of the market and

a pattern of trading with customers on each side of the market. In

particular, in the case of relatively illiquid derivatives or

structured instruments, it would not be sufficient to demonstrate that

a trading desk on occasion creates a customized instrument or provides

a price quote in response to a customer request. Instead, the trading

desk would need to be able to demonstrate a pattern of taking these

actions in response to demand from multiple customers with respect to

both long and short risk exposures in identified types of instruments.

This requirement of the final rule applies to a trading desk's

activity in one or more ``types'' of financial instruments.\741\ The

Agencies recognize that, in some markets, such as the corporate bond

market, a market maker may regularly quote a subset of instruments

(generally the more liquid instruments), but may not provide regular

quotes in other related but less liquid instruments that the market

maker is willing and available to trade. Instead, the market maker

would provide a price for those instruments upon request.\742\ The

trading desk's activity, in the aggregate for a particular type of

financial instrument, indicates whether it is engaged in activity that

is consistent with Sec. 75.4(b)(2)(i) of the final rule.

---------------------------------------------------------------------------

\741\ This approach is generally consistent with commenters'

requested clarification that a trading desk's quoting activity will

not be assessed on an instrument-by-instrument basis, but rather

across a range of similar instruments for which the trading desk

acts as a market maker. See, e.g., RBC; SIFMA et al. (Prop. Trading)

(Feb. 2012); CIEBA; Goldman (Prop. Trading).

\742\ See, e.g., Goldman (Prop. Trading); Morgan Stanley; RBC;

SIFMA et al. (Prop. Trading) (Feb. 2012).

---------------------------------------------------------------------------

Notably, this requirement provides that the types of financial

instruments for which the trading desk routinely stands ready to

purchase and sell must be related to its authorized market-maker

inventory and it authorized financial exposure. Thus, the types of

financial instruments for which the desk routinely stands ready to buy

and sell should compose a significant portion of its overall financial

exposure. The only other financial instruments contributing to the

trading desk's overall financial exposure should be those designed to

hedge or mitigate the risk of the financial instruments for which the

trading desk is making a market. It would not be consistent with the

market-making exemption for a trading desk to hold only positions in,

or be exposed to, financial instruments for which the trading desk is

not a market maker.\743\

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\743\ The Agencies recognize that there could be limited

circumstances under which a trading desk's financial exposure does

not relate to the types of financial instruments that it is standing

ready to buy and sell for a short period of time. However, the

Agencies would expect for such occurrences to be minimal. For

example, this scenario could occur if a trading desk unwinds a hedge

position after the market-making position has already been unwound

or if a trading desk acquires an anticipatory hedge position prior

to acquiring a market-making position. As discussed more thoroughly

in Part VI.A.3.c.3., a banking entity must establish written

policies and procedures, internal controls, analysis, and

independent testing that establish appropriate parameters around

such activities.

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[[Page 5869]]

A trading desk's routine presence in the market for a particular

type of financial instrument would not, on its own, be sufficient

grounds for relying on the market-making exemption. This is because the

frequency at which a trading desk is active in a particular market

would not, on its own, distinguish between permitted market making-

related activity and impermissible proprietary trading. In response to

comments, the final rule provides that a trading desk also must be

willing and available to quote, buy and sell, or otherwise enter into

long and short positions in the relevant type(s) of financial

instruments for its own account in commercially reasonable amounts and

throughout market cycles.\744\ Importantly, a trading desk would not

meet the terms of this requirement if it provides wide quotations

relative to prevailing market conditions and is not engaged in other

activity that evidences a willingness or availability to provide

intermediation services.\745\ Under these circumstances, a trading desk

would not be standing ready to purchase and sell because it is not

genuinely quoting or trading with customers.

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\744\ See, e.g., Occupy; Better Markets (Feb. 2012).

\745\ One commenter expressed concern that a banking entity may

be able to rely on the market-making exemption when it is providing

only wide, out of context quotes. See Occupy.

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In the context of this requirement, ``commercially reasonable

amounts'' means that the desk generally must be willing to quote and

trade in sizes requested by other market participants.\746\ For trading

desks that engage in block trading, this would include block trades

requested by customers, and this language is not meant to restrict a

trading desk from acting as a block positioner. Further, a trading desk

must act as a market maker on an appropriate basis throughout market

cycles and not only when it is most favorable for it to do so.\747\ For

example, a trading desk should be facilitating customer needs in both

upward and downward moving markets.

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\746\ As discussed below, this may include providing quotes in

the interdealer trading market.

\747\ Algorithmic trading strategies that only trade when market

factors are favorable to the strategy's objectives or that otherwise

frequently exit the market would not be considered to be standing

ready to purchase or sell a type of financial instrument throughout

market cycles and, thus, would not qualify for the market-making

exemption. The Agencies believe this addresses commenters' concerns

about high-frequency trading activities that are only active in the

market when it is believed to be profitable, rather than to

facilitate customers. See, e.g., Better Markets (Feb. 2012). The

Agencies are not, however, prohibiting all high-frequency trading

activities under the final rule or otherwise limiting high-frequency

trading by banking entities by imposing a resting period on their

orders, as requested by certain commenters. See, e.g., Better

Markets (Feb. 2012); Occupy; Public Citizen.

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As discussed further in Part VI.A.3.c.3., the financial instruments

the trading desk stands ready to buy and sell must be identified in the

trading desk's compliance program.\748\ Certain requirements in the

final exemption apply to the amount, types, and risks of these

financial instruments that a trading desk can hold in its market-maker

inventory, including the near term customer demand requirement \749\

and the need to have certain risk and inventory limits.\750\

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\748\ See final rule Sec. 75.4(b)(2)(iii)(A).

\749\ See final rule Sec. 75.4(b)(2)(ii).

\750\ See final rule Sec. 75.4(b)(2)(iii)(C).

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In response to the proposed requirement that a trading desk or

other organizational unit hold itself out, some commenters requested

that the Agencies limit the availability of the market-making exemption

to trading in particular asset classes or trading on particular venues

(e.g., organized trading platforms). The Agencies are not limiting the

availability of the market-making exemption in the manner requested by

these commenters.\751\ Provided there is customer demand for liquidity

in a type of financial instrument, the Agencies do not believe the

availability of the market-making exemption should depend on the

liquidity of that type of financial instrument or the ability to trade

such instruments on an organized trading platform. The Agencies see no

basis in the statutory text for either approach and believe that the

likely harms to investors seeking to trade affected instruments (e.g.,

reduced ability to purchase or sell a particular instrument,

potentially higher transaction costs) and market quality (e.g., reduced

liquidity) that would arise under such an approach would not be

justified,\752\ particularly in light of the minimal benefits that

might result from restricting or eliminating a banking entity's ability

to hold less liquid assets in connection with its market making-related

activities. The Agencies believe these commenters' concerns are

adequately addressed by the final rule's requirements in the market-

making exemption that are designed to ensure that a trading desk cannot

hold risk in excess of what is appropriate to provide intermediation

services designed not to exceed, on an ongoing basis, the reasonably

expected near term demands of clients, customers, or counterparties.

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\751\ For example, a few commenters requested that the rule

prohibit banking entities from market making in assets classified as

Level 3 under FAS 157. See supra note 656 and accompanying text. The

Agencies continue to believe that it would be inappropriate to

incorporate accounting standards in the rule because accounting

standards could change in the future without consideration of the

potential impact on the final rule. See Joint Proposal, 76 FR at

68859 n.101 (explaining why the Agencies declined to incorporate

certain accounting standards in the proposed rule); CFTC Proposal,

77 FR at 8344 n.107.

Further, a few commenters suggested that the exemption should

only be available for trading on an organized trading facility. This

type of limitation would require significant and widespread market

structure changes (with associated systems and infrastructure costs)

in a relatively short period of time, as market making in certain

assets is primarily or wholly conducted in the OTC market, and

organized trading platforms may not currently exist for these

assets. The Agencies do not believe that the costs of such market

structure changes would be warranted for purposes of this rule.

\752\ As discussed above, a number of commenters expressed

concern about the potential market impacts of the perceived

restrictions on market making under the proposed rule, particularly

with respect to less liquid markets, such as the corporate bond

market. See, e.g., Prof. Duffie; Wellington; BlackRock; ICI.

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In response to comments on the proposed interpretation regarding

anticipatory position-taking,\753\ the Agencies note that the near term

demand requirement in the final rule addresses when a trading desk may

take positions in anticipation of reasonably expected near term

customer demand.\754\ The Agencies believe this approach is generally

consistent with the comments the Agencies received on this issue.\755\

In addition, the Agencies note that modifications to the proposed near

term demand requirement in the final rule also address commenters

concerns on this issue.\756\

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\753\ Joint Proposal, 76 FR at 68871 (stating that ``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''); CFTC Proposal, 77 FR at 8356-8357; see also

Morgan Stanley (requesting certain revisions to more closely track

the statute); SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading); Chamber (Feb. 2012); Comm. on Capital Markets

Regulation; SIFMA (Asset Mgmt.) (Feb. 2012).

\754\ See final rule Sec. 75.4(b)(2)(ii); infra Part

VI.A.3.c.2.c.

\755\ See BoA; SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading); Morgan Stanley; Chamber (Feb. 2012); Comm. on

Capital Markets Regulation; SIFMA (Asset Mgmt.) (Feb. 2012).

\756\ For example, some commenters suggested that the final rule

allow market makers to make individualized assessments of

anticipated customer demand, based on their expertise and

experience, and account for differences between liquid and less

liquid markets. See Chamber (Feb. 2012); ISDA (Feb. 2012). The final

rule allows such assessments, based on historical customer demand

and other relevant factors, and recognizes that near term demand may

differ based on the liquidity, maturity, and depth of the market for

a particular type of financial instrument. See infra Part

VI.A.3.c.2.c.iii.

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[[Page 5870]]

2. Near Term Customer Demand Requirement

a. Proposed Near Term Customer Demand Requirement

Consistent with the statute, the proposed rule required that the

trading desk or other organizational unit's market making-related

activities be, with respect to the financial instrument, designed not

to exceed the reasonably expected near term demands of clients,

customers, or counterparties.\757\ This requirement is intended to

prevent a trading desk from taking a speculative proprietary position

that is unrelated to customer needs as part of the desk's purported

market making-related activities.\758\

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\757\ See proposed rule Sec. 75.4(b)(2)(iii).

\758\ See Joint Proposal, 76 FR at 68871; CFTC Proposal, 77 FR

at 8357.

---------------------------------------------------------------------------

In the proposal, the Agencies stated that a banking entity's

expectations of near term customer demand should generally be based on

the unique customer base of the banking entity's specific market-making

business lines and the near term demand of those customers based on

particular factors, beyond a general expectation of price appreciation.

The Agencies further stated that they would not expect the activities

of a trading desk or other organizational unit to qualify for the

market-making exemption if the trading desk or other organizational

unit is engaged wholly or principally in trading that is not in

response to, or driven by, customer demands, regardless of whether

those activities promote price transparency or liquidity. The proposal

stated that, 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.\759\

---------------------------------------------------------------------------

\759\ See id.

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With respect to market making in a security that is executed on an

exchange or other organized trading facility, the proposal provided

that a 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 registers market makers. Under

the proposal, activities on an exchange or other organized trading

facility that primarily take liquidity, rather than provide liquidity,

would not qualify for the market-making exemption, even if conducted by

a registered market maker.\760\

---------------------------------------------------------------------------

\760\ See Joint Proposal, 76 FR at 68871-68872; CFTC Proposal,

77 FR at 8357.

---------------------------------------------------------------------------

b. Comments Regarding the Proposed Near Term Customer Demand

Requirement

As noted above, the proposed near term customer demand requirement

would implement language found in the statute's market-making

exemption.\761\ Some commenters expressed general support for this

requirement.\762\ For example, these commenters emphasized that the

proposed near term demand requirement is an important component that

restricts disguised position-taking or market making in illiquid

markets.\763\ Several other commenters expressed concern that the

proposed requirement is too restrictive \764\ because, for example, it

may impede a market maker's ability to build or retain inventory \765\

or may impact a market maker's willingness to engage in block

trading.\766\ Comments on particular aspects of this proposed

requirement are discussed below, including the proposed interpretation

of this requirement in the proposal, the requirement's potential impact

on market maker inventory, potential differences in this standard

across asset classes, whether it is possible to predict near term

customer demand, and whether the terms ``client,'' ``customer,'' or

``counterparty'' should be defined for purposes of the exemption.

---------------------------------------------------------------------------

\761\ See supra Part VI.A.3.c.2.a.

\762\ See, e.g., Sens. Merkley & Levin (Feb. 2012); Flynn &

Fusselman; Better Markets (Feb. 2012).

\763\ See Better Markets (Feb. 2012); Sens. Merkley & Levin

(Feb. 2012).

\764\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Chamber (Feb. 2012); T. Rowe Price; SIFMA (Asset Mgmt.) (Feb. 2012);

ACLI (Feb. 2012); MetLife; Comm. on Capital Markets Regulation;

CIEBA; Credit Suisse (Seidel); SSgA (Feb. 2012); IAA (stating that

the proposed requirement is too subjective and would be difficult to

administer in a range of scenarios); Barclays; Prof. Duffie.

\765\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); T.

Rowe Price; CIEBA; Credit Suisse (Seidel); Barclays; Wellington;

MetLife; Chamber (Feb. 2012); RBC; Prof. Duffie; ICI (Feb. 2012);

SIFMA (Asset Mgmt.) (Feb. 2012). The Agencies respond to these

comments in Part VI.A.3.c.2.c., infra. For a discussion of comments

regarding inventory management activity conducted in connection with

market making, see Part VI.A.3.c.2.b.vi., infra.

\766\ See, e.g., ACLI (Feb. 2012); MetLife; Comm. on Capital

Markets Regulation (noting that a market maker may need to hold

significant inventory to accommodate potential block trade

requests). Two of these commenters stated that a market maker may

provide a worse price or may be unwilling to intermediate a large

customer position if the market maker has to determine whether

holding such position will meet the near term demand requirement,

particularly if the market maker would be required to sell the block

position over a short period of time. See ACLI (Feb. 2012); MetLife.

These comments are addressed in Part VI.A.3.c.2.c.iii., infra.

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i. The Proposed Guidance for Determining Compliance With the Near Term

Customer Demand Requirement

As discussed in more detail above, the proposal set forth proposed

guidance on how a banking entity may comply with the proposed near term

customer demand requirement.\767\ With respect to the language

indicating that a banking entity's determination of near term customer

demand should generally be based on the unique customer base of a

specific market-making business line (and not merely an expectation of

future price appreciation), one commenter stated that it is unclear how

a banking entity would be able to make such determinations in markets

where trades occur infrequently and customer demand is hard to

predict.\768\

---------------------------------------------------------------------------

\767\ See supra Part VI.A.3.c.2.a.

\768\ See SIFMA et al. (Prop. Trading) (Feb. 2012). Another

commenter suggested that the Agencies ``establish clear criteria

that reflect appropriate revenue from changes in the bid-ask

spread,'' noting that a legitimate market maker should be both

selling and buying in a rising market (or, likewise, in a declining

market). Public Citizen.

---------------------------------------------------------------------------

Several commenters expressed concern about the proposal's statement

that a trading desk or other organizational unit engaged wholly or

principally in trading that is not in response to, or driven by,

customer demands (e.g., arbitrage trading with non-customers) would not

qualify for the exemption, regardless of whether the activities promote

price transparency or liquidity.\769\ In particular, commenters stated

that it would be difficult for a market-making business to try to

divide its activities that are in response to customer demand (e.g.,

customer intermediation and hedging) from activities that promote price

transparency and liquidity (e.g., interdealer trading to test market

depth or arbitrage trading) in order to determine their

proportionality.\770\ Another commenter stated that, as a matter of

organizational efficiency, firms will often restrict arbitrage trading

[[Page 5871]]

strategies to certain specific individual traders within the market-

making organization, who may sometimes be referred to as a ``desk,''

and expressed concern that this would be prohibited under the

rule.\771\

---------------------------------------------------------------------------

\769\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); BoA; ICI

(Feb. 2012); ICI Global; Vanguard; SSgA (Feb. 2012); see also infra

Part VI.A.3.c.2.b.viii. (discussing comments on whether arbitrage

trading should be permitted under the market-making exemption under

certain circumstances).

\770\ See Goldman (Prop. Trading); RBC. One of these commenters

agreed, however, that a trading desk that is ``wholly'' engaged in

trading that is unrelated to customer demand should not qualify for

the proposed market-making exemption. See Goldman (Prop. Trading).

\771\ See JPMC.

---------------------------------------------------------------------------

In response to the proposed interpretation regarding market making

on an exchange or other organized trading facility (and certain similar

language in proposed Appendix B),\772\ several commenters indicated

that the reference to passive submission of resting orders may be too

restrictive and provided examples of scenarios where market makers may

need to use market or marketable limit orders.\773\ For example, many

of these commenters stated that market makers may need to enter market

or marketable limit orders to: (i) Build or reduce inventory; \774\

(ii) address order imbalances on an exchange by, for example, using

market orders to lessen volatility and restore pricing equilibrium;

(iii) hedge market-making positions; (iv) create markets; \775\ (v)

test the depth of the markets; (vi) ensure that ETFs, American

depositary receipts (``ADRs''), options, and other instruments remain

appropriately priced; \776\ and (vii) respond to movements in prices in

the markets.\777\ Two commenters noted that distinctions between limit

and market or marketable limit orders may not be workable in the

international context, where exchanges may not use the same order types

as U.S. trading facilities.\778\

---------------------------------------------------------------------------

\772\ See Joint Proposal, 76 FR at 68871-68,872; CFTC Proposal,

77 FR at 8357.

\773\ See, e.g., NYSE Euronext; SIFMA et al. (Prop. Trading)

(Feb. 2012); Goldman (Prop. Trading); RBC. Comments on proposed

Appendix B are discussed further in Part VI.A.3.c.8.b., infra. This

issue is addressed in note 944 and its accompanying text, infra.

\774\ Some commenters stated that market makers may need to use

market or marketable limit orders to build inventory in anticipation

of customer demand or in connection with positioning a block trade

for a customer. See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC;

Goldman (Prop. Trading). Two of these commenters noted that these

order types may be needed to dispose of positions taken into

inventory as part of market making. See RBC; Goldman (Prop.

Trading).

\775\ See NYSE Euronext.

\776\ See Goldman (Prop. Trading).

\777\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\778\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading).

---------------------------------------------------------------------------

A few commenters also addressed the proposed use of a market

maker's exchange registration status as part of the analysis.\779\ Two

commenters stated that the proposed rule should not require a market

maker to be registered with an exchange to qualify for the proposed

market-making exemption. According to these commenters, there are a

large number of exchanges and organized trading facilities on which

market makers may need to trade to maintain liquidity across the

markets and to provide customers with favorable prices. These

commenters indicated that any restrictions or burdens on such trading

may decrease liquidity or make it harder to provide customers with the

best price for their trade.\780\ One commenter, however, stated that

the exchange registration requirement is reasonable and further

supported adding a requirement that traders demonstrate adherence to

the same or commensurate standards in markets where registration is not

possible.\781\

---------------------------------------------------------------------------

\779\ See NYSE Euronext; SIFMA et al. (Prop. Trading) (Feb.

2012); Goldman (Prop. Trading); Occupy. See also infra notes 945 to

946 and accompanying text (addressing these comments).

\780\ See SIFMA et al. (Prop. Trading) (Feb. 2012) (stating that

trading units may currently register as market makers with

particular, primary exchanges on which they trade, but will serve in

a market-making capacity on other trading venues from time to time);

Goldman (Prop. Trading) (noting that there are more than 12

exchanges and 40 alternative trading systems currently trading U.S.

equities).

\781\ See Occupy. In the alternative, this commenter would

require all market making to be performed on an exchange or

organized trading facility. See id.

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Some commenters recommended certain modifications to the proposed

analysis. For example, a few commenters requested that the rule presume

that a trading unit is engaged in permitted market making-related

activity if it is registered as a market maker on a particular exchange

or organized trading facility.\782\ In support of this recommendation,

one commenter represented that it would be warranted because registered

market makers directly contribute to maintaining liquid and orderly

markets and are subject to extensive regulatory requirements in that

capacity.\783\ Another commenter suggested that the Agencies instead

use metrics to compare, in the aggregate and over time, the liquidity

that a market maker makes rather than takes as part of a broader

consideration of the market-making character of the relevant trading

activity.\784\

---------------------------------------------------------------------------

\782\ See NYSE Euronext (recognizing that registration status is

not necessarily conclusive of engaging in market making-related

activities); SIFMA et al. (Prop. Trading) (Feb. 2012) (stating that

to the extent a trading unit is registered on a particular exchange

or organized trading facility for any type of financial instrument,

all of its activities on that exchange or organized trading facility

should be presumed to be market making); Goldman (Prop. Trading).

See also infra note 945 (responding to these comments). Two

commenters noted that certain exchange rules may require market

makers to deal for their own account under certain circumstances in

order to maintain fair and orderly markets. See NYSE Euronext

(discussing NYSE rules); Goldman (Prop. Trading) (discussing NYSE

and CBOE rules). For example, according to these commenters, NYSE

Rule 104(f)(ii) requires a market maker to maintain fair and orderly

markets, which may involve dealing for their own account when there

is a lack of price continuity, lack of depth, or if a disparity

between supply and demand exists or is reasonably anticipated. See

id.

\783\ See Goldman (Prop. Trading). This commenter further stated

that trading activities of exchange market makers may be

particularly difficult to evaluate with customer-facing metrics

(because ``specialist'' market makers may not have ``customers''),

so conferring a positive presumption of compliance on such market

makers would ensure that they can continue to contribute to

liquidity, which benefits customers. This commenter noted that, for

example, NYSE designated market makers (``DMMs'') are generally

prohibited from dealing with customers and companies must ``wall

off'' any trading units that act as DMMs. See id. (citing NYSE Rule

98).

\784\ See id. (stating that spread-related metrics, such as

Spread Profit and Loss, may be useful for this purpose).

---------------------------------------------------------------------------

ii. Potential Inventory Restrictions and Differences Across Asset

Classes

A number of commenters expressed concern that the proposed

requirement may unduly restrict a market maker's ability to manage its

inventory.\785\ Several of these commenters stated that limitations on

inventory would be especially problematic for market making in less

liquid markets, like the fixed-income market, where customer demand is

more intermittent and positions may need to be held for a longer period

of time.\786\ Some commenters stated that the Agencies' proposed

interpretation of this requirement would restrict a market maker's

inventory in a manner that is inconsistent with the statute. These

commenters indicated that the ``designed'' and ``reasonably expected''

language of the statute seem to recognize that market makers must

anticipate customer requests and accumulate sufficient inventory to

meet those reasonably expected demands.\787\ In addition, one commenter

represented that a market maker must have wide latitude and incentives

for initiating trades, rather than merely reacting to customer requests

for quotes, to properly risk manage its positions or to prepare for

anticipated customer demand or supply.\788\ Many commenters requested

certain modifications to the proposed requirement to limit its impact

on

[[Page 5872]]

market maker inventory.\789\ Commenters' views on the importance of

permitting inventory management activity in connection with market

making are discussed below in Part VI.A.3.c.2.b.vi.

---------------------------------------------------------------------------

\785\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); T.

Rowe Price; CIEBA; Credit Suisse (Seidel); Barclays; Wellington;

MetLife; Chamber (Feb. 2012); RBC; Prof. Duffie; ICI (Feb. 2012);

SIFMA (Asset Mgmt.) (Feb. 2012). These concerns are addressed in

Part VI.A.3.c.2.c., infra.

\786\ See, e.g., SIFMA (Asset Mgmt.) (Feb. 2012); T. Rowe Price;

CIEBA; ICI (Feb. 2012); RBC.

\787\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Chamber (Feb. 2012).

\788\ See Prof. Duffie. However, another commenter stated that a

legitimate market maker should respond to customer demand rather

than initiate transactions, which is indicative of prohibited

proprietary trading. See Public Citizen.

\789\ See Credit Suisse (Seidel) (suggesting that the rule allow

market makers to build inventory in products where they believe

customer demand will exist, regardless of whether the inventory can

be tied to a particular customer in the near term or to historical

trends in customer demand); Barclays (recommending the rule require

that ``the market making-related activity is conducted by each

trading unit such that its activities (including the maintenance of

inventory) are designed not to exceed the reasonably expected near

term demands of clients, customers, or counterparties consistent

with the market and trading patterns of the relevant product, and

consistent with the reasonable judgment of the banking entity where

such demand cannot be determined with reasonable accuracy''); CIEBA.

In addition, some commenters suggested an interpretation that would

provide greater discretion to market makers to enter into trades

based on factors such as experience and expertise dealing in the

market and market exigencies. See SIFMA et al. (Prop. Trading) (Feb.

2012); Chamber (Feb. 2012). Two commenters suggested that the

proposed requirement should be interpreted to permit market-making

activity as it currently exists. See MetLife; ACLI (Feb. 2012). One

commenter requested that the proposed requirement be moved to

Appendix B of the rule to provide greater flexibility to consider

facts and circumstances of a particular activity. See JPMC.

---------------------------------------------------------------------------

Several commenters requested that the Agencies recognize that near

term customer demand may vary across different markets and asset

classes and implement this requirement flexibly.\790\ In particular,

many of these commenters emphasized that the concept of ``near term

demand'' should be different for less liquid markets, where

transactions may occur infrequently, and for liquid markets, where

transactions occur more often.\791\ One commenter requested that the

Agencies add the phrase ``based on the characteristics of the relevant

market and asset class'' to the end of the requirement to explicitly

acknowledge these differences.\792\

---------------------------------------------------------------------------

\790\ See CIEBA; Morgan Stanley; RBC; ICI (Feb. 2012); ISDA

(Feb. 2012); Comm. on Capital Markets Regulation; Alfred Brock. The

Agencies respond to these comments in Part VI.A.3.c.2.c.ii., infra.

\791\ See ICI (Feb. 2012); CIEBA (stating that, absent a

different interpretation for illiquid instruments, market makers

will err on the side of holding less inventory to avoid sanctions

for violating the rule); RBC.

\792\ See Morgan Stanley.

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iii. Predicting Near Term Customer Demand

Commenters provided views on whether and, if so how, a banking

entity may be able to predict near term customer demand for purposes of

the proposed requirement.\793\ For example, two commenters suggested

ways in which a banking entity could predict near term customer

demand.\794\ One of these commenters indicated that banking entities

should be able to utilize current risk management tools to predict near

term customer demand, although these tools may need to be adapted to

comply with the rule's requirements. According to this commenter,

dealers commonly assess the following factors across product lines,

which can relate to expected customer demand: (i) Recent volumes and

customer trends; (ii) trading patterns of specific customers; (iii)

analysis of whether the firm has an ability to win new customer

business; (iv) comparison of the current market conditions to prior

similar periods; (v) liquidity of large investors; and (vi) the

schedule of maturities in customers' existing positions.\795\ Another

commenter stated that the reasonableness of a market maker's inventory

can be measured by looking to the specifics of the particular market,

the size of the customer base being served, and expected customer

demand, which banking entities should be required to take into account

in both their inventory practices and policies and their actual

inventories. This commenter recommended that the rule permit a banking

entity to assume a position under the market-making exemption if it can

demonstrate a track record or reasonable expectation that it can

dispose of a position in the near term.\796\

---------------------------------------------------------------------------

\793\ See Wellington; MetLife; SIFMA et al. (Prop. Trading)

(Feb. 2012); Sens. Merkley & Levin (Feb. 2012); Chamber (Feb. 2012);

FTN; RBC; Alfred Brock. These comments are addressed in Part

VI.A.3.c.2.c.iii., infra.

\794\ See Sens. Merkley & Levin (Feb. 2012); FTN.

\795\ See FTN. The commenter further indicated that errors in

estimating customer demand are managed through kick-out rules and

oversight by risk managers and committees, with latitude in

decisions being closely related to expected or empirical costs of

hedging positions until they result in trading with counterparties.

See id.

\796\ See Sens. Merkley & Levin (Feb. 2012) (stating that

banking entities should be required to collect inventory data,

evaluate the data, develop policies on how to handle particular

positions, and make regular adjustments to ensure a turnover of

assets commensurate with near term demand of customers). This

commenter also suggested that the rule specify the types of

inventory metrics that should be collected and suggested that the

rate of inventory turnover would be helpful. See id.

---------------------------------------------------------------------------

Some commenters, however, emphasized that reasonably expected near

term customer demand cannot always be accurately predicted.\797\

Several of these commenters requested the Agencies clarify that banking

entities will not be subject to regulatory sanctions if reasonably

anticipated near term customer demand does not materialize.\798\ One

commenter further noted that a banking entity entering a new market, or

gaining or losing customers, may need greater flexibility in applying

the near term demand requirement because its anticipated demand may

fluctuate.\799\

---------------------------------------------------------------------------

\797\ See MetLife; Chamber (Feb. 2012); RBC; CIEBA; Wellington;

ICI (Feb. 2012); Alfred Brock. This issue is addressed in Part

VI.A.3.c.2.c.iii., infra.

\798\ See ICI (Feb. 2012); CIEBA; RBC; Wellington; Invesco.

\799\ See CIEBA.

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iv. Potential Definitions of ``Client,'' ``Customer,'' or

``Counterparty''

Appendix B of the proposal discussed the proposed meaning of the

term ``customer'' in the context of permitted market making-related

activity.\800\ In addition, the proposal inquired whether the terms

``client,'' ``customer,'' or ``counterparty'' should be defined in the

rule for purposes of the market-making exemption.\801\ Commenters

expressed varying views on the proposed interpretations in the proposal

and on whether these terms should be defined in the final rule.\802\

---------------------------------------------------------------------------

\800\ See Joint Proposal, 76 FR at 68960; CFTC Proposal, 77 FR

at 8439. More specifically, Appendix B stated: ``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

[financial instrument] in an OTC 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.'' Id. On this last point, the proposal

elaborated that in certain cases, depending on the conventions of

the relevant market (e.g., the OTC derivatives market), such a

``customer'' may consider itself or refer to itself more generally

as a ``counterparty.'' See Joint Proposal, 76 FR at 68960 n.2; CFTC

Proposal, 77 FR at 8439 n.2.

\801\ See Joint Proposal, 76 FR at 68874; CFTC Proposal, 77 FR

at 8359. In particular, Question 99 states: ``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?'' Id.

\802\ Comments on this issue are addressed in Part

VI.A.3.c.2.c.i., infra.

---------------------------------------------------------------------------

With respect to the proposed interpretations of the term

``customer'' in Appendix B, one commenter agreed with the proposed

interpretations and expressed the belief that the interpretations will

allow interdealer market making where brokers or other dealers act as

customers. However, this commenter also requested that the Agencies

expressly incorporate

[[Page 5873]]

providing liquidity to other brokers and dealers into the rule

text.\803\ Another commenter similarly stated that instead of focusing

solely on customer demand, the rule should be clarified to reflect that

demand can come from other dealers or future customers.\804\

---------------------------------------------------------------------------

\803\ See SIFMA et al. (Prop. Trading) (Feb. 2012). See also

Credit Suisse (Seidel); RBC (requesting that the Agencies recognize

``wholesale'' market making as permissible and representing that

``[i]t is irrelevant to an investor whether market liquidity is

provided by a broker-dealer with whom the investor maintains a

customer account, or whether that broker-dealer looks to another

dealer for market liquidity'').

\804\ See Comm. on Capital Markets Regulation.

---------------------------------------------------------------------------

In response to the proposal's question about whether the terms

``client,'' ``customer,'' and ``counterparty'' should be further

defined, a few commenters stated that that the terms should not be

defined in the rule.\805\ Other commenters indicated that further

definition of these terms would be appropriate.\806\ Some of these

commenters suggested that there should be greater limitations on who

can be considered a ``customer'' under the rule.\807\ These commenters

generally indicated that a ``customer'' should be a person or

institution with whom the banking entity has a continuing, or a direct

and substantive, relationship prior to the time of the

transaction.\808\ In the case of a new customer, some of these

commenters suggested requiring a relationship initiated by the

prospective customer with a view to engaging in transactions.\809\ A

few commenters indicated that a party should not be considered a

client, customer, or counterparty if the banking entity: (i) Originates

a financial product and then finds a counterparty to take the other

side of the transaction; \810\ or (ii) engages in transactions driven

by algorithmic trading strategies.\811\ Three commenters requested more

permissive definitions of these terms.\812\ According to one of these

commenters, because these terms are listed in the disjunctive in the

statute, the broadest term--a ``counterparty''--should prevail.\813\

---------------------------------------------------------------------------

\805\ See FTN; ISDA (Feb. 2012); Alfred Brock.

\806\ See Japanese Bankers Ass'n.; Credit Suisse (Seidel);

Occupy; AFR et al. (Feb. 2012); Public Citizen.

\807\ See AFR et al. (Feb. 2012); Occupy; Public Citizen. One of

these commenters also requested that the Agencies remove the terms

``client'' and ``counterparty'' from the proposed near term demand

requirement. See Occupy.

\808\ See AFR et al. (Feb. 2012); Occupy; Public Citizen. These

commenters stated that other banking entities should never be

``customers'' under the rule. See id. In addition, one of these

commenters would further prevent a banking entity's employees and

covered funds from being ``customers'' under the rule. See AFR et

al. (Feb. 2012).

\809\ See AFR et al. (Feb. 2012) (providing a similar definition

for the term ``client'' as well); Public Citizen.

\810\ See AFR et al. (Feb. 2012); Public Citizen. See also Sens.

Merkley & Levin (Feb. 2012) (stating that a banking entity's

activities that involve attempting to sell clients financial

instruments that it originated, rather than facilitating a secondary

market for client trades in previously existing financial products,

should be analyzed under the underwriting exemption, not the market-

making exemption; in addition, compiling inventory of financial

instruments that the bank originated should be viewed as proprietary

trading).

\811\ See AFR et al. (Feb. 2012).

\812\ See Credit Suisse (Seidel) (stating that ``customer''

should be explicitly defined to include any counterparty to whom a

banking entity is providing liquidity); ISDA (Feb. 2012)

(recommending that, if the Agencies decide to define these terms, a

``counterparty'' should be defined as the entity on the other side

of a transaction, and the terms ``client'' and ``customer'' should

not be interpreted to require a relationship beyond the isolated

provision of a transaction); Japanese Bankers Ass'n. (requesting

that it be clearly noted that interbank participants can be

customers for interbank market makers).

\813\ See ISDA (Feb. 2012). This commenter's primary position

was that further definitions are not required and could create

additional and unnecessary complexity. See id.

---------------------------------------------------------------------------

v. Interdealer Trading and Trading for Price Discovery or To Test

Market Depth

With respect to interdealer trading, many commenters expressed

concern that the proposed rule could be interpreted to restrict a

market maker's ability to engage in interdealer trading.\814\ As a

general matter, commenters attributed these concerns to statements in

proposed Appendix B \815\ or to the Customer-Facing Trade Ratio metric

in proposed Appendix A.\816\ A number of commenters requested that the

rule be modified to clearly recognize interdealer trading as a

component of permitted market making-related activity \817\ and

suggested ways in which this could be accomplished (e.g., through a

definition of ``customer'' or ``counterparty'').\818\

---------------------------------------------------------------------------

\814\ See, e.g., JPMC; Morgan Stanley; Goldman (Prop. Trading);

Chamber (Feb. 2012); MetLife; Credit Suisse (Seidel); BoA; ACLI

(Feb. 2012); RBC; AFR et al. (Feb. 2012); ISDA (Feb. 2012); Oliver

Wyman (Dec. 2011); Oliver Wyman (Feb. 2012). A few commenters noted

that the proposed rule would permit a certain amount of interdealer

trading. See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012) (citing

statements in the proposal providing that a market maker's

``customers'' vary depending on the asset class and market in which

intermediation services are provided and interpreting such

statements as allowing interdealer market making where brokers or

other dealers act as ``customers'' within the proposed construct);

Goldman (Prop. Trading) (stating that interdealer trading related to

hedging or exiting a customer position would be permitted, but

expressing concern that requiring each banking entity to justify

each of its interdealer trades as being related to one of its own

customers would be burdensome and would reduce the effectiveness of

the interdealer market). Commenters' concerns regarding interdealer

trading are addressed in Part VI.A.3.c.2.c.i., infra.

\815\ See infra Part VI.A.3.c.8.

\816\ See, e.g., JPMC; SIFMA et al. (Prop. Trading) (Feb. 2012);

Oliver Wyman (Feb. 2012) (recognizing that the proposed rule did not

include specific limits on interdealer trading, but expressing

concern that explicit or implicit limits could be established by

supervisors during or after the conformance period).

\817\ See MetLife; SIFMA et al. (Prop. Trading) (Feb. 2012);

RBC; Credit Suisse (Seidel); JPMC; BoA; ACLI (Feb. 2012); AFR et al.

(Feb. 2012); ISDA (Feb. 2012); Goldman (Prop. Trading); Oliver Wyman

(Feb. 2012).

\818\ See RBC (suggesting that explicitly incorporating

liquidity provision to other brokers and dealers in the market-

making exemption would be consistent with the statute's reference to

meeting the needs of ``counterparties,'' in addition to the needs of

clients and customers); AFR et al. (Feb. 2012) (recognizing that the

ability to manage inventory through interdealer transactions should

be accommodated in the rule, but recommending that this activity be

conditioned on a market maker having an appropriate level of

inventory after an interdealer transaction); Goldman (Prop. Trading)

(representing that the Agencies could evaluate and monitor the

amount of interdealer trading that is consistent with a particular

trading unit's market making-related or hedging activity through the

customer-facing activity category of metrics); Oliver Wyman (Feb.

2012) (recommending removal or modification of any metrics or

principles that would indicate that interdealer trading is not

permitted).

---------------------------------------------------------------------------

Commenters emphasized that interdealer trading provides certain

market benefits, including increased market liquidity; \819\ more

efficient matching of customer order flow; \820\ greater hedging

options to reduce risks; \821\ enhanced ability to accumulate inventory

for current or near term customer demand, work down concentrated

positions arising from a customer trade, or otherwise exit a position

acquired from a customer; \822\ and general price discovery among

dealers.\823\ Regarding the impact of interdealer trading on a market

maker's ability to intermediate customer needs, one commenter studied

the potential impact of interdealer trading limits--in combination with

inventory limits--on trading in the U.S. corporate bond market.

According to this commenter, if interdealer trading had been prohibited

[[Page 5874]]

and a market maker's inventory had been limited to the average daily

volume of the market as a whole, 69 percent of customer trades would

have been prevented.\824\ Some commenters stated that a banking entity

would be less able or willing to provide market-making services to

customers if it could not engage in interdealer trading.\825\

---------------------------------------------------------------------------

\819\ See Prof. Duffie; MetLife; ACLI (Feb. 2012); BDA (Feb.

2012).

\820\ See Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012);

MetLife; ACLI (Feb. 2012). See also Thakor Study (stating that, when

a market maker provides immediacy to a customer, it relies on being

able to unwind its positions at opportune times by trading with

other market makers, who may have knowledge about impending orders

from their own customers that may induce them to trade with the

market maker).

\821\ See MetLife; ACLI (Feb. 2012); Goldman (Prop. Trading);

Morgan Stanley; Oliver Wyman (Dec. 2011); Oliver Wyman (Feb. 2012).

\822\ See Goldman (Prop. Trading); Chamber (Feb. 2012). See also

Prof. Duffie (stating that a market maker acquiring a position from

a customer may wish to rebalance its inventory relatively quickly

through the interdealer network, which is often more efficient than

requesting immediacy from another customer or waiting for another

customer who wants to take the opposite side of the trade).

\823\ See Chamber (Feb. 2012); Goldman (Prop. Trading).

\824\ See Oliver Wyman (Feb. 2012) (basing its finding on data

from 2009). This commenter also represented that the natural level

of interdealer volume in the U.S. corporate bond market made up 16

percent of total trading volume in 2010. See id.

\825\ See Goldman (Prop. Trading); Morgan Stanley. See also BDA

(Feb. 2012) (stating that if dealers in the fixed-income market are

not able to trade with other dealers to ``cooperate with each other

to provide adequate liquidity to the market as a whole,'' an

essential source of liquidity will be eliminated from the market and

existing values of fixed income securities will decline and become

volatile, harming both investors who currently hold such positions

and issuers, who will experience increased interest costs).

---------------------------------------------------------------------------

As noted above, a few commenters stated that market makers may use

interdealer trading for price discovery purposes.\826\ Some commenters

separately discussed the importance of this activity and requested

that, when conducted in connection with market-making activity, trading

for price discovery be considered permitted market making-related

activity under the rule.\827\ Commenters indicated that price

discovery-related trading results in certain market benefits, including

enhancing the accuracy of prices for customers,\828\ increasing price

efficiency, preventing market instability,\829\ improving market

liquidity, and reducing overall costs for market participants.\830\ As

a converse, one of these commenters stated that restrictions on such

activity could result in market makers setting their prices too high,

exposing them to significant risk and causing a reduction of market-

making activity or widening of spreads to offset the risk.\831\ One

commenter further requested that trading to test market depth likewise

be permitted under the market-making exemption.\832\ This commenter

represented that the Agencies would be able to evaluate the extent to

which trading for price discovery and market depth are consistent with

market making-related activities for a particular market through a

combination of customer-facing activity metrics, including the

Inventory Risk Turnover metric, and knowledge of a banking entity's

trading business developed by regulators as part of the supervisory

process.\833\

---------------------------------------------------------------------------

\826\ See Chamber (Feb. 2012); Goldman (Prop. Trading).

\827\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Chamber

(Feb. 2012); Goldman (Prop. Trading). One commenter provided the

following example of such activity: if Security A and Security B

have some price correlation but neither trades regularly, then a

trader may execute a trade in Security A for price discovery

purposes, using the price of Security A to make an informed bid-ask

market to a customer in Security B. See SIFMA et al. (Prop. Trading)

(Feb. 2012).

\828\ See Goldman (Prop. Trading); Chamber (Feb. 2012) (stating

that this type of trading is necessary in more illiquid markets);

SIFMA et al. (Prop. Trading) (Feb. 2012).

\829\ See Goldman (Prop. Trading).

\830\ See Chamber (Feb. 2012).

\831\ See id.

\832\ See Goldman (Prop. Trading). This commenter represented

that market makers often make trades with other dealers to test the

depth of the markets at particular price points and to understand

where supply and demand exist (although such trading is not

conducted exclusively with other dealers). This commenter stated

that testing the depth of the market is necessary to provide

accurate prices to customers, particularly when customers seeks to

enter trades in amounts larger than the amounts offered by dealers

who have sent indications to inter-dealer brokers. See id.

\833\ See id.

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vi. Inventory Management

Several commenters requested that the rule provide banking entities

with greater discretion to manage their inventories in connection with

market making-related activity, including acquiring or disposing of

positions in anticipation of customer demand.\834\ Commenters

represented that market makers need to be able to build, manage, and

maintain inventories to facilitate customer demand. These commenters

further stated that the rule needs to provide some degree of

flexibility for inventory management activities, as inventory needs may

differ based on market conditions or the characteristics of a

particular instrument.\835\ A few commenters cited legislative history

in support of allowing banking entities to hold and manage inventory in

connection with market making-related activities.\836\ Several

commenters noted benefits that are associated with a market maker's

ability to appropriately manage its inventory, including being able to

meet reasonably anticipated future client, customer, or counterparty

demand; \837\ accommodating customer transactions more quickly and at

favorable prices; reducing near term price volatility (in the case of

selling a customer block position); \838\ helping maintain an orderly

market and provide the best price to customers (in the case of

accumulating long or short positions in anticipation of a large

customer sale or purchase); \839\ ensuring that markets continue to

have sufficient liquidity; \840\ fostering a two-way market; and

establishing a market-making presence.\841\ Some commenters noted that

market makers may need to accumulate inventory to meet customer demand

for certain products or under certain trading scenarios, such as to

create units of structured products (e.g., ETFs and asset-backed

securities) \842\ and in anticipation of an index rebalance.\843\

---------------------------------------------------------------------------

\834\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Credit Suisse (Seidel); Goldman (Prop. Trading); MFA; RBC. Inventory

management is addressed in Part VI.A.3.c.2.c., infra.

\835\ See, e.g., MFA (stating that it is critical for banking

entities to continue to be able to maintain sufficient levels of

inventory, which is dynamic in nature and requires some degree of

flexibility in application); RBC (requesting that the Agencies

explicitly acknowledge that, depending on market conditions or the

characteristics of a particular security, it may be appropriate or

necessary for a firm to maintain inventories over extended periods

of time in the course of market making-related activities).

\836\ See, e.g., RBC; NYSE Euronext; Fidelity. These commenters

cited a colloquy in the Congressional Record between Senator Bayh

and Senator Dodd, in which Senator Bayh stated: ``With respect to

[section 13 of the BHC Act], the conference report states that

banking entities are not prohibited from purchasing and disposing of

securities and other instruments in connection with underwriting or

market-making activities, provided that activity does not exceed the

reasonably expected near-term demands of clients, customers, or

counterparties. I want to clarify this language would allow banks to

maintain an appropriate dealer inventory and residual risk

positions, which are essential parts of the market-making function.

Without that flexibility, market makers would not be able to provide

liquidity to markets.'' 156 Cong. Rec. S5906 (daily ed. July 15,

2010) (statement of Sen. Bayh).

\837\ See, e.g., RBC.

\838\ See Goldman (Prop. Trading).

\839\ See id.

\840\ See MFA.

\841\ See RBC.

\842\ See Goldman (Prop. Trading); BoA.

\843\ See Oliver Wyman (Feb. 2012). As this commenter explained,

some mutual funds and ETFs track major equity indices and, when the

composition of an index changes (e.g., due to the addition or

removal of a security or to rising or falling values of listed

shares), an announcement is made and all funds tracking the index

need to rebalance their portfolios. According to the commenter,

banking entities may need to step in to provide liquidity for

rebalances of less liquid indices because trades executed on the

open market would substantially affect share prices. The commenter

estimated that if market makers are not able to provide direct

liquidity for rebalance trades, investors tracking these indices

could potentially pay incremental costs of $600 million to $1.8

billion every year. This commenter identified the proposed inventory

metrics in Appendix A as potentially limiting a banking entity's

willingness or ability to facilitate index rebalance trades. See id.

Two other commenters also discussed the index rebalancing scenario.

See Prof. Duffie; Thakor Study. Index rebalancing is addressed in

note 931, infra.

---------------------------------------------------------------------------

Commenters also expressed views with respect to how much discretion

a banking entity should have to manage its inventory under the

exemption and how to best monitor inventory levels. For example, one

commenter recommended that the rule allow market makers to build

inventory in products where they believe customer

[[Page 5875]]

demand will exist, regardless of whether the inventory can be tied to a

particular customer in the near term or to historical trends in

customer demand.\844\ A few commenters suggested that the Agencies

provide banking entities with greater discretion to accumulate

inventory, but discourage market makers from holding inventory for long

periods of time by imposing increasingly higher capital requirements on

aged inventory.\845\ One commenter represented that a trading unit's

inventory management practices could be monitored with the Inventory

Risk Turnover metric, in conjunction with other metrics.\846\

---------------------------------------------------------------------------

\844\ See Credit Suisse (Seidel).

\845\ See CalPERS; Vanguard. These commenters represented that

placing increasing capital requirements on aged inventory would ease

the rule's impact on investor liquidity, allow banking entities to

internalize the cost of continuing to hold a position at the expense

of its ability to take on new positions, and potentially decrease

the possibility of a firm realizing a loss on a position by

decreasing the time such position is held. See id. One commenter

noted that some banking entities already use this approach to manage

risk on their market-making desks. See Vanguard. See also Capital

Group (suggesting that one way to implement the statutory exemption

would be to charge a trader or a trading desk for positions held on

its balance sheet beyond set time periods and to increase the charge

at set intervals). These comments are addressed in note 923, infra.

\846\ See Goldman (Prop. Trading) (representing that the

Inventory Risk Turnover metric will allow the Agencies to evaluate

the length of time that a trading unit tends to hold risk positions

in inventory and whether that holding time is consistent with market

making-related activities in the relevant market).

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vii. Acting as an Authorized Participant or Market Maker in Exchange-

Traded Funds

With respect to ETF trading, commenters generally requested

clarification that a banking entity can serve as an authorized

participant (``AP'') to an ETF issuer or can engage in ETF market

making under the proposed exemption.\847\ According to commenters, APs

may engage in the following types of activities with respect to ETFs:

(i) Trading directly with the ETF issuer to create or redeem ETF

shares, which involves trading in ETF shares and the underlying

components; \848\ (ii) trading to maintain price alignment between the

ETF shares and the underlying components; \849\ (iii) traditional

market-making activity; \850\ (iv) ``seeding'' a new ETF by entering

into several initial creation transactions with an ETF issuer and

holding the ETF shares, possibly for an extended period of time, until

the ETF establishes regular trading and liquidity in the secondary

markets; \851\ (v) ``create to lend'' transactions, where an AP enters

a creation transaction with the ETF issuer and lends the ETF shares to

an investor; \852\ and (vi) hedging.\853\ A few commenters noted that

an AP may not engage in traditional market-making activity in the

relevant ETF and expressed concern that the proposed rule may limit a

banking entity's ability to act in an AP capacity.\854\ One commenter

estimated that APs that are banking entities make up between 20 percent

to 100 percent of creation and redemption activity for individual ETFs,

with an average of approximately 35 percent of creation and redemption

activity across all ETFs attributed to banking entities. This commenter

expressed the view that, if the rule limits banking entities' ability

to serve as APs, then individual investors' investments in ETFs will

become more expensive due to higher premiums and discounts versus the

ETF's NAV.\855\

---------------------------------------------------------------------------

\847\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); BoA; ICI

(stating that an AP may trade with the ETF issuer in different

capacities--in connection with traditional market-making activity,

on behalf of customers, or for the AP's own account); ICI Global

(discussing non-U.S. ETFs specifically); Vanguard; SSgA (Feb. 2012).

One commenter represented that an AP's transactions in ETFs do not

create risks associated with proprietary trading because, when an AP

trades with an ETF issuer for its own account, the AP typically

enters into an offsetting transaction in the underlying portfolio of

securities, which cancels out investment risk and limits the AP's

exposure to the difference between the market price for ETF shares

and the ETF's net asset value (``NAV''). See Vanguard.

With respect to market-making activity in an ETF, several

commenters noted that market makers play an important role in

maintaining price alignment by engaging in arbitrage transactions

between the ETF shares and the shares of the underlying components.

See, e.g., JPMC; Goldman (Prop. Trading) (making similar statement

with respect to ADRs as well); SSgA (Feb. 2012); SIFMA et al. (Prop.

Trading) (Feb. 2012); Credit Suisse (Seidel); RBC. AP and market

maker activity in ETFs are addressed in Part VI.A.3.c.2.c.i., infra.

\848\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA; ICI

(Feb. 2012) ICI Global; Vanguard; SSgA (Feb. 2012).

\849\ See JPMC; Goldman (Prop. Trading); SIFMA et al. (Prop.

Trading) (Feb. 2012); SSgA (Feb. 2012); ICI (Feb. 2012) ICI Global.

\850\ See ICI Global; ICI (Feb. 2012) SIFMA et al. (Prop.

Trading) (Feb. 2012); BoA.

\851\ See BoA; ICI (Feb. 2012); ICI Global.

\852\ See BoA (stating that lending the ETF shares to an

investor gives the investor a more efficient way to hedge its

exposure to assets correlated with those underlying the ETF).

\853\ See ICI Global; ICI (Feb. 2012).

\854\ See, e.g., Vanguard (noting that APs may not engage in

market-making activity in the ETF and expressing concern that if AP

activities are not separately permitted, banking entities may exit

or not enter the ETF market); SSgA (Feb. 2012) (stating that APs are

under no obligation to make markets in ETF shares and requiring such

an obligation would discourage banking entities from acting as APs);

ICI (Feb. 2012).

\855\ See SSgA (Feb. 2012). This commenter further stated that

as of 2011, an estimated 3.5 million--or 3 percent--of U.S.

households owned ETFs and, as of September 2011, ETFs represented

assets of approximately $951 billion. See id.

---------------------------------------------------------------------------

A number of commenters stated that certain requirements of the

proposed exemption may limit a banking entity's ability to serve as AP

to an ETF, including the proposed near term customer demand

requirement,\856\ the proposed source of revenue requirement,\857\ and

language in the proposal regarding arbitrage trading.\858\ With respect

to the proposed near term customer demand requirement, a few commenters

noted that this requirement could prevent an AP from building inventory

to assemble creation units.\859\ Two other commenters expressed the

view that the ETF issuer would be the banking entity's ``counterparty''

when the banking entity trades directly with the ETF issuer, so this

trading and inventory accumulation would meet the terms of the proposed

requirement.\860\ To permit banking entities to act as APs, two

commenters suggested that trading in the capacity of an AP should be

deemed permitted market making-related activity, regardless of whether

the AP is acting as a traditional market maker.\861\

---------------------------------------------------------------------------

\856\ See BoA; Vanguard (stating that this determination may be

particularly difficult in the case of a new ETF).

\857\ See BoA. This commenter noted that the proposed source of

revenue requirement could be interpreted to prevent a banking entity

acting as AP from entering into creation and redemption

transactions, ``seeding'' an ETF, engaging in ``create to lend''

transactions, and performing secondary market making in an ETF

because all of these activities require an AP to build an

inventory--either in ETF shares or the underlying components--which

often result in revenue attributable to price movements. See id.

\858\ Commenters noted that this language would restrict an AP

from engaging in price arbitrage to maintain efficient markets in

ETFs. See Vanguard; RBC; Goldman (Prop. Trading); JPMC; SIFMA et al.

(Prop. Trading) (Feb. 2012). See supra Part VI.A.3.c.2.a.

(discussing the proposal's proposed interpretation regarding

arbitrage trading).

\859\ See BoA; Vanguard (stating that this determination may be

particularly difficult in the case of a new ETF).

\860\ See ICI Global; ICI (Feb. 2012).

\861\ See ICI (Feb. 2012) ICI Global. These commenters provided

suggested rule text on this issue and suggested that the Agencies

could require a banking entity's compliance policies and internal

controls to take a comprehensive approach to the entirety of an AP's

trading activity, which would facilitate easy monitoring of the

activity to ensure compliance. See id.

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viii. Arbitrage or Other Activities That Promote Price Transparency and

Liquidity

In response to a question in the proposal,\862\ a number of

commenters

[[Page 5876]]

stated that certain types of arbitrage activity should be permitted

under the market-making exemption.\863\ For example, some commenters

stated that a banking entity's arbitrage activity should be considered

market making to the extent the activity is driven by creating markets

for customers tied to the price differential (e.g., ``box'' strategies,

``calendar spreads,'' merger arbitrage, ``Cash and Carry,'' or basis

trading) \864\ or to the extent that demand is predicated on specific

price relationships between instruments (e.g., ETFs, ADRs) that market

makers must maintain.\865\ Similarly, another commenter suggested that

arbitrage activity that aligns prices should be permitted, such as

index arbitrage, ETF arbitrage, and event arbitrage.\866\ One commenter

noted that many markets, such as futures and options markets, rely on

arbitrage activities of market makers for liquidity purposes and to

maintain convergence with underlying instruments for cash-settled

options, futures, and index-based products.\867\ Commenters stated that

arbitrage trading provides certain market benefits, including enhanced

price transparency,\868\ increased market efficiency,\869\ greater

market liquidity,\870\ and general benefits to customers.\871\ A few

commenters noted that certain types of hedging activity may appear to

have characteristics of arbitrage trading.\872\

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\862\ See Joint Proposal, 76 FR at 68873 (question 91)

(inquiring whether the proposed exemption should be modified to

permit certain arbitrage trading activities engaged in by market

makers that promote liquidity or price transparency but do not

service client, customer, or counterparty demand); CFTC Proposal, 77

FR at 8359.

\863\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); FTN; RBC;

ISDA (Feb. 2012). Arbitrage trading is further discussed in Part

VI.A.3.c.2.c.i., infra.

\864\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\865\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.

\866\ See Credit Suisse (Seidel).

\867\ See RBC.

\868\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\869\ See Credit Suisse (Seidel); RBC.

\870\ See RBC.

\871\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; FTN;

ISDA (Feb. 2012) (stating that arbitrage activities often yield

positions that are ultimately put to use in serving customer demand

and representing that the process of consistently trading makes a

dealer ready and available to serve customers on a competitive

basis).

\872\ See JPMC (stating that firms commonly organize their

market-making activities so that risks delivered to client-facing

desks are aggregated and transferred by means of internal

transactions to a single utility desk (which hedges all of the risks

in the aggregate), and this may optically bear some characteristics

of arbitrage, although the commenter requested that such activity be

recognized as permitted market making-related activity under the

rule); ISDA (Feb. 2012) (stating that in some swaps markets, dealers

hedge through multiple instruments, which can give an impression of

arbitrage in a function that is risk reducing; for example, a dealer

in a broad index equity swap may simultaneously hedge in baskets of

stocks, futures, and ETFs). But see Sens. Merkley & Levin (Feb.

2012) (``When banks use complex hedging techniques or otherwise

engage in trading that is suggestive of arbitrage, regulators should

require them to provide evidence and analysis demonstrating what

risk is being reduced.'').

---------------------------------------------------------------------------

Commenters suggested certain methods for permitting and monitoring

arbitrage trading under the exemption. For example, one commenter

suggested a framework for permitting certain arbitrage within the

market-making exemption, with requirements such as: (i) Common

personnel with market-making activity; (ii) policies that cover the

timing and appropriateness of arbitrage positions; (iii) time limits on

arbitrage positions; and (iv) compensation that does not reward

successful arbitrage, but instead pools any such revenues with market-

making profits and losses.\873\ A few commenters represented that, if

permitted under the rule, the Agencies would be able to monitor

arbitrage activities for patterns of impermissible proprietary trading

through the use of metrics, as well as compliance and examination

tools.\874\

---------------------------------------------------------------------------

\873\ See FTN.

\874\ See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC; Goldman

(Prop. Trading). One of these commenters stated that the customer-

facing activity category of metrics, as well as other metrics, would

be available to evaluate whether the trading unit is engaged in a

directly customer-facing business and the extent to which its

activities are consistent with the market-making exemption. See

Goldman (Prop. Trading).

---------------------------------------------------------------------------

Other commenters stated that the exemption should not permit

certain types of arbitrage. One commenter stated that the rule should

ensure that relative value and complex arbitrage strategies cannot be

conducted.\875\ Another commenter expressed the view that the market-

making exemption should not permit any type of arbitrage transactions.

This commenter stated that, in the event that liquidity or transparency

is inhibited by a lack of arbitrage trading, a market maker should be

able to find a customer who would seek to benefit from it.\876\

---------------------------------------------------------------------------

\875\ See Johnson & Prof. Stiglitz. See also AFR et al. (Feb.

2012) (noting that arbitrage, spread, or carry trades are a classic

type of proprietary trade).

\876\ See Occupy.

---------------------------------------------------------------------------

ix. Primary Dealer Activities

A number of commenters requested that the market-making exemption

permit banking entities to meet their primary dealer obligations in

foreign jurisdictions, particularly if trading in foreign sovereign

debt is not separately exempted in the final rule.\877\ According to

commenters, a banking entity may be obligated to perform the following

activities in its capacity as a primary dealer: undertaking to maintain

an orderly market, preventing or correcting any price

dislocations,\878\ and bidding on each issuance of the relevant

jurisdiction's sovereign debt.\879\ Commenters expressed concern that a

banking entity's trading activity as primary dealer may not comply with

the proposed near term customer demand requirement \880\ or the

proposed source of revenue requirement.\881\ To address the first

issue, one commenter stated that the final rule should clarify that a

banking entity acting as a primary dealer of foreign sovereign debt is

engaged in primary dealer activity in response to the near term demands

of the sovereign, which should be considered a client, customer, or

counterparty of the banking entity.\882\ Another commenter suggested

that the Agencies permit primary dealer activities through commentary

stating that fulfilling primary dealer obligations will not be included

in determinations of whether the market-making exemption applies to a

trading unit.\883\

---------------------------------------------------------------------------

\877\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012)

(stating that permitted activities should include trading necessary

to meet the relevant jurisdiction's primary dealer and other

requirements); JPMC (indicating that the exemption should cover all

of a firm's activities that are necessary or reasonably incidental

to its acting as a primary dealer in a foreign government's debt

securities); Goldman (Prop. Trading); Banco de M[eacute]xico; IIB/

EBF. See infra notes 905 to 906 and accompanying text (addressing

these comments).

\878\ See Goldman (Prop. Trading).

\879\ See Banco de M[eacute]xico.

\880\ See JPMC; Banco de M[eacute]xico. These commenters stated

that a primary dealer is required to assume positions in foreign

sovereign debt even when near term customer demand is unpredictable.

See id.

\881\ See Banco de M[eacute]xico (stating that primary dealers

need to be able to profit from their positions in sovereign debt,

including by holding significant positions in anticipation of future

price movements, so that the primary dealer business is financially

attractive); IIB/EBF (stating that primary dealers may actively seek

to profit from price and interest rate movements based on their debt

holdings, which governments support as providing much-needed

liquidity for securities that are otherwise purchased largely

pursuant to buy-and-hold strategies of institutional investors and

other entities seeking safe returns and liquidity buffers).

\882\ See Goldman (Prop. Trading).

\883\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

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x. New or Bespoke Products or Customized Hedging Contracts

Several commenters indicated that the proposed exemption does not

adequately address market making in new or bespoke products, including

structured, customer-driven transactions, and requested that the rule

be modified to clearly permit such activity.\884\ Many of these

commenters

[[Page 5877]]

emphasized the role such transactions play in helping customers hedge

the unique risks they face.\885\ Commenters stated that, as a result,

limiting a banking entity's ability to conduct such transactions would

subject customers to increased risks and greater transaction

costs.\886\ One commenter suggested that the Agencies explicitly state

that a banking entity's general willingness to engage in bespoke

transactions is sufficient to make it a market maker in unique products

for purposes of the rule.\887\

---------------------------------------------------------------------------

\884\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Credit Suisse (Seidel); JPMC; Goldman (Prop. Trading); SIFMA (Asset

Mgmt.) (Feb. 2012). This issue is addressed in Part

VI.A.3.c.1.c.iii., supra, and Part VI.A.3.c.2.c.iii., infra.

\885\ See Credit Suisse (Seidel); Goldman (Prop. Trading); SIFMA

(Asset Mgmt.) (Feb. 2012).

\886\ See Goldman (Prop. Trading); SIFMA (Asset Mgmt.) (Feb.

2012).

\887\ See SIFMA (Asset Mgmt.) (Feb. 2012).

---------------------------------------------------------------------------

Other commenters stated that banking entities should be limited in

their ability to rely on the market-making exemption to conduct

transactions in bespoke or customized derivatives.\888\ For example,

one commenter suggested that a banking entity be required to

disaggregate such derivatives into liquid risk elements and illiquid

risk elements, with liquid risk elements qualifying for the market-

making exemption and illiquid risk elements having to be conducted on a

riskless principal basis under Sec. 75.6(b)(1)(ii) of the proposed

rule. According to this commenter, such an approach would not impact

the end user customer.\889\ Another commenter stated that a banking

entity making a market in bespoke instruments should be required both

to hold itself out in accordance with Sec. 75.4(b)(2)(ii) of the

proposed rule and to demonstrate the purchase and the sale of such an

instrument.\890\

---------------------------------------------------------------------------

\888\ See AFR et al. (Feb. 2012); Public Citizen.

\889\ See AFR et al. (Feb. 2012).

\890\ See Public Citizen.

---------------------------------------------------------------------------

c. Final Near Term Customer Demand Requirement

Consistent with the statute, Sec. 75.4(b)(2)(ii) of the final

rule's market-making exemption requires that the amount, types, and

risks of the financial instruments in the trading desk's market-maker

inventory be designed not to exceed, on an ongoing basis, the

reasonably expected near term demands of clients, customers, or

counterparties, based on certain market factors and analysis.\891\ As

discussed above in Part VI.A.3.c.1.c.ii., the trading desk's market-

maker inventory consists of positions in financial instruments in which

the trading desk stands ready to purchase and sell consistent with the

final rule.\892\ The final rule requires the financial instruments to

be identified in the trading desk's compliance program. Thus, this

requirement focuses on a trading desk's positions in financial

instruments for which it acts as market maker. These positions of a

trading desk are more directly related to the demands of customers than

positions in financial instruments used for risk management purposes,

but in which the trading desk does not make a market. As noted above, a

position or exposure that is included in a trading desk's market-maker

inventory will remain in its market-maker inventory for as long as the

position or exposure is managed by the trading desk. As a result, the

trading desk must continue to account for that position or exposure,

together with other positions and exposures in its market-maker

inventory, in determining whether the amount, types, and risks of its

market-maker inventory are designed not to exceed, on an ongoing basis,

the reasonably expected near term demands of customers.

---------------------------------------------------------------------------

\891\ The final rule includes certain refinements to the

proposed standard, which would have required that the market making-

related activities of the trading desk or other organizational unit

that conducts the purchase or sale are, with respect to the

financial instrument, designed not to exceed the reasonably expected

near term demands of clients, customers, or counterparties. See

proposed rule Sec. 75.4(b)(2)(iii).

\892\ See supra Part VI.A.3.c.1.c.ii.; final rule Sec.

75.4(b)(5).

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While the near term customer demand requirement directly applies

only to the trading desk's market-maker inventory, this does not mean a

trading desk may establish other positions, outside its market-maker

inventory, that exceed what is needed to manage the risks of the

trading desk's market making-related activities and inventory. Instead,

a trading desk must have limits on its market-maker inventory, the

products, instruments, and exposures the trading desk may use for risk

management purposes, and its aggregate financial exposure that are

based on the factors set forth in the near term customer demand

requirement, as well as other relevant considerations regarding the

nature and amount of the trading desk's market making-related

activities. A banking entity must establish, implement, maintain, and

enforce a limit structure, as well as other compliance program elements

(e.g., those specifying the instruments a trading desk trades as a

market maker or may use for risk management purposes and providing for

specific risk management procedures), for each trading desk that are

designed to prevent the trading desk from engaging in trading activity

that is unrelated to making a market in a particular type of financial

instrument or managing the risks associated with making a market in

that type of financial instrument.\893\

---------------------------------------------------------------------------

\893\ See infra Part VI.A.3.c.3. (discussing the compliance

program requirements); final rule Sec. 75.4(b)(2)(iii).

---------------------------------------------------------------------------

To clarify the application of this standard in response to

comments,\894\ the final rule provides two factors for assessing

whether the amount, types, and risks of the financial instruments in

the trading desk's market-maker inventory are designed not to exceed,

on an ongoing basis, the reasonably expected near term demands of

clients, customers, or counterparties. Specifically, the following must

be considered under the revised standard: (i) The liquidity, maturity,

and depth of the market for the relevant type of financial

instrument(s),\895\ and (ii) demonstrable analysis of historical

customer demand, current inventory of financial instruments, and market

and other factors regarding the amount, types, and risks of or

associated with positions in financial instruments in which the trading

desk makes a market, including through block trades. Under the final

rule, a banking entity must account for these considerations when

establishing risk and inventory limits for each trading desk.\896\

---------------------------------------------------------------------------

\894\ See supra Part VI.A.3.c.2.b.i.

\895\ This language has been added to the final rule to respond

to commenters' concerns that the proposed near term demand

requirement would be unworkable in less liquid markets or would

otherwise restrict a market maker's ability to hold and manage its

inventory in less liquid markets. See supra Part VI.A.3.c.2.b.ii. In

addition, this provision is substantially similar to one commenter's

suggested approach of adding the phrase ``based on the

characteristics of the relevant market and asset class'' to the

proposed requirement, but the Agencies have added more specificity

about the relevant characteristics that should be taken into

consideration. See Morgan Stanley.

\896\ See infra Part VI.A.3.c.3.

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For purposes of this provision, ``demonstrable analysis'' means

that the analysis for determining the amount, types, and risks of

financial instruments a trading desk may manage in its market-maker

inventory, in accordance with the near term demand requirement, must be

based on factors that can be demonstrated in a way that makes the

analysis reviewable. This may include, among other things, the normal

trading records of the trading desk and market information that is

readily available and retrievable. If the analysis cannot be supported

by the banking entity's books and records and available market data, on

their own, then the other factors utilized must be identified and

documented and the analysis of those factors together with the facts

gathered from the trading and market records must be identified in a

way that makes it possible to test the analysis.

[[Page 5878]]

Importantly, a determination of whether a trading desk's market-

maker inventory is appropriate under this requirement will take into

account reasonably expected near term customer demand, including

historical levels of customer demand, expectations based on market

factors, and current demand. For example, at any particular time, a

trading desk may acquire a position in a financial instrument in

response to a customer's request to sell the financial instrument or in

response to reasonably expected customer buying interest for such

instrument in the near term.\897\ In addition, as discussed below, this

requirement is not intended to impede a trading desk's ability to

engage in certain market making-related activities that are consistent

with and needed to facilitate permissible trading with its clients,

customers, or counterparties, such as inventory management and

interdealer trading. These activities must, however, be consistent with

the analysis conducted under the final rule and the trading desk's

limits discussed below.\898\ Moreover, as explained below, the banking

entity must also have in place escalation procedures to address,

analyze, and document trades made in response to customer requests that

would exceed one of a trading desk's limits.

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\897\ As discussed further below, acquiring a position in a

financial instrument in response to reasonably expected customer

demand would not include creating a structured product for which

there is no current customer demand and, instead, soliciting

customer demand during or after its creation. See infra note 938 and

accompanying text; Sens. Merkley & Levin (Feb. 2012).

\898\ The formation of structured finance products and

securitizations is discussed in detail in Part VI.B.2.b. of this

SUPPLEMENTARY INFORMATION.

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The near term demand requirement is an ongoing requirement that

applies to the amount, types, and risks of the financial instruments in

the trading desk's market-maker inventory. For instance, a trading desk

may acquire exposures as a result of entering into market-making

transactions with customers that are within the desk's market-marker

inventory and financial exposure limits. Even if the trading desk is

appropriately managing the risks of its market-maker inventory, its

market-maker inventory still must be consistent with the analysis of

the reasonably expected near term demands of clients, customers, and

counterparties and the liquidity, maturity and depth of the market for

the relevant instruments in the inventory. Moreover, the trading desk

must take action to ensure that its financial exposure does not exceed

its financial exposure limits.\899\ A trading desk may not maintain an

exposure in its market-maker inventory, irrespective of customer

demand, simply because the exposure is hedged and the resulting

financial exposure is below the desk's financial exposure limit. In

addition, the amount, types, and risks of financial instruments in a

trading desk's market-maker inventory would not be consistent with

permitted market-making activities if, for example, the trading desk

has a pattern or practice of retaining exposures in its market-maker

inventory, while refusing to engage in customer transactions when there

is customer demand for those exposures at commercially reasonable

prices.

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\899\ See final rule Sec. 75.4(b)(2)(iii)(B), (C).

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The following is an example of the interplay between a trading

desk's market-maker inventory and financial exposure. An airline

company customer may seek to hedge its long-term exposure to price

fluctuations in jet fuel by asking a banking entity to create a

structured ten-year, $1 billion jet fuel swap for which there is no

liquid market. A trading desk that makes a market in energy swaps may

service its customer's needs by executing a custom jet fuel swap with

the customer and holding the swap in its market-maker inventory, if the

resulting transaction does not cause the trading desk to exceed its

market-maker inventory limit on the applicable class of instrument, or

the trading desk has received approval to increase the limit in

accordance with the authorization and escalation procedures under

paragraph (b)(2)(iii)(E). In keeping with the market-making exemption

as provided in the final rule, the trading desk would be required to

hedge the risk from this swap, either individually or as part of a set

of aggregated positions, if the trade would result in a financial

exposure that exceeds the desk's financial exposure limits. The trading

desk may hedge the risk of the swap, for example, by entering into one

or more futures or swap positions that are identified as permissible

hedging products, instruments, or exposures in the trading desk's

compliance program and that analysis, including correlation analysis as

appropriate, indicates would demonstrably reduce or otherwise

significantly mitigate risks associated with the financial exposure

from its market-making activities. Alternatively, if the trading desk

also acts as a market maker in crude oil futures, then the desk's

exposures arising from its market-making activities may naturally hedge

the jet fuel swap (i.e., it may reduce its financial exposure levels

resulting from such instruments).\900\ The trading desk must continue

to appropriately manage risks of its financial exposure over time in

accordance with its financial exposure limits.

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\900\ This natural hedge with futures would introduce basis risk

which, like other risks of the trading desk, must be managed within

the desk's limits.

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As discussed above, several commenters expressed concern that the

near-term customer demand requirement is too restrictive and that it

could impede a market maker's ability to build or retain inventory,

particularly in less liquid markets where demand is intermittent.\901\

Because customer demand in illiquid markets can be difficult to predict

with precision, market-maker inventory may not closely track customer

order flow. The Agencies acknowledge that market makers will face costs

associated with demonstrating that market-maker inventory is designed

not to exceed, on an ongoing basis, the reasonably expected near term

demands of customers, as required by the statute and the final rule

because this is an analysis that banking entities may not currently

undertake. However, the final rule includes certain modifications to

the proposed rule that are intended to reduce the negative impacts

cited by commenters, such as limitations on inventory management

activity and potential restrictions on market making in less liquid

instruments, which the Agencies believe should reduce the perceived

burdens of the proposed near term demand requirement. For example, the

final rule recognizes that liquidity, maturity, and depth of the market

vary across asset classes. The Agencies expect that the express

recognition of these differences in the rule should avoid unduly

impeding a market maker's ability to build or retain inventory. More

specifically, the Agencies recognize the relationship between market-

maker inventory and customer order flow can vary across asset classes

and that an inflexible standard for demonstrating that inventory does

not exceed reasonably expected near term demand could provide an

incentive to stop making markets in illiquid asset classes.

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\901\ See SIFMA (Asset Mgmt.) (Feb. 2012); T. Rowe Price; CIEBA;

ICI (Feb. 2012) RBC.

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i. Definition of ``client,'' ``customer,'' and ``counterparty''

In response to comments requesting further definition of the terms

``client,'' ``customer,'' and ``counterparty'' for purposes of this

standard,\902\ the Agencies have defined these terms in the final rule.

In particular, the final

[[Page 5879]]

rule defines ``client,'' ``customer,'' and ``counterparty'' as, on a

collective or individual basis, ``market participants that make use of

the banking entity's market making-related services by obtaining such

services, responding to quotations, or entering into a continuing

relationship with respect to such services.'' \903\ However, for

purposes of the analysis supporting the market-maker inventory held to

meet the reasonably expected near-term demands of clients, customer and

counterparties, a client, customer, or counterparty of the trading desk

does not include a trading desk or other organizational unit of another

entity if that entity has $50 billion or more in total trading assets

and liabilities, measured in accordance with Sec. 75.20(d)(1),\904\

unless the trading desk documents how and why such trading desk or

other organizational unit should be treated as a customer or the

transactions are conducted anonymously on an exchange or similar

trading facility that permits trading on behalf of a broad range of

market participants.\905\

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\902\ See Japanese Bankers Ass'n.; Credit Suisse (Seidel);

Occupy; AFR et al. (Feb. 2012); Public Citizen.

\903\ Final rule Sec. 75.4(b)(3).

\904\ See final rule Sec. 75.4(b)(3)(i). The Agencies are using

a $50 billion threshold for these purposes in recognition that firms

engaged in substantial trading activity do not typically act as

customers to other market makers, while smaller regional firms may

seek liquidity from larger firms as part of their market making-

related activities.

\905\ See final rule Sec. 75.4(b)(3)(i)(A), (B). In Appendix C

of the proposed rule, a trading unit engaged in market making-

related activities would have been required to describe how it

identifies its customers for purposes of the Customer-Facing Trading

Ratio, if applicable, including documentation explaining when, how,

and why a broker-dealer, swap dealer, security-based swap dealer, or

any other entity engaged in market making-related activities, or any

affiliate thereof, is considered to be a customer of the trading

unit. See Joint Proposal, 76 FR at 68964. While the proposed

approach would not have necessarily prevented any of these entities

from being considered a customer of the trading desk, it would have

required enhanced documentation and justification for treating any

of these entities as a customer. The final rule's exclusion from the

definition of client, customer, and counterparty is similar to the

proposed approach, but is more narrowly focused on firms that have

$50 billion or more trading assets and liabilities because, as noted

above, the Agencies believe firms engaged in such substantial

trading activity are less likely to act as customers to market

makers than smaller regional firms.

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The Agencies believe this definition is generally consistent with

the proposed interpretation of ``customer'' in the proposal. The

proposal generally provided that, for purposes of market making on an

exchange or other organized trading facility, a customer is any person

on behalf of whom a buy or sell order has been submitted. In the

context of the over-the-counter market, a customer was generally

considered to 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 for such services.\906\ The

definition of client, customer, and counterparty in the final rule

recognizes that, in the context of market making in a financial

instrument that is executed on an exchange or other organized trading

facility, a client, customer, or counterparty would be any person whose

buy or sell order executes against the banking entity's quotation

posted on the exchange or other organized trading facility.\907\ Under

these circumstances, the person would be trading with the banking

entity in response to the banking entity's quotations and obtaining the

banking entity's market making-related services. In the context of

market making in a financial instrument in the OTC market, a client,

customer, or counterparty generally would be a person that makes use of

the banking entity's intermediation services, either by requesting such

services (possibly via a request-for-quote on an established trading

facility) or entering into a continuing relationship with the banking

entity with respect to such services. For purposes of determining the

reasonably expected near-term demands of customers, a client, customer,

or counterparty generally would not include a trading desk or other

organizational unit of another entity that has $50 billion or more in

total trading assets except if the trading desk has a documented reason

for treating the trading desk or other organizational unit of such

entity as a customer or the trading desk's transactions are executed

anonymously on an exchange or similar trading facility that permits

trading on behalf of a broad range of market participants. The Agencies

believe that this exclusion balances commenters' suggested alternatives

of either defining as a client, customer, or counterparty anyone who is

on the other side of a market maker's trade \908\ or preventing any

banking entity from being a client, customer, or counterparty.\909\ The

Agencies believe that the first alternative is overly broad and would

not meaningfully distinguish between permitted market making-related

activity and impermissible proprietary trading. For example, the

Agencies are concerned that such an approach would allow a trading desk

to maintain an outsized inventory and to justify such inventory levels

as being tangentially related to expected market-wide demand. On the

other hand, preventing any banking entity from being a client,

customer, or counterparty under the final rule would result in an

overly narrow definition that would significantly impact banking

entities' ability to provide and access market making-related services.

For example, most banks look to market makers to provide liquidity in

connection with their investment portfolios.

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\906\ See Joint Proposal, 76 FR at 68960; CFTC Proposal, 77 FR

at 8439.

\907\ See, e.g., Goldman (Prop. Trading) (explaining generally

how exchange-based market makers operate).

\908\ See ISDA (Feb. 2012). In addition, a number of commenters

suggested that the rule should not limit broker-dealers from being

customers of a market maker. See SIFMA et al. (Prop. Trading) (Feb.

2012); Credit Suisse (Seidel); RBC; Comm. on Capital Markets

Regulation.

\909\ See AFR et al. (Feb. 2012); Occupy; Public Citizen.

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The Agencies further note that, with respect to a banking entity

that acts as a primary dealer (or functional equivalent) for a

sovereign government, the sovereign government and its central bank are

each a client, customer, or counterparty for purposes of the market-

making exemption as well as the underwriting exemption.\910\ The

Agencies believe this interpretation, together with the modifications

in the rule that eliminate the requirement to distinguish between

revenues from spreads and price appreciation and the recognition that

the market-making exemption extends to market making-related activities

appropriately captures the unique relationship between a primary dealer

and the sovereign government. Thus, generally a banking entity may rely

on the market-making exemption for its activities as primary dealer (or

functional equivalent) to the extent those activities are outside of

the underwriting exemption.\911\

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\910\ A primary dealer is a firm that trades a sovereign

government's obligations directly with the sovereign (in many cases,

with the sovereign's central bank) as well as with other customers

through market making. The sovereign government may impose

conditions on a primary dealer or require that it engage in certain

trading in the relevant government obligations (e.g., participate in

auctions for the government obligation or maintain a liquid

secondary market in the government obligations). Further, a

sovereign government may limit the number of primary dealers that

are authorized to trade with the sovereign. A number of countries

use a primary dealer system, including Australia, Brazil, Canada,

China-Hong Kong, France, Germany, Greece, India, Indonesia, Ireland,

Italy, Japan, Mexico, Netherlands, Portugal, South Africa, South

Korea, Spain, Turkey, the U.K., and the U.S. See, e.g., Oliver Wyman

(Feb. 2012). The Agencies note that this standard would similarly

apply to the relationship between a banking entity and a sovereign

that does not have a formal primary dealer system, provided the

sovereign's process functions like a primary dealer framework.

\911\ See Goldman (Prop. Trading). See also supra Part

VI.A.3.c.2.b.ix. (discussing commenters' concerns regarding primary

dealer activity). Each suggestion regarding the treatment of primary

dealer activity has not been incorporated into the rule.

Specifically, the exemption for market making as applied to a

primary dealer does not extend without limitation to primary dealer

activities that are not conducted under the conditions of one of the

exemptions. These interpretations would be inconsistent with

Congressional intent for the statute, to limit permissible market-

making activity through the statute's near term demand requirement

and, thus, does not permit trading without limitation. See SIFMA et

al. (Prop. Trading) (Feb. 2012) (stating that permitted activities

should include trading necessary to meet the relevant jurisdiction's

primary dealer and other requirements); JPMC (indicating that the

exemption should cover all of a firm's activities that are necessary

or reasonably incidental to its acting as a primary dealer in a

foreign government's debt securities); Goldman (Prop. Trading);

Banco de M[eacute]xico; IIB/EBF. Rather, recognizing that market

making by primary dealers is a key function, the limits and other

conditions of the rule are flexible enough to permit necessary

market making-related activities.

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[[Page 5880]]

For exchange-traded funds (``ETFs'') (and related structures),

Authorized Participants (``APs'') are generally the conduit for market

participants seeking to create or redeem shares of the fund (or

equivalent structure).\912\ For example, an AP may buy ETF shares from

market participants who would like to redeem those shares for cash or a

basket of instruments upon which the ETF is based. To provide this

service, the AP may in turn redeem these shares from the ETF itself.

Similarly, an AP may receive cash or financial instruments from a

market participant seeking to purchase ETF shares, in which case the AP

may use that cash or set of financial instruments to create shares from

the ETF. In either case, for the purpose of the market-making

exemption, such market participants as well as the ETF itself would be

considered clients, customers, or counterparties of the AP.\913\ The

inventory of ETF shares or underlying instruments held by the AP can

therefore be evaluated under the criteria of the market-making

exemption, such as how these holdings relate to reasonably expected

near term customer demand.\914\ These criteria can be similarly applied

to other activities of the AP, such as building inventory to ``seed'' a

new ETF or engaging in ETF-loan related transactions.\915\ The Agencies

recognize that banking entities currently conduct a substantial amount

of AP creation and redemption activity in the ETF market and, thus, if

the rule were to prevent or restrict a banking entity from acting as an

AP for an ETF, then the rule would impact the functioning of the ETF

market.\916\

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\912\ ETF sponsors enter into relationships with one or more

financial institutions that become APs for the ETF. Only APs are

permitted to purchase and redeem shares directly from the ETF, and

they can do so only in large aggregations or blocks that are

commonly called ``creation units.'' In response to a question in the

proposal, a number of commenters expressed concern that the proposed

market-making exemption may not permit certain AP and market maker

activities in ETFs and requested clarification that these activities

would be permitted under the market-making exemption. See Joint

Proposal, 76 FR at 68873 (question 91) (``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?''); CFTC Proposal, 77 FR at

8359 (question 91); supra Part VI.A.3.c.2.b.vii. (discussing

comments on this issue).

\913\ This is consistent with two commenters' request that an

ETF issuer be considered a ``counterparty'' of the banking entity

when it trades directly with the ETF issuer as an AP. See ICI

Global; ICI (Feb. 2012). Further, this approach is intended to

address commenters' concerns that the near term demand requirement

may limit a banking entity's ability to act as AP for an ETF. See

BoA; Vanguard. The Agencies believe that one commenter's concern

about the impact of the proposed source of revenue requirement on AP

activity should be addressed by the replacement of this proposed

requirement with a metric-based focus on when a trading desk

generates revenue from its trading activity. See BoA; infra Part

VI.A.3.c.7.c. (discussing the new approach to assessing a trading

desk's pattern of profit and loss).

\914\ This does not imply that the AP must perfectly predict

future customer demand, but rather that there is a demonstrable,

statistical, or historical basis for the size of the inventory held,

as more fully discussed below. Consider, for example, a fixed-income

ETF with $500 million in assets. If, on a typical day, an AP

generates requests for $10 to $20 million of creations or

redemptions, then an inventory of $10 to $20 million in bonds upon

which the ETF is based (or some small multiple thereof) could be

construed as consistent with reasonably expected near term customer

demand. On the other hand, if under the same circumstances an AP

holds $1 billion of these bonds solely in its capacity as an AP for

this ETF, it would be more difficult to justify this as needed for

reasonably expected near term customer demand and may be indicative

of an AP engaging in prohibited proprietary trading.

\915\ In ETF loan transactions (also referred to as ``create-to-

lend'' transactions), an AP borrows the underlying instruments that

form the creation basket of an ETF, submits the borrowed instruments

to the ETF agent in exchange for a creation unit of ETF shares, and

lends the resulting ETF shares to a customer that wants to borrow

the ETF. At the end of the ETF loan, the borrower returns the ETF

shares to the AP, and the AP redeems the ETF shares with the ETF

agent in exchange for the underlying instruments that form the

creation basket. The AP may return the underlying instruments to the

parties from whom it borrowed them or may use them for another loan,

as long as the AP is not obligated to return them at that time. For

the term of the ETF loan transaction, the AP hedges against market

risk arising from any rebalancing of the ETF, which would change the

amount or type of underlying instruments the AP would receive in

exchange for the ETF compared to the underlying instruments the AP

borrowed and submitted to the ETF agent to create the ETF shares.

See David J. Abner, ``The ETF Handbook,'' Ch. 12 (2010); Jean M.

McLoughlin, Davis Polk & Wardwell LLP, to Division of Corporation

Finance, U.S. Securities and Exchange Commission, dated Jan. 23,

2013, available at http://www.sec.gov/divisions/corpfin/cf-noaction/2013/davis-polk-wardwell-llp-012813-16a.pdf.

\916\ See SSgA (Feb. 2012).

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Some firms, whether or not an AP in a given ETF, may also actively

engage in buying and selling shares of an ETF and its underlying

instruments in the market to maintain price continuity between the ETF

and its underlying instruments, which are exchangeable for one another.

Sometimes these firms will register as market makers on an exchange for

a given ETF, but other times they may not register as market maker.

Regardless of whether or not the firm is registered as a market maker

on any given exchange, this activity not only provides liquidity for

ETFs, but also, and very importantly, helps keep the market price of an

ETF in line with the NAV of the fund. The market-making exemption can

be used to evaluate trading that is intended to maintain price

continuity between these exchangeable instruments by considering how

the firm quotes, maintains risk and exposure limits, manages its

inventory and risk, and, in the case of APs, exercises its ability to

create and redeem shares from the fund. Because customers take

positions in ETFs with an expectation that the price relationship will

be maintained, such trading can be considered to be market making-

related activity.\917\

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\917\ A number of commenters expressed concern that the proposed

rule would limit market making or AP activity in ETFs because market

makers and APs engage in trading to maintain a price relationship

between ETFs and their underlying components, which promotes ETF

market efficiency. See Vanguard; RBC; Goldman (Prop. Trading); JPMC;

SIFMA et al. (Prop. Trading) (Feb. 2012); SSgA (Feb. 2012); Credit

Suisse (Prop. Trading).

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After considering comments, the Agencies continue to take the view

that a trading desk would not qualify for the market-making exemption

if it is wholly or principally engaged in arbitrage trading or other

trading that is not in response to, or driven by, the demands of

clients, customers, or counterparties.\918\ The Agencies believe this

activity, which is not in response to or driven by customer demand, is

inconsistent with the Congressional intent that market making-related

activity be designed not to exceed the reasonably expected near term

demands

[[Page 5881]]

of clients, customers, or counterparties. For example, a trading desk

would not be permitted to engage in general statistical arbitrage

trading between instruments that have some degree of correlation but

where neither instrument has the capability of being exchanged,

converted, or exercised for or into the other instrument. A trading

desk may, however, act as market maker to a customer engaged in a

statistical arbitrage trading strategy. Furthermore as suggested by

some commenters,\919\ trading activity used by a market maker to

maintain a price relationship that is expected and relied upon by

clients, customers, and counterparties is permitted as it is related to

the demands of clients, customers, or counterparties because the

relevant instrument has the capability of being exchanged, converted,

or exercised for or into another instrument.\920\

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\918\ Some commenters suggested that a range of arbitrage

trading should be permitted under the market-making exemption. See,

e.g., Goldman (Prop. Trading); RBC; SIFMA et al. (Prop. Trading)

(Feb. 2012); JPMC. Other commenters, however, stated that arbitrage

trading should be prohibited under the final rule. See AFR et al.

(Feb. 2012); Volcker; Occupy. In response to commenters representing

that it would be difficult to comply with this standard because it

requires a trading desk to determine the proportionality of its

activities in response to customer demand compared to its activities

that are not in response to customer demand, the Agencies believe

that the statute requires a banking entity to distinguish between

market making-related activities that are designed not to exceed the

reasonably expected near term demands of customers and impermissible

proprietary trading. See Goldman (Prop. Trading); RBC.

\919\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.

\920\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC;

Credit Suisse (Seidel). For example, customers have an expectation

of general price alignment under these circumstances, both at the

time they decide to invest in the instrument and for the remaining

time they hold the instrument. To the contrary, general statistical

arbitrage does not maintain a price relationship between related

instruments that is expected and relied upon by customers and, thus,

is not permitted under the market-making exemption. Firms engage in

general statistical arbitrage to profit from differences in market

prices between instruments, assets, or price or risk elements

associated with instruments or assets that are thought to be

statistically related, but which do not have a direct relationship

of being exchangeable, convertible, or exercisable for the other.

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The Agencies recognize that a trading desk, in anticipating and

responding to customer needs, may engage in interdealer trading as part

of its inventory management activities and that interdealer trading

provides certain market benefits, such as more efficient matching of

customer order flow, greater hedging options to reduce risk, and

enhanced ability to accumulate or exit customer-related positions.\921\

The final rule does not prohibit a trading desk from using the market-

making exemption to engage in interdealer trading that is consistent

with and related to facilitating permissible trading with the trading

desk's clients, customers, or counterparties.\922\ However, in

determining the reasonably expected near term demands of clients,

customers, or counterparties, a trading desk generally may not account

for the expected trading interests of a trading desk or other

organizational unit of an entity with aggregate trading assets and

liabilities of $50 billion or greater (except if the trading desk

documents why and how a particular trading desk or other organizational

unit at such a firm should be considered a customer or the trading desk

or conduct market-making activity anonymously on an exchange or similar

trading facility that permits trading on behalf of a broad range of

market participants).\923\

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\921\ See MetLife; ACLI (Feb. 2012); Goldman (Prop. Trading);

Morgan Stanley; Chamber (Feb. 2012); Prof. Duffie; Oliver Wyman

(Dec. 2011); Oliver Wyman (Feb. 2012).

\922\ A number of commenters requested that the rule be modified

to clearly recognize interdealer trading as a component of permitted

market making-related activity. See MetLife; SIFMA et al. (Prop.

Trading) (Feb. 2012); RBC; Credit Suisse (Seidel); JPMC; BoA; ACLI

(Feb. 2012); AFR et al. (Feb. 2012); ISDA (Feb. 2012); Goldman

(Prop. Trading); Oliver Wyman (Feb. 2012). One of these commenters

analyzed the potential market impact of preventing interdealer

trading, combined with inventory limits. See Oliver Wyman (Feb.

2012). Because the final rule does not prohibit interdealer trading

or limit inventory in the manner this commenter assumed for purposes

of its analysis, the Agencies do not believe the final rule will

have the market impact cited by this commenter.

\923\ See AFR et al. (Feb. 2012) (recognizing that the ability

to manage inventory through interdealer transactions should be

accommodated in the rule, but recommending that this activity be

conditioned on a market maker having an appropriate level of

inventory after an interdealer transaction).

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A trading desk may engage in interdealer trading to: Establish or

acquire a position to meet the reasonably expected near term demands of

its clients, customers, or counterparties, including current demand;

unwind or sell positions acquired from clients, customers, or

counterparties; or engage in risk-mitigating or inventory management

transactions.\924\ The Agencies believe that allowing a trading desk to

continue to engage in customer-related interdealer trading is

appropriate because it can help a trading desk appropriately manage its

inventory and risk levels and can effectively allow clients, customers,

or counterparties to access a larger pool of liquidity. While the

Agencies recognize that effective intermediation of client, customer,

or counterparty trading may require a trading desk to engage in a

certain amount of interdealer trading, this is an activity that will

bear some scrutiny by the Agencies and should be monitored by banking

entities to ensure it reflects market-making activities and not

impermissible proprietary trading.

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\924\ Provided it is consistent with the requirements of the

market-making exemption, including the near term customer demand

requirement, a trading desk may trade for purposes of determining

how to price a financial instrument a customer seeks to trade with

the trading desk or to determine the depth of the market for a

financial instrument a customer seeks to trade with the trading

desk. See Goldman (Prop. Trading).

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ii. Impact of the Liquidity, Maturity, and Depth of the Market on the

Analysis

Several commenters expressed concern about the potential impact of

the proposed near term demand requirement on market making in less

liquid markets and requested that the Agencies recognize that near term

customer demand may vary across different markets and asset

classes.\925\ The Agencies understand that reasonably expected near

term customer demand may vary based on the liquidity, maturity, and

depth of the market for the relevant type of financial instrument(s) in

which the trading desk acts as market maker.\926\ As a result, the

final rule recognizes that these factors impact the analysis of

reasonably expected near term demands of clients, customers, or

counterparties and the amount, types, and risks of market-maker

inventory needed to meet such demand.\927\ In particular, customer

demand is likely to be more frequent in more liquid markets than in

less liquid or illiquid markets. As a result, market makers in more

liquid cash-based markets, such as liquid equity securities, should

generally have higher rates of inventory turnover and less aged

inventory than market makers in less liquid or illiquid markets.\928\

Market makers in less liquid cash-based markets are more likely to hold

a particular position for a longer period of time due to intermittent

customer demand. In the derivatives markets, market makers carry open

positions and manage various risk factors, such as exposure to

different points on a yield curve. These exposures are analogous to

inventory in the cash-based markets. Further, it may be more difficult

to reasonably predict near term customer demand in less mature markets

due to,

[[Page 5882]]

among other things, a lack of historical experience with client,

customer, or counterparty demands for the relevant product. Under these

circumstances, the Agencies encourage banking entities to consider

their experience with similar products or other relevant factors.\929\

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\925\ See CIEBA (stating that, absent a different interpretation

for illiquid instruments, market makers will err on the side of

holding less inventory to avoid sanctions for violating the rule);

Morgan Stanley; RBC; ICI (Feb. 2012) ISDA (Feb. 2012); Comm. on

Capital Markets Regulation; Alfred Brock.

\926\ See supra Part VI.A.3.c.2.b.ii. (discussing comments on

this issue).

\927\ See final rule Sec. 75.4(b)(2)(ii)(A).

\928\ The final rule does not impose additional capital

requirements on aged inventory to discourage a trading desk from

retaining positions in inventory, as suggested by some commenters.

See CalPERS; Vanguard. The Agencies believe the final rule already

limit a trading desk's ability to hold inventory over an extended

period and do not see a need at this time to include additional

capital requirements in the final rule. For example, a trading desk

must have written policies and procedures relating to its inventory

and must be able to demonstrate, as needed, its analysis of why the

levels of its market-maker inventory are necessary to meet, or is a

result of meeting, customer demand. See final rule Sec.

75.4(b)(2)(ii), (iii)(C).

\929\ The Agencies agree, as suggested by one commenter, it may

be appropriate for a market maker in a new asset class or market to

look to reasonably expected future developments on the basis of the

trading desk's customer relationships. See Morgan Stanley. As

discussed further below, the Agencies recognize that a trading desk

could encounter similar issues if it is a new entrant in an existing

market.

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iii. Demonstrable Analysis of Certain Factors

In the proposal, the Agencies stated that permitted market making

includes 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.\930\ A number of commenters

expressed concern about this proposed interpretation's impact on market

makers' inventory management activity and represented that it was

inconsistent with the statute's near term demand standard, which

permits market-making activity that is ``designed'' not to exceed the

``reasonably expected'' near term demands of customers.\931\ In

response to comments, the Agencies are permitting a trading desk to

take positions in reasonable expectation of customer demand in the near

term based on a demonstrable analysis that the amount, types, and risks

of the financial instruments in the trading desk's market-maker

inventory are designed not to exceed, on an ongoing basis, the

reasonably expected near term demands of customers.

---------------------------------------------------------------------------

\930\ See Joint Proposal, 76 FR at 68871; CFTC Proposal, 77 FR

at 8356-8357.

\931\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Goldman (Prop. Trading); Chamber (Feb. 2012); Comm. on Capital

Markets Regulation. See also Morgan Stanley; SIFMA (Asset Mgmt.)

(Feb. 2012).

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The proposal also stated that a banking entity's determination of

near term customer demand should generally be based on the unique

customer base of a specific market-making business line (and not merely

an expectation of future price appreciation). Several commenters stated

that it was unclear how such determinations should be made and

expressed concern that near term customer demand cannot always be

accurately predicted,\932\ particularly in markets where trades occur

infrequently and customer demand is hard to predict \933\ or when a

banking entity is entering a new market.\934\ To address these

comments, the Agencies are providing additional information about how a

banking entity can comply with the statute's near term customer demand

requirement, including a new requirement that a banking entity conduct

a demonstrable assessment of reasonably expected near term customer

demand and several examples of factors that may be relevant for

conducting such an assessment. The Agencies believe it is important to

require such demonstrable analysis to allow determinations of

reasonably expected near term demand and associated inventory levels to

be monitored and tested to ensure compliance with the statute and the

final rule.

---------------------------------------------------------------------------

\932\ See SIFMA et al. (Prop. Trading) (Feb. 2012); MetLife;

Chamber (Feb. 2012); RBC; CIEBA; Wellington; ICI (Feb. 2012) Alfred

Brock.

\933\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\934\ See CIEBA.

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The final rule provides that, to help determine the appropriate

amount, types, and risks of the financial instruments in the trading

desk's market-maker inventory and to ensure that such inventory is

designed not to exceed, on an ongoing basis, the reasonably expected

near term demands of client, customers, or counterparties, a banking

entity must conduct demonstrable analysis of historical customer

demand, current inventory of financial instruments, and market and

other factors regarding the amount, types, and risks of or associated

with financial instruments in which the trading desk makes a market,

including through block trades. This analysis should not be static or

fixed solely on current market or other factors. Instead, an

appropriately conducted analysis under this provision will be both

backward- and forward-looking by taking into account relevant

historical trends in customer demand \935\ and any events that are

reasonably expected to occur in the near term that would likely impact

demand.\936\ Depending on the facts and circumstances, it may be proper

for a banking entity to weigh these factors differently when conducting

an analysis under this provision. For example, historical trends in

customer demand may be less relevant when a trading desk is

experiencing or expects to experience a change in the pattern of

customer needs (e.g., requests for block positioning), adjustments to

its business model (e.g., efforts to expand or contract its market

shares), or changes in market conditions.\937\ On the other hand,

absent these types of current or anticipated events, the amount, types,

and risks of the financial instruments in the trading desk's market-

maker inventory should be relatively consistent with such trading

desk's historical profile of market-maker inventory.\938\

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\935\ To determine an appropriate historical dataset, a banking

entity should assess the relation between current or reasonably

expected near term conditions and demand and those of prior market

cycles.

\936\ This analysis may, where appropriate, take into account

prior and/or anticipated cyclicality to the demands of clients,

customers, or counterparties, which may cause variations in the

amounts, types, and risks of financial instruments needed to provide

intermediation services at different points in a cycle. For example,

the final rule recognizes that a trading desk may need to accumulate

a larger-than-average amount of inventory in anticipation of an

index rebalance. See supra note 843 (discussing a comment on this

issue). The Agencies are aware that a trading desk engaged in block

positioning activity may have a less consistent pattern of inventory

because of the need to take on large block positions at the request

of customers. See supra note 761 and accompanying text (discussing

comments on this issue).

Because the final rule does not prevent banking entities from

providing direct liquidity for rebalance trades, the Agencies do not

believe that the final rule will cause the market impacts that one

commenter predicted would occur were such a restriction adopted. See

Oliver Wyman (Feb. 2012) (estimating that if market makers are not

able to provide direct liquidity for rebalance trades, investors

tracking these indices could potentially pay incremental costs of

$600 million to $1.8 billion every year).

\937\ In addition, the Agencies recognize that a new entrant to

a particular market or asset class may not have knowledge of

historical customer demand in that market or asset class at the

outset. See supra note 924 and accompanying text (discussing factors

that may be relevant to new market entrants for purposes of

determining the reasonably expected near term demands of clients,

customers, or counterparties).

\938\ One commenter suggested an approach that would allow

market makers to build inventory in products where they believe

customer demand will exist, regardless of whether inventory can be

tied to a particular customer in the near term or to historical

trends in customer demand. See Credit Suisse (Seidel). The Agencies

believe an approach that does not provide for any consideration of

historical trends could result in a heightened risk of evasion. At

the same time, as discussed above, the Agencies recognize that

historical trends may not always determine the amount of inventory a

trading desk may need to meet reasonably expected near term demand

and it may under certain circumstances be appropriate to build

inventory in anticipation of a reasonably expected near term event

that would likely impact customer demand. While the Agencies are not

requiring that market-maker inventory be tied to a particular

customer, the Agencies are requiring that a banking entity analyze

and support its expectations for near term customer demand.

---------------------------------------------------------------------------

Moreover, the demonstrable analysis required under Sec.

75.4(b)(2)(ii)(B) should account for, among other things, how the

market factors discussed in Sec. 75.4(b)(2)(ii)(A) impact the amount,

types, and risks of market-maker inventory the trading desk may need to

facilitate reasonably expected near term demands of clients, customers,

or counterparties.\939\ Other potential

[[Page 5883]]

factors that could be used to assess reasonably expected near term

customer demand and the appropriate amount, types, and risks of

financial instruments in the trading desk's market-maker inventory

include, among others: (i) Recent trading volumes and customer trends;

(ii) trading patterns of specific customers or other observable

customer demand patterns; (iii) analysis of the banking entity's

business plan and ability to win new customer business; (iv) evaluation

of expected demand under current market conditions compared to prior

similar periods; (v) schedule of maturities in customers' existing

portfolios; and (vi) expected market events, such as an index

rebalancing, and announcements. The Agencies believe that some banking

entities already analyze these and other relevant factors as part of

their overall risk management processes.\940\

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\939\ The Agencies recognize that a trading desk could acquire

either a long or short position in reasonable anticipation of near

term demands of clients, customers, or counterparties. In

particular, if it is expected that customers will want to buy an

instrument in the near term, it may be appropriate for the desk to

acquire a long position in such instrument. If it is expected that

customers will want to sell the instrument, acquiring a short

position may be appropriate under certain circumstances.

\940\ See supra Part VI.A.3.c.2.b.iii. See FTN; Morgan Stanley

(suggesting a standard that would require a position to be

``reasonably consistent with observable customer demand patterns'').

---------------------------------------------------------------------------

With respect to the creation and distribution of complex structured

products, a trading desk may be able to use the market-making exemption

to acquire some or all of the risk exposures associated with the

product if the trading desk has evidence of customer demand for each of

the significant risks associated with the product.\941\ To have

evidence of customer demand under these circumstances, there must be

prior express interest from customers in the specific risk exposures of

the product. Without such express interest, a trading desk would not

have sufficient information to support the required demonstrable

analysis (e.g., information about historical customer demand or other

relevant factors).\942\ The Agencies are concerned that, absent express

interest in each significant risk associated with the product, a

trading desk could evade the market-making exemption by structuring a

deal with certain risk exposures, or amounts of risk exposures, for

which there is no customer demand and that would be retained in the

trading desk's inventory, potentially for speculative purposes. Thus, a

trading desk would not be engaged in permitted market making-related

activity if, for example, it structured a product solely to acquire a

desired exposure and not to respond to customer demand.\943\ When a

trading desk acquires risk exposures in these circumstances, the

trading desk would be expected to enter into appropriate hedging

transactions or otherwise mitigate the risks of these exposures,

consistent with its hedging policies and procedures and risk limits.

---------------------------------------------------------------------------

\941\ Complex structured products can contain a combination of

several different types of risks, including, among others, market

risk, credit risk, volatility risk, and prepayment risk.

\942\ In contrast, a trading desk may respond to requests for

customized transactions, such as custom swaps, provided that the

trading desk is a market maker in the risk exposures underlying the

swap or can hedge the underlying risk exposures, consistent with its

financial exposure and hedging limits, and otherwise meets the

requirements of the market-making exemption. For example, a trading

desk may routinely make markets in underlying exposures and, thus,

would meet the requirements for engaging in transactions in

derivatives that reflect the same exposures. Alternatively, a

trading desk might meet the requirements by routinely trading in the

derivative and hedging in the underlying exposures. See supra Part

VI.A.3.c.1.c.iii.

\943\ See, e.g., Sens. Merkley & Levin (Feb. 2012).

---------------------------------------------------------------------------

With regard to a trading desk that conducts its market-making

activities on an exchange or other similar anonymous trading facility,

the Agencies continue to believe that market-making 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 or by regularly

responding to requests for quotes in markets where resting orders are

not generally provided. This ensures that the trading desk has a

pattern of providing, rather than taking, liquidity. However, this does

not mean that a trading desk acting as a market maker on an exchange or

other similar anonymous trading facility is only permitted to use these

types of orders in connection with its market making-related

activities. The Agencies recognize that it may be appropriate for a

trading desk to enter market or marketable limit orders on an exchange

or other similar anonymous trading facility, or to request quotes from

other market participants, in connection with its market making-related

activities for a variety of purposes including, among others, inventory

management, addressing order imbalances on an exchange, and

hedging.\944\ In response to comments, the Agencies are not requiring a

banking entity to be registered as a market maker on an exchange or

other similar anonymous trading facility, if the exchange or other

similar anonymous trading facility registers market makers, for

purposes of the final rule.\945\ The Agencies recognize, as noted by

commenters, that there are a large number of exchanges and organized

trading facilities on which market makers may need to trade to maintain

liquidity across the markets and to provide customers with favorable

prices and that requiring registration with each exchange or other

trading facility may unnecessarily restrict or impose burdens on

exchange market-making activities.\946\

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\944\ The Agencies are clarifying this point in response to

commenters who expressed concern that the proposal would prevent an

exchange market maker from using market or marketable limit orders

under these circumstances. See, e.g., NYSE Euronext; SIFMA et al.

(Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); RBC.

\945\ See supra notes 774 to 779 and accompanying text

(discussing commenters' response to statements in the proposal

requiring exchange registration as a market maker under certain

circumstances). Similarly, the final rule does not establish a

presumption of compliance with the market-making exemption based on

registration as a market maker with an exchange, as requested by a

few commenters. See supra note 777 and accompanying text. As noted

above, activity that is considered market making for purposes of

this rule may not be considered market making for purposes of other

rules, including self-regulatory organization rules, and vice versa.

In addition, exchange requirements for registered market makers are

subject to change without consideration of the impact on this rule.

Although a banking entity is not required to be an exchange-

registered market maker under the final rule, a banking entity must

be licensed or registered to engage in market making-related

activities in accordance with applicable law. For example, a banking

entity would be required to be an SEC-registered broker-dealer to

engage in market making-related activities in securities in the U.S.

unless the banking entity is exempt from registration or excluded

from regulation as a dealer under the Exchange Act. See infra Part

VI.A.3.c.6.; final rule Sec. 75.4(b)(2)(vi).

\946\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading) (noting that there are more than 12 exchanges and 40

alternative trading systems currently trading U.S. equities).

---------------------------------------------------------------------------

A banking entity is not required to conduct the demonstrable

analysis under Sec. 75.4(b)(2)(B) of the final rule on an instrument-

by-instrument basis. The Agencies recognize that, in certain cases,

customer demand may be for a particular type of exposure, and a

customer may be willing to trade any one of a number of instruments

that would provide the demanded exposure. Thus, an assessment of the

amount, types, and risks of financial instruments that the trading desk

may hold in market-maker inventory and that would be designed not to

exceed, on an ongoing basis, the reasonably expected near term demands

of clients, customers, or counterparties does not need to be made for

each financial instrument in which the trading desk acts as market

maker. Instead, the amount and types of financial instruments in the

trading desk's market-maker inventory should be

[[Page 5884]]

consistent with the types of financial instruments in which the desk

makes a market and the amount and types of such instruments that the

desk's customers are reasonably expected to be interested in trading.

In response to commenters' concern that banking entities may be

subject to regulatory sanctions if reasonably expected customer demand

does not materialize,\947\ the Agencies recognize that predicting the

reasonably expected near term demands of clients, customers, or

counterparties is inherently subject to changes based on market and

other factors that are difficult to predict with certainty. Thus, there

may at times be differences between predicted demand and actual demand

from clients, customers, or counterparties. However, assessments of

expected near term demand may not be reasonable if, in the aggregate

and over longer periods of time, a trading desk exhibits a repeated

pattern or practice of significant variation in the amount, types, and

risks of financial instruments in its market-maker inventory in excess

of what is needed to facilitate near term customer demand.

---------------------------------------------------------------------------

\947\ See RBC; CIEBA; Wellington; ICI (Feb. 2012) Invesco.

---------------------------------------------------------------------------

iv. Relationship to Required Limits

As discussed further below, a banking entity must establish limits

for each trading desk on the amount, types, and risks of its market-

maker inventory, level of exposures to relevant risk factors arising

from its financial exposure, and period of time a financial instrument

may be held by a trading desk. These limits must be reasonably designed

to ensure compliance with the market-making exemption, including the

near term customer demand requirement, and must take into account the

nature and amount of the trading desk's market making-related

activities. Thus, the limits should account for and generally be

consistent with the historical near term demands of the desk's clients,

customers, or counterparties and the amount, types, and risks of

financial instruments that the trading desk has historically held in

market-maker inventory to meet such demands. In addition to the limits

that a trading desk selects in managing its positions to ensure

compliance with the market-making exemption set out in Sec. 75.4(b),

the Agencies are requiring, for banking entities that must report

metrics in Appendix A, such limits include, at a minimum, ``Risk Factor

Sensitivities'' and ``Value-at-Risk and Stress Value-at-Risk'' metrics

as limits, except to the extent any of the ``Risk Factor

Sensitivities'' or ``Value-at-Risk and Stress Value-at-Risk'' metrics

are demonstrably ineffective for measuring and monitoring the risks of

a trading desk based on the types of positions traded by, and risk

exposures of, that desk.\948\ The Agencies believe that these metrics

can be useful for measuring and managing many types of positions and

trading activities and therefore can be useful in establishing a

minimum set of metrics for which limits should be applied.\949\

---------------------------------------------------------------------------

\948\ See Appendix A.

\949\ The Agencies recognize that for some types of positions or

trading strategies, the use of ``Risk Factor Sensitivities'' and

``Value-at-Risk and Stress Value-at-Risk'' metrics may be

ineffective and accordingly limits do not need to be set for those

metrics if such ineffectiveness is demonstrated by the banking

entity.

---------------------------------------------------------------------------

As this requirement applies on an ongoing basis, a trade in excess

of one or more limits set for a trading desk should not be permitted

simply because it responds to customer demand. Rather, a banking

entity's compliance program must include escalation procedures that

require review and approval of any trade that would exceed one or more

of a trading desk's limits, demonstrable analysis that the basis for

any temporary or permanent increase to one or more of a trading desk's

limits is consistent with the requirements of this near term demand

requirement and with the prudent management of risk by the banking

entity, and independent review of such demonstrable analysis and

approval.\950\ The Agencies expect that a trading desk's escalation

procedures will generally explain the circumstances under which a

trading desk's limits can be increased, either temporarily or

permanently, and that such increases must be consistent with reasonably

expected near term demands of the desk's clients, customers, or

counterparties and the amount and type of risks to which the trading

desk is authorized to be exposed.

---------------------------------------------------------------------------

\950\ See final rule Sec. 75.4(b)(2)(iii); infra Part

VI.A.3.c.3.c. (discussing the meaning of ``independent'' review for

purposes of this requirement).

---------------------------------------------------------------------------

3. Compliance Program Requirement

a. Proposed Compliance Program Requirement

To ensure that a banking entity relying on the market-making

exemption had an appropriate framework in place to support its

compliance with the exemption, Sec. 75.4(b)(2)(i) of the proposed rule

required a banking entity to establish an internal compliance program,

as required by subpart D of the proposal, designed to ensure compliance

with the requirements of the market-making exemption.\951\

---------------------------------------------------------------------------

\951\ See proposed rule Sec. 75.4(b)(2)(i); Joint Proposal, 76

FR at 68870; CFTC Proposal, 77 FR at 8355.

---------------------------------------------------------------------------

b. Comments on the Proposed Compliance Program Requirement

A few commenters supported the proposed requirement that a banking

entity establish a compliance program under Sec. 75.20 of the proposed

rule as effective.\952\ For example, one commenter stated that the

requirement ``keeps a strong focus on the bank's own workings and

allows banks to self-monitor.'' \953\ One commenter indicated that a

comprehensive compliance program is a ``cornerstone of effective

corporate governance,'' but cautioned against placing ``undue

reliance'' on compliance programs.\954\ As discussed further below in

Parts VI.C.1. and VI.C.3., many commenters expressed concern about the

potential burdens of the proposed rule's compliance program

requirement, as well as the proposed requirement regarding quantitative

measurements. According to one commenter, the compliance burdens

associated with these requirements may dissuade a banking entity from

attempting to comply with the market-making exemption.\955\

---------------------------------------------------------------------------

\952\ See Flynn & Fusselman; Morgan Stanley.

\953\ See Flynn & Fusselman.

\954\ See Occupy.

\955\ See ICI (Feb. 2012).

---------------------------------------------------------------------------

c. Final Compliance Program Requirement

Similar to the proposed exemption, the market-making exemption

adopted in the final rule requires that a banking entity establish and

implement, maintain, and enforce an internal compliance program

required by subpart D that is reasonably designed to ensure the banking

entity's compliance with the requirements of the market-making

exemption, including reasonably designed written policies and

procedures, internal controls, analysis, and independent testing.\956\

This provision further requires that the compliance program include

particular written policies and procedures, internal controls,

analysis, and independent testing identifying and addressing:

---------------------------------------------------------------------------

\956\ The independent testing standard is discussed in more

detail in Part VI.C., which discusses the compliance program

requirement in Sec. 75.20 of the final rule.

---------------------------------------------------------------------------

The financial instruments each trading desk stands ready

to purchase and sell as a market maker;

The actions the trading desk will take to demonstrably

reduce or

[[Page 5885]]

otherwise significantly mitigate promptly the risks of its financial

exposure consistent with the required limits; the products,

instruments, and exposures each trading desk may use for risk

management purposes; the techniques and strategies each trading desk

may use to manage the risks of its market making-related activities and

inventory; and the process, strategies, and personnel responsible for

ensuring that the actions taken by the trading desk to mitigate these

risks are and continue to be effective;

Limits for each trading desk, based on the nature and

amount of the trading desk's market making-related activities, that

address the factors prescribed by the near term customer demand

requirement of the final rule, on:

[cir] The amount, types, and risks of its market-maker inventory;

[cir] The amount, types, and risks of the products, instruments,

and exposures the trading desk uses for risk management purposes;

[cir] Level of exposures to relevant risk factors arising from its

financial exposure; and

[cir] Period of time a financial instrument may be held;

Internal controls and ongoing monitoring and analysis of

each trading desk's compliance with its required limits; and

Authorization procedures, including escalation procedures

that require review and approval of any trade that would exceed a

trading desk's limit(s), demonstrable analysis that the basis for any

temporary or permanent increase to a trading desk's limit(s) is

consistent with the requirements of Sec. 75.4(b)(2)(ii) of the final

rule, and independent review (i.e., by risk managers and compliance

officers at the appropriate level independent of the trading desk) of

such demonstrable analysis and approval.\957\

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\957\ See final rule Sec. 75.4(b)(2)(iii).

---------------------------------------------------------------------------

The compliance program requirement in the proposed market-making

exemption did not include specific references to all the compliance

program elements now listed in the final rule. Instead, these elements

were generally included in the compliance requirements of Appendix C of

the proposed rule. The Agencies are moving certain of these

requirements into the market-making exemption to ensure that critical

components are made part of the compliance program for market making-

related activities. Further, placing these requirements within the

market-making exemption emphasizes the important role they play in

overall compliance with the exemption.\958\ Banking entities should

note that these compliance procedures must be established, implemented,

maintained, and enforced for each trading desk engaged in market

making-related activities under the final rule. Each of the

requirements in paragraphs (b)(2)(iii)(A) through (E) must be

appropriately tailored to the individual trading activities and

strategies of each trading desk on an ongoing basis.

---------------------------------------------------------------------------

\958\ The Agencies note that a number of commenters requested

that the Agencies place a greater emphasis on inventory limits and

risk limits in the final exemption. See, e.g., Citigroup (suggesting

that the market-making exemption utilize risk limits that would be

set for each trading unit based on expected levels of customer

trading--estimated by looking to historical results, target product

and customer lists, and target market share--and an appropriate

amount of required inventory to support that level of customer

trading); Prof. Colesanti et al. (suggesting that the exemption

include, among other things, a bright-line threshold of the amount

of risk that can be retained (which cannot be in excess of the size

and type required for market making), positions limits, and limits

on holding periods); Sens. Merkley & Levin (Feb. 2012) (suggesting

the use of specific parameters for inventory levels, along with a

number of other criteria, to establish a safe harbor); SIFMA et al.

(Prop. Trading) (Feb. 2012) (recommending the use of risk limits in

combination with a guidance-based approach); Japanese Bankers Ass'n.

(suggesting that the rule set risk allowances for market making-

related activities based on required capital for such activities).

The Agencies are not establishing specific limits in the final rule,

as some commenters appeared to recommend, in recognition of the fact

that appropriate limits will differ based on a number of factors,

including the size of the market-making operation and the liquidity,

depth, and maturity of the market for the particular type(s) of

financial instruments in which the trading desk is permitted to

trade. See Sens. Merkley & Levin (Feb. 2012); Prof. Colesanti et al.

However, banking entities relying on the market-making exemption

must set limits and demonstrate how the specific limits and limit

methodologies they have chosen are reasonably designed to limit the

amount, types, and risks of the financial instruments in a trading

desk's market-maker inventory consistent with the reasonably

expected near term demands of the banking entity's clients,

customers, and counterparties, subject to the market and conditions

discussed above, and to commensurately control the desk's overall

financial exposure.

---------------------------------------------------------------------------

As a threshold issue, the compliance program must identify the

products, instruments, and exposures the trading desk may trade as

market maker or for risk management purposes.\959\ Identifying the

relevant instruments in which a trading desk is permitted to trade will

facilitate monitoring and oversight of compliance with the exemption by

preventing an individual trader on a market-making desk from

establishing positions in instruments that are unrelated to the desk's

market-making function. Further, this identification of instruments

helps form the basis for the specific types of inventory and risk

limits that the banking entity must establish and is relevant to

considerations throughout the exemption regarding the liquidity, depth,

and maturity of the market for the relevant type of financial

instrument. The Agencies note that a banking entity should be able to

demonstrate the relationship between the instruments in which a trading

desk may act as market maker and the instruments the desk may use to

manage the risk of its market making-related activities and inventory

and why the instruments the desk may use to manage its risk

appropriately and effectively mitigate the risk of its market making-

related activities without generating an entirely new set of risks that

outweigh the risks that are being hedged.

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\959\ See final rule Sec. 75.4(b)(2)(iii)(A) (requiring written

policies and procedures, internal controls, analysis, and

independent testing regarding the financial instruments each trading

desk stands ready to purchase and sell in accordance with Sec.

75.4(b)(2)(i) of the final rule); final rule Sec.

75.4(b)(2)(iii)(B) (requiring written policies and procedures,

internal controls, analysis, and independent testing regarding the

products, instruments, or exposures each trading desk may use for

risk management purposes).

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The final rule provides that a banking entity must establish an

appropriate risk management framework for each of its trading desks

that rely on the market-making exemption.\960\ This includes not only

the techniques and strategies that a trading desk may use to manage its

risk exposures, but also the actions the trading desk will take to

demonstrably reduce or otherwise significantly mitigate promptly the

risks of its financial exposures consistent with its required limits,

which are discussed in more detail below. While the Agencies do not

expect a trading desk to hedge all of the risks that arise from its

market

[[Page 5886]]

making-related activities, the Agencies do expect each trading desk to

take appropriate steps consistent with market-making activities to

contain and limit risk exposures (such as by unwinding unneeded

positions) and to follow reasonable procedures to monitor the trading

desk's risk exposures (i.e., its financial exposure) and hedge risks of

its financial exposure to remain within its relevant risk limits.\961\

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\960\ This standard addresses issues raised by commenters

concerning: certain language in proposed Appendix B regarding market

making-related risk management; the market making-related hedging

provision in Sec. 75.4(b)(3) of the proposed rule; and, to some

extent, the proposed source of revenue requirement in Sec.

75.4(b)(2)(v) of the proposed rule. See Joint Proposal, 76 FR at

68960; CFTC Proposal, 77 FR at 8439-8440; proposed rule Sec.

75.4(b)(3); Joint Proposal, 76 FR at 68873; CFTC Proposal, 77 FR at

8358; Wellington; Credit Suisse (Seidel); Morgan Stanley; PUC Texas;

CIEBA; SSgA (Feb. 2012); AllianceBernstein; Investure; Invesco;

Japanese Bankers Ass'n.; SIFMA et al. (Prop. Trading) (Feb. 2012);

FTN; RBC; NYSE Euronext; MFA. As discussed in more detail above, a

number of commenters emphasized that market making-related

activities necessarily involve a certain amount of risk-taking to

provide ``immediacy'' to customers. See, e.g., Prof. Duffie; Morgan

Stanley; SIFMA et al. (Prop. Trading) (Feb. 2012). Commenters also

represented that the amount of risk a market maker needs to retain

may differ across asset classes and markets. See, e.g., Morgan

Stanley; Credit Suisse (Seidel). The Agencies believe that the

requirement we are adopting better recognizes that appropriate risk

management will tailor acceptable position, risk and inventory

limits based on the type(s) of financial instruments in which the

trading desk is permitted to trade and the liquidity, maturity, and

depth of the market for the relevant type of financial instrument.

\961\ It may be more efficient for a banking entity to manage

some risks at a higher organizational level than the trading desk

level. As a result, a banking entity's written policies and

procedures may delegate the responsibility to mitigate specific

risks of the trading desk's financial exposure to an entity other

than the trading desk, including another organizational unit of the

banking entity or of an affiliate, provided that such organizational

unit of the banking entity or of an affiliate is identified in the

banking entity's written policies and procedures. Under these

circumstances, the other organizational unit of the banking entity

or of an affiliate must conduct such hedging activity in accordance

with the requirements of the hedging exemption in Sec. 75.5 of the

final rule, including the documentation requirement in Sec.

75.5(c). As recognized in Part VI.A.4.d.4., hedging activity

conducted by a different organizational unit than the unit

responsible for the positions being hedged presents a greater risk

of evasion. Further, the risks being managed by a higher

organizational level than the trading desk may be generated by

trading desks engaged in market making-related activity or by

trading desks engaged in other permitted activities. Thus, it would

be inappropriate for such hedging activity to be conducted in

reliance on the market-making exemption.

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As discussed in Part VI.A.3.c.4.c., managing the risks associated

with maintaining a market-maker inventory that is appropriate to meet

the reasonably expected near-term demands of customers is an important

part of market making.\962\ The Agencies understand that, in the

context of market-making activities, inventory management includes

adjustment of the amount and types of market-maker inventory to meet

the reasonably expected near term demands of customers.\963\

Adjustments of the size and types of a financial exposure are also made

to reduce or mitigate the risks associated with financial instruments

held as part of a trading desk's market-maker inventory. A common

strategy in market making is to establish market-maker inventory in

anticipation of reasonably expected customer needs and then to reduce

that market-maker inventory over time as customer demand

materializes.\964\ If customer demand does not materialize, the market

maker addresses the risks associated with its market-maker inventory by

adjusting the amount or types of financial instruments in its inventory

as well as taking steps otherwise to mitigate the risk associated with

its inventory.

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\962\ See supra Part VI.A.3.c.2.c. (discussing the final near

term demand requirement).

\963\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Credit Suisse (Seidel); Goldman (Prop. Trading); MFA; RBC.

\964\ See, e.g., BoA; SIFMA et al. (Prop. Trading) (Feb. 2012);

Chamber (Feb. 2012).

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The Agencies recognize that, to provide effective intermediation

services, a trading desk engaged in permitted market making-related

activities retains a certain amount of risk arising from the positions

it holds in inventory and may hedge certain aspects of that risk. The

requirements in the final rule establish controls around a trading

desk's risk management activities, yet still recognize that a trading

desk engaged in market making-related activities may retain a certain

amount of risk in meeting the reasonably expected near term demands of

clients, customers, or counterparties. As the Agencies noted in the

proposal, 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.\965\ The Agencies emphasize that the only risk management

activities that qualify for the market-making exemption--and that are

not subject to the hedging exemption--are risk management activities

conducted or directed by the trading desk in connection with its market

making-related activities and in conformance with the trading desk's

risk management policies and procedures.\966\ A trading desk engaged in

market making-related activities would be required to comply with the

hedging exemption or another available exemption for any risk

management or other activity that is not in conformance with the

trading desk's required market-making risk management policies and

procedures.

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\965\ See Joint Proposal, 76 FR at 68873; CFTC Proposal, 77 FR

at 8358.

\966\ As discussed above, if a trading desk operating under the

market-making exemption directs a different organizational unit of

the banking entity or an affiliate to establish a hedge position on

the desk's behalf, then the other organizational unit may rely on

the market-making exemption to establish the hedge position as long

as: (i) The other organizational unit's hedging activity is

consistent with the trading desk's risk management policies and

procedures (e.g., the hedge instrument, technique, and strategy are

consistent with those identified in the trading desk's policies and

procedures); and (ii) the hedge position is attributed to the

financial exposure of the trading desk and is included in the

trading desk's daily profit and loss. If a different organizational

unit of the banking entity or of an affiliate establishes a hedge

for the trading desk's financial exposure based on its own

determination, or if such position was not established in accordance

with the trading desk's required procedures or was included in that

other organizational unit's financial exposure and/or daily profit

and loss, then that hedge position must be established in compliance

with the hedging exemption in Sec. 75.5 of the rule, including the

documentation requirement in Sec. 75.5(c). See supra Part

VI.A.3.c.1.c.ii.

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A banking entity's written policies and procedures, internal

controls, analysis, and independent testing identifying and addressing

the products, instruments, or exposures and the techniques and

strategies that may be used by each trading desk to manage the risks of

its market making-related activities and inventory must cover both how

the trading desk may establish hedges and how such hedges are removed

once the risk they were mitigating is unwound. With respect to

establishing positions that hedge or otherwise mitigate the risk(s) of

market making-related positions held by the trading desk, the written

policies and procedures may consider the natural hedging and

diversification that occurs in an aggregation of long and short

positions in financial instruments for which the trading desk is a

market maker,\967\ as it documents its specific risk-mitigating

strategies that use instruments for which the desk is a market maker or

instruments for which the desk is not a market maker. Further, the

written policies and procedures identifying and addressing permissible

hedging techniques and strategies must address the circumstances under

which the trading desk may be permitted to engage in anticipatory

hedging. Like the proposed rule's hedging exemption, a trading desk may

establish an anticipatory hedge position before it becomes exposed to a

risk that it is highly likely to become exposed to, provided there is a

sound risk management rationale for establishing such an anticipatory

hedge position.\968\ For example, a trading desk may hedge against

specific positions promised to customers, such as volume-weighted

average price (``VWAP'') orders or large block trades, to facilitate

the customer trade.\969\ The amount of time that an anticipatory hedge

may precede the establishment of the position to be hedged will depend

on market factors,

[[Page 5887]]

such as the liquidity of the hedging position.

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\967\ For example, this may occur if a U.S. corporate bond

trading desk acquires a $100 million long position in the corporate

bonds of one issuer from clients, customers, or counterparties and

separately acquires a $50 million short position in another issuer

in the same market sector in reasonable expectation of near term

demand of clients, customers, or counterparties. Although both

positions were acquired to facilitate customer demand, the positions

may also naturally hedge each other, to some extent.

\968\ See Joint Proposal, 76 FR at 68875; CFTC Proposal, 77 FR

at 8361.

\969\ Two commenters recommended that banking entities be

permitted to establish hedges prior to acquiring the underlying risk

exposure under these circumstances. See Credit Suisse (Seidel); BoA.

---------------------------------------------------------------------------

Written policies and procedures, internal controls, analysis, and

independent testing established pursuant to the final rule identifying

and addressing permissible hedging techniques and strategies should be

designed to prevent a trading desk from over-hedging its market-maker

inventory or financial exposure. Over-hedging would occur if, for

example, a trading desk established a position in a financial

instrument for the purported purpose of reducing a risk associated with

one or more market-making positions when, in fact, that risk had

already been mitigated to the full extent possible. Over-hedging

results in a new risk exposure that is unrelated to market-making

activities and, thus, is not permitted under the market-making

exemption.

A trading desk's financial exposure generally would not be

considered to be consistent with market making-related activities to

the extent the trading desk is engaged in hedging activities that are

inconsistent with the management of identifiable risks in its market-

maker inventory or maintains significant hedge positions after the

underlying risk(s) of the market-maker inventory have been unwound. A

banking entity's written policies and procedures, internal controls,

analysis, and independent testing regarding the trading desk's

permissible hedging techniques and strategies must be designed to

prevent a trading desk from engaging in over-hedging or maintaining

hedge positions after they are no longer needed.\970\ Further, the

compliance program must provide for the process and personnel

responsible for ensuring that the actions taken by the trading desk to

mitigate the risks of its market making-related activities are and

continue to be effective, which would include monitoring for and

addressing any scenarios where a trading desk may be engaged in over-

hedging or maintaining unnecessary hedge positions or new significant

risks have been introduced by the hedging activity.

---------------------------------------------------------------------------

\970\ See final rule Sec. 75.4(b)(2)(iii)(B).

---------------------------------------------------------------------------

As a result of these limitations, the size and risks of the trading

desk's hedging positions are naturally constrained by the size and

risks of its market-maker inventory, which must be designed not to

exceed the reasonably expected near term demands of clients, customers,

or counterparties, as well as by the risk limits and controls

established under the final rule. This ultimately constrains a trading

desk's overall financial exposure since such position can only contain

positions, risks, and exposures related to the market-maker inventory

that are designed to meet current or near term customer demand and

positions, risks and exposures designed to mitigate the risks in

accordance with the limits previously established for the trading desk.

The written policies and procedures identifying and addressing a

trading desk's hedging techniques and strategies also must describe how

and under what timeframe a trading desk must remove hedge positions

once the underlying risk exposure is unwound. Similarly, the compliance

program established by the banking entity to specify and control the

trading desk's hedging activities in accordance with the final rule

must be designed to prevent a trading desk from purposefully or

inadvertently transforming its positions taken to manage the risk of

its market-maker inventory under the exemption into what would

otherwise be considered prohibited proprietary trading.

Moreover, the compliance program must provide for the process and

personnel responsible for ensuring that the actions taken by the

trading desk to mitigate the risks of its market making-related

activities and inventory--including the instruments, techniques, and

strategies used for risk management purposes--are and continue to be

effective. This includes ensuring that hedges taken in the context of

market making-related activities continue to be effective and that

positions taken to manage the risks of the trading desk's market-maker

inventory are not purposefully or inadvertently transformed into what

would otherwise be considered prohibited proprietary trading. If a

banking entity's monitoring procedures find that a trading desk's risk

management procedures are not effective, such deficiencies must be

promptly escalated and remedied in accordance with the banking entity's

escalation procedures. A banking entity's written policies and

procedures must set forth the process for determining the circumstances

under which a trading desk's risk management strategies may be

modified. In addition, risk management techniques and strategies

developed and used by a trading desk must be independently tested or

verified by management separate from the trading desk.

To control and limit the amount and types of financial instruments

and risks that a trading desk may hold in connection with its market

making-related activities, a banking entity must establish, implement,

maintain, and enforce reasonably designed written policies and

procedures, internal controls, analysis, and independent testing

identifying and addressing specific limits on a trading desk's market-

maker inventory, risk management positions, and financial exposure. In

particular, the compliance program must establish limits for each

trading desk, based on the nature and amount of its market making-

related activities (including the factors prescribed by the near term

customer demand requirement), on the amount, types, and risks of its

market-maker inventory, the amount, types, and risks of the products,

instruments, and exposures the trading desk may use for risk management

purposes, the level of exposures to relevant risk factors arising from

its financial exposure, and the period of time a financial instrument

may be held.\971\ The limits would be set, as appropriate, and

supported by an analysis for specific types of financial instruments,

levels of risk, and duration of holdings, which would also be required

by the compliance appendix. This approach will build on existing risk

management infrastructure for market-making activities that subject

traders to a variety of internal, predefined limits.\972\ Each of these

limits is independent of the others, and a trading desk must maintain

its aggregated market-making position within each of these limits,

including by taking action to bring the trading desk into compliance

with the limits as promptly as possible after the limit is

exceeded.\973\ For example, if changing market conditions cause an

increase in one or more risks within the trading desk's financial

exposure and that increased risk causes the desk to exceed one or more

of its limits, the trading desk must take prompt action to reduce its

risk exposure (either by hedging the risk or unwinding its existing

positions) or receive approval of a temporary or permanent increase to

its limit through the required escalation procedures.

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\971\ See final rule Sec. 75.4(b)(2)(iii)(C).

\972\ See, e.g., Citigroup (Feb. 2012) (noting that its

suggested approach to implementing the market-making exemption,

which would focus on risk limits and risk architecture, would build

on existing risk limits and risk management systems already present

in institutions).

\973\ See final rule Sec. 75.4(b)(2)(iv).

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The Agencies recognize that trading desks' limits will differ

across asset classes and acknowledge that trading desks engaged in

market making-related activities in less liquid asset classes, such as

corporate bonds, certain derivatives, and securitized products, may

require different inventory, risk exposure, and holding period limits

than trading desks engaged in market

[[Page 5888]]

making-related activities in more liquid financial instruments, such as

certain listed equity securities. Moreover, the types of risk factors

for which limits are established should not be limited solely to market

risk factors. Instead, such limits should also account for all risk

factors that arise from the types of financial instruments in which the

trading desk is permitted to trade. In addition, these limits should be

sufficiently granular and focused on the particular types of financial

instruments in which the desk may trade. For example, a trading desk

that makes a market in derivatives would have exposures to counterparty

risk, among others, and would need to have appropriate limits on such

risk. Other types of limits that may be relevant for a trading desk

include, among others, position limits, sector limits, and geographic

limits.

A banking entity must have a reasonable basis for the limits it

establishes for a trading desk and must have a robust procedure for

analyzing, establishing, and monitoring limits, as well as appropriate

escalation procedures.\974\ Among other things, the banking entity's

compliance program must provide for: (i) Written policies and

procedures and internal controls establishing and monitoring specific

limits for each trading desk; and (ii) analysis regarding how and why

these limits are determined to be appropriate and consistent with the

nature and amount of the desk's market making-related activities,

including considerations related to the near term customer demand

requirement. In making these determinations, a banking entity should

take into account and be consistent with the type(s) of financial

instruments the desk is permitted to trade, the desk's trading and risk

management activities and strategies, the history and experience of the

desk, and the historical profile of the desk's near term customer

demand and market and other factors that may impact the reasonably

expected near term demands of customers.

---------------------------------------------------------------------------

\974\ See final rule Sec. 75.4(b)(2)(iii)(C).

---------------------------------------------------------------------------

The limits established by a banking entity should generally reflect

the amount and types of inventory and risk that a trading desk holds to

meet the reasonably expected near term demands of clients, customers,

or counterparties. As discussed above, while the trading desk's market-

maker inventory is directly limited by the reasonably expected near

term demands of customers, the positions managed by the trading desk

outside of its market-maker inventory are similarly constrained by the

near term demand requirement because they must be designed to manage

the risks of the market-maker inventory in accordance with the desk's

risk management procedures. As a result, the trading desk's risk

management positions and aggregate financial exposure are also limited

by the current and reasonably expected near term demands of customers.

A trading desk's market-maker inventory, risk management positions, or

financial exposure would not, however, be permissible under the market-

making exemption merely because the market-maker inventory, risk

management positions, or financial exposure happens to be within the

desk's prescribed limits.\975\

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\975\ For example, if a U.S. corporate bond trading desk has a

prescribed limit of $200 million net exposure to any single sector

of related issuers, the desk's limits may permit it to acquire a net

economic exposure of $400 million long to issuer ABC and a net

economic exposure of $300 million short to issuer XYZ, where ABC and

XYZ are in the same sector. This is because the trading desk's net

exposure to the sector would only be $100 million, which is within

its limits. Even though the net exposure to this sector is within

the trading desk's prescribed limits, the desk would still need to

be able to demonstrate how its net exposure of $400 million long to

issuer ABC and $300 million short to issuer XYZ is related to

customer demand.

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In addition, a banking entity must establish internal controls and

ongoing monitoring and analysis of each trading desk's compliance with

its limits, including the frequency, nature, and extent of a trading

desk exceeding its limits and patterns regarding the portions of the

trading desk's limits that are accounted for by the trading desk's

activity.\976\ This may include the use of management and exception

reports. Moreover, the compliance program must set forth a process for

determining the circumstances under which a trading desk's limits may

be modified on a temporary or permanent basis (e.g., due to market

changes or modifications to the trading desk's strategy).\977\ This

process must cover potential scenarios when a trading desk's limits

should be raised, as well as potential scenarios when a trading desk's

limits should be lowered. For example, if a trading desk experiences

reduced customer demand over a period of time, that trading desk's

limits should be decreased to address the factors prescribed by the

near term demand requirement.

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\976\ See final rule Sec. 75.4(b)(2)(iii)(D).

\977\ For example, a banking entity may determine to permit

temporary, short-term increases to a trading desk's risk limits due

to an increase in short-term credit spreads or in response to

volatility in instruments in which the trading desk makes a market,

provided the increased limit is consistent with the reasonably

expected near term demands of clients, customers, or counterparties.

As noted above, other potential circumstances that could warrant

changes to a trading desk's limits include: A change in the pattern

of customer needs, adjustments to the market maker's business model

(e.g., new entrants or existing market makers trying to expand or

contract their market share), or changes in market conditions. See

supra note 937 and accompanying text.

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A banking entity's compliance program must also include escalation

procedures that require review and approval of any trade that would

exceed one or more of a trading desk's limits, demonstrable analysis

that the basis for any temporary or permanent increase to one or more

of a trading desk's limits is consistent with the near term customer

demand requirement, and independent review of such demonstrable

analysis and approval of any increase to one or more of a trading

desk's limits.\978\ Thus, in order to increase a limit of a trading

desk--on either a temporary or permanent basis--there must be an

analysis of why such increase would be appropriate based on the

reasonably expected near term demands of clients, customers, or

counterparties, including the factors identified in Sec.

75.4(b)(2)(ii) of the final rule, which must be independently reviewed.

A banking entity also must maintain documentation and records with

respect to these elements, consistent with the requirement of Sec.

75.20(b)(6).

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\978\ See final rule Sec. 75.4(b)(2)(iii)(E).

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As already discussed, commenters have represented that the

compliance costs associated with the proposed rule, including the

compliance program and metrics requirements, may be significant and

``may dissuade a banking entity from attempting to comply with the

market making-related activities exemption.'' \979\ The Agencies

believe that a robust compliance program is necessary to ensure

adherence to the rule and to prevent evasion, although, as discussed in

Part VI.C.3., the Agencies are adopting a more tailored set of

quantitative measurements to better focus on those that are most

germane to evaluating market making-related activity. The Agencies

acknowledge that the compliance program requirements for the market-

making exemption, including reasonably designed written policies and

procedures, internal controls, analysis, and independent testing,

represent a new regulatory requirement for banking entities and the

Agencies have thus been mindful that it may impose significant costs

and may cause a banking entity to reconsider whether to conduct market

making-related activities. Despite the potential costs of the

compliance program, the Agencies believe they are warranted to ensure

that the goals of the rule and statute will be met, such as promoting

[[Page 5889]]

the safety and soundness of banking entities and the financial

stability of the United States.

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\979\ See ICI (Feb. 2012).

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4. Market Making-Related Hedging

a. Proposed Treatment of Market Making-Related Hedging

In the proposal, certain hedging transactions related to market

making were considered to be made in connection with a banking entity's

market making-related activity for purposes of the market-making

exemption. The Agencies explained that 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.\980\ To qualify for the market-

making exemption, a hedging transaction would have been required to

meet certain requirements under Sec. 75.4(b)(3) of the proposed rule.

This provision required that the purchase or sale of a financial

instrument: (i) Be conducted 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; and (ii) meet the criteria specified in

Sec. 75.5(b) of the proposed hedging exemption and, where applicable,

Sec. 75.5(c) of the proposal.\981\ In the proposal, the Agencies noted

that a market maker may often make a market in one type of financial

instrument and hedge its activities using different financial

instruments in which it does not make a market. The Agencies stated

that this type of hedging transaction would meet the terms of the

market-making exemption if the hedging transaction met the requirements

of Sec. 75.4(b)(3) of the proposed rule.\982\

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\980\ See Joint Proposal, 76 FR at 68873; CFTC Proposal, 77 FR

at 8358.

\981\ See proposed rule Sec. 75.4(b)(3); Joint Proposal, 76 FR

at 68873; CFTC Proposal, 77 FR at 8358.

\982\ See Joint Proposal, 76 FR at 68870 n.146; CFTC Proposal,

77 FR at 8356 n.152.

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b. Comments on the Proposed Treatment of Market Making-Related Hedging

Several commenters recommended that the proposed market-making

exemption be modified to establish a more permissive standard for

market maker hedging.\983\ A few of these commenters stated that,

rather than applying the standards of the risk-mitigating hedging

exemption to market maker hedging, a market maker's hedge position

should be permitted as long as it is designed to mitigate the risk

associated with positions acquired through permitted market making-

related activities.\984\ Other commenters emphasized the need for

flexibility to permit a market maker to choose the most effective

hedge.\985\ In general, these commenters expressed concern that

limitations on hedging market making-related positions may cause a

reduction in liquidity, wider spreads, or increased risk and trading

costs for market makers.\986\ For example, one commenter stated that

``[t]he ability of market makers to freely offset or hedge positions is

what, in most cases, makes them willing to buy and sell [financial

instruments] to and from customers, clients or counterparties,'' so

``[a]ny impediment to hedging market making-related positions will

decrease the willingness of banking entities to make markets and,

accordingly, reduce liquidity in the marketplace.'' \987\

---------------------------------------------------------------------------

\983\ See, e.g., Japanese Bankers Ass'n.; SIFMA et al. (Prop.

Trading) (Feb. 2012); Credit Suisse (Seidel); FTN; RBC; NYSE

Euronext; MFA. These comments are addressed in Part VI.A.3.c.4.c.,

infra.

\984\ See SIFMA et al. (Prop. Trading) (Feb. 2012); RBC. See

also FTN (stating that the principal requirement for such hedges

should be that they reduce the risk of market making).

\985\ See NYSE Euronext (stating that the best hedge sometimes

involves a variety of complex and dynamic transactions over the time

in which an asset is held, which may fall outside the parameters of

the exemption); MFA; JPMC.

\986\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit

Suisse (Seidel); NYSE Euronext; MFA; Japanese Bankers Ass'n.; RBC.

\987\ RBC.

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In addition, some commenters expressed concern that certain

requirements in the proposed hedging exemption may result in a

reduction in market-making activities under certain circumstances.\988\

For example, one commenter expressed concern that the proposed hedging

exemption would require a banking entity to identify and tag hedging

transactions when hedges in a particular asset class take place

alongside a trading desk's customer flow trading and inventory

management in that same asset class.\989\ Further, a few commenters

represented that the proposed reasonable correlation requirement in the

hedging exemption could impact market making by discouraging market

makers from entering into customer transactions that do not have a

direct hedge \990\ or making it more difficult for market makers to

cost-effectively hedge the fixed income securities they hold in

inventory, including hedging such inventory positions on a portfolio

basis.\991\

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\988\ See BoA; SIFMA (Asset Mgmt.) (Feb. 2012).

\989\ See Goldman (Prop. Trading).

\990\ See BoA.

\991\ See SIFMA (Asset Mgmt.) (Feb. 2012).

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One commenter, however, stated that the proposed approach is

effective.\992\ Another commenter indicated that it is confusing to

include hedging within the market-making exemption and suggested that a

market maker be required to rely on the hedging exemption under Sec.

75.5 of the proposed rule for its hedging activity.\993\

---------------------------------------------------------------------------

\992\ See Alfred Brock.

\993\ See Occupy.

---------------------------------------------------------------------------

As noted above in the discussion of comments on the proposed source

of revenue requirement, a number of commenters expressed concern that

the proposed rule assumed that there are effective, or perfect, hedges

for all market making-related positions.\994\ Another commenter stated

that market makers should be required to hedge whenever an inventory

imbalance arises, and the absence of a hedge in such circumstances may

evidence prohibited proprietary trading.\995\

---------------------------------------------------------------------------

\994\ See infra notes 1073 to 1075 and accompanying text.

\995\ See Public Citizen.

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c. Treatment of Market Making-Related Hedging in the Final Rule

Unlike the proposed rule, the final rule does not require that

market making-related hedging activities separately comply with the

requirements found in the risk-mitigating hedging exemption if

conducted or directed by the same trading desk conducting the market-

making activity. Instead, the Agencies are including requirements for

market making-related hedging activities within the market-making

exemption in response to comments.\996\ As discussed above, a trading

desk's compliance program must include written policies and procedures,

internal controls, independent testing and analysis identifying and

addressing the products, instruments, exposures, techniques, and

strategies a trading desk may use to manage the risks of its market

making-related activities, as well as the actions the trading desk will

take to demonstrably reduce or otherwise significant mitigate the risks

of its financial exposure consistent with its required limits.\997\ The

Agencies believe this approach addresses commenters' concerns that

limitations on hedging market making-related positions may cause a

reduction in liquidity, wider spreads, or increased risk and trading

costs for market makers because it allows banking entities to determine

[[Page 5890]]

how best to manage the risks of trading desks' market making-related

activities through reasonable policies and procedures, internal

controls, independent testing, and analysis, rather than requiring

compliance with the specific requirements of the hedging

exemption.\998\ Further, this approach addresses commenters' concerns

about the impact of certain requirements of the hedging exemption on

market making-related activities.\999\

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\996\ See, e.g., Japanese Bankers Ass'n.; SIFMA et al. (Prop.

Trading) (Feb. 2012); Credit Suisse (Seidel); FTN; RBC; NYSE

Euronext; MFA.

\997\ See final rule Sec. 75.4(b)(2)(iii)(B); supra Part

VI.A.3.c.3.c.

\998\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit

Suisse (Seidel); NYSE Euronext; MFA; Japanese Bankers Ass'n.; RBC.

\999\ See BoA; SIFMA (Asset Mgmt.) (Feb. 2012); Goldman (Prop.

Trading).

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The Agencies believe it is consistent with the statute's reference

to ``market making-related'' activities to permit market making-related

hedging activities under this exemption. In addition, the Agencies

believe it is appropriate to require a trading desk to appropriately

manage its risks, consistent with its risk management procedures and

limits, because management of risk is a key factor that distinguishes

permitted market making-related activity from impermissible proprietary

trading. As noted in the proposal, while ``a market maker attempts to

eliminate some [of the risks arising from] its retained principal

positions and risks by hedging or otherwise managing those risks [ ], 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.'' \1000\

---------------------------------------------------------------------------

\1000\ See Joint Proposal, 76 FR at 68961.

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The Agencies recognize that some banking entities may manage the

risks associated with market making at a different level than the

individual trading desk.\1001\ While this risk management activity is

not permitted under the market-making exemption, it may be permitted

under the hedging exemption, provided the requirements of that

exemption are met. Thus, the Agencies believe banking entities will

continue to have options available that allow them to efficiently hedge

the risks arising from their market-making operations. Nevertheless,

the Agencies understand that this rule will result in additional

documentation or other potential burdens for market making-related

hedging activity that is not conducted by the trading desk responsible

for the market-making positions being hedged.\1002\ As discussed in

Part VI.A.4.d.4., hedging conducted by a different organizational unit

than the trading desk that is responsible for the underlying positions

presents an increased risk of evasion, so the Agencies believe it is

appropriate for such hedging activity to be required to comply with the

hedging exemption, including the associated documentation requirement.

---------------------------------------------------------------------------

\1001\ See, e.g., letter from JPMC (stating that, to minimize

risk management costs, firms commonly organize their market-making

activities so that risks delivered to client-facing desks are

aggregated and passed by means of internal transactions to a single

utility desk and suggesting this be recognized as permitted market

making-related behavior).

\1002\ See final rule Sec. 75.5(c).

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5. Compensation Requirement

a. Proposed Compensation Requirement

Section 75.4(b)(2)(vii) of the proposed market-making exemption

would have required that the compensation arrangements of persons

performing market making-related activities at the banking entity be

designed not to reward proprietary risk-taking.\1003\ In the proposal,

the Agencies noted that activities for which a banking entity has

established a compensation incentive structure that rewards speculation

in, and appreciation of, the market value of a financial instrument

position held in inventory, rather than success in providing effective

and timely intermediation and liquidity services to customers, would be

inconsistent with the proposed market-making exemption.

---------------------------------------------------------------------------

\1003\ See proposed rule Sec. 75.4(b)(2)(vii).

---------------------------------------------------------------------------

The Agencies stated that under the proposed rule, 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. However, the Agencies

noted that a banking entity relying on the proposed market-making

exemption would be able to 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.\1004\

---------------------------------------------------------------------------

\1004\ See Joint Proposal, 76 FR at 68872; CFTC Proposal, 77 FR

at 8358.

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b. Comments Regarding the Proposed Compensation Requirement

Several commenters recommended certain revisions to the proposed

compensation requirement.\1005\ Two commenters stated that the proposed

requirement is effective,\1006\ while one commenter stated that it

should be removed from the rule.\1007\ Moreover, in addressing this

proposed requirement, commenters provided views on: identifiable

characteristics of compensation arrangements that incentivize

prohibited proprietary trading,\1008\ methods of monitoring compliance

with this requirement,\1009\ and potential negative incentives or

outcomes this requirement could cause.\1010\

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\1005\ See Prof. Duffie; SIFMA et al. (Prop. Trading) (Feb.

2012); John Reed; Credit Suisse (Seidel); JPMC; Morgan Stanley;

Better Markets (Feb. 2012); Johnson & Prof. Stiglitz; Occupy; AFR et

al. (Feb. 2012); Public Citizen.

\1006\ See FTN; Alfred Brock.

\1007\ See Japanese Bankers Ass'n.

\1008\ See Occupy.

\1009\ See Occupy; Goldman (Prop. Trading).

\1010\ See AllianceBernstein; Prof. Duffie; Investure; STANY;

Chamber (Dec. 2011).

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With respect to suggested modifications to this requirement, a few

commenters suggested that a market maker's compensation should be

subject to additional limitations.\1011\ For example, two commenters

stated that compensation should be restricted to particular sources,

such as fees, commissions, and spreads.\1012\ One commenter suggested

that compensation should not be symmetrical between gains and losses

and, further, that trading gains reflecting an unusually high variance

in position values should either not be reflected in compensation and

bonuses or should be less reflected than other gains and losses.\1013\

Another commenter recommended that the Agencies remove ``designed''

from the rule text and provide greater clarity about how a banking

entity's compensation regime must be structured.\1014\ Moreover, a

number of commenters stated that compensation should be vested for a

period of time, such as until the trader's market making positions have

been fully unwound and are no longer in the banking entity's

inventory.\1015\ As one commenter explained, such a requirement would

discourage traders from carrying inventory and encourage them to get

out of positions as soon as possible.\1016\ Some commenters also

recommended that compensation be risk adjusted.\1017\

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\1011\ See Better Markets (Feb. 2012); Public Citizen; AFR et

al. (Feb. 2012); Occupy; John Reed; AFR et al. (Feb. 2012); Johnson

& Prof. Stiglitz; Prof. Duffie; Sens. Merkley & Levin (Feb. 2012).

These comments are addressed in note 1032, infra.

\1012\ See Better Markets (Feb. 2012); Public Citizen.

\1013\ See AFR et al. (Feb. 2012)

\1014\ See Occupy.

\1015\ See John Reed; AFR et al. (Feb. 2012); Johnson & Prof.

Stiglitz; Prof. Duffie (``A trader's incentives for risk taking can

be held in check by vesting incentive-based compensation over a

substantial period of time. Pending compensation can thus be

forfeited if a trader's negligence causes substantial losses or if

his or her employer fails.''); Sens. Merkley & Levin (Feb. 2012).

\1016\ See John Reed.

\1017\ See Johnson & Prof. Stiglitz; John Reed; Sens. Merkley &

Levin (Feb. 2012).

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[[Page 5891]]

A few commenters indicated that the proposed approach may be too

restrictive.\1018\ Two of these commenters stated that the compensation

requirement should instead be set forth as guidance in Appendix

B.\1019\ In addition, two commenters requested that the Agencies

clarify that compensation arrangements must be designed not to reward

prohibited proprietary risk-taking. These commenters were concerned the

proposed approach may restrict a banking entity's ability to provide

compensation for permitted activities, which also involve proprietary

trading.\1020\

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\1018\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC;

Morgan Stanley.

\1019\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.

\1020\ See Morgan Stanley; SIFMA et al. (Prop. Trading) (Feb.

2012). The Agencies respond to these comments in note 1026 and its

accompanying text, infra.

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Two commenters discussed identifiable characteristics of

compensation arrangements that clearly incentivize prohibited

proprietary trading.\1021\ For example, one commenter stated that

rewarding pure profit and loss, without consideration for the risk that

was assumed to capture it, is an identifiable characteristic of an

arrangement that incentivizes proprietary risk-taking.\1022\ For

purposes of monitoring and ensuring compliance with this requirement,

one commenter noted that existing Board regulations for systemically

important banking entities require comprehensive firm-wide policies

that determine compensation. This commenter stated that those

regulations, along with appropriately calibrated metrics, should ensure

that compensation arrangements are not designed to reward prohibited

proprietary risk-taking.\1023\ For similar purposes, another commenter

suggested that compensation incentives should be based on a metric that

meaningfully accounts for the risk underlying profitability.\1024\

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\1021\ See Occupy; Alfred Brock.

\1022\ See Occupy. The Agencies respond to this comment in Part

VI.A.3.c.5.c., infra.

\1023\ See Goldman (Prop. Trading).

\1024\ See Occupy.

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Certain commenters expressed concern that the proposed compensation

requirement could incentivize market makers to act in a way that would

not be beneficial to customers or market liquidity.\1025\ For example,

two commenters expressed concern that the requirement could cause

market makers to widen their spreads or charge higher fees because

their personal compensation depends on these factors.\1026\ One

commenter stated that the proposed requirement could dampen traders'

incentives and discretion and may make market makers less likely to

accept trades involving significant increases in risk or profit.\1027\

Another commenter expressed the view that profitability-based

compensation arrangements encourage traders to exercise due care

because such arrangements create incentives to avoid losses.\1028\

Finally, one commenter stated that compliance with the proposed

requirement may be difficult or impossible if the Agencies do not take

into account the incentive-based compensation rulemaking.\1029\

---------------------------------------------------------------------------

\1025\ See AllianceBernstein; Investure; Prof. Duffie; STANY.

This issue is addressed in note 1032, infra.

\1026\ See AllianceBernstein; Investure.

\1027\ See Prof. Duffie.

\1028\ See STANY.

\1029\ See Chamber (Dec. 2011).

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c. Final Compensation Requirement

Similar to the proposed rule, the market-making exemption requires

that the compensation arrangements of persons performing the banking

entity's market making-related activities, as described in the

exemption, are designed not to reward or incentivize prohibited

proprietary trading.\1030\ The language of the final compensation

requirement has been modified in response to comments expressing

concern about the proposed language regarding ``proprietary risk-

taking.'' \1031\ The Agencies note that the Agencies do not intend to

preclude an employee of a market-making desk from being compensated for

successful market making, which involves some risk-taking.

---------------------------------------------------------------------------

\1030\ See final rule Sec. 75.4(b)(2)(v).

\1031\ See Morgan Stanley; SIFMA et al. (Prop. Trading) (Feb.

2012).

---------------------------------------------------------------------------

The Agencies continue to hold the view that activities for which a

banking entity has established a compensation incentive structure that

rewards speculation in, and appreciation of, the market value of a

position held in inventory, rather than use of that inventory to

successfully provide 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 retained principal risk, a banking entity relying on the

market-making exemption should provide compensation incentives that

primarily reward customer revenues and effective customer service, not

prohibited proprietary trading.\1032\ For example, a compensation plan

based purely on net profit and loss with no consideration for inventory

control or risk undertaken to achieve those profits would not be

consistent with the market-making exemption.

---------------------------------------------------------------------------

\1032\ Because the Agencies are not limiting a market maker's

compensation to specific sources, such as fees, commissions, and

bid-ask spreads, as recommended by a few commenters, the Agencies do

not believe the compensation requirement in the final rule will

incentivize market makers to widen their quoted spreads or charge

higher fees and commissions, as suggested by certain other

commenters. See Better Markets (Feb. 2012); Public Citizen;

AllianceBernstein; Investure. In addition, the Agencies note that an

approach requiring revenue from fees, commissions, and bid-ask

spreads to be fully distinguished from revenue from price

appreciation can raise certain practical difficulties, as discussed

in Part VI.A.3.c.7. The Agencies also are not requiring compensation

to be vested for a period of time, as recommended by some commenters

to reduce traders' incentives for undue risk-taking. The Agencies

believe the final rule includes sufficient controls around risk-

taking activity without a compensation vesting requirement. See John

Reed; AFR et al. (Feb. 2012); Johnson & Prof. Stiglitz; Prof.

Duffie; Sens. Merkley & Levin (Feb. 2012).

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6. Registration Requirement

a. Proposed Registration Requirement

Under Sec. 75.4(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 would be required to be appropriately

registered as a securities dealer, swap dealer, or security-based swap

dealer, or exempt from registration or excluded from regulation as such

type of dealer, under applicable securities or commodities laws.

Further, if the banking entity was 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 would be required to be subject to

substantive regulation of its dealing business in the jurisdiction in

which the business is located.\1033\

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\1033\ See proposed rule Sec. 75.4(b)(2)(iv); Joint Proposal,

76 FR at 68872; CFTC Proposal, 77 FR at 8357-8358.

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b. Comments on the Proposed Registration Requirement

A few commenters stated that the proposed dealer registration

requirement is effective.\1034\ However, a number of commenters opposed

the proposed dealer registration requirement in whole or in part.\1035\

[[Page 5892]]

Commenters' primary concern with the requirement appeared to be its

application to market making-related activities outside of the United

States for which no U.S. registration is required.\1036\ For example,

several commenters stated that many non-U.S. markets do not provide

substantive regulation of dealers for all asset classes.\1037\ In

addition, two commenters stated that booking entities may be able to

rely on intra-group exemptions under local law rather than carrying

dealer registrations, or a banking entity may execute customer trades

through an international dealer but book the position in a non-dealer

entity for capital adequacy and risk management purposes.\1038\ Several

of these commenters requested, at a minimum, that the dealer

registration requirement not apply to dealers in non-U.S.

jurisdictions.\1039\

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\1034\ See Occupy; Alfred Brock.

\1035\ See SIFMA et al. (Prop. Trading) (Feb. 2012) (stating

that if the requirement is not removed from the rule, then it should

only be an indicative factor of market making); Morgan Stanley;

Goldman (Prop. Trading); ISDA (Feb. 2012).

\1036\ See Goldman (Prop. Trading); Morgan Stanley; RBC; SIFMA

et al. (Prop. Trading) (Feb. 2012); ISDA (Feb. 2012); JPMC. This

issue is addressed in note 1044 and its accompanying text, infra.

\1037\ See Goldman (Prop. Trading); RBC; SIFMA et al. (Prop.

Trading) (Feb. 2012).

\1038\ See JPMC; Goldman (Prop. Trading).

\1039\ See Goldman (Prop. Trading); RBC; SIFMA et al. (Prop.

Trading) (Feb. 2012). See also Morgan Stanley (requesting the

addition of the phrase ``to the extent it is legally required to be

subject to such regulation'' to the non-U.S. dealer provisions).

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In addition, with respect to the provisions that would generally

require a banking entity to be a form of SEC- or CFTC-registered dealer

for market-making activities in securities or derivatives in the United

States, a few commenters stated that these provisions should be removed

from the rule.\1040\ These commenters represented that removing these

provisions would be appropriate for several reasons. For example, one

commenter stated that dealer registration does not help distinguish

between market making and speculative trading.\1041\ Another commenter

indicated that effective market making often requires a banking entity

to trade on several exchange and platforms in a variety of markets,

including through legal entities other than SEC- or CFTC-registered

dealer entities.\1042\ One commenter expressed general concern that the

proposed requirement may result in the market-making exemption being

unavailable for market making in exchange-traded futures and options

because those markets do not have a corollary to dealer registration

requirements in securities, swaps, and security-based swaps

markets.\1043\

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\1040\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading); Morgan Stanley; ISDA (Feb. 2012). Rather than

remove the requirement entirely, one commenter recommended that the

Agencies move the dealer registration requirement to proposed

Appendix B, which would allow the Agencies to take into account the

facts and circumstances of a particular trading activity. See JPMC.

\1041\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\1042\ See Goldman (Prop. Trading).

\1043\ See CME Group.

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Some commenters expressed particular concern about the provisions

that would generally require registration as a swap dealer or a

security-based swap dealer.\1044\ For example, one commenter expressed

concern that these provisions may require banking regulators to

redundantly enforce CFTC and SEC registration requirements. Moreover,

according to this commenter, the proposed definitions of ``swap

dealer'' and ``security-based swap dealer'' do not focus on the market

making core of the swap dealing business.\1045\ Another commenter

stated that incorporating the proposed definitions of ``swap dealer''

and ``security-based swap dealer'' is contrary to the Administrative

Procedure Act.\1046\

---------------------------------------------------------------------------

\1044\ See ISDA (Feb. 2012); SIFMA et al. (Prop. Trading) (Feb.

2012).

\1045\ See ISDA (Feb. 2012).

\1046\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

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c. Final Registration Requirement

The final requirement of the market-making exemption provides that

the banking entity must be licensed or registered to engage in market

making-related activity in accordance with applicable law.\1047\ The

Agencies have considered comments regarding the dealer registration

requirement in the proposed rule.\1048\ In response to comments, the

Agencies have narrowed the scope of the proposed requirement's

application to banking entities engaged in market making-related

activity in foreign jurisdictions.\1049\ Rather than requiring these

banking entities to be subject to substantive regulation of their

dealing business in the relevant foreign jurisdiction, the final rule

only require a banking entity to be a registered dealer in a foreign

jurisdiction to the extent required by applicable foreign law. The

Agencies have also simplified the language of the proposed requirement,

although the Agencies have not modified the scope of the requirement

with respect to U.S. dealer registration requirements.

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\1047\ See final rule Sec. 75.4(b)(2)(vi).

\1048\ See supra Part VI.A.3.c.5.b. One commenter expressed

concern that the instruments listed in Sec. 75.4(b)(2)(iv) of the

proposed rule could be interpreted as limiting the availability of

the market-making exemption to other instruments, such as exchange-

traded futures and options. In response to this comment, the

Agencies note that the reference to particular instruments in Sec.

75.4(b)(2)(iv) was intended to reflect that trading in certain types

of instruments gives rise to dealer registration requirements. This

provision was not intended to limit the availability of the market-

making exemption to certain types of financial instruments. See CME

Group.

\1049\ See Goldman (Prop. Trading); RBC; SIFMA et al. (Prop.

Trading) (Feb. 2012); Morgan Stanley.

---------------------------------------------------------------------------

This provision is not intended to expand the scope of licensing or

registration requirements under relevant U.S. or foreign law that are

applicable to a banking entity engaged in market-making activities.

Instead, this provision recognizes that compliance with applicable law

is an essential indicator that a banking entity is engaged in market-

making activities.\1050\ For example, a U.S. banking entity would be

expected to be an SEC-registered dealer to rely on the market-making

exemption for trading in securities--other than exempted securities,

security-based swaps, commercial paper, bankers acceptances, or

commercial bills--unless the banking entity is exempt from registration

or excluded from regulation as a dealer.\1051\ Similarly, a U.S.

banking entity is expected to be a CFTC-registered swap dealer or SEC-

registered security-based swap dealer to rely on the market-making

exemption for trading in swaps or security-based swaps,

respectively,\1052\ unless the

[[Page 5893]]

banking entity is exempt from registration or excluded from regulation

as a swap dealer or security-based swap dealer.\1053\ In response to

comments on whether this provision should generally require

registration as a swap dealer or security-based swap dealer to make a

market in swaps or security-based swaps,\1054\ the Agencies continue to

believe that this requirement is appropriate. In general, a person that

is engaged in making a market in swaps or security-based swaps or other

activity causing oneself to be commonly known in the trade as a market

maker in swaps or security-based swaps is required to be a registered

swap dealer or registered security-based swap dealer, unless exempt

from registration or excluded from regulation as such.\1055\ As noted

above, compliance with applicable law is an essential indicator that a

banking entity is engaged in market-making activities.

---------------------------------------------------------------------------

\1050\ In response to commenters who stated that the dealer

registration requirement should be removed from the rule because,

among other things, registration as a dealer does not distinguish

between permitted market making and impermissible proprietary

trading, the Agencies recognize that acting as a registered dealer

does not ensure that a banking entity is engaged in permitted market

making-related activity. See SIFMA et al. (Prop. Trading) (Feb.

2012); Goldman (Prop. Trading); Morgan Stanley; ISDA (Feb. 2012).

However, this requirement recognizes that registration as a dealer

is an indicator of market making-related activities in the

circumstances in which a person is legally obligated to be a

registered dealer to act as a market maker.

\1051\ A banking entity relying on the market-making exemption

for transactions in security-based swaps would generally be required

to be a registered security-based swap dealer and would not be

required to be a registered securities dealer. However, 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. The

definition of ``dealer'' in section 3(a)(5) of the Exchange Act

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.'' 15 U.S.C.

78c(a)(5).

To the extent, if any, that a banking entity relies on the

market-making exemption for its trading in municipal securities or

government securities, rather than the exemption in Sec. 75.6(a) of

the final rule, this provision may require the banking entity to be

registered or licensed as a municipal securities dealer or

government securities dealer.

\1052\ As noted above, under certain circumstances, a banking

entity acting as market maker in security-based swaps may be

required to be a registered securities dealer. See supra note 1051.

\1053\ For example, a banking entity meeting the conditions of

the de minimis exception in SEC Rule 3a71-2 under the Exchange Act

would not need to be a registered security-based swap dealer to act

as a market maker in security-based swaps. See 17 CFR 240.3a71-2.

\1054\ See ISDA (Feb. 2012); SIFMA et al. (Prop. Trading) (Feb.

2012).

\1055\ See 7 U.S.C. 1a(49)(A); 15 U.S.C. 78c(a)(71)(A).

---------------------------------------------------------------------------

As noted above, the Agencies have determined that, rather than

require a banking entity engaged in the business of a securities

dealer, swap dealer, or security-based swap dealer outside the United

States to be subject to substantive regulation of its dealing business

in the foreign jurisdiction in which the business is located, a banking

entity's dealing activity outside the U.S. should only be subject to

licensing or registration requirements under applicable foreign law

(provided no U.S. registration or licensing requirements apply to the

banking entity's activities). As a result, this requirement will not

impact a banking entity's ability to engage in permitted market making-

related activities in a foreign jurisdiction that does not provide for

substantive regulation of dealers.\1056\

---------------------------------------------------------------------------

\1056\ See Goldman (Prop. Trading); RBC; SIFMA et al. (Prop.

Trading) (Feb. 2012); Morgan Stanley. This is consistent with one

commenter's suggestion that the Agencies add ``to the extent it is

legally required to be subject to such regulation'' to the non-U.S.

dealer provisions. See Morgan Stanley.

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7. Source of Revenue Analysis

a. Proposed Source of Revenue Requirement

To qualify for the market-making exemption, the proposed rule

required that the market making-related activities of the trading desk

or other organizational unit be designed to generate revenues primarily

from fees, commissions, bid/ask spreads or other income not

attributable to appreciation in the value of financial instrument

positions it holds in trading accounts or the hedging of such

positions.\1057\ This proposed requirement was 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.\1058\

---------------------------------------------------------------------------

\1057\ See proposed rule Sec. 75.4(b)(2)(v).

\1058\ See Joint Proposal, 76 FR at 68872; CFTC Proposal, 77 FR

at 8358.

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b. Comments Regarding the Proposed Source of Revenue Requirement

As discussed in more detail below, many commenters expressed

concern about the proposed source of revenue requirement. These

commenters raised a number of concerns including, among others, the

proposed requirement's potential impact on a market maker's inventory

or on costs to customers, the difficulty of differentiating revenues

from spreads and revenues from price appreciation in certain markets,

and the need for market makers to be compensated for providing

intermediation services.\1059\ Several of these commenters requested

that the proposed source of revenue requirement be removed from the

rule or modified in certain ways. Some commenters, however, expressed

support for the proposed requirement or requested that the Agencies

place greater restrictions on a banking entity's permissible sources of

revenue under the market-making exemption.\1060\

---------------------------------------------------------------------------

\1059\ These concerns are addressed in Part VI.A.3.c.7.c.,

infra.

\1060\ See infra note 1103 (responding to these comments).

---------------------------------------------------------------------------

i. Potential Restrictions on Inventory, Increased Costs for Customers,

and Other Changes to Market-Making Services

Many commenters stated that the proposed source of revenue

requirement may limit a market maker's ability to hold sufficient

inventory to facilitate customer demand.\1061\ Several of these

commenters expressed particular concern about applying this requirement

to less liquid markets or to facilitating large customer positions,

where a market maker is more likely to hold inventory for a longer

period of time and has increased risk of potential price appreciation

(or depreciation).\1062\ Further, another commenter questioned how the

proposed requirement would apply when unforeseen market pressure or

disappearance of customer demand results in a market maker holding a

particular position in inventory for longer than expected.\1063\ In

response to this proposed requirement, a few commenters stated that it

is important for market makers to be able to hold a certain amount of

inventory to: provide liquidity (particularly in the face of order

imbalances and market volatility),\1064\ facilitate large trades, and

hedge positions acquired in the course of market making.\1065\

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\1061\ See, e.g., NYSE Euronext; SIFMA et al. (Prop. Trading)

(Feb. 2012); Morgan Stanley; Goldman (Prop. Trading); BoA; Citigroup

(Feb. 2012); STANY; BlackRock; SIFMA (Asset Mgmt.) (Feb. 2012); ACLI

(Feb. 2012); T. Rowe Price; PUC Texas; SSgA (Feb. 2012); ICI (Feb.

2012) Invesco; MetLife; MFA.

\1062\ See, e.g., Morgan Stanley; BoA; BlackRock; T. Rowe Price;

Goldman (Prop. Trading); NYSE Euronext (suggesting that principal

trading by market makers in large sizes is essential in some

securities, such as an AP's trading in ETFs); Prof. Duffie; SSgA

(Feb. 2012); CIEBA; SIFMA et al. (Prop. Trading) (Feb. 2012); MFA.

To explain its concern, one commenter stated that bid-ask spreads

are useful to capture the concept of market-making revenues when a

market maker is intermediating on a close to real-time basis between

balanced customer buying and selling interest for the same

instrument, but such close-in-time intermediation does not occur in

many large or illiquid assets, where demand gaps may be present for

days, weeks, or months. See Morgan Stanley.

\1063\ See Capital Group.

\1064\ See NYSE Euronext; CIEBA (stating that if the rule

discourages market makers from holding inventory, there will be

reduced liquidity for investors and issuers).

\1065\ See NYSE Euronext. For a more in-depth discussion of

comments regarding the benefits of permitting market makers to hold

and manage inventory, see Part VI.A.3.c.2.b.vi., infra.

---------------------------------------------------------------------------

Several commenters expressed concern that the proposed source of

revenue requirement may incentivize a market maker to widen its quoted

spreads or otherwise impose higher fees to the detriment of its

customers.\1066\ For example, some commenters stated that the proposed

requirement could result in a market maker having to sell a position in

its inventory within an artificially prescribed period of time and, as

a result, the market maker would pay less to initially acquire the

position from a customer.\1067\ Other commenters represented that the

proposed source of revenue requirement would compel market makers to

hedge their exposure

[[Page 5894]]

to price movements, which would likely increase the cost of

intermediation.\1068\

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\1066\ See, e.g., Wellington; CIEBA; MetLife; ACLI (Feb. 2012);

SSgA (Feb. 2012); PUC Texas; ICI (Feb. 2012) BoA.

\1067\ See MetLife; ACLI (Feb. 2012); ICI (Feb. 2012) SSgA (Feb.

2012).

\1068\ See SSgA (Feb. 2012); PUC Texas.

---------------------------------------------------------------------------

Some commenters stated that the proposed source of revenue

requirement may make a banking entity less willing to make markets in

instruments that it may not be able to resell immediately or in the

short term.\1069\ One commenter indicated that this concern may be

heightened in times of market stress.\1070\ Further, a few commenters

expressed the view that the proposed requirement would cause banking

entities to exit the market-making business due to restrictions on

their ability to make a profit from market-making activities.\1071\

Moreover, in one commenter's opinion, the proposed requirement would

effectively compel market makers to trade on an agency basis.\1072\

---------------------------------------------------------------------------

\1069\ See ICI (Feb. 2012) SSgA (Feb. 2012); SIFMA (Asset Mgmt.)

(Feb. 2012); BoA.

\1070\ See CIEBA (arguing that banking entities may be reluctant

to provide liquidity when markets are declining and there are more

sellers than buyers because it would be necessary to hold positions

in inventory to avoid losses).

\1071\ See Credit Suisse (Seidel) (arguing that banking entities

are likely to cease being market makers if they are: (i) Unable to

take into account the likely direction of a financial instrument, or

(ii) forced to take losses if a financial instrument moves against

them, but cannot take gains if the instrument's price moves in their

favor); STANY (contending that banking entities cannot afford to

maintain unprofitable or marginally profitable operations in highly

competitive markets, so this requirement would cause banking

entities to eliminate a majority of their market-making functions).

\1072\ See IR&M (arguing that domestic corporate and securitized

credit markets are too large and heterogeneous to be served

appropriately by a primarily agency-based trading model).

---------------------------------------------------------------------------

ii. Certain Price Appreciation-Related Profits Are an Inevitable or

Important Component of Market Making

A number of commenters indicated that market makers will inevitably

make some profit from price appreciation of certain inventory positions

because changes in market values cannot be precisely predicted or

hedged.\1073\ In particular, several commenters emphasized that matched

or perfect hedges are generally unavailable for most types of

positions.\1074\ According to one commenter, a provision that

effectively requires a market-making business to hedge all of its

principal positions would discourage essential market-making activity.

The commenter explained that effective hedges may be unavailable in

less liquid markets and hedging can be costly, especially in relation

to the relative risk of a trade and hedge effectiveness.\1075\ A few

commenters further indicated that making some profit from price

appreciation is a natural part of market making or is necessary to

compensate a market maker for its willingness to take a position, and

its associated risk (e.g., the risk of market changes or decreased

value), from a customer.\1076\

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\1073\ See Wellington; Credit Suisse (Seidel); Morgan Stanley;

PUC Texas (contending that it is impossible to predict the behavior

of even the most highly correlated hedge in comparison to the

underlying position); CIEBA; SSgA (Feb. 2012); AllianceBernstein;

Investure; Invesco.

\1074\ See Morgan Stanley; Credit Suisse (Seidel); SSgA (Feb.

2012); PUC Texas; Wellington; AllianceBernstein; Investure.

\1075\ See Wellington. Moreover, one commenter stated that, as a

general matter, market makers need to be compensated for bearing

risk related to providing immediacy to a customer. This commenter

stated that ``[t]he greater the inventory risk faced by the market

maker, the higher the expected return (compensation) that the market

maker needs,'' to compensate the market maker for bearing the risk

and reward its specialization skills in that market (e.g., its

knowledge about market conditions and early indicators that may

imply future price movements in a particular direction). This

commenter did not, however, discuss the source of revenue

requirement in the proposed rule. See Thakor Study.

\1076\ See Capital Group; Prof. Duffie; Investure; SIFMA et al.

(Prop. Trading) (Feb. 2012); STANY; SIFMA (Asset Mgmt.) (Feb. 2012);

RBC; PNC.

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iii. Concerns Regarding the Workability of the Proposed Standard in

Certain Markets or Asset Classes

Some commenters represented that it would be difficult or

burdensome to identify revenue attributable to the bid-ask spread

versus revenue arising from price appreciation, either as a general

matter or for specific markets.\1077\ For example, one commenter

expressed the opinion that the difference between the bid-ask spread

and price appreciation is ``metaphysical'' in some sense,\1078\ while

another stated that it is almost impossible to objectively identify a

bid-ask spread or to capture profit and loss solely from a bid-ask

spread in most markets.\1079\ Other commenters represented that it is

particularly difficult to make this distinction when trades occur

infrequently or where prices are not transparent, such as in the fixed-

income market where no spread is published.\1080\

---------------------------------------------------------------------------

\1077\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Goldman (Prop. Trading); BoA; Citigroup (Feb. 2012); Japanese

Bankers Ass'n.; Sumitomo Trust; Morgan Stanley; Barclays; RBC;

Capital Group.

\1078\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\1079\ See Citigroup (Feb. 2012). See also Barclays (arguing

that a bid-ask spread cannot be defined on a consistent basis with

respect to many instruments).

\1080\ See Goldman (Prop. Trading); BoA; Morgan Stanley

(``Observable, actionable, bid/ask spreads exist in only a small

subset of institutional products and markets. Indicative bid/ask

spreads may be observable for certain products, but this pricing

would typically be specific to small size standard lot trades and

would not represent a spread applicable to larger and/or more

illiquid trades. End-of-day valuations for assets are calculated,

but they are not an effective proxy for real-time bid/ask spreads

because of intra-day price movements.''); RBC; Capital Group

(arguing that bid-ask spreads in fixed-income markets are not always

quantifiable or well defined and can fluctuate widely within a

trading day because of small or odd lot trades, price discovery

activity, a lack of availability to cover shorts, or external

factors not directly related to the security being traded).

---------------------------------------------------------------------------

Many commenters expressed particular concern about the proposed

requirement's application to specific markets, including: The fixed-

income markets; \1081\ the markets for commodities, derivatives,

securitized products, and emerging market securities; \1082\ equity and

physical commodity derivatives markets; \1083\ and customized swaps

used by customers of banking entities for hedging purposes.\1084\

Another commenter expressed general concern about extremely volatile

markets, where market makers often see large upward or downward price

swings over time.\1085\

---------------------------------------------------------------------------

\1081\ See Capital Group; CIEBA; SIFMA et al. (Prop. Trading)

(Feb. 2012); SSgA (Feb. 2012). These commenters stated that the

requirement may be problematic for the fixed-income markets because,

for example, market makers must hold inventory in these markets for

a longer period of time than in more liquid markets. See id.

\1082\ See SIFMA et al. (Prop. Trading) (Feb. 2012) (stating

that these markets are characterized by even less liquidity and less

frequent trading than the U.S. corporate bond market). This

commenter also stated that in markets where trades are large and

less frequent, such as the market for customized securitized

products, appreciation in price of one position may be a predominate

contributor to the overall profit and loss of the trading unit. See

id.

\1083\ See BoA. According to this commenter, the distinction

between capturing a spread and price appreciation is fundamentally

flawed in some markets, like equity derivatives, because the market

does not trade based on movements of a particular security or

underlying instrument. This commenter indicated that expected

returns are instead based on the bid-ask spread the market maker

charges for implied volatility as reflected in options premiums and

hedging of the positions. See id.

\1084\ See CIEBA (stating that because it would be difficult for

a market maker to enter promptly into an offsetting swap, the market

maker would not be able to generate income from the spread).

\1085\ See SIFMA et al. (Prop. Trading) (Feb. 2012). This

commenter questioned whether proposed Appendix B's reference to

``unexpected market disruptions'' as an explanatory fact and

circumstance was intended to permit such market making. See id.

---------------------------------------------------------------------------

Two commenters emphasized that the revenues a market maker

generates from hedging the positions it holds in inventory are

equivalent to spreads in many markets. These commenters explained that,

under these circumstances, a market maker generates revenue from the

difference between the customer price for the position and the banking

entity's price for the hedge. The commenters noted that proposed

Appendix B expressly recognizes this in the case of derivatives and

recommended that Appendix B's

[[Page 5895]]

guidance on this point apply equally to certain non-derivative

positions.\1086\

---------------------------------------------------------------------------

\1086\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading). In its discussion of ``customer revenues,''

Appendix B states: ``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.'' Joint Proposal, 76 FR at

68960; CFTC Proposal, 77 FR at 8440. See also RBC (requesting

clarification on how the proposed standard would apply if a market

maker took an offsetting position in a different instrument (e.g., a

different bond) and inquiring whether, if the trader took the

offsetting position, its revenue gain is attributable to price

appreciation of the two offsetting positions or from the bid-ask

spread in the respective bonds).

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A few commenters questioned how this requirement would work in the

context of block trading or otherwise facilitating large trades, where

a market maker may charge a premium or discount for taking on a large

position to provide ``immediacy'' to its customer.\1087\ One commenter

further explained that explicitly quoted bid-ask spreads are only valid

for indicated trade sizes that are modest enough to have negligible

market impact, and such spreads cannot be used for purposes of a

significantly larger trade.\1088\

---------------------------------------------------------------------------

\1087\ See Prof. Duffie; NYSE Euronext; Capital Group; RBC;

Goldman (Prop. Trading). See also Thakor Study (discussing market

makers' role of providing ``immediacy'' in general).

\1088\ See CIEBA.

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iv. Suggested Modifications to the Proposed Requirement

To address some or all of the concerns discussed above, many

commenters recommended that the source of revenue requirement be

modified \1089\ or removed from the rule entirely.\1090\ With respect

to suggested changes, some commenters stated that the Agencies should

modify the rule text,\1091\ use a metrics-based approach to focus on

customer revenues,\1092\ or replace the proposed requirement with

guidance.\1093\ Some commenters requested that the Agencies modify the

focus of the requirement so that, for example, dealers' market-making

activities in illiquid securities can function as close to normal as

possible \1094\ or market makers can take short-term positions that may

ultimately result in a profit or loss.\1095\ As discussed below, some

commenters stated that the Agencies should modify the proposed

requirement to place greater restrictions on market maker revenue.

---------------------------------------------------------------------------

\1089\ See, e.g., JPMC; Barclays; Goldman (Prop. Trading); BoA;

CFA Inst.; ICI (Feb. 2012) Flynn & Fusselman.

\1090\ See, e.g., CIEBA; SIFMA et al. (Prop. Trading) (Feb.

2012); Morgan Stanley; Goldman (Prop. Trading); Capital Group; RBC.

In addition to the concerns discussed above, one commenter stated

that the proposed requirement may set limits on the values of

certain metrics, and it would be inappropriate to prejudge the

appropriate results of such metrics at this time. See SIFMA et al.

(Prop. Trading) (Feb. 2012).

\1091\ See, e.g., Barclays. This commenter provided alternative

rule text stating that ``market making-related activity is conducted

by each trading unit such that its activities are reasonably

designed to generate revenues primarily from fees, commissions, bid-

ask spreads, or other income attributable to satisfying reasonably

expected customer demand.'' See id.

\1092\ See Goldman (Prop. Trading) (suggesting that the Agencies

use a metrics-based approach to focus on customer revenues, as

measured by Spread Profit and Loss (when it is feasible to

calculate) or other metrics, especially because a proprietary

trading desk would not be expected to earn any revenues this way).

This commenter also indicated that the ``primarily'' standard in the

proposed rule is problematic and can be read to mean ``more than

50%,'' which is different from Appendix B's acknowledgment that the

proportion of customer revenues relative to total revenues will vary

by asset class. See id.

\1093\ See BoA (recommending that the guidance state that the

Agencies would consider the design and mix of such revenues as an

indicator of potentially prohibited proprietary trading, but only

for those markets for which revenues are quantifiable based on

publicly available data, such as segments of certain highly liquid

equity markets).

\1094\ See CFA Inst.

\1095\ See ICI (Feb. 2012).

---------------------------------------------------------------------------

v. General Support for the Proposed Requirement or for Placing Greater

Restrictions on a Market Maker's Sources of Revenue

Some commenters expressed support for the proposed source of

revenue requirement or stated that the requirement should be more

restrictive.\1096\ For example, one of these commenters stated that a

real market maker's trading book should be fully hedged, so it should

not generate profits in excess of fees and commissions except in times

of rare and extraordinary market conditions.\1097\ According to another

commenter, the final rule should make it clear that banking entities

seeking to rely on the market-making exemption may not generally seek

to profit from price movements in their inventories, although their

activities may give rise to modest and relatively stable profits

arising from their limited inventory.\1098\ One commenter recommended

that the proposed requirement be interpreted to limit market making in

illiquid positions because a banking entity cannot have the required

revenue motivation when it enters into a position for which there is no

readily discernible exit price.\1099\

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\1096\ See Sens. Merkley & Levin (Feb. 2012); Better Markets

(Feb. 2012); FTN; Public Citizen; Occupy; Alfred Brock.

\1097\ See Better Markets (Feb. 2012). See also Public Citizen

(arguing that the imperfection of a hedge should signal potential

disqualification of the underlying position from the market-making

exemption).

\1098\ See Sens. Merkley & Levin (Feb. 2012). This commenter

further suggested that the rule identify certain red flags and

metrics that could be used to monitor this requirement, such as: (i)

Failure to obtain relatively low ratios of revenue-to-risk, low

volatility, and relatively high turnover; (ii) significant revenues

from price appreciation relative to the value of securities being

traded; (iii) volatile revenues from price appreciation; or (iv)

revenue from price appreciation growing out of proportion to the

risk undertaken with the security. See id.

\1099\ See AFR et al. (Feb. 2012).

---------------------------------------------------------------------------

Further, some commenters suggested that the Agencies remove the

word ``primarily'' from the provision to limit banking entities to

specified sources of revenue.\1100\ In addition, one of these

commenters requested that the Agencies restrict a market maker's

revenue to fees and commissions and remove the allowance for revenue

from bid-ask spreads because generating bid-ask revenues relies

exclusively on changes in market values of positions held in

inventory.\1101\ For enforcement purposes, a few commenters suggested

that the Agencies require banking entities to disgorge any profit

obtained from price appreciation.\1102\

---------------------------------------------------------------------------

\1100\ See Occupy; Better Markets (Feb. 2012). See supra note

1108 (addressing these comments).

\1101\ See Occupy.

\1102\ See Occupy; Public Citizen.

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c. Final Rule's Approach To Assessing Revenues

Unlike the proposed rule, the final rule does not include a

requirement that a trading desk's market making-related activity be

designed to generate revenue primarily from fees, commissions, bid-ask

spreads, or other income not attributable to appreciation in the value

of a financial instrument or hedging.\1103\ The revenue requirement was

one of the most commented upon aspects of the market-making exemption

in the proposal.\1104\

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\1103\ See proposed rule Sec. 75.4(b)(2)(v).

\1104\ See infra Part VI.A.3.c.7.b.

---------------------------------------------------------------------------

The Agencies believe that an analysis of patterns of revenue

generation and profitability can help inform a judgment regarding

whether trading activity is consistent with the intermediation and

liquidity services that a market maker provides to its customers in the

context of the liquidity, maturity, and depth of the relevant market,

as opposed to prohibited proprietary trading activities. To facilitate

this type of analysis, the Agencies have included a metrics data

reporting requirement that is refined from the proposed metric

regarding profits and losses. The Comprehensive Profit and Loss

Attribution metric collects information regarding the daily fluctuation

in the value of a trading desk's positions to various sources, along

with its volatility, including: (i)

[[Page 5896]]

Profit and loss attributable to current positions that were also held

by the banking entity as of the end of the prior day (``existing

positions); (ii) profit and loss attributable to new positions

resulting from the current day's trading activity (``new positions'');

and (iii) residual profit and loss that cannot be specifically

attributed to existing positions or new positions.\1105\

---------------------------------------------------------------------------

\1105\ See Appendix A of the final rule (describing the

Comprehensive Profit and Loss Attribution metric). This approach is

generally consistent with one commenter's suggested metrics-based

approach to focus on customer-related revenues. See Goldman (Prop.

Trading); see also Sens. Merkley & Levin (Feb. 2012) (suggesting the

use of metrics to monitor a firm's source of revenue); proposed

Appendix A.

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This quantitative measurement has certain conceptual similarities

to the proposed source of revenue requirement in Sec. 75.4(b)(2)(v) of

the proposed rule and certain of the proposed quantitative

measurements.\1106\ However, in response to comments on those

provisions, the Agencies have determined to modify the focus from

particular revenue sources (e.g., fees, commissions, bid-ask spreads,

and price appreciation) to when the trading desk generates revenue from

its positions. The Agencies recognize that when the trading desk is

engaged in market making-related activities, the day one profit and

loss component of the Comprehensive Profit and Loss Attribution metric

may reflect customer-generated revenues, like fees, commissions, and

spreads (including embedded premiums or discounts), as well as that

day's changes in market value. Thereafter, profit and loss associated

with the position carried in the trading desk's book may reflect

changes in market price until the position is sold or unwound. The

Agencies also recognize that the metric contains a residual component

for profit and loss that cannot be specifically attributed to existing

positions or new positions.

---------------------------------------------------------------------------

\1106\ See supra Part VI.A.3.c.7. and infra Part VI.C.3.

---------------------------------------------------------------------------

The Agencies believe that evaluation of the Comprehensive Profit

and Loss Attribution metric could provide valuable information

regarding patterns of revenue generation by market-making trading desks

involved in market-making activities that may warrant further review of

the desk's activities, while eliminating the requirement from the

proposal that the trading desk demonstrate that its primary source of

revenue, under all circumstances, is fees, commissions and bid/ask

spreads. This modified focus will reduce the burden associated with the

proposed source of revenue requirement and better account for the

varying depth and liquidity of markets.\1107\ In addition, the Agencies

believe these modifications appropriately address commenters' concerns

about the proposed source of revenue requirement and reduce the

potential for negative market impacts of the proposed requirement cited

by commenters, such as incentives to widen spreads or disincentives to

engage in market making in less liquid markets.\1108\

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\1107\ The Agencies understand that some commenters interpreted

the proposed requirement as requiring that both the bid-ask spread

for a financial instrument and the revenue a market maker acquired

from such bid-ask spread through a customer trade be identifiable on

a close-to-real-time basis and readily distinguishable from any

additional revenue gained from price appreciation (both on the day

of the transaction and for the rest of the holding period). See,

e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman (Prop.

Trading); BoA; Citigroup (Feb. 2012); Japanese Bankers Ass'n.;

Sumitomo Trust; Morgan Stanley; Barclays; RBC; Capital Group. We

recognize that such a requirement would be unduly burdensome. In

fact, the proposal noted that bid-ask spreads or similar spreads may

not be widely disseminated on a consistent basis or otherwise

reasonably ascertainable in certain asset classes for purposes of

the proposed Spread Profit and Loss metric in Appendix A of the

proposal. See Joint Proposal, 76 FR at 68958-68959; CFTC Proposal,

77 FR at 8438. Moreover, the burden associated with the proposed

requirement should be further reduced because we are not adopting a

stand-alone requirement regarding a trading desk's source of

revenue. Instead, when and how a trading desk generates profit and

loss from its trading activities is a factor that must be considered

for purposes of the near term customer demand requirement. It is not

a dispositive factor for determining compliance with the exemption.

Further, some commenters expressed concern that the proposed

requirement suggested market makers were not permitted to profit

from price appreciation, but rather only from observable spreads or

explicit fees or commissions. See, e.g., Wellington, Credit Suisse

(Seidel); Morgan Stanley; PUC Texas; CIEBA; SSgA (Feb. 2012);

AllianceBernstein; Investure; Invesco. The Agencies confirm that the

intent of the market-making exemption is not to preclude a trading

desk from generating any revenue from price appreciation. Because

this approach clarifies that a trading desk's source of revenue is

not limited to its quoted spread, the Agencies believe this

quantitative measurement will address commenters concerns that the

proposed source of revenue requirement could create incentives for

market makers to widen their spreads, result in higher transaction

costs, require market makers to hedge any exposure to price

movements, or discourage a trading desk from making a market in

instruments that it may not be able to sell immediately. See

Wellington; CIEBA; MetLife; ACLI (Feb. 2012); SSgA (Feb. 2012); PUC

Texas; ICI (Feb. 2012) BoA; SIFMA (Asset Mgmt.) (Feb. 2012). The

modifications to this provision are designed to better reflect when,

on average and across many transactions, profits are gained rather

than how they are gained, similar to the way some firms measure

their profit and loss today. See, e.g., Goldman (Prop. Trading).

\1108\ See, e.g., Wellington; CIEBA; MetLife; ACLI (Feb. 2012);

SSgA (Feb. 2012); PUC Texas; ICI (Feb. 2012) BoA. The Agencies are

not adopting an approach that limits a market maker to specified

revenue sources (e.g., fees, commissions, and spreads), as suggested

by some commenters, due to the considerations discussed above. See

Occupy; Better Markets (Feb. 2012). In response to the proposed

source of revenue requirement, some commenters noted that a market

maker may charge a premium or discount for taking on a large

position from a customer. See Prof. Duffie; NYSE Euronext; Capital

Group; RBC; Goldman (Prop. Trading).

---------------------------------------------------------------------------

The Agencies recognize that this analysis is only informative over

time, and should not be determinative of an analysis of whether the

amount, types, and risks of the financial instruments in the trading

desk's market-maker inventory are designed not to exceed the reasonably

expected near term demands of clients, customers, or counterparties.

The Agencies believe this quantitative measurement provides appropriate

flexibility to obtain information on market-maker revenues, which is

designed to address commenters' concerns about the proposal's source of

revenue requirement (e.g., the burdens associated with differentiating

spread revenue from price appreciation revenue) while also helping

assess patterns of revenue generation that may be informative over time

about whether a market maker's activities are designed to facilitate

and provide customer intermediation.

8. Appendix B of the Proposed Rule

a. Proposed Appendix B Requirement

The proposed market-making exemption would have required that the

market making-related activities of the trading desk or other

organizational unit of the banking entity be consistent with the

commentary in proposed Appendix B.\1109\ In this proposed Appendix, the

Agencies provided overviews of permitted market making-related activity

and prohibited proprietary trading activity.\1110\

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\1109\ See proposed rule Sec. 75.4(b)(2)(vi).

\1110\ See Joint Proposal, 76 FR at 68873, 68960-68961; CFTC

Proposal, 77 FR at 8358, 8439-8440.

---------------------------------------------------------------------------

The proposed Appendix also set forth various factors that the

Agencies proposed to use to help distinguish prohibited proprietary

trading from permitted market making-related activity. More

specifically, proposed Appendix B set forth six factors that, absent

explanatory facts and circumstances, would cause particular trading

activity to be considered prohibited proprietary trading activity and

not permitted market making-related activity. The proposed factors

focused on: (i) Retaining risk in excess of the size and type required

to provide intermediation services to customers (``risk management

factor''); (ii) primarily generating revenues from price movements of

retained principal positions and risks, rather than customer revenues

(``source of revenues factor''); (iii) generating only very small

[[Page 5897]]

or very large amounts of revenue per unit of risk, not demonstrating

consistent profitability, or demonstrating high earnings volatility

(``revenues relative to risk factor''); (iv) not trading 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 retaining principal positions in excess of

reasonably expected near term customer demands (``customer-facing

activity factor''); (v) routinely paying rather than earning fees,

commissions, or spreads (``payment of fees, commissions, and spreads

factor''); and (vi) providing compensation incentives to employees that

primarily reward proprietary risk-taking (``compensation incentives

factor'').\1111\

---------------------------------------------------------------------------

\1111\ See Joint Proposal, 76 FR at 68873, 68961-68963; CFTC

Proposal, 77 FR at 8358, 8440-8442.

---------------------------------------------------------------------------

b. Comments on Proposed Appendix B

Commenters expressed differing views about the accuracy of the

commentary in proposed Appendix B and the appropriateness of including

such commentary in the rule. For example, some commenters stated that

the description of market making-related activity in the proposed

appendix is accurate \1112\ or appropriately accounts for differences

among asset classes.\1113\ Other commenters indicated that the appendix

is too strict or narrow.\1114\ Some commenters recommended that the

Agencies revise proposed Appendix B's approach by, for example, placing

greater focus on what market making is rather than what it is

not,\1115\ providing presumptions of activity that will be treated as

permitted market making-related activity,\1116\ re-formulating the

appendix as nonbinding guidance,\1117\ or moving certain requirements

of the proposed exemption to the appendix.\1118\ One commenter

suggested the Agencies remove Appendix B from the rule and instead use

the conformance period to analyze and develop a body of supervisory

guidance that appropriately characterizes the nature of market making-

related activity.\1119\

---------------------------------------------------------------------------

\1112\ See MetLife; ACLI (Feb. 2012).

\1113\ See Alfred Brock. But see, e.g., Occupy (stating that the

proposed commentary only accounts for the most liquid and

transparent markets and fails to accurately describe market making

in most illiquid or OTC markets).

\1114\ See Morgan Stanley; IIF; Sumitomo Trust; ISDA (Apr.

2012); BDA (Feb. 2012) (Oct. 2012) (stating that proposed Appendix B

places too great of a focus on derivatives trading and does not

reflect how principal trading operations in equity and fixed income

markets are structured). One of these commenters requested that the

appendix be modified to account for certain activities conducted in

connection with market making in swaps. This commenter indicated

that a swap dealer may not regularly enjoy a dominant flow of

customer revenues and may consistently need to make revenue from its

book management. In addition, the commenter stated that the appendix

should recognize that making a two-way market may be a dominant

theme, but there are certain to be frequent occasions when, as a

matter of market or internal circumstances, a market maker is

unavailable to trade. See ISDA (Apr. 2012).

\1115\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\1116\ See Sens. Merkley & Levin (Feb. 2012). This commenter

stated that, for example, Appendix B could deem market making

involving widely-traded stocks and bonds issued by well-established

corporations, government securities, or highly liquid asset-backed

securities as the type of plain vanilla, low risk capital activities

that are presumptively permitted, provided the activity is within

certain, specified parameters for inventory levels, revenue-to-risk

metrics, volatility, and hedging. See id.

\1117\ See Morgan Stanley; Flynn & Fusselman.

\1118\ See JPMC. In support of such an approach, the commenter

argued that sometimes proposed Sec. 75.4(b) and Appendix B

addressed the same topic and, when this occurs, it is unclear

whether compliance with Appendix B constitutes compliance with Sec.

75.4(b) or if additional compliance steps are required. See id.

\1119\ See Morgan Stanley.

---------------------------------------------------------------------------

A few commenters expressed concern about the appendix's facts-and-

circumstances-based approach to distinguishing between prohibited

proprietary trading and permitted market making-related activity and

stated that such an approach will make it more difficult or burdensome

for banking entities to comply with the proposed rule \1120\ or will

generate regulatory uncertainty.\1121\ As discussed below, other

commenters opposed proposed Appendix B because of its level of

granularity \1122\ or due to perceived restrictions on interdealer

trading or generating revenue from retained principal positions or

risks in the proposed appendix.\1123\ A number of commenters expressed

concern about the complexity or prescriptiveness of the six proposed

factors for distinguishing permitted market making-related activity

from prohibited proprietary trading.\1124\

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\1120\ See NYSE Euronext; Morgan Stanley.

\1121\ See IAA.

\1122\ See Wellington; Goldman (Prop. Trading); SIFMA (Asset

Mgmt.) (Feb. 2012).

\1123\ See Morgan Stanley; Chamber (Feb. 2012); Goldman (Prop.

Trading).

\1124\ See Japanese Bankers Ass'n.; Credit Suisse (Seidel);

Chamber (Feb. 2012); ICFR; Morgan Stanley; Goldman (Prop. Trading);

Occupy; Oliver Wyman (Feb. 2012); Oliver Wyman (Dec. 2011); Public

Citizen; NYSE Euronext. But see Alfred Brock (stating that the

proposed factors are effective).

---------------------------------------------------------------------------

With respect to the level of granularity of proposed Appendix B, a

number of commenters expressed concern that the reference to a ``single

significant transaction'' indicated that the Agencies will review

compliance with the proposed market-making exemption on a trade-by-

trade basis and stated that assessing compliance at the level of

individual transactions would be unworkable.\1125\ One of these

commenters further stated that assessing compliance at this level of

granularity would reduce a market maker's willingness to execute a

customer sell order as principal due to concern that the market maker

may not be able to immediately resell such position. The commenter

noted that this chilling effect would be heightened in declining

markets.\1126\

---------------------------------------------------------------------------

\1125\ See Wellington; Goldman (Prop. Trading); SIFMA (Asset

Mgmt.) (Feb. 2012). In particular, proposed Appendix B provided that

``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.'' Joint Proposal, 76

FR at 68961; CFTC Proposal, 77 FR at 8441. The Agencies address

commenters' trade-by-trade concerns in Part VI.A.3.c.1.c.ii., infra.

\1126\ See Goldman (Prop. Trading).

---------------------------------------------------------------------------

A few commenters interpreted certain statements in proposed

Appendix B as limiting interdealer trading and expressed concerns

regarding potential limitations on this activity.\1127\ These

commenters emphasized that market makers may need to trade with non-

customers to: (i) Provide liquidity to other dealers and, indirectly,

their customers, or to otherwise allow customers to access a larger

pool of liquidity; \1128\ (ii) conduct price discovery to inform the

prices a market maker can offer to customers; \1129\ (iii) unwind or

sell positions acquired from

[[Page 5898]]

customers; \1130\ (iv) establish or acquire positions to meet

reasonably expected near term customer demand; \1131\ (v) hedge; \1132\

and (vi) sell a financial instrument when there are more buyers than

sellers for the instrument at that time.\1133\ Further, one of these

commenters expressed the view that the proposed appendix's statements

are inconsistent with the statutory market-making exemption's reference

to ``counterparties.'' \1134\

---------------------------------------------------------------------------

\1127\ See Morgan Stanley; Goldman (Prop. Trading); Chamber

(Feb. 2012). Specifically, commenters cited statements in proposed

Appendix B indicating that market makers ``typically only engage in

transactions with non-customers to the extent that these

transactions directly facilitate or support customer transactions.''

On this issue, the appendix further stated that ``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 appendix recognized, however, that 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.'' Joint Proposal, 76

FR at 68961; CFTC Proposal, 77 FR at 8440. Commenters' concerns

regarding interdealer trading are addressed in Part VI.A.3.c.2.c.i.,

infra.

\1128\ See Morgan Stanley; Goldman (Prop. Trading).

\1129\ See Morgan Stanley; Goldman (Prop. Trading); Chamber

(Feb. 2012).

\1130\ See Morgan Stanley; Chamber (Feb. 2012) (stating that

market makers in the corporate bond, interest rate derivative, and

natural gas derivative markets frequently trade with other dealers

to work down a concentrated position originating with a customer

trade).

\1131\ See Morgan Stanley; Chamber (Feb. 2012).

\1132\ See Goldman (Prop. Trading).

\1133\ See Chamber (Feb. 2012).

\1134\ See Goldman (Prop. Trading).

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In addition, a few commenters expressed concern about statements in

proposed Appendix B about a market maker's source of revenue.\1135\

According to one commenter, the statement that profit and loss

generated by inventory appreciation or depreciation must be

``incidental'' to customer revenues is inconsistent with market making-

related activity in less liquid assets and larger transactions because

market makers often must retain principal positions for longer periods

of time in such circumstances and are unable to perfectly hedge these

positions.\1136\ As discussed above with respect to the source of

revenue requirement in Sec. 75.4(b)(v) of the proposed rule, a few

commenters requested that Appendix B's discussion of ``customer

revenues'' be modified to state that revenues from hedging will be

considered to be customer revenues in certain contexts beyond

derivatives contracts.\1137\

---------------------------------------------------------------------------

\1135\ See Morgan Stanley; SIFMA et al. (Prop. Trading) (Feb.

2012); Goldman (Prop. Trading). On this issue, Appendix B stated

that certain types of ``customer revenues'' provide the primary

source of a market maker's profitability and, while a market maker

also incurs losses or generates profits as price movements occur in

its retained principal positions and risks, ``such losses or profits

are incidental to customer revenues and significantly limited by the

banking entity's hedging activities.'' Joint Proposal, 76 FR at

68960; CFTC Proposal, 77 FR at 8440. The Agencies address

commenters' concerns about proposed requirements regarding a market

maker's source of revenue in Part VI.A.3.c.7.c., infra.

\1136\ See Morgan Stanley.

\1137\ See supra note 1086 and accompanying text.

---------------------------------------------------------------------------

A number of commenters discussed the six proposed factors in

Appendix B that, absent explanatory facts and circumstances, would have

caused a particular trading activity to be considered prohibited

proprietary trading activity and not permitted market making-related

activity.\1138\ With respect to the proposed factors, one commenter

indicated that they are appropriate,\1139\ while another commenter

stated that they are complex and their effectiveness is

uncertain.\1140\ Another commenter expressed the view that ``[w]hile

each of the selected factors provides evidence of `proprietary

trading,' warrants regulatory attention, and justifies a shift in the

burden of proof, some require subjective judgments, are subject to

gaming or data manipulation, and invite excessive reliance on

circumstantial evidence and lawyers' opinions.'' \1141\

---------------------------------------------------------------------------

\1138\ See supra note 1111 and accompanying text.

\1139\ See Alfred Brock.

\1140\ See Japanese Bankers Ass'n.

\1141\ Sens. Merkley & Levin (Feb. 2012).

---------------------------------------------------------------------------

In response to the proposed risk management factor,\1142\ one

commenter expressed concern that it could prevent a market maker from

warehousing positions in anticipation of predictable but unrealized

customer demands and, further, could penalize a market maker that

misestimated expected demand. This commenter expressed the view that

such an outcome would be contrary to the statute and would harm market

liquidity.\1143\ Another commenter requested that this presumption be

removed because in less liquid markets, such as markets for corporate

bonds, equity derivatives, securitized products, emerging markets,

foreign exchange forwards, and fund-linked products, a market maker

needs to act as principal to facilitate client requests and, as a

result, will be exposed to risk.\1144\

---------------------------------------------------------------------------

\1142\ The proposed appendix stated that the Agencies would use

certain quantitative measurements required in proposed Appendix A to

help assess the extent to which a trading unit's risks are

potentially being retained in excess amounts, including VaR, Stress

VaR, VaR Exceedance, and Risk Factor Sensitivities. See Joint

Proposal, 76 FR at 68961-68962; CFTC Proposal, 77 FR at 8441. One

commenter questioned whether, assuming such metrics are effective

and the activity does not exceed the banking entity's expressed risk

appetite, it is necessary to place greater restrictions on risk-

taking, based on the Agencies' judgment of the level of risk

necessary for bona fide market making. See ICFR.

\1143\ See Chamber (Feb. 2012).

\1144\ See Credit Suisse (Seidel).

---------------------------------------------------------------------------

Two commenters expressed concern about the proposed source of

revenue factor.\1145\ One commenter stated that this factor does not

accurately reflect how market making occurs in a majority of markets

and asset classes.\1146\ The other commenter expressed concern that

this factor shifted the emphasis of Sec. 75.4(b)(v) of the proposed

rule, which required that market making-related activities be

``designed'' to generate revenue primarily from certain sources, to the

actual outcome of activities.\1147\

---------------------------------------------------------------------------

\1145\ See Goldman (Prop. Trading); Morgan Stanley.

\1146\ See Morgan Stanley.

\1147\ See Goldman (Prop. Trading). This commenter suggested

that the Agencies remove any negative presumptions based on revenues

and instead use revenue metrics, such as Spread Profit and Loss

(when it is feasible to calculate) or other metrics for purposes of

monitoring a banking entity's trading activity. See id.

---------------------------------------------------------------------------

With respect to the proposed revenues relative to risk factor, one

commenter supported this aspect of the proposal.\1148\ Some commenters,

however, expressed concern about using these factors to differentiate

permitted market making-related activity from prohibited proprietary

trading.\1149\ These commenters stated that volatile risk-taking and

revenue can be a natural result of principal market-making

activity.\1150\ One commenter noted that customer flows are often

``lumpy'' due to, for example, a market maker's facilitation of large

trades.\1151\

---------------------------------------------------------------------------

\1148\ See Occupy (stating that these factors are important and

will provide invaluable information about the nature of the banking

entity's trading activity).

\1149\ See Morgan Stanley; Credit Suisse (Seidel); Oliver Wyman

(Feb. 2012); Oliver Wyman (Dec. 2011).

\1150\ See Morgan Stanley; Credit Suisse (Seidel); Oliver Wyman

(Feb. 2012); Oliver Wyman (Dec. 2011). For example, one commenter

stated that because markets and trading volumes are volatile,

consistent profitability and low earnings volatility are outside a

market maker's control. In support of this statement, the commenter

indicated that: (i) Customer trading activity varies significantly

with market conditions, which results in volatility in a market

maker's earnings and profitability; and (ii) a market maker will

experience volatility associated with changes in the value of its

inventory positions, and principal risk is a necessary feature of

market making. See Morgan Stanley.

\1151\ See Oliver Wyman (Feb. 2012); Oliver Wyman (Dec. 2011).

---------------------------------------------------------------------------

A few commenters indicated that the analysis in the proposed

customer-facing activity factor may not accurately reflect how market

making occurs in certain markets and asset classes due to potential

limitations on interdealer trading.\1152\ According to another

commenter, however, a banking entity's non-customer facing trades

should be required to be matched with existing customer

counterparties.\1153\ With respect to the near term customer demand

component of this factor, one commenter expressed concern that it goes

farther than the statute's activity-based ``design'' test by analyzing

whether a trading unit's inventory has exceeded reasonably expected

near term customer demand at any particular point in time.\1154\

---------------------------------------------------------------------------

\1152\ See Morgan Stanley; Goldman (Prop. Trading).

\1153\ See Public Citizen.

\1154\ See Oliver Wyman (Feb. 2012).

---------------------------------------------------------------------------

Some commenters expressed concern about the payment of fees,

commissions,

[[Page 5899]]

and spreads factor.\1155\ One commenter appeared to support this

proposed factor.\1156\ According to one commenter, this factor fails to

recognize that market makers routinely pay a variety of fees in

connection with their market making-related activity, including, for

example, fees to access liquidity on another market to satisfy customer

demand, transaction fees as a matter of course, and fees in connection

with hedging transactions. This commenter also indicated that, because

spreads in current, rapidly-moving markets are volatile, short-term

measurements of profit compared to spread revenue is problematic,

particularly for less liquid stocks.\1157\ Another commenter stated

that this factor reflects a bias toward agency trading and principal

market making in highly liquid, exchange-traded markets and does not

reflect the nature of principal market making in most markets.\1158\

One commenter recommended that the rule require that a trader who pays

a fee be prepared to document the chain of custody to show that the

instrument is shortly re-sold to an interested customer.\1159\

---------------------------------------------------------------------------

\1155\ See NYSE Euronext; Morgan Stanley.

\1156\ See Public Citizen.

\1157\ See NYSE Euronext.

\1158\ See Morgan Stanley.

\1159\ See Public Citizen.

---------------------------------------------------------------------------

Regarding the proposed compensation incentives factor, one

commenter requested that the Agencies make clear that explanatory facts

and circumstances cannot justify a trading unit providing compensation

incentives that primarily reward proprietary risk-taking to employees

engaged in market making. In addition, the commenter recommended that

the Agencies delete the word ``primarily'' from this factor.\1160\

---------------------------------------------------------------------------

\1160\ See Occupy. This commenter also stated that the

commentary in Appendix B stating that a banking entity may give some

consideration of profitable hedging activities in determining

compensation would provide inappropriate incentives. See id.

---------------------------------------------------------------------------

c. Determination to Not Adopt Proposed Appendix B

To improve clarity, the final rule establishes particular criteria

for the exemption and does not incorporate the commentary in proposed

Appendix B regarding the identification of permitted market making-

related activities. This SUPPLEMENTARY INFORMATION provides guidance on

the standards for compliance with the market-making exemption.

9. Use of Quantitative Measurements

Consistent with the FSOC study and the proposal, the Agencies

continue to believe that quantitative measurements can be useful to

banking entities and the Agencies to help assess the profile of a

trading desk's trading activity and to help identify trading activity

that may warrant a more in-depth review.\1161\ The Agencies will not

use quantitative measurements as a dispositive tool for differentiating

between permitted market making-related activities and prohibited

proprietary trading. Like the framework the Agencies have developed for

the market-making exemption, the Agencies recognize that there may be

differences in the quantitative measurements across markets and asset

classes.

---------------------------------------------------------------------------

\1161\ See infra Part VI.C.3.; final rule Appendix A.

---------------------------------------------------------------------------

4. Section 75.5: Permitted Risk-Mitigating Hedging Activities

Section 75.5 of the proposed rule implemented 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.\1162\ Section 13(d)(1)(C) provides an exemption 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 ``hedging exemption''). Section 75.5

of the final rule implements the hedging exemption with a number of

modifications from the proposed rule to respond to commenters' concerns

as described more fully below.

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\1162\ See 12 U.S.C. 1851(d)(1)(C); proposed rule Sec. 75.5.

---------------------------------------------------------------------------

a. Summary of Proposal's Approach To Implementing the Hedging Exemption

The proposed rule would have required seven criteria to be met in

order for a banking entity's activity to qualify for the hedging

exemption. First, Sec. Sec. 75.5(b)(1) and 75.5(b)(2)(i) of the

proposed rule generally required that the banking entity establish an

internal compliance program that is designed to ensure the banking

entity's compliance with the requirements of the hedging limitations,

including reasonably designed written policies and procedures, internal

controls, and independent testing, and that a transaction for which the

banking entity is relying on the hedging exemption be made in

accordance with the compliance program established under Sec.

75.5(b)(1). Next, Sec. 75.5(b)(2)(ii) of the proposed rule required

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 the banking

entity. Moreover, Sec. 75.5(b)(2)(iii) of the proposed rule required

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. Furthermore, Sec.

75.5(b)(2)(iv) of the proposed rule required that the hedging

transaction not give rise, at the inception of the hedge, to

significant exposures that are not themselves hedged in a

contemporaneous transaction. Section 75.5(b)(2)(v) of the proposed rule

required that any hedge position established in reliance on the hedging

exemption be subject to continuing review, monitoring and management.

Finally, Sec. 75.5(b)(2)(vi) of the proposed rule required that the

compensation arrangements of persons performing the risk-mitigating

hedging activities be designed not to reward proprietary risk-taking.

Additionally, Sec. 75.5(c) of the proposed rule required the banking

entity to document certain hedging transactions at the time the hedge

is established.

b. Manner of Evaluating Compliance With the Hedging Exemption

A number of commenters expressed concern that the final rule

required application of the hedging exemption on a trade-by-trade

basis.\1163\ One commenter argued that the text of the proposed rule

seemed to require a trade-by-trade analysis because each ``purchase or

sale'' or ``hedge'' was subject to the requirements.\1164\ The final

rule modifies the proposal by generally replacing references to a

``purchase or sale'' in the Sec. 75.5(b) requirements with ``risk-

mitigating hedging activity.'' The Agencies believe this approach is

consistent with the statute, which refers to ``risk-mitigating hedging

activity.'' \1165\

---------------------------------------------------------------------------

\1163\ See Ass'n. of Institutional Investors (Feb. 2012); see

also Barclays; ICI (Feb. 2012); Investure; MetLife; RBC; SIFMA et

al. (Prop. Trading) (Feb. 2012); SIFMA (Asset Mgmt.) (Feb. 2012);

Morgan Stanley; Fixed Income Forum/Credit Roundtable; Fidelity; FTN.

\1164\ See Barclays.

\1165\ See 12 U.S.C. 1851(d)(1)(C) (stating that ``risk-

mitigating hedging activities'' are permitted under certain

circumstances).

---------------------------------------------------------------------------

[[Page 5900]]

Section 13(d)(1)(C) of the BHC Act specifically authorizes risk-

mitigating hedging activities in connection with and related to

``individual or aggregated positions, contracts or other holdings.''

\1166\ Thus, the statute does not require that exempt hedging be

conducted on a trade-by-trade basis, and permits hedging of aggregated

positions. The Agencies recognized this in the proposed rule, and the

final rule continues to permit hedging activities in connection with

and related to individual or aggregated positions.

---------------------------------------------------------------------------

\1166\ See 12 U.S.C. 1851(d)(1)(C).

---------------------------------------------------------------------------

The statute also requires that, to be exempt under section

13(d)(1)(C), hedging activities be risk-mitigating. The final rule

incorporates this statutory requirement. As explained in more detail

below, the final rule requires that, in order to qualify for the

exemption for risk-mitigating hedging activities: The banking entity

implement, maintain, and enforce an internal compliance program,

including policies and procedures that govern and control these hedging

activities; the hedging activity be designed to reduce or otherwise

significantly mitigate and demonstrably reduces or otherwise

significantly mitigates specific, identifiable risks; the hedging

activity not give rise to significant new risks that are left unhedged;

the hedging activity be subject to continuing review, monitoring and

management to address risk that might develop over time; and the

compensation arrangements for persons performing risk-mitigating

hedging activities be designed not to reward or incentivize prohibited

proprietary trading. These requirements are designed to focus the

exemption on hedging activities that are designed to reduce risk and

that also demonstrably reduce risk, in accordance with the requirement

under section 13(d)(1)(C) that hedging activities be risk-mitigating to

be exempt. Additionally, the final rule imposes a documentation

requirement on certain types of hedges.

Consistent with the other exemptions from the ban on proprietary

trading for market-making and underwriting, the Agencies intend to

evaluate whether an activity complies with the hedging exemption under

the final rule based on the totality of circumstances involving the

products, techniques, and strategies used by a banking entity as part

of its hedging activity.\1167\

---------------------------------------------------------------------------

\1167\ See Part VI.A.4.b., infra.

---------------------------------------------------------------------------

c. Comments on the Proposed Rule and Approach To Implementing the

Hedging Exemption

Commenters expressed a variety of views on the proposal's hedging

exemption. A few commenters offered specific suggestions described more

fully below regarding how, in their view, the hedging exemption should

be strengthened to ensure proper oversight of hedging activities.\1168\

These commenters expressed concern that the proposal's exemption was

too broad and argued that all proprietary trading could be designated

as a hedge under the proposal and thereby evade the prohibition of

section 13.\1169\

---------------------------------------------------------------------------

\1168\ See, e.g., AFR et al. (Feb. 2012); AFR (June 2013);

Better Markets (Feb. 2012); Sens. Merkley & Levin (Feb. 2012).

\1169\ See, e.g., Occupy.

---------------------------------------------------------------------------

By contrast, a number of other commenters argued that the proposal

imposed burdensome requirements that were not required by statute,

would limit the ability of banking entities to hedge in a prudent and

cost-effective manner, and would reduce market liquidity.\1170\ These

commenters argued that implementation of the requirements of the

proposal would decrease safety and soundness of banking entities and

the financial system by reducing cost-effective risk management

options. Some commenters emphasized that the ability of banking

entities to hedge their positions and manage risks taken in connection

with their permissible activities is a critical element of liquid and

efficient markets, and that the cumulative impact of the proposal would

inhibit this risk-mitigation by raising transaction costs and

suppressing essential and beneficial hedging activities.\1171\

---------------------------------------------------------------------------

\1170\ See, e.g., Australian Bankers' Ass'n (Feb. 2012); BoA;

Barclays; Credit Suisse (Seidel); Goldman (Prop. Trading); HSBC; ICI

(Feb. 2012); Japanese Bankers Ass'n.; JPMC; Morgan Stanley; Chamber

(Feb. 2012); Wells Fargo (Prop. Trading); Rep. Bachus et al.; RBC;

SIFMA et al. (Prop. Trading) (Feb. 2012); see also Stephen Roach.

\1171\ See Credit Suisse (Seidel); ICI (Feb. 2012); Wells Fargo

(Prop. Trading); see also Banco de M[eacute]xico; SIFMA et al.

(Prop. Trading) (Feb. 2012); Goldman (Prop. Trading); BoA.

---------------------------------------------------------------------------

A number of commenters expressed concern that the proposal's

hedging exemption did not permit the full breadth of transactions in

which banking entities engage to hedge or mitigate risks, such as

portfolio hedging,\1172\ dynamic hedging,\1173\ anticipatory

hedging,\1174\ or scenario hedging.\1175\ Some commenters stated that

restrictions on a banking entity's ability to hedge may have a chilling

effect on its willingness to engage in other permitted activities, such

as market making.\1176\ In addition, many of these commenters stated

that, if a banking entity is limited in its ability to hedge its

market-making inventory, it may be less willing or able to assume risk

on behalf of customers or provide financial products to customers that

are used for hedging purposes. As a result, according to these

commenters, it will be more difficult for customers to hedge their

risks and customers may be forced to retain risk.\1177\

---------------------------------------------------------------------------

\1172\ See MetLife; SIFMA et al. (Prop. Trading) (Feb. 2012);

Morgan Stanley; Barclays; Goldman (Prop. Trading); BoA; ABA; HSBC;

Fixed Income Forum/Credit Roundtable; ICI (Feb. 2012); ISDA (Feb.

2012).

\1173\ See Goldman (Prop. Trading); BoA.

\1174\ See Barclays; State Street (Feb. 2012); SIFMA et al.

(Prop. Trading) (Feb. 2012); Japanese Bankers Ass'n.; Credit Suisse

(Seidel); BoA; PNC et al.; ISDA (Feb. 2012).

\1175\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC;

Goldman (Prop. Trading); BoA; Comm. on Capital Markets Regulation.

Each of these types of activities is discussed further below. See

infra Part VI.A.4.d.2.

\1176\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit

Suisse (Seidel); Barclays; Goldman (Prop. Trading); BoA.

\1177\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Goldman

(Prop. Trading); Credit Suisse (Seidel).

---------------------------------------------------------------------------

Another commenter contended that the proposal represented an

inappropriate ``one-size-fits-all'' approach to hedging that did not

properly take into account the way banking entities and especially

market intermediaries operate, particularly in less-liquid

markets.\1178\ Two commenters requested that the Agencies clarify that

a banking entity may use its discretion to choose any hedging strategy

that meets the requirements of the proposed exemption and, in

particular, that a banking entity is not obligated to choose the ``best

hedge'' and may use the cheapest instrument available.\1179\ One

commenter suggested uncertainty about the permissibility of a situation

where gains on a hedge position exceed losses on the underlying

position. The commenter suggested that uncertainty may lead banking

entities to not use the most cost-effective hedge, which would make

hedging less efficient and raise costs for banking entities and

customers.\1180\ However, another commenter expressed concern about

banking entities relying on the cheapest satisfactory hedge. The

commenter explained that such hedges lead to more complicated risk

profiles and require banking entities to engage in additional

transactions to hedge the

[[Page 5901]]

exposures resulting from the imperfect, cheapest hedge.\1181\

---------------------------------------------------------------------------

\1178\ See Barclays.

\1179\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit

Suisse (Seidel).

\1180\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\1181\ See Occupy.

---------------------------------------------------------------------------

A few commenters suggested the hedging exemption be modified in

favor of a simpler requirement that banking entities adopt risk limits

and policies and procedures commensurate with qualitative guidance

issued by the Agencies.\1182\ Many of these commenters also expressed

concerns that the proposed rule's hedging exemption would not allow so-

called asset-liability management (``ALM'') activities.\1183\ Some

commenters proposed that the risk-mitigating hedging exemption

reference a set of relevant descriptive factors rather than specific

prescriptive requirements.\1184\ Other alternative frameworks suggested

by commenters include: (i) Reformulating the proposed requirements as

supervisory guidance; \1185\ (ii) establishing a safe harbor,\1186\

presumption of compliance,\1187\ or bright line test; \1188\ or (iii) a

principles-based approach that would require a banking entity to

document its risk-mitigating hedging strategies for submission to its

regulator.\1189\

---------------------------------------------------------------------------

\1182\ See BoA; Barclays; CH/ABASA; Credit Suisse (Seidel);

HSBC; ICI (Feb. 2012); ISDA (Apr. 2012); JPMC; Morgan Stanley; PNC;

SIFMA et al. (Prop. Trading) (Feb. 2012); see also Stephen Roach.

\1183\ A detailed discussion of ALM activities is provided in

Part VI.A.1.d.2 of this SUPPLEMENTARY INFORMATION relating to the

definition of trading account. As explained in that part, the final

rule does not allow use of the hedging exemption for ALM activities

that are outside of the hedging activities specifically permitted by

the final rule.

\1184\ See BoA; JPMC; Morgan Stanley.

\1185\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; PNC

et al.; ICI.

\1186\ See Prof. Richardson; ABA (Keating).

\1187\ See Barclays; BoA; ISDA (Feb. 2012).

\1188\ See Johnson & Prof. Stiglitz.

\1189\ See HSBC.

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d. Final Rule

The final rule provides a multi-faceted approach to implementing

the hedging exemption that seeks to ensure that hedging activity is

designed to be risk-reducing in nature and not designed to mask

prohibited proprietary trading.\1190\ The final rule includes a number

of modifications in response to comments.

---------------------------------------------------------------------------

\1190\ See final rule Sec. 75.5.

---------------------------------------------------------------------------

This multi-faceted approach is intended to permit hedging

activities that are risk-mitigating and to limit 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. This approach is also intended to ensure that any banking

entity relying on the hedging exemption has in place appropriate

internal control processes to support its compliance with the terms of

the exemption. While commenters proposed a number of alternative

frameworks for the hedging exemption, the Agencies believe the final

rule's multi-faceted approach most effectively balances commenter

concerns with statutory purpose. In response to commenter requests to

reformulate the proposed rule as supervisory guidance,\1191\ including

the suggestion that the Agencies simply require banking entities to

adopt risk limits and policies and procedures commensurate with

qualitative Agency guidance,\1192\ the Agencies believe that such an

approach would provide less clarity than the adopted approach. Although

a purely guidance-based approach could provide greater flexibility, it

would also provide less specificity, which could make it difficult for

banking entity personnel and the Agencies to determine whether an

activity complies with the rule and could lead to an increased risk of

evasion of the statutory requirements. Further, while a bright-line or

safe harbor approach to the hedging exemption would generally provide a

high degree of certainty about whether an activity qualifies for the

exemption, it would also provide less flexibility to recognize the

differences in hedging activity across markets and asset classes.\1193\

In addition, the use of any bright-line approach would more likely be

subject to gaming and avoidance as new products and types of trading

activities are developed than other approaches to implementing the

hedging exemption. Similarly, the Agencies decline to establish a

presumption of compliance because, in light of the constant innovation

of trading activities and the differences in hedging activity across

markets and asset classes, establishing appropriate parameters for a

presumption of compliance with the hedging exemption would potentially

be less capable of recognizing these legitimate differences than our

current approach.\1194\ Moreover, the Agencies decline to follow a

principles-based approach requiring a banking entity to document its

hedging strategies for submission to its regulator.\1195\ The Agencies

believe that evaluating each banking entity's trading activity based on

an individualized set of documented hedging strategies could be

unnecessarily burdensome and result in unintended competitive impacts

since banking entities would not be subject to one uniform rule. The

Agencies believe the multi-faceted approach adopted in the final rule

establishes a consistent framework applicable to all banking entities

that will reduce the potential for such adverse impacts.

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\1191\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC; PNC

et al.; ICI (Feb. 2012); BoA; Morgan Stanley.

\1192\ See BoA; Barclays; CH/ABASA; Credit Suisse (Seidel);

HSBC; ICI (Feb. 2012); ISDA (Apr. 2012); JPMC; Morgan Stanley; PNC;

SIFMA et al. (Prop. Trading) (Feb. 2012); see also Stephen Roach.

\1193\ Some commenters requested that the Agencies establish a

safe harbor. See Prof. Richardson; ABA (Keating). One commenter

requested that the Agencies adopt a bright-line test. See Johnson &

Prof. Stiglitz.

\1194\ A few commenters requested that the Agencies establish a

presumption of compliance. See Barclays; BoA; ISDA (Feb. 2012).

\1195\ One commenter suggested this principles-based approach.

See HSBC.

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Further, the Agencies believe the scope of the final hedging

exemption is appropriate because it permits risk-mitigating hedging

activities, as mandated by section 13 of the BHC Act,\1196\ while

requiring a robust compliance program and other internal controls to

help ensure that only genuine risk-mitigating hedges can be used in

reliance on the exemption.\1197\ In response to concerns that the

proposed hedging exemption would reduce legitimate hedging activity and

thus impact market liquidity and the banking entity's willingness to

engage in permissible customer-related activity,\1198\ the Agencies

note that the requirements of the final hedging exemption are designed

to permit banking entities to properly mitigate specific risk

exposures, consistent with the statute. In addition, hedging related to

market-making activity conducted by a market-making desk is subject to

the requirements of the market-making exemption, which are designed to

permit banking entities to continue providing valuable intermediation

and liquidity services, including related risk-management

activity.\1199\ Thus, the final hedging exemption will not negatively

impact the safety and soundness of banking entities or the

[[Page 5902]]

financial system or have a chilling effect on a banking entity's

willingness to engage in other permitted activities, such as market

making.\1200\

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\1196\ Section 13(d)(1)(C) of the BHC Act permits ``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.'' 12 U.S.C. 1851(d)(1)(C).

\1197\ Some commenters were concerned that the proposed hedging

exemption was too broad and that all proprietary trading could be

designated as a hedge. See, e.g., Occupy.

\1198\ See, e.g., Australian Bankers Ass'n. (Feb. 2012); BoA;

Barclays; Credit Suisse (Seidel); Goldman (Prop. Trading); HSBC;

Japanese Bankers Ass'n.; JPMC; Morgan Stanley; Chamber (Feb. 2012);

Wells Fargo (Prop. Trading); Rep. Bachus et al.; RBC; SIFMA et al.

(Prop. Trading) (Feb. 2012).

\1199\ See supra Part VI.A.3.c.4.

\1200\ Some commenters believed that restrictions on hedging

would have a chilling effect on banking entities' willingness to

engage in market making, and may result in customers experiencing

difficulty in hedging their risks or force customers to retain risk.

See SIFMA et al. (Prop. Trading) (Feb. 2012); Credit Suisse

(Seidel); Barclays; Goldman (Prop. Trading); BoA; IHS.

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These limits and requirements are designed to prevent the type of

activity conducted by banking entities in the past that involved taking

large positions using novel strategies to attempt to profit from

potential effects of general economic or market developments and

thereby potentially offset the general effects of those events on the

revenues or profits of the banking entity. The documentation

requirements in the final rule support these limits by identifying

activity that occurs in reliance on the risk-mitigating hedging

exemption at an organizational level or desk that is not responsible

for establishing the risk or positions being hedged.

1. Compliance Program Requirement

The first criterion of the proposed hedging exemption required a

banking entity to establish an internal compliance program designed to

ensure the banking entity's compliance with the requirements of the

hedging exemption and conduct its hedging activities in compliance with

that program. While the compliance program under the proposal was

expected to be appropriate for the size, scope, and complexity of each

banking entity's activities and structure, the proposal would have

required each banking entity with significant trading activities to

implement robust, detailed hedging policies and procedures and related

internal controls and independent testing designed to prevent

prohibited proprietary trading in the context of permitted hedging

activity.\1201\ These enhanced programs for banking entities with large

trading activity were expected to include written hedging policies at

the trading unit level and clearly articulated trader mandates for each

trader designed to ensure that hedging strategies mitigated risk and

were not for the purpose of engaging in prohibited proprietary trading.

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\1201\ These aspects of the compliance program requirement are

described in further detail in Part VI.C. of this SUPPLEMENTARY

INFORMATION.

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Commenters, including industry groups, generally expressed support

for requiring policies and procedures to monitor the safety and

soundness, as well as appropriateness, of hedging activity.\1202\ Some

of these commenters advocated that the final rule presume that a

banking entity is in compliance with the hedging exemption if the

banking entity's hedging activity is done in accordance with the

written policies and procedures required under its compliance

program.\1203\ One commenter represented that the proposed compliance

framework was burdensome and complex.\1204\

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\1202\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\1203\ See BoA; Barclays; HSBC; JPMC; Morgan Stanley; see also

Goldman (Prop. Trading); RBC; Barclays; ICI (Feb. 2012); ISDA (Apr.

2012); PNC; SIFMA et al. (Prop. Trading) (Feb. 2012). See the

discussion of why the Agencies decline to take a presumption of

compliance approach above.

\1204\ See Barclays.

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Other commenters expressed concerns that the hedging exemption

would be too limiting and burdensome for community and regional

banks.\1205\ Some commenters argued that foreign banking entities

should not be subject to the requirements of the hedging exemption for

transactions that do not introduce risk into the U.S. financial

system.\1206\ Other commenters stated that coordinated hedging through

and by affiliates should qualify as permitted risk-mitigating hedging

activity.\1207\

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\1205\ See ICBA; M&T Bank.

\1206\ See, e.g., Bank of Canada; Allen & Overy (on behalf of

Canadian Banks). Additionally, foreign banking entities engaged in

hedging activity may be able to rely on the exemption for trading

activity conducted by foreign banking entities in lieu of the

hedging exemption, provided they meet the requirements of the

exemption for trading by foreign banking entities under Sec.

75.6(e) of the final rule. See infra Part VI.A.8.

\1207\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.

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Some commenters urged the Agencies to adopt detailed limitations on

hedging activities. For example, one commenter urged that all hedging

trades be labeled as such at the inception of the trade and detailed

information regarding the trader, manager, and supervisor authorizing

the trade be kept and reviewed.\1208\ Another commenter suggested that

the hedging exemption contain a requirement that the banking entity

employee who approves a hedge affirmatively certify that the hedge

conforms to the requirements of the rule and has not been put in place

for the direct or indirect purpose or effect of generating speculative

profits.\1209\ A few commenters requested limitations on instruments

that can be used for hedging purposes.\1210\

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\1208\ See Sens. Merkley & Levin (Feb. 2012).

\1209\ See Better Markets (Feb. 2012).

\1210\ See Sens. Merkley & Levin (Feb. 2012); Occupy; Andrea

Psoras.

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The final rule retains the proposal's requirement that a banking

entity establish an internal compliance program that is designed to

ensure the banking entity limits its hedging activities to hedging that

is risk-mitigating.\1211\ The final rule largely retains the proposal's

approach to the compliance program requirement, except to the extent

that, as requested by some commenters,\1212\ the final rule modifies

the proposal to provide additional detail regarding the elements that

must be included in a compliance program. Similar to the proposal, the

final rule contemplates that the scope and detail of a compliance

program will reflect the size, activities, and complexity of banking

entities in order to ensure that banking entities engaged in more

active trading have enhanced compliance programs without imposing undue

burden on smaller organizations and entities that engage in little or

no trading activity.\1213\ The final rule also requires, like the

proposal, that the banking entity implement, maintain, and enforce the

program.\1214\

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\1211\ See final rule Sec. 75.5(b)(1). The final rule retains

the proposal's requirement that the compliance program include,

among other things, written hedging policies.

\1212\ See, e.g., BoA; ICI (Feb. 2012); ISDA (Feb. 2012); JPMC;

Morgan Stanley; PNC; SIFMA et al. (Prop. Trading) (Feb. 2012).

\1213\ See final rule Sec. 75.20(a) (stating that ``[t]he

terms, scope and detail of [the] compliance program shall be

appropriate for the types, size, scope and complexity of activities

and business structure of the banking entity''). The Agencies

believe this helps address some commenters' concern that the hedging

exemption would be too limiting and burdensome for community and

regional banks. See ICBA; M&T Bank.

\1214\ Many of these policies and procedures were contained as

part of the proposed rule's compliance program requirements under

Appendix C. They have been moved, and in some cases modified, in

order to more clearly demonstrate how they are incorporated into the

requirements of the hedging exemption.

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In response to commenter concerns about ensuring the appropriate

level of senior management involvement in establishing these

policies,\1215\ the final rule requires that the written policies and

procedures be developed and implemented by a banking entity at the

appropriate level of organization and expressly address the banking

entity's requirements for escalation procedures, supervision, and

governance related to hedging activities.\1216\

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\1215\ See Better Markets (Feb. 2012). The final rule does not

require affirmative certification of each hedge, as suggested by

this commenter, because the Agencies believe it would unnecessarily

slow legitimate transactions. The Agencies believe the final rule's

required management framework and escalation procedures achieve the

same objective as the commenter's suggested approach, while imposing

fewer burdens on legitimate risk-mitigating hedging activity.

\1216\ See final rule Sec. Sec. 75.20(b), 75.5(b). This

approach builds on the proposal's requirement that senior management

and intermediate managers be accountable for the effective

implementation of the compliance program.

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[[Page 5903]]

Like the proposal, the final rule specifies that a banking entity's

compliance regime must include reasonably designed written policies and

procedures regarding the positions, techniques and strategies that may

be used for hedging, including documentation indicating what positions,

contracts or other holdings a trading desk may use in its risk-

mitigating hedging activities.\1217\ The focus on policies and

procedures governing risk identification and mitigation, analysis and

testing of position limits and hedging strategies, and internal

controls and ongoing monitoring is expected to limit use of the hedging

exception to risk-mitigating hedging. The final rule adds to the

proposed compliance program approach by requiring that the banking

entity's written policies and procedures include position and aging

limits with respect to such positions, contracts, or other

holdings.\1218\ The final rule, similar to the proposed rule, also

requires that the compliance program contain internal controls and

ongoing monitoring, management, and authorization procedures, including

relevant escalation procedures.\1219\ Further, the final rule retains

the proposed requirement that the compliance program provide for the

conduct of analysis and independent testing designed to ensure that the

positions, techniques, and strategies that may be used for hedging may

reasonably be expected to demonstrably reduce or otherwise

significantly mitigate the specific, identifiable risks being

hedged.\1220\

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\1217\ This approach is generally consistent with some

commenters' suggested approach of limiting the instruments that can

be used for hedging purposes; although the final rules provide

banking entities with discretion to determine the types of

positions, contracts, or other holdings that will mitigate specific

risks of individual or aggregated holdings and thus may be used for

risk-mitigating hedging activity. See Sens. Merkley & Levin (Feb.

2012); Occupy; Andrea Psoras. In response to one commenter's request

that the final rule require all hedges to be labeled at inception

and certain detailed information be documented for each hedge, the

Agencies note that the final rules continue to require detailed

documentation for hedging activity that presents a heightened risk

of evasion. See Sens. Merkley & Levin (Feb. 2012); final rule Sec.

75.5(c); infra Part VI.A.4.d.4. The Agencies believe a documentation

requirement targeted at these scenarios balances the need to prevent

evasion of the general prohibition on proprietary trading with the

concern that documentation requirements can slow or impede

legitimate risk-mitigating activity in the normal course.

\1218\ See final rule Sec. 75.5(b)(1)(i). Some commenters

expressed support for the use of risk limits in determining whether

trading activity qualifies for the hedging exemption. See, e.g.,

Barclays; Credit Suisse (Seidel); ICI (Feb. 2012); Morgan Stanley.

\1219\ See final rule Sec. 75.5(b)(1)(ii).

\1220\ See final rule Sec. 75.5(b)(1)(iii). The final rule's

requirement to demonstrably reduce or otherwise significantly

mitigate is discussed in greater detail below.

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The final rule also adds that correlation analysis be undertaken as

part of the analysis of the hedging positions, techniques, and

strategies that may be used. This provision effectively changes the

requirement in the proposed rule that the hedge must maintain

correlation into a requirement that correlation be analyzed as part of

the compliance program before a hedging activity is undertaken. This

provision incorporates the concept in the proposed rule that a hedge

should be correlated (negatively, when sign is considered) to the risk

being hedged. However, the Agencies recognize that some effective

hedging activities, such as deep out-of-the-money puts and calls, may

not be exhibit a strong linear correlation to the risks being hedged

and also that correlation over a period of time between two financial

positions does not necessarily mean one position will in fact reduce or

mitigate a risk of the other. Rather, the Agencies expect the banking

entity to undertake a correlation analysis that will, in many but not

all instances, provide a strong indication of whether a potential

hedging position, strategy, or technique will or will not demonstrably

reduce the risk it is designed to reduce. It is important to recognize

that the rule does not require the banking entity to prove correlation

mathematically or by other specific methods. Rather, the nature and

extent of the correlation analysis undertaken would be dependent on the

facts and circumstances of the hedge and the underlying risks targeted.

If correlation cannot be demonstrated, then the Agencies would expect

that such analysis would explain why not and also how the proposed

hedging position, technique, or strategy is designed to reduce or

significantly mitigate risk and how that reduction or mitigation can be

demonstrated without correlation.

Moreover, the final rule requires hedging activity conducted in

reliance on the hedging exemption be subject to continuing review,

monitoring, and management that is consistent with the banking entity's

written hedging policies and procedures and is designed to reduce or

otherwise significantly mitigate, and demonstrably reduces or otherwise

significantly mitigates, the specific, identifiable risks that develop

over time from hedging activity and underlying positions.\1221\ This

ongoing review should consider market developments, changes in

positions or the configuration of aggregated positions, changes in

counterparty risk, and other facts and circumstances related to the

risks associated with the underlying and hedging positions, contracts,

or other holdings.

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\1221\ The proposal also contained a continuing review,

monitoring, and management requirement. See proposed rule Sec.

75.5(b)(2)(v). The final rule modifies the proposed requirement,

however, by removing the ``reasonable correlation'' requirement and

instead requiring that the hedge demonstrably reduce or otherwise

significantly mitigate specific identifiable risks. Correlation

analysis is, however, a necessary component of the analysis element

in the compliance program requirement of the hedging exemption in

the final rule. See final rule Sec. 75.5(b). This change is

discussed below.

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The Agencies believe that requiring banking entities to develop and

follow detailed compliance policies and procedures related to risk-

mitigating hedging activity will help both banking entities and

examiners understand the risks to which banking entities are exposed

and how these risks are managed in a safe and sound manner. With this

increased understanding, banking entities and examiners will be better

able to evaluate whether banking entities are engaged in legitimate,

risk-reducing hedging activity, rather than impermissible proprietary

trading. While the Agencies recognize there are certain costs

associated with this compliance program requirement,\1222\ we believe

this provision is necessary to ensure compliance with the statute and

the final rule. As discussed in Part VI.C.1., the Agencies have

modified the proposed compliance program structure to reduce burdens on

small banking entities.\1223\

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\1222\ See Barclays.

\1223\ See infra Part VI.C.1. Some commenters expressed concern

that the compliance program requirement would place undue burden on

regional or community banks. See ICBA; M&T Bank.

---------------------------------------------------------------------------

The Agencies note that hedging may occur across affiliates under

the hedging exemption.\1224\ To ensure that hedging across trading

desks or hedging done at a level of the organization outside of the

trading desk does not result in prohibited proprietary trading, the

final rule imposes enhanced documentation requirements on these

activities, which are discussed more fully below. The Agencies also

note that nothing in the final rule limits or restricts the ability of

the appropriate supervisory agency of a banking entity to place limits

on interaffiliate hedging in a manner consistent with their safety and

soundness authority to the extent the

[[Page 5904]]

agency has such authority.\1225\ Additionally, nothing in the final

rule limits or modifies the applicability of CFTC regulations with

respect to the clearing of interaffiliate swaps.\1226\

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\1224\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC.

\1225\ In addition, section 608 of the Dodd-Frank Act added

credit exposure arising from securities borrowing and lending or a

derivative transaction with an affiliate to the list of covered

transactions subject to the restrictions of section 23A of the FR

Act, in each case to the extent that such transaction causes a bank

to have credit exposure to the affiliate. See 12 U.S.C. 371c(b)(7)

and (8). As a consequence, interaffiliate hedging activity within a

banking entity may be subject to limitation or restriction under

section 23A of the FR Act.

\1226\ See 17 CFR 50.52.

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2. Hedging of Specific Risks and Demonstrable Reduction of Risk

Section 75.5(b)(2)(ii) of the proposed rule required that a

qualifying 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.\1227\ This criterion implemented the essential element of the

hedging exemption that the transaction be risk-mitigating.

---------------------------------------------------------------------------

\1227\ See proposed rule Sec. 75.5(b)(2)(ii); see also Joint

Proposal, 76 FR at 68875.

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Some commenters expressed support for this provision, particularly

the requirement that a banking entity be able to tie a hedge to a

specific risk.\1228\ One of these commenters stated that a demonstrated

reduction in risk should be a key indicator of whether a hedge is in

fact permitted.\1229\ However, some commenters argued that the list of

risks eligible to be hedged under the proposed rule, which included

risks arising from aggregated positions, could justify transactions

that should be viewed as prohibited proprietary trading.\1230\ Another

commenter contended that the term ``basis risk'' was undefined and

could heighten the potential that this exemption would be used to evade

the prohibition on proprietary trading.\1231\

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\1228\ See AFR (June 2013); Sens. Merkley & Levin (Feb. 2012);

Public Citizen; Johnson & Prof. Stiglitz.

\1229\ See Sens. Merkley & Levin (Feb. 2012).

\1230\ See Public Citizen; see also Occupy.

\1231\ See Occupy.

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Other commenters argued that requiring a banking entity to specify

the particular risk being hedged discourages effective hedging and

increases the risk at banking entities. These commenters contended that

hedging activities must address constantly changing positions and

market conditions.\1232\ Another commenter argued that this requirement

could render a banking entity's hedges impermissible if those hedges do

not succeed in fully hedging or mitigating an identified risk as

determined by a post hoc analysis and could prevent banking entities

from entering into hedging transactions in anticipation of risks that

the banking entity expects will arise (or increase).\1233\ Certain

commenters requested that the hedging exemption provide a safe harbor

for positions that satisfy FASB ASC Topic 815 (formerly FAS 133)

hedging accounting standards, which provides that an entity recognize

derivative instruments, including certain derivative instruments

embedded in other contracts, as assets or liabilities in the statement

of financial position and measure them at fair value.\1234\ Another

commenter suggested that scenario hedges could be identifiable and

subject to review by the Agencies using VaR, Stress VaR, and VaR

Exceedance, as well as revenue metrics.\1235\

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\1232\ See, e.g., Japanese Bankers Ass'n.

\1233\ See Barclays.

\1234\ See ABA (Keating); Wells Fargo (Prop. Trading). Although

certain accounting standards, such as FASB ASC Topic 815 hedge

accounting standards, address circumstances in which a transaction

may be considered a hedge of another transaction, the final rule

does not refer to or expressly 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.

\1235\ See JPMC.

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The Agencies have considered these comments carefully in light of

the statute. Section 13(d)(1)(C) of the BHC Act provides an exemption

from the prohibition on proprietary trading only for hedging activity

that is ``designed to reduce the specific risks to the banking entity

in connection with and related to'' individual or aggregated positions,

contracts, or other holdings of the banking entity.\1236\ Thus, while

the statute permits hedging of individual or aggregated positions (as

discussed more fully below), the statute requires that, to be exempt

from the prohibition on proprietary trading, hedging transactions be

designed to reduce specific risks.\1237\ Moreover, it requires that

these specific risks be in connection with or related to the individual

or aggregated positions, contracts, or other holdings of the banking

entity.

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\1236\ 12 U.S.C. 1851(d)(1)(C).

\1237\ Some commenters expressed support for the requirement

that a banking entity tie a hedge to a specific risk. See AFR (June

2012); Sens. Merkley & Levin (Feb. 2012); Public Citizen; Johnson &

Prof. Stiglitz.

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The final rule implements these requirements. To ensure that exempt

hedging activities are designed to reduce specific risks, the final

rule requires that the hedging activity at inception of the hedging

activity, including, without limitation, any adjustments to the hedging

activity, be designed to reduce or otherwise significantly mitigate and

demonstrably reduces or otherwise significantly mitigates one or more

specific, identifiable risks, including market risk, counterparty or

other credit risk, currency or foreign exchange risk, interest rate

risk, commodity price risk, basis risk, or similar risks, arising in

connection with and related to identified individual or aggregated

positions, contracts, or other holdings of the banking entity, based

upon the facts and circumstances of the individual or aggregated

underlying and hedging positions, contracts, or other holdings of the

banking entity and the risks and liquidity thereof.\1238\ Hedging

activities and limits should be based on analysis conducted by the

banking entity of the appropriateness of hedging instruments,

strategies, techniques, and limits. As discussed above, this analysis

must include analysis of correlation between the hedge and the specific

identifiable risk or risks that the hedge is designed to reduce or

significantly mitigate.\1239\

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\1238\ See final rule Sec. 75.5(b)(2)(ii).

\1239\ See final rule Sec. 75.5(b)(1)(iii).

---------------------------------------------------------------------------

This language retains the focus of the statute and the proposed

rule on reducing or mitigating specific and identified risks.\1240\ As

discussed more fully above, banking entities are required to describe

in their compliance policies and procedures the types of strategies,

techniques, and positions that may be used for hedging.

---------------------------------------------------------------------------

\1240\ Some commenters represented that the proposed list of

risks eligible to be hedged could justify transactions that should

be considered proprietary trading. See Public Citizen; Occupy. One

commenter was concerned about the proposed inclusion of ``basis

risk'' in this list. See Occupy. As noted in the proposal, the

Agencies believe the inclusion of a list of eligible risks,

including basis risk, helps implement the essential element of the

statutory hedging exemption--i.e., that the transaction is risk-

reducing in connection with a specific risk. See Joint Proposal, 76

FR at 68875. See also 12 U.S.C. 1851(d)(1)(C). Further, the Agencies

believe the other requirements of the final hedging exemption,

including requirements regarding internal controls and a compliance

program, help to ensure that only legitimate hedging activity

qualifies for the exemption.

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The final rule does not prescribe the hedging strategy that a

banking entity must employ. While one commenter urged that the final

rule require each banking entity to adopt the ``best hedge'' for every

transaction,\1241\ the Agencies believe that the complexity of

positions, market conditions at the time of a transaction, availability

of hedging

[[Page 5905]]

transactions, costs of hedging, and other circumstances at the time of

the transaction make a requirement that a banking entity always adopt

the ``best hedge'' impractical, unworkable, and subjective.

---------------------------------------------------------------------------

\1241\ See, e.g., Occupy.

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Nonetheless, the statute requires that, to be exempt under section

13(d)(1)(C), hedging activity must be risk-mitigating. To ensure that

only risk-mitigating hedging is permitted under this exemption, the

final rule requires that in its written policies and procedures the

banking entity identify the instruments and positions that may be used

in hedging, the techniques and strategies the banking entity deems

appropriate for its hedging activities, as well as position limits and

aging limits on hedging positions. These written policies and

procedures also must specify the escalation and approval procedures

that apply if a trader seeks to conduct hedging activities beyond the

limits, position types, strategies, or techniques authorized for the

trader's activities.\1242\

---------------------------------------------------------------------------

\1242\ A banking entity must satisfy the enhanced documentation

requirements of Sec. 75.5(c) if it engages in hedging activity

utilizing positions, contracts, or holdings that were not identified

in its written policies and procedures.

---------------------------------------------------------------------------

As noted above, commenters were concerned that risks associated

with permitted activities and holdings change over time, making a

determination regarding the effectiveness of hedging activities in

reducing risk dependent on the time when risk is measured. To address

this, the final rule requires that the exempt hedging activity be

designed to reduce or otherwise significantly mitigate, and

demonstrably reduces or otherwise significantly mitigates, risk at the

inception of the hedge. As explained more fully below, because risks

and the effectiveness of a hedging strategy may change over time, the

final rule also requires the banking entity to implement a program to

review, monitor, and manage its hedging activity over the period of

time the hedging activity occurs in a manner designed to reduce or

significantly mitigate and demonstrably reduce or otherwise

significantly mitigate new or changing risks that may develop over time

from both the banking entity's hedging activities and the underlying

positions. Many commenters expressed concern that the proposed ongoing

review, monitoring, and management requirement would limit a banking

entity's ability to engage in aggregated position hedging.\1243\ One

commenter stated that because aggregated position hedging may result in

modification of hedging exposures across a variety of underlying risks,

even as the overall risk profile of a banking entity is reduced, it

would become impossible to subsequently review, monitor, and manage

individual hedging transactions for compliance.\1244\ The Agencies note

that the final rule, like the statute, requires that the hedging

activity relate to individual or aggregated positions, contracts or

other holdings being hedged, and accordingly, the review, monitoring

and management requirement would not limit the extent of permitted

hedging provided for in section 13(d)(1)(C) as implied by some

commenters. Further, the final rule recognizes that the determination

of whether hedging activity demonstrably reduces or otherwise

significantly mitigates risks that may develop over time should be

``based upon the facts and circumstances of the underlying and hedging

positions, contracts and other holdings of the banking entity and the

risks and liquidity thereof.'' \1245\

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\1243\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Barclays;

ICI (Feb. 2012); Morgan Stanley.

\1244\ See Barclays.

\1245\ Final rule Sec. 75.5(b)(2)(iv)(B). The Agencies believe

this provision addresses some commenters' concern that the ongoing

review, monitoring, and management requirement would limit hedging

of aggregated positions, and that such ongoing review of individual

hedge transactions with a variety of underlying risks would be

impossible. See SIFMA (Prop. Trading) (Feb. 2012); Barclays; ICI

(Feb. 2012); Morgan Stanley.

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A number of other commenters argued that a legitimate risk-reducing

hedge may introduce new risks at inception.\1246\ A few commenters

contended that a requirement that no new risks be associated with a

hedge would be inconsistent with prudent risk management and greatly

reduce the ability of banking entities to reduce overall risk through

hedging.\1247\ A few commenters stated that the proposed requirement

does not recognize that it is not always possible to hedge a new risk

exposure arising from a hedge in a cost-effective manner.\1248\ With

respect to the timing of the initial hedge and any additional

transactions necessary to reduce significant exposures arising from it,

one of these commenters represented that requiring contemporaneous

hedges is impracticable, would raise transaction costs, and would make

hedging uneconomic.\1249\ Another commenter stated that this

requirement could have a chilling effect on risk managers' willingness

to engage in otherwise permitted hedging activity.\1250\

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\1246\ See ABA (Keating); BoA; Barclays; Credit Suisse (Seidel);

Goldman (Prop. Trading); SIFMA et al. (Prop. Trading) (Feb. 2012);

see also AFR et al. (Feb. 2012).

\1247\ See Credit Suisse (Seidel); Goldman (Prop. Trading);

SIFMA et al. (Prop. Trading) (Feb. 2012).

\1248\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Barclays.

\1249\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\1250\ See BoA.

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Other commenters stated that a position that does not fully offset

the risk of an underlying position is not in fact a hedge.\1251\ These

commenters believed that the introduction of new risks at inception of

a transaction indicated that the transaction was impermissible

proprietary trading and not a hedge.\1252\

---------------------------------------------------------------------------

\1251\ See Sens. Merkley & Levin (Feb. 2012); Public Citizen;

AFR (Nov. 2012).

\1252\ See Better Markets (Feb. 2012); AFR et al. (Feb. 2012).

---------------------------------------------------------------------------

The Agencies recognize that prudent risk-reducing hedging

activities by banking entities are important to the efficiency of the

financial system.\1253\ The Agencies further recognize that hedges are

generally imperfect; consequently, hedging activities can introduce new

and sometimes significant risks, such as credit risk, basis risk, or

new market risk, especially when hedging illiquid positions.\1254\

However, the Agencies also recognize that hedging activities present an

opportunity to engage in impermissible proprietary trading designed to

profit from exposure to these types of risks.

---------------------------------------------------------------------------

\1253\ See FSOC study (stating that ``[p]rudent risk management

is at the core of both institution-specific safety and soundness, as

well as macroprudential and financial stability'').

\1254\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012).

---------------------------------------------------------------------------

To address these competing concerns, the final rule substantially

retains the proposed requirement that, at the inception of the hedging

activity, the risk-reducing hedging activity does not give rise to

significant new or additional risk that is not itself contemporaneously

hedged. This approach is designed to allow banking entities to continue

to engage in prudent risk-mitigating activities while ensuring that the

hedging exemption is not used to engage in prohibited proprietary

trading by taking on prohibited short-term exposures under the guise of

hedging.\1255\ As noted in the proposal,

[[Page 5906]]

however, the Agencies recognize that exposure to new risks may result

from legitimate hedging transactions; \1256\ this provision only

prohibits the introduction of additional significant exposures through

the hedging transaction unless those additional exposures are

contemporaneously hedged.

---------------------------------------------------------------------------

\1255\ Some commenters stated that it is not always possible to

hedge a new risk exposure arising from a hedge in a cost-effective

manner, and requiring contemporaneous hedges would raise transaction

costs and the potential for hedges to become uneconomical. See SIFMA

et al. (Prop. Trading) (Feb. 2012); Barclays. As noted in the

proposal, the Agencies believe that requiring a contemporaneous

hedge of any significant new risk that arises at the inception of a

hedge is appropriate because 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. See Joint

Proposal, 76 FR at 68876. Thus, the Agencies believe this

requirement is necessary to prevent evasion of the general

prohibition on proprietary trading. In response to commenters'

concerns about transaction costs and uneconomical hedging, the

Agencies note that this provision only requires additional hedging

of ``significant'' new or additional risk and does not apply to any

risk exposure arising from a hedge.

\1256\ See Joint Proposal, 76 FR at 68876.

---------------------------------------------------------------------------

As noted above, the final rule recognizes that whether hedging

activity will demonstrably reduce risk must be based upon the facts and

circumstances of the individual or aggregated underlying and hedging

positions, contracts, or other holdings of the banking entity and the

risks and liquidity thereof.\1257\ The Agencies believe this approach

balances commenters' request that the Agencies clarify that a banking

entity may use its discretion to choose any hedging strategy that meets

the requirements of the proposed exemption \1258\ with concerns that

allowing banking entities to rely on the cheapest satisfactory hedge

will lead to additional hedging transactions.\1259\ The Agencies expect

that hedging strategies and techniques, as well as assessments of risk,

will vary across positions, markets, activities and banking entities,

and that a ``one-size-fits-all'' approach would not accommodate all

types of appropriate hedging activity.\1260\

---------------------------------------------------------------------------

\1257\ See final rule Sec. 75.5(b)(2)(ii).

\1258\ See SIFMA (Prop. Trading) (Feb. 2012); Credit Suisse

(Seidel); Barclays; Goldman (Prop. Trading); BoA.

\1259\ See Occupy.

\1260\ See Barclays.

---------------------------------------------------------------------------

By its terms, section 13(d)(1)(C) of the BHC Act permits a banking

entity to engage in risk-mitigating hedging activity ``in connection

with and related to individual or aggregated positions . . . .'' \1261\

The preamble to the proposed rule made clear that, consistent with the

statutory reference to mitigating risks of individual or aggregated

positions, this criterion permits hedging of risks associated with

aggregated positions.\1262\ This approach is consistent with prudent

risk-management and safe and sound banking practice.\1263\

---------------------------------------------------------------------------

\1261\ 12 U.S.C. 1851(d)(1)(C).

\1262\ See Joint Proposal, 76 FR at 68875.

\1263\ See, e.g., Australian Bankers' Ass'n. (Feb. 2012); BoA;

Barclays; Credit Suisse (Seidel); Goldman (Prop. Trading); HSBC; ICI

(Feb. 2012); Japanese Bankers Ass'n.; JPMC; Morgan Stanley; Wells

Fargo (Prop. Trading); Rep. Bachus et al.; RBC; SIFMA (Prop.

Trading) (Feb. 2012).

---------------------------------------------------------------------------

The proposed rule explained that, to be exempt under this

provision, hedging activities must reduce risk with respect to

``positions, contracts, or other holdings of the banking entity.'' The

proposal also required that a banking entity relying on the exemption

be prepared to identify the specific position or risks associated with

aggregated positions being hedged and demonstrate that the hedging

transaction was risk-reducing in the aggregate, as measured by

appropriate risk management tools.

Some commenters were of the view that the hedging exemption applied

to aggregated positions or portfolio hedging and was consistent with

prudent risk-management practices. These commenters argued that

permitting a banking entity to hedge aggregate positions and risks

arising from a portfolio of assets would be more efficient from both a

procedural and business standpoint.\1264\

---------------------------------------------------------------------------

\1264\ See, e.g. ABA (Keating); Ass'n. of Institutional

Investors (Sept. 2012); BoA; see also Barclays (expressing concern

that the proposed rule could result in regulatory review of

individual hedging trades for compliance on a post hoc basis); HSBC;

ISDA (Apr. 2012); ICI (Feb. 2012); PNC; MetLife; RBC; SIFMA (Prop.

Trading) (Feb. 2012).

---------------------------------------------------------------------------

By contrast, other commenters argued that portfolio-based hedging

could be used to mask prohibited proprietary trading.\1265\ One

commenter contended that the statute provides no basis for portfolio

hedging, and another commenter similarly suggested that portfolio

hedging should be prohibited.\1266\ Another commenter suggested

adopting limits that would prevent the use of the hedging exemption to

conduct proprietary activity at one desk as a theoretical ``hedge for

proprietary trading at another desk.'' \1267\ Among the limits

suggested by these commenters were a requirement that a banking entity

have a well-defined compliance program, the formation of central ``risk

management'' groups to perform and monitor hedges of aggregated

positions, and a requirement that the banking entity demonstrate the

capacity to measure aggregate risk across the institution with

precision using proven models.\1268\ A few commenters suggested that

the presence of portfolio hedging should be viewed as an indicator of

imperfections in hedging at the desk level and be a flag used by

examiners to identify and review the integrity of specific

hedges.\1269\

---------------------------------------------------------------------------

\1265\ See, e.g., AFR et al. (Feb. 2012); Sens. Merkley & Levin

(Feb. 2012); Occupy; Public Citizen; Johnson & Prof. Stiglitz.

\1266\ See Sens. Merkley & Levin (Feb. 2012) (commenting that

the use of the term ``aggregate'' positions was intended to note

that firms do not have to hedge on a trade-by-trade basis but could

not hedge on a portfolio basis); Johnson & Prof. Stiglitz.

\1267\ See AFR et al. (Feb. 2012) (citing 156 Cong. Rec. S5898

(daily ed. July 15, 2010) (statement of Sen. Merkley)).

\1268\ See, e.g., Occupy; Public Citizen.

\1269\ See Public Citizen; Occupy; AFR et al. (Feb. 2012).

---------------------------------------------------------------------------

The final rule, like the proposed rule, implements the statutory

language providing for risk-mitigating hedging activities related to

individual or aggregated positions. For example, activity permitted

under the hedging exemption would include the hedging of one or more

specific risks arising from identified positions, contracts, or other

holdings, such as the hedging of the aggregate risk of identified

positions of one or more trading desks. Further, the final rule

requires that these hedging activities be risk-reducing with respect to

the identified positions, contracts, or other holdings being hedged and

that the risk reduction be demonstrable. Specifically, the final rule

requires, among other things: That the banking entity has a robust

compliance program reasonably designed to ensure compliance with the

exemption; that each hedge is subject to continuing review, monitoring

and management designed to demonstrably reduce or otherwise

significantly mitigate the specific, identifiable risks that develop

over time related to the hedging activity and the underlying positions,

contracts, or other holdings of the banking entity; and that the

banking entity meet a documentation requirement for hedges not

established by the trading desk responsible for the underlying position

or for hedges effected through a financial instrument, technique or

strategy that is not specifically identified in the trading desk's

written policies and procedures. The Agencies believe this approach

addresses concerns that a banking entity could use the hedging

exemption to conduct proprietary activity at one desk as a theoretical

hedge for proprietary trading at another desk in a manner consistent

with the statute.\1270\ Further, the Agencies believe the adopted

exemption allows banking entities to engage in hedging of aggregated

positions \1271\ while helping to ensure that such hedging activities

are truly risk-mitigating.\1272\

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\1270\ See AFR et al. (Feb. 2012) (citing 156 Cong. Rec. S5898

(daily ed. July 15, 2010) (statement of Sen. Merkley)).

\1271\ See MetLife; SIFMA et al. (Prop. Trading) (Feb. 2012);

Morgan Stanley; Barclays; Goldman (Prop. Trading); BoA; ABA

(Keating); HSBC; Fixed Income Forum/Credit Roundtable; ICI (Feb.

2012); ISDA (Feb. 2012).

\1272\ The Agencies believe certain limits suggested by

commenters, such as the formation of central ``risk management''

groups to monitor hedges of aggregated positions, are unnecessary

given the aforementioned limits in the final rule. See Occupy;

Public Citizen.

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[[Page 5907]]

As noted above, several commenters questioned whether the hedging

exemption should apply to ``portfolio'' hedging and whether portfolio

hedging may create the potential for abuse of the hedging exemption.

The term ``portfolio hedging'' is not used in the statute. The language

of section 13(d)(1)(C) of the BHC Act permits a banking entity to

engage in risk-mitigating hedging activity ``in connection with and

related to individual or aggregated positions . . . .'' \1273\ After

consideration of the comments regarding portfolio hedging, and in light

of the statutory language, the Agencies are of the view that the

statutory language is clear on its face that a banking entity may

engage in risk-mitigating hedging in connection with aggregated

positions of the banking entity. The permitted hedging activity, when

involving more than one position, contract, or other holding, must be

in connection with or related to aggregated positions of the banking

entity.

---------------------------------------------------------------------------

\1273\ See 12 U.S.C. 1851(d)(1)(C).

---------------------------------------------------------------------------

Moreover, hedging of aggregated positions under this exemption must

be related to identifiable risks related to specific positions,

contracts, or other holdings of the banking entity. Hedging activity

must mitigate one or more specific risks arising from an identified

position or aggregation of positions. The risks in this context are not

intended to be more generalized risks that a trading desk or

combination of desks, or the banking entity as a whole, believe exists

based on non-position-specific modeling or other considerations. For

example, the hedging activity cannot be designed to: Reduce risks

associated with the banking entity's assets and/or liabilities

generally, general market movements or broad economic conditions;

profit in the case of a general economic downturn; counterbalance

revenue declines generally; or otherwise arbitrage market imbalances

unrelated to the risks resulting from the positions lawfully held by

the banking entity.\1274\ Rather, the hedging exemption permits the

banking entity to engage in trading activity designed to reduce or

otherwise mitigate specific identifiable risks related to identified

individual or aggregated positions that the banking entity is otherwise

lawfully permitted to have.

---------------------------------------------------------------------------

\1274\ The Agencies believe that it would be inconsistent with

Congressional intent to permit some or all of these activities under

the hedging exemption, regardless of whether certain metrics could

be useful for monitoring such activity. See JPMC.

---------------------------------------------------------------------------

When undertaking a hedge to mitigate the risk of an aggregation of

positions, the banking entity must be able to specifically identify the

risk factors arising from this set of positions. In identifying the

aggregate set of positions that is being hedged for purposes of Sec.

75.5(b)(2)(ii) and, where applicable, Sec. 75.5(c)(2)(i), the banking

entity needs to identify the positions being hedged with sufficient

specificity so that at any point in time, the specific financial

instrument positions or components of financial instrument positions

held by the banking entity that comprise the set of positions being

hedged can be clearly identified.

The proposal would have permitted a series of hedging transactions

designed to rebalance hedging position(s) based on changes resulting

from permissible activities or from a change in the price or other

characteristic of the individual or aggregated positions, contracts, or

other holdings being hedged.\1275\ The Agencies recognized that, in

such dynamic hedging, material changes in risk may require a

corresponding modification to the banking entity's current hedge

positions.\1276\

---------------------------------------------------------------------------

\1275\ See proposed rule Sec. 75.5(b)(2)(ii) (requiring that

the hedging transaction ``hedges or otherwise mitigates one or more

specific risks . . . arising in connection with and related to

individual or aggregated positions, contracts, or other holdings of

[the] banking entity''). The proposal noted that this requirement

would include, for example, dynamic hedging. See Joint Proposal, 76

FR at 68875.

\1276\ The proposal noted that 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 Sec. 75.5(b)(2)(iii) of the proposed

rule.

---------------------------------------------------------------------------

Some commenters questioned the risk-mitigating nature of a hedge

if, at inception, that hedge contained component risks that must be

dynamically managed throughout the life of the hedge. These commenters

stated that hedges that do not continuously match the risk of

underlying positions are not in fact risk-mitigating hedges in the

first place.\1277\

---------------------------------------------------------------------------

\1277\ See AFR et al. (Feb. 2012); Public Citizen; see also

Better Markets (Feb. 2012), Sens. Merkley & Levin (Feb. 2012).

---------------------------------------------------------------------------

On the other hand, other commenters argued that banking entities

must be permitted to engage in dynamic hedging activity, such as in

response to market conditions which are unforeseeable or out of the

control of the banking entity,\1278\ and expressed concern that the

limitations of the proposed rule, especially the requirement that

hedging transactions ``maintain a reasonable level of correlation,''

might impede truly risk-reducing hedging activity.\1279\

---------------------------------------------------------------------------

\1278\ See Japanese Bankers Ass'n.

\1279\ See, e.g., BoA; Barclays; ISDA (Apr. 2012); PNC; PNC et

al.; SIFMA et al. (Prop. Trading) (Feb. 2012).

---------------------------------------------------------------------------

A number of commenters asserted that there could be confusion over

the meaning of ``reasonable correlation,'' which was used in the

proposal as part of explaining what type of activity would qualify for

the hedging exemption. Some commenters urged requiring that there be a

``high'' or ``strong'' correlation between the hedge and the risk of

the underlying asset.\1280\

---------------------------------------------------------------------------

\1280\ See, e.g., Occupy; Public Citizen; AFR et. al. (Feb.

2012); AFR (June 2013); Better Markets (Feb. 2012); Sens. Merkley &

Levin (Feb. 2012).

---------------------------------------------------------------------------

Other commenters indicated that uncertainty about the meaning of

reasonable correlation could limit valid risk-mitigating hedging

activities because the level of correlation between a hedge and the

risk of the position or aggregated positions being hedged changes over

time as a result of changes in market factors and conditions.\1281\

Some commenters represented that the proposed provision would cause

certain administrative burdens \1282\ or may result in a reduction in

market-making activities in certain asset classes.\1283\ A few

commenters expressed concern that the reasonable correlation

requirement could render a banking entity's hedges impermissible if

they do not succeed in being reasonably correlated to the relevant risk

or risks based on an after-the-fact analysis that incorporates market

developments that could not have been foreseen at the time the hedge

was placed. These commenters tended to favor a different approach or a

type of safe harbor based on an initial determination of

correlation.\1284\ Some commenters argued the focus of the hedging

exemption should be on risk reduction and not on reasonable

[[Page 5908]]

correlation.\1285\ One commenter suggested that risk management metrics

such as VaR and risk factor sensitivities could be the focus for

permitted hedging instead of requirements like reasonable correlation

under the proposal.\1286\

---------------------------------------------------------------------------

\1281\ See BoA; Barclays; Comm. on Capital Markets Regulation;

Credit Suisse (Seidel); FTN; Goldman (Prop. Trading); ICI (Feb.

2012); Japanese Bankers Ass'n.; JPMC; Morgan Stanley; SIFMA et al.

(Prop. Trading) (Feb. 2012); STANY; see also Chamber (Feb. 2012).

\1282\ See Japanese Bankers Ass'n.; Goldman (Prop. Trading);

BoA.

\1283\ See BoA; SIFMA (Asset Mgmt.) (Feb. 2012). As discussed

above, market-maker hedging at the trading desk level is no longer

subject to the hedging exemption and is instead subject to the

requirements of the market-making exemption, which is designed to

permit banking entities to continue providing legitimate market-

making services, including managing the risk of market-making

activity. See also supra Part VI.A.3.c.4. of this SUPPLEMENTARY

INFORMATION.

\1284\ See Barclays; Goldman (Prop. Trading); Chamber (Feb.

2012); SIFMA et al. (Prop. Trading) (Feb. 2012); see also FTN; BoA.

\1285\ See, e.g., FTN; Goldman (Prop. Trading); ISDA (Apr.

2012); see also Sens. Merkley & Levin (Feb. 2012); Occupy.

\1286\ See Goldman (Prop. Trading). Consistent with the FSOC

study and the proposal, the Agencies continue to believe that

quantitative measurements can be useful to banking entities and the

Agencies to help assess the profile of a trading desk's trading

activity and to help identify trading activity that may warrant a

more in-depth review. See infra Part VI.C.3.; final rule Appendix A.

The Agencies do not intend to use quantitative measurements as a

dispositive tool for differentiating between permitted hedging

activities and prohibited proprietary trading.

---------------------------------------------------------------------------

In consideration of commenter concerns about the proposed

reasonable correlation requirement, the final rule modifies the

proposal in the following key respects. First, the final rule modifies

the requirement of ``reasonable correlation'' by providing that the

hedge demonstrably reduce or otherwise significantly mitigate specific

identifiable risks.\1287\ This change is designed to reinforce that

hedging activity should be demonstrably risk reducing or mitigating

rather than simply correlated to risk. This change acknowledges that

hedges need not simply be correlated to underlying positions, and that

hedging activities should be consciously designed to reduce or mitigate

identifiable risks, not simply the result of pairing correlated

positions, as some commenters suggested.\1288\ As discussed above, the

Agencies do, however, recognize that correlation is often a critical

element of demonstrating that a hedging activity reduces the risks it

is designed to address. Accordingly, the final rule requires that

banking entities conduct correlation analysis as part of the required

compliance program in order to utilize the hedging exemption.\1289\ The

Agencies believe this change better allows consideration of the facts

and circumstances of the particular hedging activity as part of the

correlation analysis and therefore addresses commenters' concerns that

the proposed reasonable correlation requirement could cause

administrative burdens, impede legitimate hedging activity,\1290\ and

require an after-the-fact analysis.\1291\

---------------------------------------------------------------------------

\1287\ Some commenters stated that the hedging exemption should

focus on risk reduction, not reasonable correlation. See, e.g., FTN;

Goldman (Prop. Trading); ISDA (Apr. 2012); Sens. Merkley & Levin

(Feb. 2012); Occupy. One of these commenters noted that demonstrated

risk reduction should be a key requirement. See Sens. Merkley &

Levin (Feb. 2012).

\1288\ See FTN; Goldman (Prop. Trading); ISDA (Apr. 2012); see

also Sens. Merkley & Levin (Feb. 2012); Occupy.

\1289\ See final rule Sec. 75.5(b)(1)(iii).

\1290\ Some commenters expressed concern that the proposed

``reasonable correlation'' requirement might impede truly risk-

reducing activity. See, e.g., BoA; Barclays; Comm. on Capital

Markets Regulation; Credit Suisse (Seidel); FTN; Goldman (Prop.

Trading); ICI (Feb. 2012); ISDA (Apr. 2012); Japanese Bankers

Ass'n.; JPMC; Morgan Stanley; PNC; PNC et al.; SIFMA et al. (Prop.

Trading) (Feb. 2012); STANY. Some of these commenters stated that

the proposed requirement would cause administrative burdens. See

Japanese Bankers Ass'n.; Goldman (Prop. Trading); BoA.

\1291\ See Barclays; Goldman (Prop. Trading); Chamber (Feb.

2012); SIFMA et al. (Prop. Trading) (Feb. 2012; see also FTN.

---------------------------------------------------------------------------

Second, the final rule provides that the determination of whether

an activity or strategy is risk-reducing or mitigating must, in the

first instance, be made at the inception of the hedging activity. A

trade that is not risk-reducing at its inception is not viewed as a

hedge for purposes of the exemption in Sec. 75.5.\1292\

---------------------------------------------------------------------------

\1292\ By contrast, the proposed requirement did not specify

that the hedging activity reduce risk ``at the inception of the

hedge.'' See proposed rule Sec. 75.5(b)(2)(ii).

---------------------------------------------------------------------------

Third, the final rule requires that the banking entity conduct

analysis and independent testing designed to ensure that the positions,

techniques, and strategies used for hedging are reasonably designed to

reduce or otherwise mitigate the risk being hedged. As noted above,

such analysis and testing must include correlation analysis. Evidence

of negative correlation may be a strong indicator that a given hedging

position or strategy is risk-reducing. Moreover, positive correlation,

in some instances, may be an indicator that a hedging position or

strategy is not designed to be risk-mitigating. The type of analysis

and factors considered in the analysis should take account of the facts

and circumstances, including type of position being hedged, market

conditions, depth and liquidity of the market for the underlying and

hedging position, and type of risk being hedged.

The Agencies recognize that markets and risks are dynamic and that

the risks from a permissible position or aggregated positions may

change over time, new risks may emerge in the positions underlying the

hedge and in the hedging position, new risks may emerge from the

hedging strategy over time, and hedges may become less effective over

time in addressing the related risk.\1293\ The final rule, like the

proposal, continues to allow dynamic hedging. Additionally, the final

rule requires the banking entity to engage in ongoing review,

monitoring, and management of its positions and related hedging

activity to reduce or otherwise significantly mitigate the risks that

develop over time. This ongoing hedging activity must be designed to

reduce or otherwise significantly mitigate, and must demonstrably

reduce or otherwise significantly mitigate, the material changes in

risk that develop over time from the positions, contracts, or other

holdings intended to be hedged or otherwise mitigated in the same way,

as required for the initial hedging activity. Moreover, the banking

entity is required under the final rule to support its decisions

regarding appropriate hedging positions, strategies and techniques for

its ongoing hedging activity in the same manner as for its initial

hedging activities. In this manner, the final rule permits a banking

entity to engage in effective management of its risks throughout

changing market conditions \1294\ while also seeking to prohibit the

banking entity from taking large proprietary positions through action

or inaction related to an otherwise permissible hedge.\1295\

---------------------------------------------------------------------------

\1293\ Some commenters noted that hedging activities must

address constantly changing positions and market conditions and

expressed concern about requiring a banking entity to identify the

particular risk being hedged. See Japanese Bankers Ass'n.; Barclays.

\1294\ A few commenters expressed concern that the proposed

``reasonable correlation'' requirement would render hedges

impermissible if not reasonably correlated to the relevant risk(s)

based on a post hoc analysis. See, e.g., Barclays; Goldman (Prop.

Trading); Chamber (Feb. 2012); SIFMA et al. (Prop. Trading) (Feb.

2012).

\1295\ Some commenters questioned the risk-mitigating nature of

a hedge if, at inception, it contained risks that must be

dynamically managed throughout the life of the hedge. See, e.g., AFR

et al. (Feb. 2012); Public Citizen.

---------------------------------------------------------------------------

As explained above, the final rule requires a banking entity

relying on the hedging exemption to be able to demonstrate that the

banking entity is exposed to the specific risks being hedged at the

inception of the hedge and any adjustments thereto. However, in the

proposal, the Agencies requested comment on whether the hedging

exemption should be available in certain cases where hedging activity

begins before the banking entity becomes exposed to the underlying

risk. The Agencies proposed that 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) Was consistent with appropriate

risk management practices; (ii) otherwise met the terms of the hedging

exemption; and (iii) did not involve the potential for speculative

profit. For example, a banking entity that was contractually obligated

or otherwise highly likely to

[[Page 5909]]

become exposed to a particular risk could engage in hedging that risk

in advance of actual exposure.\1296\

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\1296\ See Joint Proposal, 76 FR at 68875.

---------------------------------------------------------------------------

A number of commenters argued that anticipatory hedging is a

necessary and prudent activity and that the final rule should permit

anticipatory hedging more broadly than did the proposed rule.\1297\ In

particular, commenters were concerned that permitting hedging activity

only if it occurs ``slightly'' before a risk is taken could limit

hedging activities that are crucial to risk management.\1298\

Commenters expressed concern that the proposed approach would, among

other things, make it difficult for banking entities to accommodate

customer requests for transactions with specific price or size

executions \1299\ and limit dynamic hedging activities that are

important to sound risk management.\1300\ In addition, a number of

commenters requested that the rule permit banking entities to engage in

scenario hedging, a form of anticipatory hedging that addresses

potential exposures to ``tail risks.'' \1301\

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\1297\ See, e.g., Barclays; SIFMA et al. (Prop. Trading);

Japanese Bankers Ass'n.; Credit Suisse (Seidel); BoA; PNC et al.;

ISDA (Feb. 2012).

\1298\ See BoA; Credit Suisse (Seidel); ISDA (Feb. 2012); JPMC;

Morgan Stanley; PNC et al.; SIFMA et al. (Prop. Trading) (Feb.

2012).

\1299\ See Credit Suisse (Seidel); BoA.

\1300\ See PNC et al.

\1301\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC;

Goldman (Prop. Trading); BoA; Comm. on Capital Market Regulation. As

discussed above, hedging activity relying on this exemption cannot

be designed to: Reduce risks associated with the banking entity's

assets and/or liabilities generally, general market movements or

broad economic conditions; profit in the case of a general economic

downturn; counterbalance revenue declines generally; or otherwise

arbitrage market imbalances unrelated to the risks resulting from

the positions lawfully held by the banking entity.

---------------------------------------------------------------------------

Some commenters expressed concern about the proposed criterion that

the hedging activity not involve the potential for speculative

profit.\1302\ These commenters argued that the proper focus of the

hedging exemption should be on the purpose of the transaction, and

whether the hedge is correlated to the underlying risks being hedged

(in other words, whether the hedge is effective in mitigating

risk).\1303\ By contrast, another commenter urged the Agencies to adopt

a specific metric to track realized profits on hedging activities as an

indicator of prohibited arbitrage trading.\1304\

---------------------------------------------------------------------------

\1302\ See ABA (Keating); CH/ABASA; see also Credit Suisse

(Seidel); PNC; PNC et al.; SIFMA et al. (Prop. Trading) (Feb. 2012).

One commenter argued that anticipatory hedging should not be

permitted because it represents illegal front running. See Occupy.

The Agencies note that not all anticipatory hedging would constitute

illegal front running. Any activity that is illegal under another

provision of law, such as front running under section 10(b) of the

Exchange Act, remains illegal; and section 13 of the BHC Act and any

implementing rules thereunder do not represent a grant of authority

to engage in any such activity. See 15 U.S.C. 78j.

\1303\ As discussed above, the final hedging exemption replaces

the ``reasonable correlation'' concept with the requirement that

hedging activity ``demonstrably reduce or otherwise significantly

mitigate'' specific, identifiable risks.

\1304\ See AFR et al. (Feb. 2012); see also Part VI.C.3.d.,

infra.

---------------------------------------------------------------------------

Like the proposal, the final rule does not prohibit anticipatory

hedging. However, in response to commenter concerns that the proposal

would limit a banking entity's ability to respond to customer requests

and engage in prudent risk management, the final rule does not retain

the proposed requirement discussed above that an anticipatory hedge be

established ``slightly'' before the banking entity becomes exposed to

the underlying risk and meet certain conditions. To address commenter

concerns with the statutory mandate, several parts of the final rule

are designed to ensure that all hedging activities, including

anticipatory hedging activities, are designed to be risk reducing and

not impermissible proprietary trading activities. For example, the

final rule retains the proposed requirement that a banking entity have

reasonably designed policies and procedures indicating the positions,

techniques and strategies that each trading desk may use for hedging.

These policies and procedures should specifically address when

anticipatory hedging is appropriate and what policies and procedures

apply to anticipatory hedging.

The final rule also requires that a banking entity relying on the

hedging exemption be able to demonstrate that the hedging activity is

designed to reduce or significantly mitigate, and does demonstrably

reduce or otherwise significantly mitigate, specific, identifiable

risks in connection with individual or aggregated positions of the

banking entity.\1305\ Importantly, to use the hedging exemption, the

final rule requires that the banking entity subject its hedging

activity to continuing review, monitoring, and management that is

designed to reduce or significantly mitigate specific, identifiable

risks, and that demonstrably reduces or otherwise significantly

mitigates identifiable risks, in connection with individual or

aggregated positions of the banking entity.\1306\ The final rule also

requires ongoing recalibration of the hedging activity by the banking

entity to ensure that the hedging activity satisfies the requirements

set out in Sec. 75.5(b)(2) and is not prohibited proprietary trading.

If an anticipated risk does not materialize within a limited time

period contemplated when the hedge is entered into, under these

provisions, the banking entity would be required to extinguish the

anticipatory hedge or otherwise demonstrably reduce the risk associated

with that position as soon as reasonably practicable after it is

determined that the anticipated risk will not materialize. This

requirement focuses on the purpose of the hedge as a trade designed to

reduce anticipated risk and not for other purposes. The Agencies will

(and expect that banking entities also will) monitor the activities of

banking entities to identify prohibited trading activity that is

disguised as anticipatory hedging.

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\1305\ This requirement modifies proposed rule Sec.

75.5(b)(2)(ii) and (iii). As discussed above, the addition of

``demonstrably reduces or significantly mitigates'' language

replaces the proposed ``reasonable correlation'' requirement.

\1306\ The proposed rule contained a similar provision, except

that the proposed provision also required that the continuing review

maintain a reasonable level of correlation between the hedge

transaction and the risk being hedged. See proposed rule Sec.

75.5(b)(2)(v). As discussed above, the proposed ``reasonable

correlation'' requirement was removed from that provision and

instead a requirement has been added to the compliance program

provision that correlation analysis be undertaken when analyzing

hedging positions, techniques, and strategies before they are

implemented.

---------------------------------------------------------------------------

As noted above, one commenter suggested the Agencies adopt a metric

to monitor the profitability of a banking entity's hedging

activity.\1307\ We are not adopting such a metric because we do not

believe it would be useful to monitor the profit and loss associated

with hedging activity in isolation without considering the profit and

loss associated with the individual or aggregated positions being

hedged. For example, the commenter's suggested metric would not appear

to provide information about whether the gains arising from hedging

positions offset or mitigate losses from individual or aggregated

positions being hedged.

---------------------------------------------------------------------------

\1307\ See AFR et al. (Feb. 2012).

---------------------------------------------------------------------------

3. Compensation

The proposed rule required that the compensation arrangements of

persons performing risk-mitigating hedging activities be designed not

to reward proprietary risk-taking.\1308\ In the proposal, the Agencies

stated that 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

[[Page 5910]]

risk, are inconsistent with permitted risk-mitigating hedging

activities.\1309\

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\1308\ See proposed rule Sec. 75.5(b)(2)(vi).

\1309\ See Joint Proposal, 76 FR at 68868.

---------------------------------------------------------------------------

Commenters generally supported this requirement and indicated that

its inclusion was very important and valuable.\1310\ Some commenters

argued that the final rule should limit compensation based on profits

derived from hedging transactions, even if those hedging transactions

were in fact risk-mitigating hedges, and urged that employees be

compensated instead based on success in risk mitigation at the end of

the life of the hedge.\1311\ In contrast, other commenters argued that

the compensation requirement should restrict only compensation

arrangements that incentivize employees to engage in prohibited

proprietary risk-taking.\1312\

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\1310\ See, e.g., AFR et al. (Feb. 2012); Sens. Merkley & Levin

(Feb. 2012); Public Citizen.

\1311\ See AFR et al. (Feb. 2012); AFR (June 2013).

\1312\ See Morgan Stanley.

---------------------------------------------------------------------------

After considering comments received on the compensation

requirements of the proposed hedging exemption, the final rule

substantially retains the proposed requirement that the compensation

arrangements of persons performing risk-mitigating hedging activities

be designed not to reward prohibited proprietary trading. The final

rule is also modified to make clear that rewarding or incentivizing

profit making from prohibited proprietary trading is not

permitted.\1313\

---------------------------------------------------------------------------

\1313\ One commenter stated that the compensation requirement

should restrict only compensation arrangements that incentivize

employees to engage in prohibited proprietary risk-taking, rather

than apply to hedging activities. See Morgan Stanley.

---------------------------------------------------------------------------

The Agencies recognize that compensation, especially incentive

compensation, may be both an important motivator for employees as well

as a useful indicator of the type of activity that an employee or

trading desk is engaged in. For instance, an incentive compensation

plan that rewards an employee engaged in activities under the hedging

exemption based primarily on whether that employee's positions

appreciate in value instead of whether such positions reduce or

mitigate risk would appear to be designed to reward prohibited

proprietary trading rather than risk-reducing hedging activities.\1314\

Similarly, a compensation arrangement that is designed to incentivize

an employee to exceed the potential losses associated with the risks of

the underlying position rather than reduce risks of underlying

positions would appear to reward prohibited proprietary trading rather

than risk-mitigating hedging activities. The banking entity should

review its compensation arrangements in light of the guidance and rules

imposed by the appropriate Federal supervisor for the entity regarding

compensation.\1315\

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\1314\ Thus, the Agencies agree with one commenter who stated

that compensation for hedging should not be based purely on profits

derived from hedging. However, the final rule does not require

compensation vesting, as suggested by this commenter, because the

Agencies believe the final hedging exemption includes sufficient

requirements to ensure that only risk-mitigating hedging is

permitted under the exemption without a compensation vesting

provision. See AFR et al. (Feb. 2012); AFR (June 2013).

\1315\ See 12 U.S.C. 5641.

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4. Documentation Requirement

Section 75.5(c) of the proposed rule would have imposed 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 involved a hedge established at

a level of organization different than the level of organization

establishing or responsible for the positions, contracts, or other

holdings the risks of which the hedging transaction is designed to

reduce, the banking entity was required, at a minimum, to document: The

risk-mitigating purpose of the transaction; the risks of the individual

or aggregated positions, contracts, or other holdings of a banking

entity that the transaction is designed to reduce; and the level of

organization that is establishing the hedge.\1316\ Such documentation

was required to be established at the time the hedging transaction is

effected. The Agencies expressed concern in the proposal 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, either at the trading desk level or at

the level instituting the hedging transaction. In other words, the

further removed hedging activities are from the specific positions,

contracts, or other holdings the banking entity intends to hedge, the

greater the danger that such activity is not limited to hedging

specific risks of individual or aggregated positions, contracts, or

other holdings of the banking entity, as required by the rule.

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\1316\ For example, as explained under the proposal, 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 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. See

Joint Proposal, 76 FR at 68876 n.161.

---------------------------------------------------------------------------

Some commenters argued that the final rule should require

comprehensive documentation for all activity conducted pursuant to the

hedging exemption, regardless of where it occurs in an

organization.\1317\ One of these commenters stated that such

documentation can be easily and quickly produced by traders and noted

that traders already record execution details of every trade.\1318\

Several commenters argued that the rule should impose a requirement

that banks label all hedges at their inception and provide information

regarding the specific risk being offset, the expected duration of the

hedge, how it will be monitored, how it will be wound down, and the

names of the trader, manager, and supervisor approving the hedge.\1319\

---------------------------------------------------------------------------

\1317\ See AFR (June 2013); Occupy.

\1318\ See Occupy.

\1319\ See Sens. Merkley & Levin (Feb. 2012); Occupy; AFR (June

2013).

---------------------------------------------------------------------------

Some commenters requested that the documentation requirement be

applied at a higher level of organization,\1320\ and some commenters

noted that policies and procedures alone would be sufficient to address

hedging activity, wherever conducted within the organization.\1321\ Two

commenters indicated that making the documentation requirement narrower

is necessary to avoid impacts or delays in daily trading operations

that could lead to a banking entity being exposed to greater

risks.\1322\ A number of commenters stated that any enhanced

documentation requirement would be burdensome and costly, and would

impede rapid and effective risk mitigation, whether done at a trading

desk or elsewhere in the banking entity.\1323\

---------------------------------------------------------------------------

\1320\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC;

Barclays; see also Japanese Bankers Ass'n.

\1321\ See JPMC; SIFMA et al. (Prop. Trading) (Feb. 2012).

\1322\ See JPMC; Barclays.

\1323\ See Barclays; JPMC; SIFMA et al. (Prop. Trading) (Feb.

2012); see also Japanese Bankers Ass'n.

---------------------------------------------------------------------------

At least one commenter also argued that a banking entity should be

permitted to consolidate some or all of its hedging activity into a

trading desk that is not responsible for the underlying positions

without triggering a requirement that all hedges undertaken by a

trading desk be documented solely because the hedges are not undertaken

by the trading desk that originated the underlying position.\1324\

---------------------------------------------------------------------------

\1324\ See JPMC.

---------------------------------------------------------------------------

The final rule substantially retains the proposed requirement for

enhanced documentation for hedging activity

[[Page 5911]]

conducted under the hedging exemption if the hedging is not conducted

by the specific trading desk establishing or responsible for the

underlying positions, contracts, or other holdings, the risks of which

the hedging activity is designed to reduce. The final rule clarifies

that a banking entity must prepare enhanced documentation if a trading

desk establishes a hedging position and is not the trading desk that

established the underlying positions, contracts, or other holdings. The

final rule also requires enhanced documentation for hedges established

to hedge aggregated positions across two or more desks. This change in

the final rule clarifies that the level of the organization at which

the trading desk exists is important for determining whether the

trading desk established or is responsible for the underlying

positions, contracts, or other holdings. The final rule recognizes that

a trading desk may be responsible for hedging aggregated positions of

that desk and other desks, business units, or affiliates. In that case,

the trading desk putting on the hedge is at least one step removed from

some of the positions being hedged. Accordingly, the final rule

provides that the documentation requirements in Sec. 75.5 apply if a

trading desk is hedging aggregated positions that include positions

from more than one trading desk.

The final rule adds to the proposal by requiring enhanced

documentation for hedges established by the specific trading desk

establishing or directly responsible for the underlying positions,

contracts, or other holdings, the risks of which the purchases or sales

are designed to reduce, if the hedge is effected through a financial

instrument, technique, or strategy that is not specifically identified

in the trading desk's written policies and procedures as a product,

instrument, exposure, technique, or strategy that the trading desk may

use for hedging.\1325\ The Agencies note that this documentation

requirement does not apply to hedging activity conducted by a trading

desk in connection with the market making-related activities of that

desk or by a trading desk that conducts hedging activities related to

the other permissible trading activities of that desk so long as the

hedging activity is conducted in accordance with the compliance program

for that trading desk.

---------------------------------------------------------------------------

\1325\ One commenter suggested that the rule require

documentation when a banking entity needs to engage in new types of

hedging transactions that are not covered by its hedging policies,

although this commenter's suggested approach would only apply when a

hedge is conducted two levels above the level at which the risk

arose. See SIFMA et al. (Prop. Trading) (Feb. 2012). The Agencies

agree that documentation is needed when a trading desk is acting

outside of its hedging policies and procedures. However, the final

rule does not limit this documentation requirement to circumstances

when the hedge is conducted two organizational levels above the

trading desk. Such an approach would be less effective than the

adopted approach at addressing evasion concerns.

---------------------------------------------------------------------------

The Agencies continue to believe that, for the reasons stated in

the proposal, it is appropriate to retain documentation of hedging

transactions conducted by those other than the traders responsible for

the underlying position in order to permit evaluation of the activity.

In order to reduce the burden of the documentation requirement while

still giving effect to the rule's purpose, the final rule requires

limited documentation for hedging activity that is subject to a

documentation requirement, consisting of: (1) The specific,

identifiable risk(s) of the identified positions, contracts, or other

holdings that the purchase or sale is designed to reduce; (2) the

specific risk-mitigating strategy that the purchase or sale is designed

to fulfill; and (3) the trading desk or other business unit that is

establishing and responsible for the hedge transaction. As in the

proposal, this documentation must be established contemporaneously with

the hedging transaction. Documentation would be contemporaneous if it

is completed reasonably promptly after a trade is executed. The banking

entity is required to retain records for no less than 5 years (or such

longer period as may be required under other law) in a form that allows

the banking entity to promptly produce such records to the Agency on

request.\1326\ While the Agencies recognize this documentation

requirement may result in certain costs, the Agencies believe this

requirement is necessary to prevent evasion of the statute and final

rule.

---------------------------------------------------------------------------

\1326\ See final rule Sec. 75.5(c)(3).

---------------------------------------------------------------------------

5. Section 75.6(a)-(b): Permitted Trading in Certain Government and

Municipal Obligations

Section 75.6 of the proposed rule permitted a banking entity to

engage in trading activities that were authorized by section 13(d)(1)

of the BHC Act,\1327\ including 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.\1328\ Section 75.6 of the final rule generally

incorporates these same statutory exemptions. However, the final rule

has been modified in some ways in response to comments received on the

proposal.

---------------------------------------------------------------------------

\1327\ See proposed rule Sec. 75.6.

\1328\ See 12 U.S.C. 1851(d)(1)(A), (C), (F), and (H).

---------------------------------------------------------------------------

a. Permitted Trading in U.S. Government Obligations

Section 13(d)(1)(A) permits trading in various U.S. government,

U.S. agency and municipal securities.\1329\ Section 75.6(a) of the

proposed rule, which implemented section 13(d)(1)(A) of the BHC Act,

permitted the purchase or sale of a financial instrument that is an

obligation of the United States or any agency thereof or 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.).\1330\ The

proposal did not contain an exemption for trading in derivatives

referencing exempt U.S. government and agency securities, but requested

comment on whether the final rule should contain an exemption for

proprietary trading in options or other derivatives referencing an

exempt government obligation.\1331\

---------------------------------------------------------------------------

\1329\ 12 U.S.C. 1851(d)(1)(A).

\1330\ The Agencies proposed that United States ``agencies'' for

this purpose would include those agencies described in section

201.108(b) of the Board's Regulation A. See 12 CFR 201.108(b). The

Agencies also noted 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). In addition, this

would include pass-through or participation certificates that are

issued and guaranteed by a government-sponsored entity (e.g., the

Federal National Mortgage Association and the Federal Home Loan

Mortgage Corporation) in connection with its securitization

activities.

\1331\ See Joint Proposal, 76 FR at 68878.

---------------------------------------------------------------------------

Commenters were generally supportive of the manner in which the

proposal implemented the exemption for permitted trading in U.S.

government and U.S. agency obligations.\1332\ Many commenters argued

that the exemption for permissible proprietary trading in government

obligations should be expanded, however, to include trading in

derivatives on government obligations.\1333\ These commenters asserted

that failure to provide an exemption would adversely impact liquidity

in the underlying government obligations themselves and increase

[[Page 5912]]

borrowing costs to governments.\1334\ Several commenters asserted that

U.S. government and agency obligations and derivatives on those

instruments are substitutes and pose the same investment risks and

opportunities.\1335\ According to some commenters, the significant

connections between these markets and the interchangeable nature of

these instruments significantly contribute to price discovery, in

particular, in the cash market for U.S. Treasury obligations.\1336\

Commenters also argued that trading in Treasury futures and options

improves liquidity in Treasury securities markets by providing an

outlet to relieve any supply and demand imbalances in spot obligations.

Many commenters argued that the authority to engage in trading in

derivatives on U.S. government, agency, and municipal obligations is

inherent in the statutory exceptions granted by section 13(d)(1)(A) to

trade in the underlying obligation.\1337\ To the extent there is any

doubt about the scope of those exemptions, commenters urged the

Agencies to use the exemptive authority under section 13(d)(1)(J) if

necessary to permit proprietary trading in derivatives on government

obligations.\1338\ Two commenters opposed providing an exemption for

proprietary trading in derivatives on exempt government

obligations.\1339\

---------------------------------------------------------------------------

\1332\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Sens. Merkley & Levin (Feb. 2012).

\1333\ See BoA; CalPERS; Credit Suisse (Seidel); CME Group;

Fixed Income Forum/Credit Roundtable; FIA; JPMC; Morgan Stanley;

PNC; SIFMA et al. (Prop. Trading) (Feb. 2012); Wells Fargo (Prop.

Trading).

\1334\ See BoA; FIA; HSBC; JPMC; Morgan Stanley; Wells Fargo

(Prop. Trading).

\1335\ See Barclays; Credit Suisse (Seidel); Fixed Income Forum/

Credit Roundtable; FIA.

\1336\ See Barclays; CME Group; Fixed Income Forum/Credit

Roundtable; see also UBS.

\1337\ See CME Group; see also Morgan Stanley; PNC; SIFMA et al.

(Prop. Trading) (Feb. 2012); Wells Fargo (Prop. Trading).

\1338\ See Barclays; CME Group; JPMC.

\1339\ See Occupy; Alfred Brock.

---------------------------------------------------------------------------

The final rule has not been modified to permit a banking entity to

engage in proprietary trading of derivatives on U.S. government and

agency obligations.

The Agencies note that the cash market for exempt government

obligations is already one of the most liquid markets in the world, and

the final rule will permit banking entities to participate fully in

these cash markets. In addition, the final rule permits banking

entities to make a market in U.S. government securities and in

derivatives on those securities. Moreover, the final rule allows

banking entities to continue to use U.S. government obligations and

derivatives on those obligations in risk-mitigating hedging activities

permitted by the rule. Further, proprietary trading in derivatives on

such obligations will continue by entities other than banking entities.

Proprietary trading of derivatives on U.S. government obligations

is not necessary to promote and protect the safety and soundness of a

banking entity or the financial stability of the United States.

Commenters offered no compelling reasons why derivatives on exempt

government obligations pose little or no risk to the financial system

as compared to derivatives on other financial products for which

proprietary trading is generally prohibited and did not indicate how

proprietary trading in derivatives of U.S. government and agency

obligations by banking entities would promote the safety and soundness

of those entities or the financial stability of the United States. For

these reasons, the Agencies have not determined to provide an exemption

for proprietary trading in derivatives on exempt government

obligations.

The Agencies believe banking entities will continue to provide

significant support and liquidity to the U.S. government and agency

security markets through permitted trading in the cash exempt

government obligations markets, making markets in government obligation

derivatives and through derivatives trading for hedging purposes. The

final rule adopts the same approach as the proposed rule for the

exemption for permitted trading in U.S. government and U.S. agency

obligations. In response to commenters, the Agencies are clarifying how

banking entities would be permitted to use Treasury derivatives on

Treasury securities when relying on the exemptions for market-making

related activities and risk-mitigating hedging activities. The Agencies

agree with commenters that some Treasury derivatives are close economic

substitutes for Treasury securities and provide many of the same

economic exposures.\1340\ The Agencies also understand that the markets

for Treasury securities and Treasury futures are fully integrated, and

that trading in these derivative instruments is essential to ensuring

the continued smooth functioning of market-making related activities in

Treasury securities. Treasury derivatives are frequently used by market

makers to hedge their market-making related positions across many

different types of fixed-income securities. Under the final rule,

market makers will generally be able to continue their practice of

using Treasury futures to hedge their activities as block positioners

off exchanges. Additionally, when engaging in permitted market-making

related or risk-mitigating hedging activities in accordance with the

requirements in Sec. Sec. 75.4(b) or 75.(5), the final rule permits

banking entities to acquire a short or long position in Treasury

futures through manual trading or automated processes. For example, a

banking entity would be permitted to use Treasury futures to hedge the

duration risk (i.e., the measure of a bond's price sensitivity to

interest rates movements) associated with the banking entity's market-

making in Treasury securities or other fixed-income products, provided

that the banking entity complies with the market-making requirements in

Sec. 75.4(b). In their market making, banking entities also frequently

trade Treasury futures (and acquire a corresponding long or short

position) in reasonable anticipation of the near-term demands of their

clients, customers, and counterparties. For example, banking entities

may acquire a long or short position in Treasury futures to hedge

anticipated market risk when they reasonably expect clients, customers,

or counterparties will seek to establish long or short positions in on-

or off-the-run Treasury securities. Similarly, banking entities could

acquire a long or short position in the ``Treasury basis'' to hedge the

anticipated basis risk associated with making markets for clients,

customers, or counterparties that are reasonably expected to engage in

basis trading of the price spread between Treasury futures and Treasury

securities. A banking entity can also use Treasury futures (or other

derivatives on exempt government obligations) to hedge other risks such

as the aggregated interest rate risk for specifically identified loans

as well as other financial instruments such as asset-backed securities,

corporate bonds, and interest rate swaps. Therefore, depending on the

relevant facts and circumstances, banking entities would be permitted

to acquire a very large long or short position in Treasury derivatives

provided that they comply with the requirements in Sec. Sec. 75.4(b)

or 75.(5). The Agencies also understand that banking entities that have

been designated as ``primary dealers'' by the Federal Reserve Bank of

New York are required to underwrite issuances of Treasury securities.

This necessitates the banking entities to frequently establish very

large short positions in Treasury futures to order to hedge the

duration risk associated with potentially owning a large volume of

Treasury securities. As described below,\1341\ the Agencies note that,

with

[[Page 5913]]

respect to a banking entity that acts as a primary dealer for Treasury

securities, the U.S. government will be considered a client, customer,

or counterparty of the banking entity for purposes of the market-making

exemption.\1342\ We believe this interpretation appropriately captures

the unique relationship between a primary dealer and the government.

Moreover, this interpretation clarifies that a banking entity may rely

on the market-making exemption for its activities as primary dealer to

the extent those activities are outside the scope of the underwriting

exemption.\1343\

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\1340\ See supra note 1335.

\1341\ See infra Part VI.A.3.c.2.c.i.

\1342\ See supra note 910 (explaining the functions of primary

dealers).

\1343\ See supra Part VI.A.3.c.2.b.ix. (discussing commenters'

concerns regarding primary dealer activity, as well as one

commenter's request for such an interpretation).

---------------------------------------------------------------------------

The final rule also includes an exemption for obligations of or

guaranteed by the United States or an agency of the United States. An

obligation guaranteed by the U.S. or an agency of the U.S. is, in

effect, an obligation of the U.S. or that agency.

The final rule also includes an exemption for an obligation of the

FDIC, or any entity formed by or on behalf of the FDIC for the purpose

of facilitating the disposal of assets acquired or held by the FDIC in

its corporate capacity or as conservator or receiver under the Federal

Deposit Insurance Act (``FDI Act'') or Title II of the Dodd-Frank

Act.\1344\ These FDIC receivership and conservatorship operations are

authorized under the FDI Act and Title II of the Dodd-Frank Act and are

designed to lower the FDIC's resolution costs. The Agencies believe

that an exemption for these types of obligations would promote and

protect the safety and soundness of banking entities and the financial

stability of the United States because they facilitate the FDIC's

ability to conduct receivership and conservatorship operations in an

orderly manner, thereby limiting risks to the financial system

generally that might otherwise occur if the FDIC was restricted in its

ability to conduct these operations.

---------------------------------------------------------------------------

\1344\ See final rule Sec. 75.6(a)(4).

---------------------------------------------------------------------------

b. Permitted Trading in Foreign Government Obligations

The proposed rule did not contain an exemption for trading in

obligations of foreign sovereign entities. As part of the proposal,

however, the Agencies specifically requested comment on whether

proprietary trading in the obligations of foreign governments would

promote and protect the safety and soundness of banking entities and

the financial stability of the United States under section 13(d)(1)(J)

of the BHC Act.\1345\

---------------------------------------------------------------------------

\1345\ See Joint Proposal, 76 FR at 68878.

---------------------------------------------------------------------------

The treatment of proprietary trading in foreign sovereign

obligations prompted a significant number of comments. Many commenters,

including foreign governments, foreign and domestic banking entities,

and various trade groups, argued that the final rule should permit

trading in foreign sovereign debt, including obligations issued by

political subdivisions of foreign governments.\1346\ Representatives

from foreign governments such as Canada, Germany, Luxembourg, Japan,

Australia, and Mexico specifically requested an exemption for trading

in obligations of their governments and argued that an exemption was

necessary and appropriate to maintain and promote financial stability

in their markets.\1347\ Some commenters also requested an exemption for

trading in obligations of multinational central banks, such as

Eurobonds issued or guaranteed by the European Central Bank.\1348\

---------------------------------------------------------------------------

\1346\ See, e.g., Allen & Overy (Gov't Obligations); Allen &

Overy (Canadian Banks); BoA; Australian Bankers Ass'n. (Feb. 2012);

AFMA; Banco de M[eacute]xico; Bank of Canada; Ass'n of German Banks;

BAROC; Barclays; BEC (citing the National Institute of Banking and

Finance); British Bankers' Ass'n.; BaFin/Deutsche Bundesbank;

Chamber (Feb. 2012); Mexican Banking Comm'n.; French Treasury et

al.; EFAMA; ECOFIN; EBF; French Banking Fed'n.; FSA (Apr. 2012);

FIA; Goldman (Prop. Trading); HSBC; Hong Kong Inv. Funds

Association; IIB/EBF; ICFR; ICSA; IRSG; Japanese Bankers Ass'n.;

Ass'n. of Banks in Malaysia; OSFI; British Columbia; Qu[eacute]bec;

Sumitomo Trust; TMA Hong Kong; UBS; Union Asset.

\1347\ See, e.g., Allen & Overy (Gov't Obligations); Bank of

Canada; British Columbia; Ontario; IIAC; Quebec; IRSG; IIB/EBF;

Mitsubishi; Gov't of Japan/Bank of Japan; Australian Bankers Ass'n

(Feb. 2012); AFMA; Banco de M[eacute]xico; Ass'n. of German Banks;

ALFI; Embassy of Switzerland.

\1348\ See Ass'n. of German Banks; Goldman (Prop. Trading); IIB/

EBF; ICFR; FIA; Mitsubishi; Sumitomo Trust; Allen & Overy (Gov't

Obligations).

---------------------------------------------------------------------------

Many commenters argued that the same rationale for the statutory

exemption for proprietary trading in U.S. government obligations

supported exempting proprietary trading in foreign sovereign debt and

related obligations.\1349\ Commenters contended that lack of an express

exemption for trading in foreign sovereign obligations could critically

impact the functioning of money market operations of foreign central

banks and limit the ability of foreign sovereign governments to conduct

monetary policy or finance their operations.\1350\ These commenters

also contended that an exemption for proprietary trading in foreign

sovereign debt would promote and protect the safety and soundness and

the financial stability of the United States by avoiding the possible

negative effects of a contraction of government bond market

liquidity.\1351\

---------------------------------------------------------------------------

\1349\ See Allen & Overy (Gov't. Obligations); Banco de

M[eacute]xico; Barclays; BaFIN/Deutsche Bundesbank; EFAMA; Union

Asset; TMA Hong Kong; ICI (Feb. 2012) (arguing that such an

exemption would be consistent with Congressional intent to limit the

extra-territorial application of U.S. law).

\1350\ See Banco de M[eacute]xico; Barclays; BoA; Gov't of

Japan/Bank of Japan; IIAC; OSFI.

\1351\ See, e.g., Allen & Overy (Gov't. Obligations); AFMA;

Banco de M[eacute]xico; Ass'n. of German Banks; Barclays; Mexican

Banking Comm'n.; EFAMA; EBF; French Banking Fed'n.; Goldman (Prop.

Trading); HSBC; IIB/EBF; HSBC; ICSA; T. Rowe Price; UBS; Union

Asset; IRSG; EBF; Mitsubishi (citing Japanese Bankers Ass'n. and

IIB); Wells Fargo (Prop. Trading); ICI Global.

---------------------------------------------------------------------------

Commenters also contended that in some foreign markets, local

regulations or market practice require U.S. banking entities operating

in those jurisdictions to hold, trade or support government issuance of

local sovereign securities. They also indicated that these instruments

are traded in the United States or on U.S. markets.\1352\ In addition,

a number of commenters contended that U.S. and foreign banking entities

often perform functions for foreign governments similar to those

provided in the United States by U.S. primary dealers and alleged that

restricting these trading activities would have a significant negative

impact on the ability of foreign governments to implement their

monetary policy and on liquidity for such securities in many foreign

markets.\1353\ A few commenters further argued that banking entities

use foreign sovereign debt, particularly debt of their home country and

of the country in which they are operating, to manage their risk by

posting sovereign securities as collateral in foreign jurisdictions, to

manage international rate and foreign exchange risk (particularly in

local operations), and for liquidity and asset-liability management

purposes in different

[[Page 5914]]

countries.\1354\ Similarly, commenters expressed concern that the lack

of an exemption for trading in foreign government obligations could

adversely interact with other banking regulations, such as liquidity

requirements under the Basel III capital rules that encourage financial

institutions to hold large concentrations of sovereign bonds to match

foreign currency denominated obligations.\1355\ Commenters also

expressed particular concern that the limitations and obligations of

section 13 of the BHC Act would likely be problematic and unduly

burdensome if banking entities were able to trade in foreign sovereign

obligations only under the market making or other proposed exemptions

from the proprietary trading prohibition.\1356\ One commenter expressed

the view that lack of an exemption for proprietary trading in foreign

government obligations together with the proposed exemption for trading

that occurs solely outside the U.S. may cause foreign banks to close

their U.S. branches to avoid being subject to section 13 of the BHC Act

and any final rule thereunder.\1357\

---------------------------------------------------------------------------

\1352\ See Allen & Overy (Gov't. Obligations) (contending that

``even if not primary dealers, banking entities or their branches or

agencies acting in certain foreign jurisdictions, such as Singapore

and India, are still required to hold or transact in local sovereign

debt under local law''); BoA; Barclays; Citigroup; SIFMA et al.

(Prop. Trading) (Feb. 2012).

\1353\ See Allen & Overy (Gov't. Obligations); Australian

Bankers Ass'n. (Feb. 2012); BoA; Banco de M[eacute]xico; Barclays;

Citigroup; Goldman (Prop. Trading); IIB/EBF; see also JPMC

(suggesting that, at a minimum, the Agencies should make clear that

all of a firm's activities that are necessary or reasonably

incidental to its acting as a primary dealer in a foreign

government's debt securities are protected by the market-making-

related permitted activity); SIFMA et al. (Prop. Trading) (Feb.

2012). As discussed in Parts VI.A.2.c.2.c. and VI.A.2.c.2.b.ix of

this SUPPLEMENTARY INFORMATION, the Agencies believe primary dealing

activities would generally qualify under the scope of the market-

making or underwriting exemption.

\1354\ See Citigroup; SIFMA et al. (Prop. Trading) (Feb. 2012).

\1355\ See Allen & Overy (Gov't. Obligations); BoA.

\1356\ See Barclays; IIAC; UBS; Ass'n. of Banks in Malaysia;

IIB/EBF.

\1357\ See Comm. on Capital Markets Regulation.

---------------------------------------------------------------------------

According to some commenters, providing an exemption only for

proprietary trading in U.S. government obligations, without a similar

exemption for foreign government obligations, would be discriminatory

and inconsistent with longstanding principles of national treatment and

with U.S. treaty obligations, such as obligations under the World Trade

Organization framework or bilateral trade agreements.\1358\ In

addition, several commenters argued that not exempting proprietary

trading of foreign sovereign debt may encourage foreign regulators to

enact similar regulations to the detriment of U.S. financial

institutions operating abroad.\1359\ However, another commenter

disagreed that the failure to exempt trading in foreign government

obligations would violate trade agreements or that the proposal

discriminated in any way against foreign banking entities' ability to

compete with U.S. banking entities in the U.S.\1360\

---------------------------------------------------------------------------

\1358\ See Allen & Overy (Gov't. Obligations); Banco de

M[eacute]xico; IIB/EBF; Ass'n. of Banks in Malaysia.

\1359\ See Sumitomo Trust; SIFMA et al. (Prop. Trading) (Feb.

2012); Allen & Overy (Govt. Obligations); BoA; ICI Global; RBC;

ICFR; ICI (Feb. 2012); Bank of Canada; Cadwalader (on behalf of

Singapore Banks); Ass'n. of Banks in Malaysia; Cadwalader (on behalf

of Thai Banks); Chamber (Feb. 2012); BAROC. See also IIB/EBF.

\1360\ See Sens. Merkley & Levin (Feb. 2012).

---------------------------------------------------------------------------

Based on these concerns, some commenters suggested that the

Agencies exempt proprietary trading by foreign banking entities in

obligations of their home or host country.\1361\ Other commenters

suggested allowing trading in foreign government obligations that meet

some condition on quality (e.g., OECD-member country obligations,

government bonds eligible as collateral for Federal Reserve advances,

sovereign bonds issued by G-20 countries, or other highly liquid or

rated instruments).\1362\ One commenter indicated that in their view,

provided appropriate risk-management procedures are followed, investing

in non-U.S. government securities is as low risk as investing in U.S.

government securities despite current price volatility in certain types

of sovereign debt.\1363\ Some commenters also suggested the final rule

give deference to home country regulation and permit foreign banking

entities to engage in proprietary trading in any government obligation

to the extent that such trading is permitted by the entity's primary

regulator.\1364\

---------------------------------------------------------------------------

\1361\ See Cadwalader (on behalf of Thai Banks); IIB/EBF; Ass'n.

of Banks in Malaysia; UBS; see also BAROC.

\1362\ See BoA; Cadwalader (on behalf of Singapore Banks); IIB/

EBF; Norinchukin; OSFI; Cadwalader (on behalf of Thai Banks); Ass'n.

of Banks in Malaysia; UBS; see also BAROC; ICFR; Japanese Bankers

Ass'n.; JPMC; Qu[eacute]bec.

\1363\ See, e.g., Allen & Overy (Gov't Obligations).

\1364\ See Allen & Overy (Gov't. Obligations); HSBC.

---------------------------------------------------------------------------

By contrast, other commenters argued that proprietary trading in

foreign sovereign obligations represents a risky activity and that

there is no effective way to draw the line between safe and unsafe

foreign debt.\1365\ Two of these commenters pointed to several publicly

reported instances where proprietary trading in foreign sovereign

obligations resulted in significant losses to certain firms. These

commenters argued that restricting proprietary trading in foreign

sovereign debt would not cause reduced liquidity in government bond

markets since banking entities would still be permitted to make a

market in and underwrite foreign government obligations.\1366\ A few

commenters suggested that, if the final rule exempted proprietary

trading in foreign sovereign debt, foreign governments should commit to

pay for any damage to the U.S. financial system related to proprietary

trading in their obligations pursuant to such exemption.\1367\

---------------------------------------------------------------------------

\1365\ See Better Markets (Feb. 2012); Occupy; Prof. Johnson;

Sens. Merkley & Levin (Feb. 2012).

\1366\ See Prof. Johnson; Better Markets (Feb. 2012).

\1367\ See Better Markets (Feb. 2012); see also Prof. Johnson.

---------------------------------------------------------------------------

The Agencies carefully considered all the comments related to

proprietary trading in foreign sovereign debt in light of the language,

purpose and standards for exempting activity contained in section 13 of

the BHC Act. Under section 13(d)(1)(J), the Agencies may grant an

exemption from the prohibitions of the section for any activity that

the Agencies determine would promote and protect the safety and

soundness of the banking entity and the financial stability of the

United States.

The Agencies note as an initial matter that section 13 permits

banking entities--both inside the United States and outside the United

States--to make markets in and to underwrite all types of securities,

including all types of foreign sovereign debt. The final rule

implements the statutory market-making and underwriting exemptions, and

thus, the key role of banking entities in facilitating trading and

liquidity in foreign government debt through market-making and

underwriting is maintained. This includes underwriting and marketmaking

as a primary dealer in foreign sovereign obligations. Banking entities

may also hold foreign sovereign debt in their long-term investment

book. In addition, the final rule does not prevent foreign banking

entities from engaging in proprietary trading outside of the United

States in any type of sovereign debt.\1368\ Moreover, the Agencies

continue to believe that positions, including positions in foreign

government obligations, acquired or taken for the bona fide purpose of

liquidity management and in accordance with a documented liquidity

management plan that is consistent with the relevant Agency's

supervisory requirements, guidance and expectations regarding liquidity

management are not covered by the prohibitions in section 13.\1369\ The

final rule continues to incorporate this view.\1370\

---------------------------------------------------------------------------

\1368\ See final rule Sec. 75.6(e).

\1369\ See Joint Proposal, 76 FR at 68862.

\1370\ See final rule Sec. 75.3(d)(3).

---------------------------------------------------------------------------

The issue raised by commenters, therefore, is the extent to which

proprietary trading in foreign sovereign obligations by U.S. banking

entities anywhere in the world and by foreign banking entities in the

United States is consistent with promoting and protecting the safety

and soundness of the banking entity and the financial stability of the

United States. Taking

[[Page 5915]]

into account the information provided by commenters, the Agencies'

understanding of market operations, and the purpose and language of

section 13, the Agencies have determined to grant a limited exemption

to the prohibition on proprietary trading for trading in foreign

sovereign obligations under certain circumstances.

This exemption, which is contained in Sec. 75.6(b) of the final

rule, permits the U.S. operations of foreign banking entities to engage

in proprietary trading in the United States in the foreign sovereign

debt of the foreign sovereign under whose laws the banking entity--or

the banking entity that controls it--is organized (hereinafter, the

``home country''), and any multinational central bank of which the

foreign sovereign is a member so long as the purchase or sale as

principal is not made by an insured depository institution.\1371\

Similar to the exemption for proprietary trading in U.S. government

obligations, the permitted trading activity in the U.S. by the eligible

U.S. operations of a foreign banking entity would extend to obligations

of political subdivisions of the foreign banking entity's home

country.\1372\

---------------------------------------------------------------------------

\1371\ See final rule Sec. 75.6(b). Some commenters requested

an exemption for trading in obligations of multinational central

banks. See Ass'n. of German Banks; Goldman (Prop. Trading); IIB/EBF;

ICFR; FIA; Mitsubishi; Sumitomo Trust; Allen & Overy (Gov't.

Obligations). In the case of a foreign banking entity that is owned

or controlled by a second foreign banking entity domiciled in a

country other than the home country of the first foreign banking

entity, the final rule would permit the eligible U.S. operations of

the first foreign banking entity to engage in proprietary trading

only in the sovereign debt of the first foreign banking entity's

home country, and would permit the U.S. operations of the second

foreign banking entity to engage in proprietary trading only in the

sovereign debt of the home country of the second foreign banking

entity. As noted earlier, other provisions of the final rule make

clear that the rule does not restrict the proprietary trading

outside of the United States of either foreign banking organization

in debt of any foreign sovereign.

\1372\ See Part VI.A.5.c., infra. Many commenters requested an

exemption for trading in foreign sovereign debt, including

obligations issued by political subdivisions of foreign governments.

See, e.g., Allen & Overy (Gov't. Obligations); BoA; Australian

Bankers Ass'n. (Feb. 2012); Banco de M[eacute]xico; Bank of Canada;

Ass'n. of German Banks; BAROC; Barclays.

---------------------------------------------------------------------------

Permitting the eligible U.S. operations of a foreign banking entity

to engage in proprietary trading in the United States in the foreign

sovereign obligations of the foreign entity's home country allows these

U.S. operations of foreign banking entities to continue to support the

smooth functioning of markets in foreign sovereign obligations in the

same manner as U.S. banking entities are permitted to support the

smooth functioning of markets in U.S. government and agency

obligations.\1373\ At the same time, the risk of these trading

activities is largely determined by the foreign sovereign that charters

the foreign bank. By not permitting proprietary trading in foreign

sovereign debt in insured depository institutions (other than in

accordance with the limitations in other exemptions), the exemption

limits the direct risks of these activities to insured depository

institutions in keeping with the statute.\1374\ Thus, the Agencies have

determined that this limited exemption for proprietary trading in

foreign sovereign obligations promotes and protects the safety and

soundness of banking entities and also promotes and protects the

financial stability of the United States.

---------------------------------------------------------------------------

\1373\ As part of this exemption, for example, the U.S.

operations of a European bank would be able to trade in obligations

issued by the European Central Bank. Many commenters represented

that the same rationale for exempting trading in U.S. government

obligations supports exempting trading in foreign sovereign debt.

See, e.g., Allen & Overy (Gov't. Obligations); Banco de

M[eacute]xico; Barclays; EFAMA; ICI (Feb. 2012).

\1374\ The Agencies believe this approach appropriately balances

commenter concerns that proprietary trading in foreign sovereign

obligations represents a risky activity and the interest in

preserving the ability of U.S. operations of foreign banking

entities to continue to support the smooth functioning of markets in

foreign sovereign obligations in the same manner as U.S. banking

entities are permitted to support the smooth functioning of markets

in U.S. government and agency obligations. See Better Markets (Feb.

2012); Occupy; Prof. Johnson; Sens. Merkley & Levin (Feb. 2012).

---------------------------------------------------------------------------

The Agencies have also determined to permit a foreign bank or

foreign broker-dealer regulated as a securities dealer and controlled

by a U.S. banking entity to engage in proprietary trading in the

obligations of the foreign sovereign under whose laws the foreign

entity is organized (hereinafter, the ``home country''), including

obligations of an agency or political subdivision of that foreign

sovereign.\1375\ This limited exemption is necessary to allow U.S.

banking organizations to continue to own and acquire foreign banking

organizations and broker-dealers without requiring those foreign

banking organizations and broker-dealers to discontinue proprietary

trading in the sovereign debt of the foreign banking entity's home

country.\1376\ The Agencies have determined that this limited exemption

will promote the safety and soundness of banking entities and the

financial stability of the United States by allowing U.S. banking

entities to continue to be affiliated with and operate foreign banking

entities and benefit from international diversification and

participation in global financial markets.\1377\ However, the Agencies

intend to monitor activity of banking entities under this exemption to

ensure that U.S. banking entities are not seeking to evade the

restrictions of section 13 by using an affiliated foreign bank or

broker-dealer to engage in proprietary trading in foreign sovereign

debt on behalf of or for the benefit of other parts of the U.S. banking

entity.

---------------------------------------------------------------------------

\1375\ See final rule Sec. 75.6(c). Many commenters requested

an exemption for trading in foreign sovereign debt, and some

commenters suggested exempting proprietary trading by foreign

banking entities in obligations of their home country. See, e.g.,

Allen & Overy (Gov't. Obligations); BoA; FSA (Apr. 2012); Cadwalader

(on behalf of Thai Banks); IIB/EBF; Ass'n. of Banks in Malaysia;

UBS.

\1376\ Commenters argued that in some foreign markets, U.S.

banks operating in those jurisdictions are required by local

regulation or market practice to trade in local sovereign

securities. See, e.g., Allen & Overy (Gov't. Obligations); AFMA;

Ass'n. of German Banks; Barclays; EBF; Goldman (Prop. Trading); UBS.

\1377\ Some commenters represented that the limitations and

obligations of section 13 would be problematic and unduly burdensome

on banking entities because they would only be able to trade in

foreign sovereign obligations under existing exemptions, such as the

market-making exemption. See Barclays; IIAC; UBS; Ass'n. of Banks in

Malaysia; IIB/EBF.

---------------------------------------------------------------------------

Apart from this limited exemption, the Agencies have not extended

this exemption to proprietary trading in foreign sovereign debt by U.S.

banking entities for several reasons. First, section 13 was primarily

concerned with the risks posed to the U.S. financial system by

proprietary trading activities. This risk is most directly transmitted

by U.S. banking entities, and while commenters alleged that prohibiting

U.S. banking entities from engaging in proprietary trading in debt of

foreign sovereigns would harm liquidity in those markets, the evidence

provided by commenters did not sufficiently indicate that permitting

U.S. banking entities to engage in proprietary trading (as opposed to

market-making or underwriting) in debt of foreign sovereigns

contributed in any significant degree to the liquidity of markets in

foreign sovereign instruments.\1378\ Thus, expanding the exemption to

permit U.S. banking entities to engage in proprietary trading in debt

of foreign sovereigns would likely increase the risks to these entities

and the U.S. financial system without a significant concomitant and

offsetting benefit. As explained above, these U.S.

[[Page 5916]]

entities are permitted by the final rule to continue to engage fully in

market-making in and underwriting of debt of foreign sovereigns

anywhere in the world. The only restriction placed on these entities is

on the otherwise impermissible proprietary trading in these instruments

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.

---------------------------------------------------------------------------

\1378\ See, e.g., BoA; Citigroup; Goldman (Prop. Trading); IIB/

EBF; Allen & Overy (Gov't. Obligations); Australian Bankers Ass'n.

(Feb. 2012).; Banco de M[eacute]xico; Barclays. The Agencies

recognize some commenters' representation that restricting trading

in foreign sovereign debt would not necessarily cause reduced

liquidity in government bond markets because banking entities would

still be able to make a market in and underwrite foreign government

obligations. See Prof. Johnson; Better Markets (Feb. 2012).

---------------------------------------------------------------------------

The Agencies recognize that, depending on the extent to which

banking entities subject to the rule have contributed to the liquidity

of trading markets for foreign sovereign debt, the lack of an exemption

for proprietary trading in foreign sovereign debt could result in

certain negative impacts on the markets for such debt. In general, the

Agencies believe these concerns should be mitigated somewhat by the

refined exemptions for market making, underwriting and permitted

trading activity of foreign banking entities; however, those exemptions

do not address certain of the collateral, capital, and other

operational issues identified by commenters.\1379\ Foreign sovereign

debt of home and host countries generally serves these purposes. Due to

the relationships among global financial markets, permitting trading

that supports these essential functions promotes the financial

stability and the safety and soundness of banking entities.\1380\ In

contrast, a broad exemption for proprietary trading in all foreign

sovereign debt without the limitations contained in the underwriting,

market making and hedging exemptions could lead to more complicated

risk profiles and significant unhedged risk exposures that section 13

of the BHC Act is designed to address. Thus, the Agencies believe use

of section 13(d)(1)(J) exemptive authority to permit proprietary

trading in foreign government obligations in certain limited

circumstances is appropriate.

---------------------------------------------------------------------------

\1379\ Representatives from foreign governments stated that an

exemption allowing trading in obligations of their governments is

necessary to maintain financial stability in their markets. See,

e.g., Allen & Overy (Gov't. Obligations); Bank of Canada; IRSG; IIB/

EBF; Gov't of Japan/Bank of Japan; Australian Bankers Ass'n. (Feb.

2012); Banco de M[eacute]xico; Ass'n. of German Banks; ALFI.

Commenters argued that exempting trading in foreign sovereign debt

would avoid the possible negative impacts of a contraction of

government bond market liquidity. See, e.g., BoA; Citigroup; Goldman

(Feb. 2012); IIB/EBF. Additionally, commenters suggested that

failing to provide an exemption for this activity would impact money

market operations of foreign central banks and limit the ability of

foreign sovereign governments to conduct monetary policy or finance

their operations. See, e.g., Barclays; BoA; Gov't of Japan/Bank of

Japan; OSFI. A number of commenters also argued that, since U.S. and

foreign banking entities often perform functions for foreign

governments similar to those provided in the U.S. by U.S. primary

dealers, the lack of an exemption would have a significant, negative

impact on the ability of foreign governments to implement monetary

policy and on liquidity in many foreign markets. See, e.g., Allen &

Overy (Gov't. Obligations); Australian Bankers Ass'n. (Feb. 2012);

BoA; Banco de M[eacute]xico; Barclays; Citigroup (Feb. 2012);

Goldman (Prop. Trading); IIB/EBF. Some commenters argued that

banking entities and their customers use foreign sovereign debt to

manage their risk by posting collateral in foreign jurisdictions and

to manage international rate and foreign exchange risk. See

Citigroup (Feb. 2012); SIFMA et al. (Prop. Trading) (Feb. 2012).

\1380\ The Agencies generally concur with commenters' concerns

that because the lack of an exemption could result in negative

consequences--such as harming liquidity in foreign sovereign debt

markets, making it more difficult and more costly for foreign

governments to fund themselves, or subjecting banking entities to

increased concentration risk--systemic risk could increase or there

could be spillover effects that would harm global markets, including

U.S. markets. See IIF; EBF; ICI Global; HSBC; Barclays; ICI (Feb.

2012); IIB/EBF; Union Asset. Additionally, in consideration of one

commenter's statements, the Agencies believe that failing to provide

this exemption may cause foreign banks to close their U.S. branches,

which could harm U.S. markets. See Comm. on Capital Markets

Regulation.

---------------------------------------------------------------------------

The Agencies decline to follow commenters' suggested alternative of

allowing trading in foreign government obligations if the obligations

meet a particular condition on quality, such as obligations of OECD

member countries.\1381\ The Agencies do not believe such an approach

responds to the statutory purpose of limiting risks posed to the U.S.

financial system by proprietary trading activities as directly as our

current approach, which is structured to limit the exposure of banking

entities, including insured depository institutions, to the risks of

foreign sovereign debt. Additionally, the Agencies decline to permit

proprietary trading in any obligation permitted under the laws of the

foreign banking entity's home country,\1382\ because such an approach

could result in unintended competitive impacts since banking entities

would not be subject to one uniform standard inside the United States.

Further, unlike some commenters, the Agencies do not believe it is

appropriate to require foreign governments to commit to paying for any

damage to the U.S. financial system resulting from the foreign

sovereign debt exemption.\1383\

---------------------------------------------------------------------------

\1381\ See, e.g., BoA; Cadwalader (on behalf of Singapore

Banks); IIB/EBF; OSFI; UBS; BAROC; Japanese Bankers Ass'n.; JPMC.

\1382\ Some commenters suggested permitting non-U.S. banking

entities to trade in any government obligation to the extent that

such trading is permitted by the entity's primary regulator. See

Allen & Overy (Gov't. Obligations); HSBC.

\1383\ See Better Markets (Feb. 2012); see also Prof. Johnson.

---------------------------------------------------------------------------

The proposal also did not contain an exemption for trading in

derivatives on foreign government obligations. Many commenters who

recommended providing an exemption for proprietary trading in foreign

government obligations also requested that the exemption be extended to

derivatives on foreign government obligations.\1384\ Two of these

commenters urged that trading in derivatives on foreign sovereign

obligations should be exempt for the same reason that trading in

derivatives on U.S. government obligations is exempt because such

trading supports liquidity and price stability in the market for the

underlying government obligations.\1385\ One commenter recommended that

the Agencies use the authority in section 13(d)(1)(J) to grant an

exemption for proprietary trading in derivatives on foreign government

obligations.\1386\

---------------------------------------------------------------------------

\1384\ See Barclays; Credit Suisse (Seidel); IIB/EBF; Japanese

Bankers Ass'n.; Norinchukin; RBC; Sumitomo Trust; UBS.

\1385\ See Barclays; FIA.

\1386\ See Barclays.

---------------------------------------------------------------------------

The final rule has not been modified in Sec. 75.6(b) to permit a

banking entity to engage in proprietary trading in derivatives on

foreign government obligations. As noted above, the Agencies have

determined not to permit proprietary trading in derivatives on U.S.

exempt government obligations under section 13(d) and, for the same

reasons, have determined not to extend the permitted activities to

include proprietary trading in derivatives on foreign government

obligations.

c. Permitted Trading in Municipal Securities

Section 75.6(a) of the proposed rule implemented an exemption to

the prohibition against proprietary trading under section 13(d)(1)(A)

of the BHC Act, which permits trading in certain governmental

obligations. This exemption permits the purchase or sale of obligations

issued by any State or any political subdivision thereof (the

``municipal securities trading exemption''). The proposed rule included

both general obligation bonds and limited obligation bonds, such as

revenue bonds, within the scope of this municipal securities trading

exemption. The proposed rule, however, did not extend to obligations of

``agencies'' of States or political subdivisions thereof.\1387\

---------------------------------------------------------------------------

\1387\ See Joint Proposal, 76 FR at 68878 n.165.

---------------------------------------------------------------------------

Many commenters, including industry participants, trade groups, and

Federal and state governmental representatives, argued that the

municipal securities trading exemption should be interpreted to permit

banking entities to engage in proprietary trading in a broader range of

municipal securities, including the

[[Page 5917]]

following: Obligations issued directly by States and political

subdivisions thereof; obligations issued by agencies, constituted

authorities, and similar governmental entities acting as

instrumentalities on behalf of States and political subdivisions

thereof; and obligations issued by such governmental entities that are

treated as political subdivisions under various more expansive

definitions of political subdivisions under Federal and state

laws.\1388\ These commenters argued that States and municipalities

often issue obligations through agencies and instrumentalities and that

these obligations generally have the same level of risk as direct

obligations of States and political subdivisions.\1389\ Commenters

asserted that permitting trading in a broader group of municipal

securities would be consistent with the terms and purposes of section

13 and would not adversely affect the safety and soundness of banking

entities involved in these transactions or create additional risk to

the financial stability of the United States.\1390\

---------------------------------------------------------------------------

\1388\ See, e.g., ABA (Keating); Ashurst; Ass'n. of

Institutional Investors (Feb. 2012); BoA; BDA (Feb. 2012); Capital

Group; Chamber (Feb. 2012); Citigroup (Jan. 2012); CHFA; Eaton

Vance; Fidelity; Fixed Income Forum/Credit Roundtable; HSBC; MEFA;

Nuveen Asset Mgmt.; Sens. Merkley & Levin (Feb. 2012); Am. Pub.

Power et al.; MSRB; Fidelity; State of New York; STANY; SIFMA

(Municipal Securities) (Feb. 2012); State Street (Feb. 2012); North

Carolina; T. Rowe Price; Sumitomo Trust; UBS; Washington State

Treasurer; Wells Fargo (Prop. Trading).

\1389\ See, e.g., CHFA; Sens. Merkley & Levin (Feb. 2012); Am.

Pub. Power et al.; North Carolina; Washington State Treasurer; see

also NABL; Ashurst; BDA (Feb. 2012); Chamber (Feb. 2012); Eaton

Vance; Fidelity; MEFA; MSRB; Am. Pub. Power et al.; Nuveen Asset

Mgmt.; PNC; SIFMA (Municipal Securities) (Feb. 2012); UBS.

\1390\ See Ashurst; Citigroup (Jan. 2012); Eaton Vance; Am. Pub.

Power et al.; SIFMA (Municipal Securities) (Feb. 2012); North

Carolina; T. Rowe Price; Wells Fargo (Prop. Trading); see also

Capital Group (arguing that municipal securities are not generally

used as a profit making strategy and thus, including all municipal

securities in the exemption by itself should not adversely affect

the safety and soundness of banking entities); PNC (arguing that the

safe and sound nature of trading in State and municipal agency

obligations was ``a fact recognized by Congress in 1999 when it

authorized well capitalized national banks to underwrite and deal

in, without limit, general obligation, limited obligation and

revenue bonds issued by or on behalf of any State, or any public

agency or authority of any State or political subdivision of a

State''); Sens. Merkley & Levin (Feb. 2012).

---------------------------------------------------------------------------

Commenters expressed concerns that the proposed rule would result

in a bifurcation of the municipal securities market that would achieve

no meaningful benefits to the safety and soundness of banking entities,

create administrative burdens for determining whether or not a

municipal security qualifies for the exemption, result in inconsistent

applications across different States, increase costs, and decrease

liquidity in the diverse municipal securities market.\1391\ Commenters

also argued that the market for securities issued by agencies and

instrumentalities of States and political subdivisions thereof would be

especially disrupted, and would affect about 40 percent of the

municipal securities market.\1392\

---------------------------------------------------------------------------

\1391\ See, e.g., MSRB; City of New York; Am. Pub. Power et al.;

Wells Fargo; State of New York; Washington State Treasurer; ABA

(Keating); Capital Group; North Carolina; Eaton Vance; Port

Authority; Connecticut; Citigroup (Jan. 2012); Ashurst; Nuveen Asset

Mgmt.; SIFMA (Municipal Securities) (Feb. 2012).

\1392\ See, e.g., MSRB (stating that, based on data from Thomson

Reuters, 41.4 percent of the municipal securities issued in FY 2011

were issued by agencies and authorities).

---------------------------------------------------------------------------

Commenters recommended that the final rule provide a broad

exemption to the prohibition on proprietary trading for municipal

securities, based on the definition of ``municipal securities'' used in

section 3(a)(29) of the Exchange Act,\1393\ which is understood by

market participants and by Congress, and has a well-settled meaning and

an established body of law. \1394\ Other commenters contended that

adopting the same definition of municipal securities as used in the

Federal securities laws would reduce regulatory burden, remove

uncertainty, and lead to consistent treatment of these securities under

the banking and securities laws.\1395\ According to some commenters,

the terms ``agency'' and ``political subdivision'' are used differently

under some State laws, and some State laws identify certain agencies as

political subdivisions or define political subdivision to include

agencies.\1396\ Commenters also noted that a number of Federal statutes

and regulations define the term ``political subdivision'' to include

municipal agencies and instrumentalities.\1397\ Commenters suggested

that the Agencies interpret the term ``political subdivision'' in

section 13 more broadly than in the proposal to include a wider range

of State and municipal governmental obligations issued by agencies and

instrumentalities or, alternatively, that the Agencies use the

exemptive authority in section 13(d)(1)(J) if necessary to permit

proprietary trading of a broader array of State and municipal

obligations.\1398\

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\1393\ See 15 U.S.C. 78c(a)(29).

\1394\ See ABA (Keating); Ashurst; BoA; Capital Group; Chamber

(Feb. 2012); Comm. on Capital Markets Regulation; Citigroup (Jan.

2012); Eaton Vance; Fidelity; MEFA; MTA-NY; MSRB; Am. Pub. Power et

al.; NABL; NCSL; State of New York; Nuveen Asset Mgmt.; Port

Authority; PNC; SIFMA (Municipal Securities) (Feb. 2012); North

Carolina; T. Rowe Price; UBS; Washington State Treasurer; Wells

Fargo (Prop. Trading).

\1395\ See Ashurst; Citigroup (Jan. 2012) (noting that the

National Bank Act explicitly lists State agencies and authorities as

examples of political subdivisions); MSRB.

\1396\ See, e.g., Citigroup (Jan. 2012).

\1397\ See, e.g., MSRB; Citigroup (Jan. 2012). In addition to

the Federal securities laws, the National Bank Act explicitly

includes agencies and authorities as examples of political

subdivisions. See 12 U.S.C. 24(seventh) (permitting investments in

securities ``issued by or on behalf of any State or political

subdivision of a State, including any municipal corporate

instrumentality of 1 or more States, or any public agency or

authority of any State or political subdivision of a State . . .

.''). In addition, a number of banking regulations also include

agencies as examples of political subdivisions or define political

subdivision to include municipal agencies, authorities, districts,

municipal corporations and similar entities. See, e.g., 12 CFR 1.2;

12 CFR 160.30; 12 CFR 161.38; 12 CFR 330.15. Further, for purposes

of the tax-exempt bond provisions in the Internal Revenue Code,

Treasury regulations treat obligations issued by or ``on behalf of''

States or political subdivisions by ``constituted authorities'' as

obligations of such States or political subdivisions, and the

Treasury regulations define the term ``political subdivision'' to

mean ``any division of any State or local governmental unit which is

a municipal corporation or which has been delegated the right to

exercise part of the sovereign power of the unit. . . .'' See 26 CFR

1.103-1(b).

\1398\ See ABA (Keating); Ashurst; Ass'n. of Institutional

Investors (Feb. 2012); Citigroup (Jan. 2012); Comm. on Capital

Markets Regulation; Sens. Merkley & Levin (Feb. 2012); MSRB; Wells

Fargo (Prop. Trading); SIFMA et al. (Prop. Trading) (Feb. 2012).

---------------------------------------------------------------------------

On the other hand, one commenter contended that bonds issued by

agencies and instrumentalities of States or municipalities pose risks

to the banking system because the commenter believed the market for

these bonds has not been properly regulated or controlled.\1399\ A few

commenters also recommended tightening the proposed municipal

securities trading exemption to exclude conduit obligations that

benefit private businesses and private organizations.\1400\ One

commenter suggested that the proposed municipal securities trading

exemption should not apply to tax-exempt municipal bonds that benefit

private businesses (referred to as ``private activity bonds'' in the

Internal Revenue Code \1401\) and that allow private businesses to

finance private projects at lower interest rates as

[[Page 5918]]

a result of the exemption from Federal income taxation for the interest

received by investors.\1402\

---------------------------------------------------------------------------

\1399\ See Occupy.

\1400\ See AFR et al. (Feb. 2012); Occupy.

\1401\ See 26 U.S.C. 141. In general, the rules applicable to

the issuance of tax-exempt private activity bonds under the Internal

Revenue Code of 1986, as amended (the ``Code'') are more restrictive

than those applicable to traditional governmental bonds issued by

States or political subdivisions thereof. Section 146 of the Code

imposes an annual State bond volume cap on most tax-exempt private

activity bonds that is tied to measures of State populations.

Sections 141-150 of the Code impose other additional restrictions on

tax-exempt private activity bonds, including, among others, eligible

project and use restrictions, bond maturity restrictions, land and

existing property financing restrictions, an advance refunding

prohibition, and a public approval requirement.

\1402\ See AFR et al. (Feb. 2012).

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The final rule includes the statutory exemption for proprietary

trading of obligations of any State or political subdivision

thereof.\1403\ In response to the public comments and for the reasons

discussed below, this exemption uses the definition of the term

``municipal security'' modeled after the definition of ``municipal

securities'' under section 3(a)(29) of the Exchange Act,\1404\ but with

simplifications.\1405\ The final rule defines the term ``municipal

security'' to mean ``a security which is a direct obligation of or

issued by, or an obligation guaranteed as to principal or interest by,

a State or any political subdivision thereof, or any agency or

instrumentality of a State or any political subdivision thereof, or any

municipal corporate instrumentality of one or more States or political

subdivisions thereof.''

---------------------------------------------------------------------------

\1403\ See final rule Sec. 75.6(a)(3).

\1404\ Many commenters requested that the final rule use the

definition of ``municipal securities'' used in the Federal

securities laws because, among other reasons, the industry is

familiar with that definition and such an approach would promote

consistent treatment of these securities under banking and

securities laws. See, e.g., ABA (Keating); Ashurst; BoA; Comm. on

Capital Markets Regulation; Citigroup (Jan. 2012); NCSL; Port

Authority; SIFMA (Municipal Securities) (Feb. 2012); MSRB. Section

3(a)(29) of the Exchange Act defines the term ``municipal

securities'' to mean ``securities which are direct obligations of,

or obligations guaranteed as to principal or interest by, a State or

any political subdivision thereof, or any agency or instrumentality

of a State or any political subdivision thereof, or any municipal

corporate instrumentality of one or more States, or any security

which is an industrial development bond (as defined in section

103(c)(2) of Title 26) the interest on which is excludable from

gross income under section 103(a)(1) of Title 26 if, by reason of

the application of paragraph (4) or (6) of section 103(c) of Title

26 (determined as if paragraphs (4)(A), (5), and (7) were not

included in such section 103(c)), paragraph (1) of such section

103(c) does not apply to such security.'' See 15 U.S.C. 78c(a)(29).

\1405\ The definition of municipal securities in section

3(a)(29) of the Exchange Act has outdated tax references to the

prior law under the former Internal Revenue Code of 1954, including

particularly references to certain provisions involving the concept

of ``industrial development bonds.'' The successor current Internal

Revenue Code of 1986, as amended, replaces the prior definition of

``industrial development bonds'' with a revised, more restrictive

successor definition of ``private activity bonds'' and related

definitions of ``exempt facility bonds'' and ``small issue bonds.''

In recognition of the numerous tax law changes since the last

statutory revision of section 3(a)(29) of the Exchange Act in 1970

and the potential attendant confusion, the Agencies determined to

use a simpler, streamlined, independent definition of municipal

securities for purposes of the municipal securities trading

exception. This revised definition is intended to encompass, among

others, any securities that are covered by the definition of the

term ``municipal securities'' under section 3(a)(29) of the Exchange

Act.

---------------------------------------------------------------------------

The final rule modifies the proposal to permit proprietary trading

in obligations issued by agencies and instrumentalities acting on

behalf of States and municipalities (e.g., port authority bonds and

bonds issued by municipal agencies or corporations).\1406\ As noted by

commenters, many States and municipalities rely on securities issued by

agencies and instrumentalities to fund essential activities, including

utility systems, infrastructure projects, affordable housing,

hospitals, universities, and other nonprofit institutions.\1407\ Both

obligations issued directly by States and political subdivisions

thereof and obligations issued by an agency or instrumentality of such

a State or local governmental entity are ultimately obligations of the

State or local governmental entity on whose behalf they act. Moreover,

exempting obligations issued by State and municipal agencies and

instrumentalities in the same manner as the direct obligations of

States and municipalities lessens potential inconsistent treatment of

government obligations across States and municipalities that use

different funding methods for government projects.\1408\

---------------------------------------------------------------------------

\1406\ Many commenters requested that the municipal securities

trading exemption be interpreted to include a broader range of State

and municipal obligations issued by agencies and instrumentalities.

See, e.g., ABA (Keating); Ashurst; BoA; BDA (Feb. 2012); Fixed

Income Forum/Credit Roundtable; Sens. Merkley & Levin (Feb. 2012);

SIFMA (Municipal Securities) (Feb. 2012); Citigroup (Jan. 2012);

Comm. on Capital Markets Regulation.

\1407\ See, e.g., Citigroup (Jan. 2012); Ashurst; SIFMA et al.

(Prop. Trading) (Feb. 2012); SIFMA (Municipal Securities) (Feb.

2012); Chamber (Dec. 2011); BlackRock; Fixed Income Forum/Credit

Roundtable.

\1408\ Commenters represented that the proposed rule would

result in inconsistent applications of the exemption across States

and political subdivisions. The Agencies also recognize, as noted by

commenters, that the proposed rule would likely have resulted in a

bifurcation of the municipal securities market and associated

administrative burdens and disruptions. See, e.g., MSRB; Am. Pub.

Power et al.; Port Authority; Citigroup (Jan. 2012); SIFMA et al.

(Prop. Trading) (Feb. 2012); SIFMA (Municipal Securities) (Feb.

2012).

---------------------------------------------------------------------------

The Agencies believe that interpreting the language of section

13(d)(1)(A) of the BHC Act to provide an exemption to the prohibition

on proprietary trading for obligations issued by States and municipal

agencies and instrumentalities as described above is consistent with

the terms and purposes of section 13 of the BHC Act.\1409\ The Agencies

recognize that state and political subdivision agency obligations

generally present the same level of risk as direct obligations of

States and political subdivisions.\1410\ Moreover, the Agencies

recognize that other Federal laws and regulations define the term

``political subdivision'' to include municipal agencies and

instrumentalities.\1411\ The Agencies decline to exclude from this

exemption conduit obligations that benefit private entities, as

suggested by some commenters.\1412\

---------------------------------------------------------------------------

\1409\ Commenters asserted that permitting trading in a broader

group of municipal securities would be consistent with the terms and

purposes of section 13. See, e.g., Ashurst; Citigroup (Jan. 2012);

Eaton Vance; Am. Pub. Power et al.; SIFMA (Municipal Securities)

(Feb. 2012).

\1410\ Commenters argued that obligations issued by agencies and

instrumentalities generally have the same level of risk as direct

obligations of States and political subdivisions. See, e.g., CHFA;

Sens. Merkley & Levin (Feb. 2012); Am. Pub. Power et al.; North

Carolina. In response to one commenter's concern that the markets

for bonds issued by agencies and instrumentalities are not properly

regulated, the Agencies note that all types of municipal securities,

as defined under the securities laws to include, among others, State

direct obligation bonds and agency or instrumentality bonds, are

generally subject to the same regulations under the securities laws.

Thus, the Agencies do not believe that obligations of agencies and

instrumentalities are subject to less effective regulation than

obligations of States and political subdivisions. See Occupy.

\1411\ Commenters noted that a number of Federal statutes and

regulations define ``political subdivision'' to include municipal

agencies and instrumentalities. See, e.g., MSRB; Citigroup (Jan.

2012).

\1412\ See AFR et al. (Feb. 2012); Occupy. The Agencies do not

believe it is appropriate to exclude conduit obligations, which are

tax-exempt municipal bonds, from this exemption because such

obligations are used to finance important projects related to, for

example, multi-family housing, healthcare (hospitals and nursing

homes), colleges and universities, power and energy companies and

resource recovery facilities. See U.S. Securities & Exchange

Comm'n., Report on the Municipal Securities Market 7 (2012),

available at http://www.sec.gov/news/studies/2012/munireport073112.pdf.

---------------------------------------------------------------------------

The proposal did not exempt proprietary trading of derivatives on

obligations of States and political subdivisions. The proposal

solicited comment on whether exempting proprietary trading in options

or other derivatives referencing an obligation of a State or political

subdivision thereof was consistent with the terms and purpose of the

statute.\1413\ The Agencies did not receive persuasive information on

this topic and, for the same reasons discussed above related to

derivatives on U.S. government securities, the Agencies have determined

not to provide an exemption for proprietary trading in municipal

securities, beyond the underwriting, market-making, hedging and other

exemptions provided generally in the rule. The Agencies note that

banking entities may trade derivatives on municipal securities under

any other available exemption to the prohibition on proprietary

trading,

[[Page 5919]]

providing the requirements of the relevant exemption are met.

---------------------------------------------------------------------------

\1413\ See Joint Proposal, 76 FR at 68878.

---------------------------------------------------------------------------

d. Determination to Not Exempt Proprietary Trading in Multilateral

Development Bank Obligations

The proposal did not exempt proprietary trading in obligations of

multilateral banks or derivatives on multilateral development bank

obligations but requested comment on this issue.\1414\ A number of

commenters argued that the final rule should include an exemption for

obligations of multilateral development banks.\1415\

---------------------------------------------------------------------------

\1414\ See id.

\1415\ Commenters argued that including obligations of

multilateral developments banks in a foreign sovereign debt

exemption is necessary to avoid endangering international

cooperation in financial regulation and potential retaliatory

prohibitions against U.S. government obligations. See Ass'n. of

German Banks; Sumitomo; SIFMA et al. (Prop. Trading) (Feb. 2012).

Additionally, some commenters represented that an exemption for

obligations of international and multilateral development banks is

appropriate for many of the same reasons provided for exempting U.S.

government obligations and foreign sovereign debt generally. See

Ass'n. of German Banks; Barclays; Goldman (Prop. Trading); IIB/EBF;

ICFR; ICI Global; FIA; Sumitomo Trust; Allen & Overy (Gov't.

Obligations); SIFMA et al. (Prop. Trading) (Feb. 2012).

---------------------------------------------------------------------------

The Agencies have not included an exemption to permit banking

entities to engage in proprietary trading in obligations of

multilateral development banks at this time. The Agencies do not

believe that providing an exemption for trading obligations of

multilateral development banks will help enhance the markets for these

obligations and therefore promote and protect the safety and soundness

of banking entities and U.S. financial stability.

6. Section 75.6(c): Permitted Trading on Behalf of Customers

Section 13(d)(1)(D) of the BHC Act provides an exemption from the

prohibition on proprietary trading for the purchase, sale, acquisition,

or disposition of financial instruments on behalf of customers.\1416\

The statute does not define when a transaction or activity is conducted

``on behalf of customers.''

---------------------------------------------------------------------------

\1416\ 12 U.S.C. 1851(d)(1)(D).

---------------------------------------------------------------------------

a. Proposed Exemption for Trading on Behalf of Customers

Section 75.6(b) of the proposed rule implemented the exemption for

trading on behalf of customers by exempting three types of trading

activity. Section 75.6(b)(i) of the proposed rule provided that a

purchase or sale of a financial instrument occurred on behalf of

customers if the transaction (i) was conducted by a banking entity

acting as investment adviser, commodity trading advisor, trustee, or in

a similar fiduciary capacity for the account of that customer, and (ii)

involved solely financial instruments for which the banking entity's

customer, and not the banking entity or any affiliate of the banking

entity, was the beneficial owner. This exemption was intended to permit

trading activity that a banking entity conducts in the context of

providing investment advisory, trust, or fiduciary services to

customers provided that the banking entity structures the activity so

that the customer, and not the banking entity, benefits from any gains

and suffers any losses on the traded positions.

Section 75.6(b)(ii) of the proposed rule exempted the purchase or

sale of a covered financial position if the banking entity was acting

as riskless principal.\1417\ Under the proposed rule, a banking entity

qualified as a riskless principal if the banking entity, after having

received an order to purchase or sell a covered financial position from

a customer, purchased or sold the covered financial position for its

own account to offset a contemporaneous sale to or purchase from the

customer.\1418\

---------------------------------------------------------------------------

\1417\ See Joint Proposal, 76 FR at 68879.

\1418\ This language generally mirrors that used in the Board's

Regulation Y, OCC interpretive letters, and the SEC's Rule 3a5-1

under the Exchange Act. See 12 CFR 225.28(b)(7)(ii); 17 CFR 240.3a5-

1(b); OCC Interpretive Letter 626 (July 7, 1993).

---------------------------------------------------------------------------

Section 75.6(b)(iii) of the proposed rule permitted trading by a

banking entity that was an insurance company for the separate account

of insurance policyholders. Under the proposed rule, only a banking

entity that is an insurance company directly engaged in the business of

insurance and subject to regulation by a State insurance regulator or

foreign insurance regulator was eligible for this prong of the

exemption for trading on behalf of customers. Additionally, the

purchase or sale of the covered financial position was exempt only if

it was solely for a separate account established by the insurance

company in connection with one or more insurance policies issued by

that insurance company under which all profits and losses arising from

the purchase or sale of the financial instrument were allocated to the

separate account and inured to the benefit or detriment of the owners

of the insurance policies supported by the separate account, and not

the banking entity. These types of transactions are 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 is treated as

the owner of those assets for certain purposes.

b. Comments on the Proposed Rule

Several commenters contended that the Agencies construed the

statutory exemption too narrowly by limiting permissible proprietary

trading on behalf of customers to only three categories of

transactions.\1419\ Some of these commenters argued the exemption in

the proposal was not consistent with the statutory language or

Congressional intent to permit all transactions that are ``on behalf of

customers.'' \1420\ One of these commenters expressed concern that the

proposed exemption for trading on behalf of customers may be construed

to permit only customer-driven transactions involving securities and

not other financial instruments such as foreign exchange forwards and

other derivatives.\1421\

---------------------------------------------------------------------------

\1419\ See, e.g., Am. Express; BoA; ISDA (Apr. 2012); RBC; SIMFA

et al. (Prop. Trading) (Feb. 2012); Wells Fargo (Prop. Trading).

\1420\ See, e.g., Am. Express; SIMFA et al. (Prop. Trading)

(Feb. 2012).

\1421\ See Am. Express.

---------------------------------------------------------------------------

Several commenters urged the Agencies to expand the exemption for

trading on behalf of customers to permit other categories of customer-

driven transactions in which the banking entity may be acting as

principal but that serve legitimate customer needs including capital

formation. For example, one commenter urged the Agencies to permit

customer-driven transactions in which the banking entity has no ready

counterparty but that are undertaken at the instruction or request of a

customer or client or in anticipation of such an instruction or

request, such as facilitating customer liquidity needs or block

positioning transactions.\1422\ Other commenters urged the Agencies to

exempt transactions where the banking entity acts as principal to

accommodate a customer and substantially and promptly hedges the risks

of the transaction.\1423\ Commenters argued that these kinds of

transactions are similar in purpose and level of risk to riskless

principal transactions.\1424\ Commenters also argued that these

transactions could be viewed as market-making related activities, but

indicated that the potential uncertainty and costs of making that

determination would discourage banking entities from taking principal

risks to accommodate customer needs.\1425\ Commenters also requested

that the Agencies expressly

[[Page 5920]]

permit transactions on behalf of customers to create structured

products, as well as for client funding needs, customer clearing, and

prime brokerage, if these transactions are included within the trading

account.\1426\

---------------------------------------------------------------------------

\1422\ See RBC. The Agencies note that acting as a block

positioner is expressly contemplated and included as part of the

exemption for market making-related activities under the final rule.

\1423\ See BoA; SIMFA et al. (Prop. Trading) (Feb. 2012).

\1424\ See SIMFA et al. (Prop. Trading) (Feb. 2012).

\1425\ See SIMFA et al. (Prop. Trading) (Feb. 2012).

\1426\ See SIMFA et al. (Prop. Trading) (Feb. 2012).

---------------------------------------------------------------------------

In contrast, some commenters supported the proposed approach for

implementing the exemption for trading on behalf of customers or urged

narrowing the exemption.\1427\ One commenter expressed general support

for the requirement that all profits (or losses) from the transaction

flow to the customer and not the banking entity providing the service

for a transaction to be exempt.\1428\ One commenter contended that the

statute did not permit transactions on behalf of customers to be

performed by an investment adviser.\1429\ Another commenter argued that

the final rule should permit a banking entity to engage in a riskless

principal transaction only where the banking entity has already

arranged for another customer to be on the other side of the

transaction.\1430\ Other commenters urged the Agencies to ensure that

both parties to the transaction agree beforehand to the time and price

of any relevant trade to ensure that the banking entity solely stands

in the middle of the transaction and in fact passes on all gains (or

losses) from the transaction to the customers.\1431\ Commenters also

urged the Agencies to define other key terms used in the exemption. For

instance, some commenters requested that the final rule define which

entities may qualify as a ``customer'' for purposes of the

exemption.\1432\

---------------------------------------------------------------------------

\1427\ See, e.g., Alfred Brock; ICBA; Occupy.

\1428\ See ICBA.

\1429\ See Occupy.

\1430\ See Public Citizen.

\1431\ See Occupy; Alfred Brock.

\1432\ See Occupy; Public Citizen. Conversely, other commenters

supported the approach taken in the proposed rule without requesting

such a definition. See Alfred Brock.

---------------------------------------------------------------------------

Some commenters urged the Agencies to provide uniform guidance on

how the Agencies will interpret the riskless principal exemption.\1433\

One commenter urged the Agencies to clarify how the riskless principal

exemption would be implemented with respect to transactions in

derivatives, including a hedged derivative transaction executed at the

request of a customer.\1434\

---------------------------------------------------------------------------

\1433\ See, e.g., Am. Express; SIMFA et al. (Prop. Trading)

(Feb. 2012).

\1434\ See Am. Express.

---------------------------------------------------------------------------

Several commenters generally expressed support for the exemption

for trading for the separate account of insurance policyholders under

the proposed rule.\1435\ One commenter requested that the final rule

more clearly articulate who may qualify as a permissible owner of an

insurance policy to whom the profits and losses arising from the

purchase or sale of a financial instrument allocated to the separate

account may inure.\1436\

---------------------------------------------------------------------------

\1435\ See ACLI; Chris Barnard; NAMIC; Fin. Services Roundtable

(Feb. 3, 2012).

\1436\ See Chris Barnard.

---------------------------------------------------------------------------

Several commenters argued that certain types of separate account

activities, including the allocation of seed money by an insurance

company to a separate account or the offering of certain non-variable

separate account contracts by the insurance company, would not appear

to be permitted under the proposal.\1437\ Commenters also expressed

concern that these separate account activities might not satisfy the

proposed requirement that all profits and losses arising from the

purchase or sale of the financial position inure to the benefit or

detriment of the owners of the insurance policies supported by the

separate account, and not the insurance company.\1438\ In addition,

commenters argued that under the proposed rule, these activities would

appear to fall outside of the exemption for activities in the general

account of an insurance company because the proposed rule defined a

general account as excluding a separate account.\1439\ Commenters urged

the Agencies to more closely align the exemptions for trading by an

insurance company for the general account and separate account.\1440\

According to these commenters, this change would permit insurance

companies to continue to engage in the business of insurance by

offering the full suite of insurance products to their customers.\1441\

---------------------------------------------------------------------------

\1437\ See ACLI; Sutherland (on behalf of Comm. of Annuity

Insurers); Fin. Services Roundtable (Feb. 3, 2012); NAMIC.

\1438\ See ACLI; Sutherland (on behalf of Comm. of Annuity

Insurers); Fin. Services Roundtable (Feb. 3, 2012); NAMIC.

\1439\ See ACLI; Sutherland (on behalf of Comm. of Annuity

Insurers); Fin. Services Roundtable (Feb. 3, 2012); NAMIC.

\1440\ See ACLI; Sutherland (on behalf of Comm. of Annuity

Insurers); Fin. Services Roundtable (Feb. 3, 2012); NAMIC.

\1441\ See ACLI; Sutherland (on behalf of Comm. of Annuity

Insurers); Fin. Services Roundtable (Feb. 3, 2012); NAMIC.

---------------------------------------------------------------------------

c. Final Exemption for Trading on Behalf of Customers

The Agencies have carefully considered the comments and are

adopting the exemption for trading on behalf of customers with several

modifications. The Agencies believe that the final rule implements the

exemption in section 13(d)(1)(D) in a manner consistent with the

legislative intent to allow banking entities to use their own funds to

purchase or sell financial instruments when acting on behalf of their

customers.\1442\ At the same time, the limited activities permitted

under the final rule limit the potential for abuse.\1443\

---------------------------------------------------------------------------

\1442\ See 156 Cong. Rec. S5896 (daily ed. July 15, 2010)

(statement of Sen. Merkley) (arguing that ``this permitted activity

is intended to allow financial firms to use firm funds to purchase

assets on behalf of their clients, rather than on behalf of

themselves.'').

\1443\ Some commenters urged narrowing the exemption. See, e.g.,

Alfred Brock; ICBA; Occupy. The Agencies believe the final rule is

appropriately narrow to limit potential abuse.

---------------------------------------------------------------------------

The final rule slightly modifies the proposed rule by providing

that a banking entity is not prohibited from trading on behalf of

customers when that activity is conducted by the banking entity as

trustee or in a similar fiduciary capacity for a customer and so long

as the transaction is conducted for the account of, or on behalf of the

customer and the banking entity does not have or retain a beneficial

ownership of the financial instruments. The final rule removes the

proposal's express exemption for investment advisers. After further

consideration, the Agencies do not believe an express reference to

investment advisers is necessary because investment advisers generally

act in a fiduciary capacity on behalf of clients in a manner that is

separately covered by other exclusions and exemptions in the final

rule. Additionally, the final rule deletes the proposal's express

exemption for commodity trading advisors because the legal relationship

between a commodity trading advisor and its client depends on the facts

and circumstances of each relationship. Therefore, the Agencies

determined that it was appropriate to limit the discussion to fiduciary

obligations generally and to omit any specific discussion of commodity

trading advisors. In order to ensure that a banking entity utilizes

this exemption to engage only in transactions for customers and not to

conduct its own trading activity, the final rule (consistent with the

proposed rule) requires that the purchase or sale of financial

instruments be conducted for the account of the customer and that it

involve solely financial instruments of which the customer, and not the

banking entity, is beneficial owner.\1444\ The final rule, like the

proposed rule, permits transactions in any financial instrument,

including derivatives such as foreign exchange forwards, so long as

[[Page 5921]]

those transactions are on behalf of customers.\1445\

---------------------------------------------------------------------------

\1444\ See final rule Sec. 75.6(c)(1)(ii)-(iii). See also

proposed rule Sec. 75.6(b)(2)(i)(B)-(C).

\1445\ Some commenters expressed concern that the proposed

exemption for trading on behalf of customers may be construed to not

permit transactions in foreign exchange forwards and other

derivatives. See Am. Express; SIFMA et al. (Prop. Trading) (Feb.

2012).

---------------------------------------------------------------------------

While some commenters requested that the final rule define

``customer'' for purposes of this exemption,\1446\ the Agencies believe

the requirements of this exemption address commenters' underlying

concerns about what constitutes a ``customer.'' Specifically, the

Agencies believe that requiring a transaction relying on this exemption

to be conducted in a fiduciary capacity for a customer, to be conducted

for the account of the customer, and to involve solely financial

instruments of which the customer is beneficial owner address the

underlying concerns that a transaction could qualify for this exemption

if done on behalf of an indirect customer or on behalf of a customer

not served by the banking entity.

---------------------------------------------------------------------------

\1446\ See Occupy; Public Citizen.

---------------------------------------------------------------------------

The final rule also provides that a banking entity may act as

riskless principal in a transaction in which the banking entity, after

receiving an order to purchase (or sell) a financial instrument from a

customer, purchases (or sells) the financial instrument for its own

account to offset the contemporaneous sale of the financial instrument

to (purchase from) the customer.\1447\ Any transaction conducted

pursuant to the exemption for riskless principal activity must be

customer-driven and may not expose the banking entity to gains (or

losses) on the value of the traded instruments as principal.\1448\

Importantly, the final rule does not permit a banking entity to

purchase (or sell) a financial instrument without first having a

customer order to buy (sell) the instrument. While some commenters

requested that the Agencies modify the final rule to permit activity

without a customer order,\1449\ the Agencies are concerned that

broadening the exemption in this manner would enable banking entities

to evade the requirements of section 13 and engage in prohibited

proprietary trading under the guise of trading on behalf of customers.

---------------------------------------------------------------------------

\1447\ See final rule Sec. 75.6(c)(2).

\1448\ Some commenters urged the Agencies to ensure that the

banking entity passes on all gains (or losses) from the transaction

to the customers. See Occupy; Public Citizen.

\1449\ See RBC; SIFMA et al. (Prop. Trading) (Feb. 2012).

---------------------------------------------------------------------------

Several commenters requested that the final rule explain how a

banking entity may determine when it is acting as riskless

principal.\1450\ The Agencies note that riskless principal transactions

typically are undertaken as an alternative method of executing orders

by customers to buy or sell financial instruments on an agency basis.

Acting as riskless principal does not include acting as underwriter or

market maker in the particular financial instrument and is generally

understood to be equivalent to agency or brokerage transactions in

which all of the risks associated with ownership of financial

instruments are borne by customers. The Agencies have generally

equivalent standards for determining when a banking entity acts as

riskless principal and require that the banking entity, after receiving

an order to buy (or sell) a financial instrument from a customer, buys

(or sells) the instrument for its own account to offset a

contemporaneous sale to (or purchase from) the customer.\1451\ The

Agencies intend to determine whether a banking entity acts as riskless

principal in accordance with and subject to the requirements of these

standards.

---------------------------------------------------------------------------

\1450\ See, e.g., Am. Express; SIFMA et al. (Prop. Trading)

(Feb. 2012).

\1451\ See, e.g., 12 CFR 225.28(b)(7)(ii); 17 CFR 240.3a5-1(b);

OCC Interpretive Letter 626 (July 7, 1993). One commenter stated

that a banking entity should only be allowed to engage in a riskless

principal transaction where the banking entity has already arranged

for another customer to be on the other side of the transaction. See

Public Citizen. The Agencies believe that the contemporaneous

requirement in the final rule addresses this comment.

---------------------------------------------------------------------------

Some commenters requested that the final rule permit a greater

variety of transactions to be conducted on behalf of customers. Many of

these transactions, such as transactions that facilitate customer

liquidity needs or block positioning transactions \1452\ or

transactions in which the banking entity acts as principal to

accommodate a customer and substantially and promptly hedges the risks

of the transaction,\1453\ may be permissible under the market-making

exemption. To the extent these transactions are conducted by a market

maker, the Agencies believe that the restrictions and limits required

in connection with market making-related activities are important for

limiting the risks to the banking entity from these transactions.\1454\

While some commenters requested that clearing and settlement activities

and prime brokerage activities be viewed as permitted proprietary

trading on behalf of customers,\1455\ these transactions are not

considered proprietary trading as an initial matter under the final

rule.\1456\

---------------------------------------------------------------------------

\1452\ One commenter requested an exemption for transactions at

the instruction or request of a customer or client or in

anticipation of such an instruction or request, such as facilitating

customer liquidity needs or block positioning transactions. See RBC.

\1453\ Some commenters requested an exemption for these types of

transactions. See BoA; SIFMA et al. (Prop. Trading) (Feb. 2012).

\1454\ Some commenters stated that the potential uncertainty and

costs of determining whether an activity qualifies for the market-

making exemption would discourage banking entities from taking

principal risks to accommodate customer needs. See, e.g., SIFMA et

al. (Prop. Trading) (Feb. 2012). The Agencies believe that

adjustments made to the market-making exemption in the final rule

help address this concern. Specifically, the final market-making

exemption better accounts for the varying characteristics of market-

making across markets and assets classes.

\1455\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012).

\1456\ See final rule Sec. 75.3(d)(4)-(6). See also infra Part

VI.A.1.d.3-4.

---------------------------------------------------------------------------

Finally, the Agencies have decided to move the exemption for

trading activity conducted by an insurance company for a separate

account into the provision exempting trading activity in an insurance

company's general account in order to better align the two

exemptions.\1457\ As discussed below in Part VI.A.7., the final rule

provides exemptions for trading activity conducted by an insurance

company that is a banking entity either in the general account or in a

separate account of customers in Sec. 75.6(d). As explained below, the

statute specifically exempts trading activity that is conducted by a

regulated insurance company engaged in the business of insurance for

the general account of the company if conducted in accordance with

applicable state law and if not prohibited by the appropriate Federal

banking agencies.\1458\ Unlike activity for the general account of an

insurance company, investments made by regulated insurance companies in

separate accounts in accordance with applicable state law are made on

behalf of and for the benefit of customers of the insurance

company.\1459\ Also unlike

[[Page 5922]]

general accounts (which are supported by all of the assets of the

insurance company), a separate account is supported only by the assets

in that account and does not have call on the other assets of the

company. The customer benefits (or loses) based solely on the

performance of the assets in the separate account. These arrangements

are the equivalent for insurance companies of fiduciary accounts at

banks. For these reasons, the final rule recognizes that separate

accounts at regulated insurance companies maintained in accordance with

applicable state insurance laws are exempt from the prohibitions in

section 13 as acquisitions on behalf of customers.

---------------------------------------------------------------------------

\1457\ Some commenters requested that the Agencies more closely

align the exemptions for trading by an insurance company for the

general account and separate account. See ACLI; Sutherland (on

behalf of Comm. of Annuity Insurers); Fin. Services Roundtable (Feb.

3, 2012); NAMIC.

\1458\ See 12 U.S.C. 1851(d)(1)(F).

\1459\ One commenter requested clarification on who may qualify

as a permissible owner of an insurance policy to whom the profits

and losses arising from the purchase or sale of a financial

instrument allocated to the separate account may inure. See Chris

Barnard. The Agencies note that the proposed requirement that all

profits and losses arising from the purchase or sale of a financial

instrument inure to the benefit or detriment of the ``owners of the

insurance policies supported by the separate account'' has been

removed. See proposed rule Sec. 75.6(b)(2)(iii)(C). Instead, the

final rule requires that the income, gains, and losses from assets

allocated to a separate account be credited to or charged against

the account without regard to other income, gains or losses of the

insurance company. See final rule Sec. 75.2(z) (definition of

``separate account''). Thus, the final rule no longer references

``owners of the insurance policies supported by the separate

account.'' The Agencies note, however, that the final rule requires

exempted separate account transactions to 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.'' See final rule Sec.

75.6(d)(3).

---------------------------------------------------------------------------

7. Section 75.6(d): Permitted Trading by a Regulated Insurance Company

Section 13(d)(1)(F) permits a banking entity that 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,

to purchase or sell a financial instrument subject to certain

conditions (the ``general account exemption'').\1460\ Section

13(d)(1)(D) permits a banking entity to purchase or sell a financial

instrument on behalf of customers.\1461\ In the proposed rule, the

Agencies viewed Section 13(d)(1)(D) as permitting an insurance company

to purchase or sell a financial instrument for certain separate

accounts (the ``separate account exemption''). The proposal implemented

both these exemptions with respect to activities of insurance

companies, in each case subject to the restrictions discussed

below.\1462\

---------------------------------------------------------------------------

\1460\ See 12 U.S.C. 1851(d)(1)(F).

\1461\ See 12 U.S.C. 1851(d)(1)(D).

\1462\ See proposed rule Sec. Sec. 75.6(b)(2)(iii), 75.6(c).

---------------------------------------------------------------------------

Section 75.6(c) of the proposed rule implemented the general

account exemption by generally restating the statutory requirements of

the exemption that:

The insurance company 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 purchase or sell

the financial instrument solely for the general account of the

insurance company;

The purchase or sale 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.

The proposed rule defined the term ``general account'' to include

all of the assets of the insurance company that are not legally

segregated and allocated to separate accounts under applicable State

law.\1463\

---------------------------------------------------------------------------

\1463\ See proposed rule Sec. 75.3(c)(6).

---------------------------------------------------------------------------

As noted above in Part VI.A.6.a., Sec. 75.6(b)(iii) of the

proposed rule provided an exemption for a banking entity that is an

insurance company when it acted through a separate account for the

benefit of insurance policyholders. The proposed rule defined 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.\1464\

---------------------------------------------------------------------------

\1464\ See proposed rule Sec. 75.2(z).

---------------------------------------------------------------------------

To limit the potential for abuse of the separate account exemption,

the proposed rule included 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.\1465\ In particular, the proposed rule

provided that a purchase or sale of a financial instrument qualified

for the separate account exemption only if:

---------------------------------------------------------------------------

\1465\ The Agencies noted in the proposal they 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.

---------------------------------------------------------------------------

The banking entity is an insurance company directly

engaged in the business of insurance and subject to regulation by a

State insurance regulator or foreign insurance regulator; \1466\

---------------------------------------------------------------------------

\1466\ The proposed rule provided definitions of the terms

``State insurance regulator'' and ``foreign insurance regulator.''

See proposed rule Sec. 75.3(c)(4), (13).

---------------------------------------------------------------------------

The banking entity purchases or sells the financial

instrument 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 financial instrument 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.

The proposal explained that the proposed separate account exception

represented transactions on behalf of customers because the 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.

Commenters generally supported the general account exemption and

the separate account exemption for regulated insurance companies as

consistent with both the statute and Congressional intent to

accommodate the business of insurance.\1467\ For instance, commenters

argued that the statute was designed to appropriately accommodate the

business of insurance, subject to regulation in accordance with

relevant insurance company investment laws, in recognition that

insurance company investment activities are already subject to

comprehensive regulation and oversight.\1468\

---------------------------------------------------------------------------

\1467\ See, e.g., Alfred Brock; Chris Barnard; Fin. Services

Roundtable (Feb. 3, 2012); Sutherland (on behalf of Comm. of Annuity

Insurers); TIAA-CREF; NAMIC.

\1468\ See, e.g., ACLI (Jan. 2012); Fin. Services Roundtable

(Feb. 3, 2012); Country Fin. et al.; Sutherland (on behalf of Comm.

of Annuity Insurers).

---------------------------------------------------------------------------

A few commenters expressed concerns about the definition of

``general account'' and ``separate

[[Page 5923]]

account.'' \1469\ One commenter argued the definition of general

account was unclear.\1470\ A few commenters expressed concern that the

proposed definition of separate account inappropriately excluded some

separate accounts, such as certain insurance company investment

activities such as guaranteed investment contracts, which would also

not fall within the proposed definition of general account.\1471\

Several commenters argued that the final rule should be modified so

that all insurance company investment activity permitted under

applicable insurance laws would qualify for either the general account

exemption or the separate account exemption.\1472\

---------------------------------------------------------------------------

\1469\ See, e.g., Fin. Services Roundtable (Feb. 3, 2012); ACLI

(Jan. 2012); Sutherland (on behalf of Comm. of Annuity Insurers).

\1470\ See Sutherland (on behalf of Comm. of Annuity Insurers).

\1471\ See ACLI (Jan. 2012); NAMIC.

\1472\ See Fin. Services Roundtable (Feb. 3, 2012); ACLI (Jan.

2012); NAMIC; see also Nationwide.

---------------------------------------------------------------------------

Some commenters argued that the prohibition in the proposed

definition of separate account against any profits or losses from

activity in the account inuring to the benefit (or detriment) of the

insurance company would exclude some activity permitted by insurance

regulation in separate accounts.\1473\ For example, commenters

contended that an insurer may allocate its own funds to a separate

account as ``seed money'' and the profits and losses on those funds

inure to the benefit or detriment of the insurance company.\1474\

---------------------------------------------------------------------------

\1473\ See Fin. Services Roundtable (Feb. 3, 2012); ACLI (Jan.

2012); NAMIC; Sutherland (on behalf of Comm. of Annuity Insurers);

see also Nationwide.

\1474\ See Fin. Services Roundtable (Feb. 3, 2012); ACLI (Jan.

2012).

---------------------------------------------------------------------------

Some commenters expressed specific concerns about the scope or

requirements of the proposal. For instance, one commenter argued that

the final rule should provide that a trade is exempt if the trade is

made by an affiliate of the insurance company in accordance with state

insurance law.\1475\ Another commenter urged that the Agencies consult

with the foreign insurance supervisor of an insurance company regulated

outside of the United States before finding that an insurance activity

conducted by the foreign insurance company was inconsistent with the

safety and soundness or financial stability.\1476\

---------------------------------------------------------------------------

\1475\ See USAA.

\1476\ See HSBC Life.

---------------------------------------------------------------------------

One commenter suggested that insurance company affiliates of

banking entities should expressly be made subject to data collection

and reporting requirements to prevent possible evasion of the

restrictions of section 13 and the final rule using their insurance

affiliates.\1477\ By contrast, other commenters argued that the

reporting and recordkeeping and compliance requirements of the rule

should not apply to permitted insurance company investment

activities.\1478\ These commenters argued that insurance companies are

already subject to comprehensive regulation of the kinds and amounts of

investments they can make under insurance laws and regulations and that

additional recordkeeping obligations would impose unnecessary

compliance burdens on these entities without producing significant

offsetting benefits.

---------------------------------------------------------------------------

\1477\ See Sens. Merkley & Levin (Feb. 2012).

\1478\ See ACLI (Jan. 2012); Fin. Services Roundtable (Feb. 3,

2012); Mutual of Omaha; NAMIC.

---------------------------------------------------------------------------

After considering the comments received and the language and

purpose of the statute, the final rule has been modified to better

account for the language of the statute and more appropriately

accommodate the business of insurance.

As explained in the proposal, section 13(d)(1)(F) of the BHC Act

specifically and broadly exempts the purchase, sale, acquisition, or

disposition of securities and other instruments by a regulated

insurance company engaged in the business of insurance for the general

account of the company (and by an affiliate solely for the general

account of the regulated insurance company). Section 13(d)(1)(D) of the

statute also specifically exempts the same activity when done on behalf

of customers. As explained in the proposal, separate accounts managed

and maintained by insurance companies as part of the business of

insurance are generally customer-driven and do not expose the banking

entity to gains or losses on the value of assets held in the separate

account, even though the banking entity may be treated as the owner of

the assets for certain purposes. Unlike the general account of the

insurance company, separate accounts are managed on behalf of specific

customers, much as a bank would manage a trust or fiduciary account.

For these reasons, the final rule retains both the general account

exemption and the separate account exemption. The final rule removes

any gap between the definition of general account and the definition of

separate account by defining the general account to be all of the

assets of an insurance company except those allocated to one or more

separate accounts.\1479\

---------------------------------------------------------------------------

\1479\ See final rule Sec. 75.2(p), (bb). Some commenters

expressed concerns about the proposed definitions of ``general

account'' and ``separate account,'' including that the proposed

definition of ``separate account'' excluded some legitimate separate

account activities that do not fall within the proposed general

account definition. See, e.g., ACLI (Jan. 2012); NAMIC; Sutherland

(on behalf of Comm. of Annuity Insurers). See also proposed rule

Sec. Sec. 75.2(z), 75.3(c)(5).

---------------------------------------------------------------------------

The final rule also combines the general account exemption and the

separate account exemption into a single section. This makes clear that

both exemptions are available only:

If the insurance company or its affiliate purchases or

sells the financial instruments solely for the general account of the

insurance company or a separate account of the insurance company;

The purchases or sales of financial instruments are

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 Financial Stability Oversight Council and the

relevant insurance commissioners of the States and relevant foreign

jurisdictions, as appropriate, have not jointly determined, after

notice and comment, that a particular law, regulation, or written

guidance regarding insurance is insufficient to protect the safety and

soundness of the banking entity, or the financial stability of the

United States.\1480\

---------------------------------------------------------------------------

\1480\ The Federal banking agencies have not at this time

determined, as part of the final 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 FSOC, 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 Agencies believe the final

approach addresses one commenter's request that the Agencies consult

with the foreign insurance supervisor of an insurance company

regulated outside of the United States before finding that an

insurance activity conducted by the foreign company was inconsistent

with the safety and soundness or financial stability. See HSBC Life.

---------------------------------------------------------------------------

Like section 13(d)(1)(F) of the BHC Act, the final rule permits an

affiliate of an insurance company to purchase and sell financial

instruments in reliance on the general account exemption, so long as

that activity is for the general account of the insurance company.

Similarly, the final rule implements section 13(d)(1)(D) and permits an

affiliate of an insurance company to purchase and sell financial

instruments for a separate account of the insurance company, so long as

the separate account is

[[Page 5924]]

established and maintained at the insurance company.

Importantly, the final rule applies only to covered trading

activity in a general or separate account of a licensed insurance

company engaged in the business of insurance under the supervision of a

State or foreign insurance regulator. As in the statute, an affiliate

of an insurance company may not rely on this exemption for activity in

any account of the affiliate (unless it, too, meets the definition of

an insurance company). An affiliate may rely on the exemption to the

limited extent that the affiliate is acting solely for the account of

the insurance company.\1481\

---------------------------------------------------------------------------

\1481\ Although one commenter requested that the final rule

exempt a trade as long as the trade is made by an affiliate of the

insurance company in accordance with state insurance law, the

Agencies believe the final approach properly implements the statute.

See USAA.

---------------------------------------------------------------------------

As noted above, one commenter requested that the final rule impose

special data and reporting obligations on insurance companies. Other

commenters argued that insurance companies are already subject to

comprehensive regulation under insurance laws and regulations and that

additional recordkeeping obligations would impose unnecessary

compliance burdens on these entities without producing significant

offsetting benefits. In accordance with the statute,\1482\ the Agencies

expect insurance companies to have appropriate compliance programs in

place for any activity subject to section 13 of the BHC Act.

---------------------------------------------------------------------------

\1482\ See 12 U.S.C. 1851(e)(1) (requiring that the Agencies

issue regulations regarding ``internal controls and recordkeeping,

in order to insure compliance with this section'').

---------------------------------------------------------------------------

The final rule contains a number of other related definitions that

are intended to help make clear the limitations of the insurance

company exemption, including definitions of foreign insurance regulator

and State insurance regulator.

8. Section 75.6(e): Permitted Trading Activities of a Foreign Banking

Entity

Section 13(d)(1)(H) of the BHC Act \1483\ permits certain foreign

banking entities to engage in proprietary trading that occurs solely

outside of the United States (the ``foreign trading exemption'').\1484\

The statute does not define when a foreign banking entity's trading

occurs solely outside of the United States.

---------------------------------------------------------------------------

\1483\ Section 13(d)(1)(H) of the BHC Act provides an exemption

to the prohibition on proprietary trading for trading conducted by a

foreign banking entity pursuant to paragraph (9) or (13) of section

4(c) of the BHC Act, if 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).

\1484\ This section's discussion of the concept ``solely outside

of the United States'' is provided solely for purposes of the 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.

---------------------------------------------------------------------------

The proposed rule defined both the type of foreign banking entity

that is eligible for the exemption and activity that constitutes

trading solely outside of the United States. The proposed rule

effectively precluded a foreign banking entity from engaging in

proprietary trading through a transaction that had any connection with

the United States, including: Trading with any party located in the

United States; allowing U.S. personnel of the foreign banking entity to

be involved in the purchase or sale; or executing any transaction in

the United States (on an exchange or otherwise).\1485\

---------------------------------------------------------------------------

\1485\ See proposed rule Sec. 75.6(d).

---------------------------------------------------------------------------

In general, commenters emphasized the importance of and supported

an exemption for foreign trading activities of foreign banking

entities. However, a number of commenters expressed concerns that the

proposed foreign trading exemption was too narrow and would not be

effective in permitting foreign banking entities to engage in foreign

trading activities.\1486\ For instance, many commenters stated that the

proposal's prohibition on trading activities that have any connection

to the U.S. was not consistent with the purpose of section 13 of the

BHC Act where the risk of the trading activity is taken or held outside

of the United States and does not implicate the U.S. safety net.\1487\

These commenters argued that, since one of the principal purposes of

section 13 of the BHC Act is to limit the risk posed by prohibited

proprietary trading to the Federal safety net, the safety and soundness

of U.S. banking entities, and the financial stability of the United

States, the exemption for foreign trading activity should similarly

focus on whether the trading activity involves principal risk being

taken or held by the foreign banking entity inside the United

States.\1488\

---------------------------------------------------------------------------

\1486\ See, e.g., IIB/EBF; ICI Global; ICI (Feb. 2012); Wells

Fargo (Prop. Trading); BoA.

\1487\ See IIB/EBF; Ass'n. of Banks in Malaysia; EBF; Credit

Suisse (Seidel); Cadwalader (on behalf of Thai Banks).

\1488\ See BaFin/Deutsche Bundesbank; ICSA; IIB/EBF; Allen &

Overy (on behalf of Canadian Banks); Credit Suisse (Seidel); George

Osbourne.

---------------------------------------------------------------------------

Many commenters argued that the proposal's transaction-based

approach to implementing the foreign trading exemption would harm U.S.

markets and U.S. market participants. For example, some commenters

argued that the proposed exemption would cause foreign banks to exit

U.S. markets or shrink their U.S.-based operations, thereby resulting

in less liquidity and greater fragmentation in markets without

producing any significant offsetting benefit.\1489\ Commenters also

asserted that the proposal would impose significant compliance costs on

the foreign operations of foreign banking entities and would lead to

foreign firms refusing to trade with U.S. counterparties, including the

foreign operations of U.S. entities, to avoid compliance costs

associated with relying on another exemption under the proposed

rule.\1490\ Additionally, commenters argued that the proposal

represented an improper extraterritorial application of U.S. law that

could be found to violate international treaty obligations of the

United States, such as those under the North American Free Trade

Agreement, and might result in retaliation by foreign countries in

their treatment of U.S. banking entities abroad.\1491\

---------------------------------------------------------------------------

\1489\ See ICE; ICI Global; BoA; Citigroup (Feb. 2012); British

Bankers' Ass'n.; IIB/EBF.

\1490\ See BaFin/Deutsche Bundesbank; Norinchukin; IIF; Allen &

Overy (on behalf of Canadian Banks); ICFR; BoA; Citigroup (Feb.

2012). As discussed below in Part VI.C. of this SUPPLEMENTARY

INFORMATION, other parts of the final rule address commenters'

concerns regarding the compliance burden on foreign banking

entities.

\1491\ See Norinchukin; Cadwalader (on behalf of Thai Banks);

Barclays; EBF; Commissioner Barnier; Ass'n. of German Banks;

Soci[eacute]t[eacute] G[eacute]n[eacute]rale; Chamber (Dec. 2012).

---------------------------------------------------------------------------

a. Foreign Banking Entities Eligible for the Exemption

The statutory language of section 13(d)(1)(H) 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. The proposed rule limited the scope of the exemption to

banking entities that are organized under foreign law and, as

applicable, controlled only by entities organized under foreign law.

Commenters generally supported this aspect of the proposal.\1492\

However, some commenters requested that the final rule be modified to

allow U.S. banking entities' affiliates or branches that are physically

located outside of the United States (``foreign operations of U.S.

banking entities'') to engage in proprietary trading outside of the

United States pursuant to this

[[Page 5925]]

exemption.\1493\ These commenters argued that, unless foreign

operations of U.S. banking entities are provided similar authority to

engage in proprietary trading outside of the United States, foreign

operations of U.S. banking entities would be at a competitive

disadvantage abroad with respect to foreign banking entities. One

commenter also asserted that, unless foreign operations of U.S. banking

entities were able to effectively access foreign markets, they could be

shut out of those markets and would be unable to effectively manage

their risks in a safe and sound manner.\1494\

---------------------------------------------------------------------------

\1492\ See Sens. Merkley & Levin (Feb. 2012) (arguing that the

final rule's foreign trading exemption should not exempt foreign

affiliates of U.S. banking entities when they engage in trading

activity abroad); see also Occupy; Alfred Brock.

\1493\ See Citigroup (Feb. 2012); Sen. Carper; IIF; ABA

(Keating); Wells Fargo (Prop. Trading); Abbot Labs. et al. (Feb. 14,

2012).

\1494\ See Citigroup (Feb. 2012).

---------------------------------------------------------------------------

As noted above, section 13(d)(1)(H) of the BHC Act specifically

provides that its exemption is available only to a banking entity that

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.\1495\ Because of this express statutory threshold requirement,

a foreign subsidiary controlled, directly or indirectly, by a banking

entity organized under the laws of the United States or one of its

States, and a foreign branch office of a banking entity organized under

the laws of the United States or one of the States, may not take

advantage of this exemption.

---------------------------------------------------------------------------

\1495\ See 12 U.S.C. 1851(d)(1)(H).

---------------------------------------------------------------------------

Like the proposal, the final rule incorporates the statutory

requirement that the banking entity conduct its trading activities

pursuant to sections 4(c)(9) or 4(c)(13) of the BHC Act.\1496\ The

final rule retains the tests in the proposed rule for determining when

a banking entity would meet that requirement. The final rule provides

qualifying criteria for both a banking entity that is a qualifying

foreign banking organization under the Board's Regulation K and a

banking entity that is not a foreign banking organization for purposes

of Regulation K.\1497\

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\1496\ See final rule Sec. 75.6(e)(1)(ii).

\1497\ Section 75.6(e)(2) addresses only 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 to date applied the general 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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Section 4(c)(9) of the BHC Act applies to 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.\1498\ The Board has implemented

section 4(c)(9) as part of subpart B of the Board's Regulation K,\1499\

which specifies a number of conditions and requirements that a foreign

banking organization must meet in order to act pursuant to that

authority.\1500\ The qualifying conditions and requirements include,

for example, that the foreign banking organization 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.\1501\ Under

the final rule a banking entity that is a qualifying foreign banking

organization for purposes of the Board's Regulation K, other than a

foreign bank as defined in section 1(b)(7) of the International Banking

Act of 1978 that is organized under the laws of any commonwealth,

territory, or possession of the United States, will qualify for the

exemption for proprietary trading activity of a foreign banking

entity.\1502\

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\1498\ See 12 U.S.C. 1843(c)(9).

\1499\ See 12 CFR 211.20 et seq.

\1500\ Commenters noted that the Board's Regulation K contains a

number of limitations that may not be appropriate to include as part

of the requirements of the foreign trading exemption. See Allen &

Overy (on behalf of Foreign Bank Group); HSBC Life. Accordingly, the

final rule does not retain the proposal's requirement that the

activity be conducted in compliance with subpart B of the Board's

Regulation K (12 CFR 211.20 through 211.30). However, the exemption

in section 13(d)(1)(H) of the BHC Act and the final rule operates as

an exemption and is not a separate grant of authority to engage in

an otherwise impermissible activity. To the extent a banking entity

is a foreign banking organization, it remains subject to the Board's

Regulation K and must, as a separate matter, comply with any and all

applicable rules and requirements of that regulation.

\1501\ See 12 CFR 211.23(a), (c), and (e). The proposed rule

referenced only the qualifying test under section 211.23(a) of the

Board's Regulation K; however, because there are two other methods

by which a foreign banking organization may meet the requirements to

be considered a qualified foreign banking organization, the final

rule incorporates a reference to those provisions as well.

\1502\ This modification to the definition of foreign banking

organization is necessary because, under the International Banking

Act and the Board's Regulation K, depository institutions that are

located in, or organized under the laws of a commonwealth,

territory, or possession of the United States, are foreign banking

organizations. However, for purposes of the Federal securities laws

and certain banking statutes, such as section 2(c)(1) of the BHC Act

and section 3 of the FDI Act, these same entities are defined to be

and treated as domestic entities. For instance, these entities act

as domestic broker-dealers under U.S. securities laws and their

deposits are insured by the FDIC. Because one of the purposes of

section 13 is to protect insured depository institutions and the

U.S. financial system from the perceived risks of proprietary

trading and covered fund activities, the Agencies believe that these

entities should be considered to be located within the United States

for purposes of section 13. The final rule includes within the

definition of State a commonwealth, territory or possession of the

United States, the District of Columbia, the Commonwealth of Puerto

Rico, the Commonwealth of the Northern Mariana Islands, American

Samoa, Guam, or the United States Virgin Islands.

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Section 13 of the BHC Act also applies to foreign companies that

control a U.S. insured depository institution but that 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 final rule also provides that a foreign banking entity that is not

a foreign banking organization would be considered to be conducting

activities ``pursuant to section 4(c)(9)'' for purposes of this

exemption \1503\ if the entity, on a fully-consolidated basis, meets at

least two of three requirements that evaluate the extent to which the

foreign banking entity's business is conducted outside the United

States, as measured by assets, revenues, and income.\1504\ This test

largely mirrors the qualifying foreign banking organization test that

is made applicable under section 4(c)(9) of the BHC Act and section

211.23(a), (c), or (e) of the Board's Regulation K, except that the

test does not require the foreign entity to demonstrate that more than

half of its banking business is outside the United States.\1505\ 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.

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\1503\ 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.

\1504\ See final rule Sec. 75.6(e)(2)(ii)(B). For purposes of

determining whether, on a fully consolidated basis, it meets the

requirements under Sec. 75.6(e)(2)(ii)(B), a foreign banking entity

that is not a foreign banking organization should base its

calculation on the consolidated global assets, revenues, and income

of the top-tier affiliate within the foreign banking entity's

structure.

\1505\ See 12 U.S.C. 1843(c)(9); 12 CFR 211.23(a), (c), and (e);

final rule Sec. 75.6(e)(2)(ii)(B).

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b. Permitted Trading Activities of a Foreign Banking Entity

As noted above, the proposed rule laid out a transaction-based

approach to

[[Page 5926]]

implementing the foreign trading exemption and provided that a

transaction would be considered to qualify for the exemption only if

(i) the transaction was conducted by a banking entity not organized

under the laws of the United States or of one or more States; (ii) no

party to the transaction was a resident of the United States; (iii) no

personnel of the banking entity that was directly involved in the

transaction was physically located in the United States; and (iv) the

transaction was executed wholly outside the United States.\1506\

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\1506\ See proposed rule Sec. 75.6(d).

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Many commenters objected to the proposed exemption, arguing that it

was unworkable and would have unintended consequences. For example,

commenters argued that prohibiting a foreign banking entity from

conducting a proprietary trade with a resident of the United States,

including a subsidiary or branch of a U.S. banking entity, wherever

located, would likely cause foreign banking entities to be unwilling to

enter into permitted trading transactions with foreign subsidiaries or

branches of U.S. firms.\1507\ In addition, some commenters represented

that it would be difficult to determine and track whether a party is a

resident of the United States or that this requirement would require

non-U.S. banking entities to inefficiently bifurcate their activities

into U.S.-facing and non-U.S.-facing trading desks.\1508\ For example,

one commenter noted that trading on many exchanges and platforms is

anonymous (i.e., each party to the trade is unaware of the identity of

the other party to the trade), so a foreign banking entity would likely

have to avoid U.S. trading platforms and exchanges entirely to avoid

transactions with any resident of the United States.\1509\ Further,

commenters stated that the proposed rule could deter foreign banking

entities from conducting business with U.S. parties outside of the

United States, which could also incentivize foreign market centers to

limit participation by U.S. parties on their markets.\1510\

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\1507\ See BoA; Citigroup (Feb. 2012); British Bankers' Ass'n.;

Credit Suisse (Seidel); George Osbourne; IIB/EBF.

\1508\ See Cadwalader (on behalf of Singapore Banks); Ass'n. of

Banks in Malaysia; Cadwalader (on behalf of Thai Banks); IIF; ICE;

Banco de M[eacute]xico; ICFR; Australian Bankers Ass'n. (Feb. 2012);

BAROC.

\1509\ See ICE.

\1510\ See, e.g., RBC.

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Commenters also expressed concern about the requirement that

transactions be executed wholly outside of the United States in order

to qualify for the proposed foreign trading exemption. Commenters

represented that foreign banking entities currently use U.S. trading

platforms to trade in certain products (such as U.S.-listed securities

or a variety of derivatives contracts), to take advantage of robust

U.S. infrastructure, and for time zone reasons.\1511\ Commenters

indicated that the proposed requirement could harm the competitiveness

of U.S. trading platforms and the liquidity available on such

facilities.\1512\ Some commenters stated that this requirement would

effectively result in most foreign banking entities moving their

trading operations and personnel outside of the United States and

executing transactions on exchanges outside of the United States.\1513\

These commenters stated that the relocation of these activities would

reduce trading activity in the United States that supports the

financial stability and efficiency of U.S. markets. Moreover, these

commenters argued that, if foreign banking entities relocate their

personnel from the United States to overseas, this would diminish U.S.

jobs with no concomitant benefit. They also contended that the proposal

was at cross purposes with other parts of the Dodd-Frank Act and would

hinder growth of market infrastructure being developed under the

requirements of Title VII of that Act, including use of swap execution

facilities and security-based swap execution facilities to enhance

transparency in the swaps markets and use of central clearinghouses to

reduce counterparty risk for the parties to a swap transaction.\1514\

For example, one commenter represented that the proposed exemption

could make it difficult for non-U.S. swap entities to comply with

potential mandatory execution requirements under Title VII of the Dodd-

Frank Act and could cause market fragmentation across borders through

the creation of parallel execution facilities outside of the United

States, which would result in less transparency and greater systemic

risk.\1515\ In addition, another commenter stated that the proposed

requirement would force issuers to dually list their securities to

permit trading on non-U.S. exchanges and, further, clearing and

settlement systems would have to be set up outside of the United

States, which would create inefficiencies, operational risks, and

potentially systemic risk by adding needless complexity to the

financial system.\1516\

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\1511\ See, e.g., IIF; ICE; Soci[eacute]t[eacute]

G[eacute]n[eacute]rale; Mexican Banking Comm'n.; Australian Bankers

Ass'n. (Feb. 2012); Banco de M[eacute]xico; OSFI. In addition, a few

commenters argued that Canadian and Mexican financial firms

frequently use U.S. infrastructure to conduct their trading

activities in Canada or Mexico. See, e.g., OSFI; Banco de

M[eacute]xico; Mexican Banking Comm'n.

\1512\ See, e.g., ICE; Soci[eacute]t[eacute]

G[eacute]n[eacute]rale (arguing that the requirement would impair

capital raising efforts of many U.S. companies); Australian Bankers

Ass'n. (Feb. 2012); Canadian Minister of Fin.; Ass'n. of German

Banks.

\1513\ See IIB/EBF.

\1514\ See Bank of Canada; Banco de M[eacute]xico; Allen & Overy

(on behalf of Canadian Banks).

\1515\ See Allen & Overy (on behalf of Candian Banks).

\1516\ See IIF.

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Instead of the proposal's transaction-based approach to

implementing the foreign trading exemption, many commenters suggested

the final rule adopt a risk-based approach.\1517\ These commenters

noted that a risk-based approach would prohibit or significantly limit

the amount of financial risk from such activities that could be

transferred to the United States by the foreign trading activity of

foreign banking entities.\1518\ Commenters also noted that foreign

trading activities of most foreign banking entities are already subject

to activities limitations, capital requirements, and other prudential

requirements of their home-country supervisor(s).\1519\

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\1517\ See BaFin/Deutsche Bundesbank; ICSA; IIB/EBF; Allen &

Overy (on behalf of Canadian Banks); Credit Suisse (Seidel); George

Osbourne.

\1518\ See IIB/EBF.

\1519\ See IIB/EBF.

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The Agencies have carefully considered these comments and have

determined to modify the approach in the final rule. The Agencies

believe that the revisions mitigate the potential adverse impacts of

the proposed approach while still remaining faithful to the overall

purpose of section 13(d)(1)(H). Also, the Agencies believe that section

13(d)(1)(J) of the BHC Act, which authorizes the Agencies to provide an

exemption from the prohibition on proprietary trading for any activity

the Agencies determine by rule ``would promote and protect the safety

and soundness of the banking entity and the financial stability of the

United States,'' \1520\ supports allowing foreign banking entities to

use U.S. infrastructure and trade with certain U.S. counterparties in

certain circumstances, which will promote and protect the safety and

soundness of banking entities and U.S. financial stability.

---------------------------------------------------------------------------

\1520\ See 12 U.S.C. 1851(d)(1)(J).

---------------------------------------------------------------------------

Overall, the comments illustrated that both the mechanical steps of

the specified transactions to purchase or sell various instruments

(e.g., execution, clearing), and the identity of the entity for whose

trading account the specified trading is conducted are important.\1521\

Consistent with the comments described above, the Agencies believe that

the

[[Page 5927]]

application of section 13(d)(1)(H) and their exemptive authority under

section 13(d)(1)(J) should focus on both how the transaction occurs and

which entity will bear the risk of those transactions. Although the

statute does not define expressly what it means to act ``as a

principal'' (acting as principal ordinarily means acting for one's own

account), the combination of references to engaging as principal and to

a trading account focuses on an entity's incurring risks of profit and

loss through taking ownership of securities and other instruments.

Thus, the final rule provides an exemption for trading activities of

foreign banking entities that addresses both the location of the

facilities that effect the acquisition, holding, and disposition of

such positions, and the location of the banking entity that incurs such

risks through acquisition, holding, and disposition of such positions.

The Agencies believe this approach is consistent with one of the

principal purposes of section 13, which is to limit risks that

proprietary trading poses to the U.S. financial system.\1522\ Further,

the purpose of section 13(d)(1)(H) is to limit the extraterritorial

application of section 13 as it applies to foreign banking

entities.\1523\

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\1522\ See, e.g., 12 U.S.C. 1851(b)(1) (directing the FSOC to

study and make recommendations on implementing section 13 so as to,

among other things, protect taxpayers and consumers and enhance

financial stability by minimizing the risk that insured depository

institutions and the affiliates of insured depository institutions

will engage in unsafe and unsound activities).

\1523\ See, e.g., 156 Cong. Rec. S5897 (daily ed. July 15, 2010)

(statement of Sen. Merkley) (stating that the foreign trading

exemption ``recognize[s] rules of international comity by permitting

foreign banks, regulated and backed by foreign taxpayers, in the

course of operating outside of the United States to engage in

activities permitted under relevant foreign law.'').

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In addition, prohibiting foreign banking entities from using U.S.

infrastructure or trading with all U.S. counterparties could cause

certain trading activities to move offshore, with corresponding

negative impacts on U.S. market participants, including U.S. banking

entities. For example, movement of trading activities offshore,

particularly in U.S. financial instruments, could result in bifurcated

markets for these instruments that are less efficient and less liquid

and could reduce transparency for oversight of trading in these

instruments. In addition, reducing access to foreign counterparties for

U.S. instruments could concentrate risks in the United States and to

its financial system. Moreover, the statute provides separate

exemptions for U.S. banking entities to engage in underwriting and

market making-related activities, subject to certain requirements, and

there is no evidence that limiting the range of potential customers for

these entities would further the purposes of the statute. In fact, it

is possible that limiting the customer bases of U.S. banking entities,

as well as other U.S. firms that are not banking entities, could reduce

their ability to effectively manage their inventories and risks and

could also result in concentration risk.

These potential effects of the approach taken in the proposal

appear to be inconsistent with the statute's goals, including the

promotion and protection of the safety and soundness of banking

entities and U.S. financial stability. To the contrary, the exemptive

approach taken in the final rule appears to be more consistent with the

goals of the statute and would promote and protect the safety and

soundness of banking entities and U.S. financial stability by limiting

the risks of foreign banking entities' proprietary trading activities

to the U.S. financial system, while also allowing U.S. markets to

continue to operate efficiently in conjunction with foreign markets

(rather than creating incentives to establish barriers between U.S. and

foreign markets).\1524\

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\1524\ 12 U.S.C. 1851(d)(1)(J).

---------------------------------------------------------------------------

Thus, in response to commenter concerns, the final rule has been

modified to better reflect the text and achieve the overall purposes of

the statute (by ensuring that the principal risks of proprietary

trading by foreign banking entities allowed under the foreign trading

exemption remain solely outside of the United States) while mitigating

potentially adverse effects on competition.\1525\ In order to ensure

these risks remain largely outside of the United States, and to limit

potential risk that could flow to the U.S. financial system through

trades by foreign banking entities with or through U.S. entities, the

final rule includes several conditions on the availability of the

exemption. Specifically, in addition to limiting the exemption to

foreign banking entities, the final rule provides that the exemption

for the proprietary trading activity of a foreign banking entity is

available only if:

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\1525\ The proposed rule also contained a definition of

``resident of the United States'' that was designed to capture the

scope of U.S. counterparties that, if involved in the transaction,

would preclude that transaction from being considered to have

occurred solely outside the United States. The final rule addresses

this point by including a definition, for purposes of Sec. 75.6(e)

only, of the term ``U.S. entity.''

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The banking entity engaging as principal in the purchase

or sale (including any personnel of the banking entity or its affiliate

that arrange, negotiate or execute such purchase or sale) is not

located in the United States or organized under the laws of the United

States or of any State; \1526\

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\1526\ Personnel that arrange, negotiate, or execute a purchase

or sale conducted under the exemption for trading activity of a

foreign banking entity must be located outside of the United States.

Thus, for example, personnel in the United States cannot solicit or

sell to or arrange for trades conducted under this exemption.

Personnel in the United States also cannot serve as decision makers

in transactions conducted under this exemption. Personnel that

engage in back-office functions, such as clearing and settlement of

trades, would not be considered to arrange, negotiate, or execute a

purchase or sale for purposes of this provision.

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The banking entity (including relevant personnel) that

makes the decision to purchase or sell as principal is not located in

the United States or organized under the laws of the United States or

of any State;

The purchase or sale, including any transaction arising

from risk-mitigating hedging related to the instruments purchased or

sold, is not accounted for as principal directly or on a consolidated

basis by any branch or affiliate that is located in the United States

or organized under the laws of the United States or of any State;

No financing for the banking entity's purchase or sale is

provided, directly or indirectly, by any branch or affiliate that is

located in the United States or organized under the laws of the United

States or of any State; \1527\

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\1527\ This provision is not intended to restrict the ability of

a U.S. branch or affiliate of a foreign banking entity to provide

funds collected in the United States to its foreign parent for

general purposes.

---------------------------------------------------------------------------

The purchase or sale is not conducted with or through any

U.S. entity,\1528\ other than:

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\1528\ ``U.S. entity'' is defined for purposes of this provision

as any entity that is, or is controlled by, or is acting on behalf

of, or at the direction of, any other entity that is, located in the

United States or organized under the laws of the United States or of

any State. See final rule Sec. 75.6(e)(4).

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[cir] A purchase or sale with the foreign operations of a U.S.

entity, if no personnel of such U.S. entity that are located in the

United States are involved in the arrangement, negotiation or execution

of such purchase or sale.

The Agencies believe it is appropriate to exercise their exemptive

authority under section 13(d)(1)(J) to also allow, under clause (vi) of

the final rule, the following types of purchases or sales conducted

with a U.S. entity:

[cir] A purchase or sale with an unaffiliated market intermediary

acting as principal,\1529\ provided the purchase

[[Page 5928]]

or sale is promptly cleared and settled through a clearing agency or

derivatives clearing organization acting as a central counterparty; or

---------------------------------------------------------------------------

\1529\ This provision would generally allow market

intermediaries to engage in market-making, underwriting or similar

market intermediation functions.

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[cir] A purchase or sale through an unaffiliated market

intermediary, provided the purchase or sale is conducted anonymously

(i.e. each party to the purchase or sale is unaware of the identity of

the other party(ies) to the purchase or sale) on an exchange or similar

trading facility and promptly cleared and settled through a clearing

agency or derivatives clearing organization acting as a central

counterparty.

The requirements are designed to ensure that any foreign banking

entity engaging in trading activity under this exemption does so in a

manner that ensures the risk, decision-making, arrangement,

negotiation, execution and financing of the activity resides solely

outside the United States and limits the risk to the U.S. financial

system from trades by foreign banking entities with or through U.S.

entities.

The final rule specifically recognizes that, for purposes of the

exemption for trading activity of a foreign banking entity, a U.S.

branch, agency, or subsidiary of a foreign bank, or any subsidiary

thereof, is located in the United States; however, a foreign bank that

operates or controls that branch, agency, or subsidiary is not

considered to be located in the United States solely by virtue of

operation of the U.S. branch, agency, or subsidiary.\1530\ This

provision helps give effect to the statutory language limiting the

foreign trading exemption to activities of foreign banking entities

that occur solely outside of the United States by clarifying that the

U.S. operations of foreign banking entities may not conduct proprietary

trading based on this exemption.

---------------------------------------------------------------------------

\1530\ See final rule Sec. 75.6(e)(5).

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The Agencies have considered whether the concerns raised by

commenters that the foreign operations of U.S. banking entities would

be disadvantaged in competing outside the United States warrant an

exemption under section 13(d)(1)(J) of the BHC Act that extends to

foreign operations of U.S. banking entities. The competitiveness of

U.S. banking entities outside the United States often improves the

potential for the operations of U.S. firms outside the United States to

succeed and be profitable, and thereby, often improves the safety and

soundness of the entity and financial stability in the United States.

However, Congress has determined to generally prohibit U.S. banking

entities (including foreign branches and subsidiaries thereof) from

engaging in proprietary trading because of the perceived risks of those

activities to banking entities and the U.S. economy.\1531\ Allowing

U.S. banking entities to conduct, through branches or subsidiaries that

are physically located outside the United States, the same proprietary

trading activities those U.S. firms are expressly prohibited from

conducting directly through their operations located within the United

States would subject U.S. banking entities and the U.S. economy to the

very risks section 13 is designed to avoid. The risks of proprietary

trading would continue to be borne by the U.S. banking entity whether

the activity is conducted by the U.S. banking entity through units

physically located inside or outside of the United States. Moreover,

the robust trading markets that exist overseas could allow U.S. banking

entities to shift their prohibited proprietary trading activities to

branches or subsidiaries that are physically located outside the United

States under such an exemption, without achieving a meaningful

elimination of risk. Accordingly, the Agencies have not exercised their

authority under section 13(d)(1)(J) at this time to allow U.S. banking

entities to conduct otherwise prohibited proprietary trading activities

through operations located outside the United States. As a consequence,

and consistent with the statutory language and purpose of section

13(d)(1)(H) of the BHC Act, the final rule provides that the exemption

is available only if the banking entity is not organized under, or

directly or indirectly controlled by a banking entity that is organized

under, the laws of the United States or of one or more States.\1532\

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\1531\ See, e.g., 156 Cong. Rec. S5897 (daily ed. July 15, 2010)

(statement of Sen. Merkley) (``However, these subparagraphs are not

intended to permit a U.S. banking entity to avoid the restrictions

on proprietary trading simply by setting up an offshore subsidiary

or reincorporating offshore, and regulators should enforce them

accordingly.'').

\1532\ See final rule Sec. 75.6(e)(1)(i).

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As discussed above, many commenters requested that the final rule

permit a foreign banking entity to engage in proprietary trading

transactions with a greater variety of counterparties, including

counterparties that are located in or organized and incorporated under

the laws of the United States or of one or more States.\1533\ These

commenters also requested that the final rule not require that any

purchase or sale under the exemption be executed wholly outside of the

United States.

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\1533\ A number of commenters also requested that the foreign

trading exemption permit proprietary trading of foreign sovereign

debt or similar obligations of foreign governments. As discussed in

Part VI.A.5.b. of this SUPPLEMENTARY INFORMATION, the final rule

addresses banking entities' ability to engage in transaction in

these types of instruments in Sec. 75.6(b).

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As described above and in response to commenters' concerns, the

final rule provides that a foreign banking entity generally may engage

in trading activity under the exemption with U.S. entities, provided

the transaction is with the foreign operations of an unaffiliated U.S.

firm (whether or not the U.S. firm is a banking entity subject to

section 13 of the BHC Act) and does not involve any personnel of the

U.S. entity that are in the United States and involved in the

arrangement, negotiation, or execution of the transaction. The Agencies

have also exercised their exemptive authority under section 13(d)(1)(J)

to allow foreign banking entities to engage in a transaction that is

either through an unaffiliated market intermediary and executed

anonymously on an exchange or similar trading facility (regardless of

whether the ultimate counterparty is a U.S. entity or not) or is

executed with a U.S. entity that is an unaffiliated market intermediary

acting as principal, provided in either case that the transaction is

promptly cleared and settled through a clearing agency or derivatives

clearing organization acting as a central counterparty.

For purposes of the final rule, market intermediary is defined as

an unaffiliated entity, acting as an intermediary, that is: (i) A

broker or dealer registered with the SEC under section 15 of the

Exchange Act or exempt from registration or excluded from regulation as

such; (ii) a swap dealer registered with the CFTC under section 4s of

the Commodity Exchange Act or exempt from registration or excluded from

regulation as such; (iii) a security-based swap dealer registered with

the SEC under section 15F of the Exchange Act or exempt from

registration or excluded from regulation as such; or (iv) a futures

commission merchant registered with the CFTC under section 4f of the

Commodity Exchange Act or exempt from registration or excluded from

regulation as such.\1534\

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\1534\ See final rule Sec. 75.6(e)(5). For example, under this

definition, a bank that is exempt from registration as a swap dealer

under the de minimis exception to swap dealer registration

requirements could be a market intermediary for transactions in

swaps. See 17 CFR 1.3(ggg)(4).

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These provisions of the final rule, viewed as a whole, prevent the

[[Page 5929]]

exemption for trading of foreign banking entities from weakening U.S.

trading markets and U.S. firms that are either not subject to the

provisions of section 13 or that conduct activities in compliance with

other parts of section 13. For instance, the final rule permits a

foreign banking entity to trade under the exemption with the foreign

operations of a U.S. firm, so long as the purchase or sale does not

involve any personnel of the U.S. firm who are located in the United

States and involved in arranging, negotiating or executing the

trade.\1535\ Transactions that occur outside of the United States

between foreign operations of U.S. entities and foreign banking

entities improve access to and functioning of liquid markets without

raising the concerns for increased risk to banking entities in the U.S.

that motivated enactment of section 13 of the BHC Act. The final rule

permits a foreign banking entity to engage in transactions with the

foreign operations of both U.S. non-banking and U.S. banking entities.

Among other things, this approach will ensure that the foreign

operations of U.S. banking entities continue to be able to access

foreign markets.\1536\ The language of the exemption expressly requires

that trading with the foreign operations of a U.S. entity may not

involve the use of personnel of the U.S. entity who are located in the

United States for purposes of arranging, negotiating, or executing

transactions.

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\1535\ See final rule Sec. 75.6(e)(3)(v)(A).

\1536\ The Agencies believe that this provision should address

commenters' concerns that the proposed rule could cause foreign

banking entities to avoid conducting business with U.S. firms

outside the United States or could incentivize foreign market places

to restrict access to U.S. firms. See, e.g., RBC.

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Under the final rule, the exemption in no way exempts the U.S. or

foreign operations of the U.S. banking entities from having to comply

with the restrictions and limitations of section 13. Thus, the U.S. and

foreign operations of a U.S. banking entity that is engaged in

permissible market making-related activities or other permitted

activities may engage in those transactions with a foreign banking

entity that is engaged in proprietary trading in accordance with the

exemption under Sec. 75.6(e) of the final rule. Importantly, the final

rule does not impose a duty on the foreign banking entity or the U.S.

banking entity to ensure that its counterparty is conducting its

activity in conformance with section 13 of the BHC Act and the final

rule. Rather, that burden is at all times on each party subject to

section 13 to ensure that it is conducting its activities in accordance

with section 13 and this implementing rule.

The final rule also permits, pursuant to section 13(d)(1)(J), a

foreign banking entity to trade through an unaffiliated market

intermediary if the trade is conducted anonymously on an exchange or

similar trading facility and is promptly cleared and settled through a

clearing agency or derivatives clearing organization.\1537\ Allowing

foreign banking entities to generally conduct anonymous proprietary

trades on U.S. exchanges and similar anonymous trading facilities

allows these exchanges and facilities--which are generally not subject

to section 13 and do not take the risks section 13 is designed to

address--to serve the widest possible range of counterparties. This

prevents the potential adverse impacts from possible reductions in

competitiveness of or liquidity available on these regulated exchanges

and facilities, which could also harm other U.S. market participants

who trade on these exchanges and facilities. In addition, the Agencies

recognize that anonymous trading on exchanges and similar anonymous

trading facilities promotes transparency and that prohibiting foreign

banking entities from trading on U.S. exchanges and similar anonymous

trading facilities under this exemption would likely reduce

transparency for trading in U.S. financial instruments. All of these

considerations support the Agencies' exercise of their exemptive

authority under section 13(d)(1)(J) to allow such trading by foreign

banking entities.

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\1537\ Under the final rule, ``anonymous'' means that each party

to a purchase or sale is unaware of the identity of the other

party(ies) to the purchase or sale. See final rule Sec. 75.3(e)(1).

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The final rule requires that foreign banking entities trade through

an unaffiliated market intermediary to access a U.S. exchange or

trading facility in recognition that existing laws and regulations

generally require this structure.\1538\ For purposes of this exemption,

an exchange would include, unless the context otherwise requires, any

designated contract market, swap execution facility, or foreign board

of trade registered with the CFTC, and any exchange or security-based

swap execution facility, as such terms are defined under the Exchange

Act.\1539\

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\1538\ See, e.g., 15 U.S.C. 78f(c)(1) (providing that a national

securities exchange shall deny membership to (A) any person, other

than a natural person, which is not a registered broker or dealer or

(B) any natural person who is not, or is not associated with, a

registered broker or dealer).

\1539\ See final rule Sec. 75.3(e)(6) (defining the term

``exchange''). The rule refers to an ``exchange or similar trading

facility.'' A similar trading facility for these purposes may

include, for example, an alternative trading system.

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This provision of the final rule requires that foreign banking

entities trade anonymously and that the trade be centrally cleared and

settled. The Agencies understand that in these circumstances, the

foreign banking entity would not have any prior information regarding

its counterparty to the trade. Requiring that the trade be executed

anonymously preserves the benefits of allowing U.S. entities to

participate in such trades, while reducing the potential for evasion of

section 13 that could occur if foreign banking entities directly

arranged purchases and sales with U.S. entities.\1540\ The final rule

specifies that a trade is anonymous if each party to the purchase or

sale is unaware of the identity of the other party(ies) to the purchase

or sale. That is, it is lack of knowledge of the identity of the

counterparty(ies) to the trade that is relevant. The final rule does

not prohibit foreign banking entities from accessing a trading facility

through an unaffiliated U.S. market intermediary (which the foreign

banking entity would necessarily know), so long as the foreign banking

entity is not aware of the identity of the counterparty to the

transaction.

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\1540\ In addition, allowing a foreign banking entity to trade

directly with a U.S. end user customer under the foreign trading

exemption could give the foreign banking entity a competitive

advantage over U.S. banking entities with respect to trading in the

United States.

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Similarly, also pursuant to section 13(d)(1)(J), the final rule

allows a foreign banking entity to trade with an unaffiliated market

intermediary acting in a principal capacity and effecting a market

intermediation function, in a transaction that is not conducted on an

exchange or similar anonymous trading facility, as long as the trade is

promptly cleared and settled through a clearing agency or derivatives

clearing organization. This provision recognizes that not all financial

instruments are traded on an exchange or similar anonymous trading

facility and, thus, allows foreign banking entities to trade and

contribute to market liquidity in all types of U.S. financial

instruments without requiring separate market infrastructure to be

developed outside the U.S. for such trading activity, which could

result in inefficiencies and reduce U.S. market liquidity. Market

intermediaries can serve the same general purpose as exchanges or

similar trading facilities in intermediating between buyers and

sellers, particularly in asset classes that do not generally trade on

these exchanges or facilities, although this intermediation function

[[Page 5930]]

may not be as immediate in the case of market intermediaries.

In either case (i.e., for either an anonymous trade or a trade with

an unaffiliated market intermediary), if the U.S. counterparty to the

transaction is a banking entity subject to section 13 and these rules,

it must comply with an exemption to the prohibition on proprietary

trading, such as the market-making exemption or the exemption for

riskless principal transactions. Allowing foreign banking entities to

trade with unaffiliated U.S. market intermediaries, including banking

entities engaged in permitted market making-related activities, expands

the range of potential buyers and sellers for which the U.S. entities

can trade and may result in more efficient and timely matching of

trades, reducing inventory risks to the U.S. market intermediary. At

the same time, this exemption does not permit a U.S. market

intermediary that is subject to section 13 of the BHC Act to conduct

trading activities other than in compliance with the provisions of

section 13. Thus, the Agencies believe it is appropriate to allow

foreign banking entities to conduct such trading under the exemption in

section 13(d)(1)(J).

To reduce risks to U.S. entities and the potential for evasion, the

provisions allowing trading with U.S. entities include two additional

protections. First, the final rule does not allow a foreign banking

entity to trade through an affiliated U.S. entity under the exemption

out of concern that it could increase the risk of evasion.\1541\

Second, a foreign banking entity's trades conducted through an

unaffiliated market intermediary on an exchange or conducted directly

with an unaffiliated market intermediary must be promptly cleared and

settled through a clearing agency or derivatives clearing organization

acting as central counterparty. Consistent with the goals of section 13

to reduce risk to banking entities and the U.S. financial system, this

requirement is designed to reduce risk to U.S. entities arising from

foreign banking entities' proprietary trading activity, particularly

counterparty risk, and preclude foreign banking entities from relying

on the exemption for trading that creates exposure of U.S.

counterparties pursuant to bilateral, uncleared transactions, which

poses heightened counterparty credit risks.\1542\ This condition is

also consistent with the systemic risk benefits of central clearing and

may incentivize the use of central clearing for trading by foreign

banking entities and foreign affiliates of U.S. banking entities. The

Agencies believe this approach is consistent with and reinforces the

goals of the central clearing framework of Title VIII of the Dodd-Frank

Act.

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\1541\ In addition, allowing a foreign banking entity to trade

through or with a U.S. affiliate under the exemption for trading

activity of a foreign banking entity could give the foreign banking

entity a competitive advantage over U.S. banking entities that are

subject to limitations on their trading activities. Thus, the

Agencies are not permitting a foreign banking entity to trade

through a U.S. affiliate as agent, as requested by some commenters.

See, e.g., IIB/EBF. However, the Agencies recognize that, with

respect to trading anonymously, there is no way to know the identity

of the counterparty to the trade. Thus, a foreign banking entity

would not be in violation of this rule if it traded through an

unaffiliated market intermediary on an exchange, in accordance with

the exemption for trading activity of a foreign banking entity, and

the counterparty to its trade happened to be an affiliated entity.

\1542\ As discussed above, centralized clearing redistributes

counterparty risk among members of a clearing agency or derivatives

clearing organization through mutualization of losses, reducing the

likelihood of sequential counterparty failure and contagion. See

supra note 271 and accompanying text.

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The final rule does not allow a foreign banking entity to trade

with a broader range of U.S. entities under the exemption because the

Agencies are concerned such an approach may result in adverse

competitive impacts between U.S. banking entities and foreign banking

entities with respect to their trading in the United States, which

could harm the safety and soundness of banking entities and U.S.

financial stability. For example, such an approach could allow foreign

banking entities to act as market makers for U.S. customers under the

exemption in Sec. 75.6(e) of the final rule so long as the foreign

banking entity held the risk of its market-making trades outside the

United States. In turn, this could give foreign banking entities a

competitive advantage over U.S. banking entities with respect to U.S.

market-making activities because foreign banking entities could trade

directly with U.S. non-banking entities without incurring the

additional costs, or being subject to the limitations, associated with

the market-making or other exemptions under the rule. This competitive

disparity in turn could create a significant potential for regulatory

arbitrage. The Agencies do not believe this result was intended by the

statute. Instead, the final rule seeks to alleviate the concern that an

overly broad approach to the exemption (e.g., permitting trading with

all U.S. counterparties) may result in competitive impacts and

increased risks to the U.S. financial system, while mitigating the

concern that an overly narrow approach to the exemption (e.g.,

prohibiting trading with any U.S. counterparty) may cause market

bifurcations, reduce the efficiency and liquidity of markets, and harm

U.S. market participants.

9. Section 75.7: Limitations on Permitted Trading Activities

Section 75.8 of the proposed rule implemented section 13(d)(2) of

the BHC Act,\1543\ which provides that a banking entity may not engage

in certain exempt activities (e.g., permitted market making-related

activities, risk-mitigating hedging, etc.) if the 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 U.S. financial

stability.\1544\ The Agencies sought comment on proposed definitions of

the terms ``material conflict of interest,'' ``high-risk asset,'' and

``high-risk trading strategy'' for these purposes.

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\1543\ Section 75.8 of the proposed rule regarding limitations

on permitted trading activities is consistent with Sec. 75.17 of

the proposed rule regarding other limitations on permitted covered

funds activities. Accordingly, the discussion regarding proposed

rule Sec. 75.8 and final rule Sec. 75.7 in this part also pertain

to Sec. 75.17 of the proposed rule and Sec. 75.16 of the final

rule. See also Part VI.B.6., infra.

\1544\ See 12 U.S.C. 1851(d)(2).

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With respect to general comments regarding the proposed rule,

commenters generally agreed on the need to limit banking entities'

proprietary trading activities so as to avoid material conflicts of

interest and material exposures to high-risk trading strategies and

high-risk assets.\1545\ One commenter expressed support for the

Agencies' proposed approach, stating that the proposed rule was clear

and structured in such a manner so that it should remain effective even

as financial markets evolve and change.\1546\ As discussed in greater

detail below, most commenters suggested amendments, clarification, or

alternative approaches. For example, some commenters expressed concern

regarding the application of the prudential backstops to the activities

of foreign banking entities.\1547\ The Agencies did not receive any

comments on the prohibition against transactions or activities that

pose a threat to the safety or soundness of the banking entity or the

financial stability of the United States.

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\1545\ See, e.g., Sens. Merkley & Levin (Feb. 2012); Public

Citizen; Paul Volcker.

\1546\ See Alfred Brock.

\1547\ See IIB/EBF; Ass'n. of German Banks.

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As explained in detail below, the Agencies have carefully reviewed

[[Page 5931]]

comments on the proposed rule's implementation of the prudential

backstops under section 13(d)(2) of the BHC Act, including commenters'

suggestions for expanding, contracting, or revising the proposed rule.

After carefully considering these comments, the Agencies continue to

believe the expansive scope of section 13 of the BHC Act supports a

similarly inclusive approach focusing on the facts and circumstances of

each potential conflict or high-risk activity. Therefore, and in

consideration of all issues discussed below, the Agencies are adopting

the final rule substantially as proposed.\1548\ The Agencies intend to

develop additional guidance regarding best practices for addressing

potential material conflicts of interest, high-risk assets and trading

strategies and practices that pose significant risks to safety and

soundness and to the U.S. financial system as the Agencies and banking

entities gain experience with implementation of the requirements and

limitations in section 13 of the BHC Act and this rule, which are all

generally designed to limit risky behavior in trading and investment

activities.

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\1548\ The Agencies note that proposed Appendix C, which

required banking entities to describe how they comply with these

provisions, will be adopted as Appendix B with similar requirements

regarding compliance with the limitations on permitted activities.

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a. Scope of ``Material Conflict of Interest''

1. Proposed Rule

Section 75.8(b) of the proposed rule defined the scope of material

conflicts of interest which, if arising in connection with a permitted

trading activity, were prohibited under the proposal.\1549\ As noted in

the proposal, 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.\1550\ In all cases, the existence of a material conflict

of interest depends on the specific facts and circumstances.\1551\

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\1549\ Section 75.17(b) of the proposed rule defined the scope

of material conflicts of interest which, if arising in connection

with permitted covered fund activities, are prohibited.

\1550\ 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.

\1551\ See Joint Proposal, 76 FR at 68893.

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To address these types of material conflicts of interest, Sec.

75.8(b) of the proposed rule specified 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, and

subject to specific requirements provided in the proposal, through

either (i) timely and effective disclosure, or (ii) information

barriers.\1552\ 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. 75.4 through 75.6 of the proposed

rule.\1553\

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\1552\ See proposed rule Sec. 75.8(b)(1).

\1553\ See Joint Proposal, 76 FR at 68893.

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However, the Agencies determined that 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, derivatives, and

banking laws and regulations.

Section 75.8(b)(1) of the proposed rule described 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. 75.8(b)(1)(A)(i) of the proposed

rule required 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. 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.\1554\

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. 75.8(b)(1)(ii)

of the proposed rule required 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.\1555\

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\1554\ See id.

\1555\ See proposed rule Sec. 75.8(b)(1)(B).

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The Agencies noted 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 a particular transaction, such that the

client, customer, or counterparty is unlikely to take that disclosure

into account when evaluating the 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

[[Page 5932]]

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 reflected 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. 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

were provided solely for purposes of the proposed rule's definition of

material conflict of interest, and did 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 75.8(b)(2) of the proposed rule described 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.\1556\

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\1556\ See, e.g., 15 U.S.C. 78c(a)(4)(B)(i)(I)-(IV) (finding

that disclosure and physical separation of personnel and activities

addresses the potential that consumers might be misled by the

broker-dealer activities of banks). 15 U.S.C. 80b-6(3) (``It shall

be unlawful for any investment adviser, by use of the mails or any

means or instrumentality of interstate commerce, directly or

indirectly . . . acting as principal for his own account, knowingly

to sell any security to or purchase any security from a client, or

acting as broker for a person other than such client, knowingly to

effect any sale or purchase of any security for the account of such

client, without disclosing to such client in writing before the

completion of such transaction the capacity in which he is acting

and obtaining the consent of the client to such transaction.''). See

also Form ADV, the form used by investment advisers to register with

the Securities and Exchange Commission and state securities

authorities, and, in particular, Form ADV Part 2: Uniform

Requirements for the Investment Adviser Brochure and Brochure

Supplements. A registered investment adviser generally must deliver

the Form ADV brochure, which contains disclosure about conflicts of

interest, to its prospective and existing clients. See 17 CFR

275.204-3; Amendments to Form ADV, Investment Advisers Act Release

No. 3060 (July 28, 2010) 75 FR 49234 (Aug. 12, 2010) (``We are

adopting a requirement that investment advisers registered with us

provide prospective and existing clients with a narrative brochure

written in plain English . . . We believe these amendments will

greatly improve the ability of clients and prospective clients to

evaluate firms offering advisory services and the firms' personnel,

and to understand relevant conflicts of interest that the firms and

their personnel face and their potential effect on the firms'

services.'').

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In order to address and mitigate a conflict of interest through the

use of the information barriers pursuant to Sec. 75.8(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. Importantly, the proposed rule also provided

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 complied with the requirements of proposed

Sec. 75.8(b)(1).\1557\ This aspect of the proposal was 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.\1558\

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\1557\ See proposed rule Sec. 75.8(b)(2).

\1558\ See Joint Proposal, 76 FR at 68894.

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The proposed definition of material conflict of interest did 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. This is because such misrepresentations are

generally illegal under a variety of Federal and State regulatory

schemes (e.g., the Federal securities laws).\1559\ In addition, the

Agencies noted 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.

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\1559\ See 12 U.S.C. 1851(g)(3).

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2. Comments on the Proposed Limitation on Material Conflicts of

Interest

Commenters expressed a variety of views regarding the treatment of

material conflicts of interest under the proposal, including the manner

in which conflicts may be mitigated or eliminated. One commenter

believed that the proposed material conflict of interest provisions

would be effective.\1560\ Another commenter stated that conflicts of

interest were unavoidable but that the final rule should ensure that

institutional investors have confidence that the banking entities they

are dealing with

[[Page 5933]]

are not operating at a conflict with investors' goals.\1561\

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\1560\ See Alfred Brock.

\1561\ See Paul Volcker.

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Other commenters expressed differing views on whether the proposed

rule's provisions for addressing conflicts of interest through

disclosure or information barriers were appropriate. A few commenters

stated there is no statutory basis for allowing conflicts of interest

in connection with exempted activities even if banking entities provide

disclosure or establish information barriers, and the rule should

prohibit banking entities from engaging in permitted activities if

material conflicts of interest exist.\1562\ One commenter believed the

definition did not appear to address issues of customer favoritism, in

which a bank is financially incentivized to treat one customer more

favorably than another (typically less sophisticated) customer.\1563\

Some commenters believed that the proposed definition of material

conflict of interest was too vague or narrow and suggested it should be

strengthened by either expanding the types of transactions that may

result in a material conflict of interest or by imposing additional

limitations or restrictions on transactions.\1564\ For instance, one

commenter suggested the final rule consider depositors of a banking

entity to be ``customers'' for the purpose of this provision, impose a

fiduciary duty on any banking entity conducting an exempt activity

pursuant to section 13(d)(1) of the BHC Act, and impose size

restrictions on any banking entity engaging in proprietary trading

under an exemption. This commenter also stated that a banking entity

inherently has a material conflict of interest with its customer when

it takes the opposite side of a transaction and, therefore, that the

final rule should require a banking entity to disgorge all principal

gains from transactions conducted pursuant to any exemption under

section 13(d)(1) of the BHC Act, including market-making, trading in

U.S. government obligations, insurance company activities and other

exempt activities.\1565\ In addition, a few commenters stated that, if

disclosure or information barriers were permitted to mitigates

conflicts under the final rule, clients of the banking entity must be

required to acknowledge in writing that they understand the potential

conflicts of interest present in order for any disclosure to be

effective in mitigating a conflict of interest.\1566\

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\1562\ See Public Citizen; Sens. Merkley & Levin; Occupy; AFR et

al. (Feb. 2012).

\1563\ See Public Citizen.

\1564\ See, e.g., Occupy; AFR et al. (Feb. 2012); Sens. Merkley

& Levin (Feb. 2012).

\1565\ See Occupy.

\1566\ See, e.g., Lynda Aiman-Smith; AFR et al. (Feb. 2012);

Sens. Merkley & Levin (Feb. 2012).

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Some commenters believed that the Agencies should consider issuing

additional guidance regarding the definition of material conflicts of

interest, high-risk assets, and high-risk trading strategies.\1567\ One

commenter stated that the final rule should limit the extraterritorial

impact of section 13 by only applying the restrictions of section

13(d)(2) of the BHC Act to the U.S. operations or activities of foreign

banking entities and that the regulation of safety and soundness of the

foreign operations and activities of foreign banking entities should be

left to the home country regulator or supervisor of a foreign banking

entity.\1568\

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\1567\ See Rep. Blumenauer et al.; Sens. Merkley & Levin (Feb.

2012).

\1568\ See IIB/EBF; EBF.

---------------------------------------------------------------------------

Some commenters provided general suggestions on enhancing

compliance with the prohibition on material conflicts of interest. A

common suggestion among industry participants was to implement the

prohibition on material conflicts of interest under these rules in a

manner consistent with the implementation of section 621 of Dodd-

Frank.\1569\ One commenter suggested that trading in government

obligations should not be subject to the material conflict of interest

provision because government obligations are broadly traded and do not

present the types of conflicts addressed by the proposed rule.\1570\ In

contrast, one commenter stated banking entities should be required to

receive pre-trade clearance from the Federal Reserve for trading in

certain government obligations like municipal bonds and mortgage-backed

securities, due to their role in the 2008 financial crisis.\1571\

---------------------------------------------------------------------------

\1569\ See ASF (Conflicts) (Feb. 2012); SIFMA et al. (Prop.

Trading) (Feb. 2012); SIFMA (Securitization) (Feb. 2012); LSTA (Feb.

2012); Sens. Merkley & Levin (Feb. 2012).

\1570\ See BDA (Feb. 2012).

\1571\ See Occupy.

---------------------------------------------------------------------------

a. Disclosure

Some commenters expressed concern about potential difficulties

associated with the proposed disclosure provision and provided

suggestions to address these difficulties. For example, a few

commenters noted the difficulty in determining what constitutes

effective disclosure,\1572\ especially in relation to the volume of

disclosure or the impact of information asymmetry in illiquid

markets.\1573\ One commenter stated that unless the rule requires full

disclosure of a banking entity's trading strategy and the rationale

behind it, allowing disclosure will permit the banking entity to

protect itself without adequately mitigating the harm of the conflict.

This commenter also noted the practical difficulties associated with

disclosing anticipated future conflicts and conflicts in the context of

block trading.\1574\ Another commenter stated market participants

understand inherent conflicts of interest and believed disclosure in

such situations would be burdensome and unnecessary.\1575\ One

commenter stated that the rule should require a banking entity to

negate, not just permit the client, customer, or counterparty to

substantially mitigate, the materially adverse effect of the

conflict.\1576\

---------------------------------------------------------------------------

\1572\ See Occupy; ISDA (Apr. 2012); Better Markets (Feb. 2012);

SIFMA et al. (Prop. Trading) (Feb. 2012); ICFR.

\1573\ See Occupy.

\1574\ See Public Citizen; see also AFR et al. (Feb. 2012).

\1575\ See SIFMA et al. (Prop. Trading) (Feb. 2012)

\1576\ See Occupy.

---------------------------------------------------------------------------

A few commenters disagreed with the disclosure provision, noting

that Congress specifically considered and rejected disclosure as a

mitigation method for purposes of section 621 of the Dodd-Frank Act and

that this indicates the Agencies should not permit a material conflict

of interest to be mitigated through disclosure for purposes of section

13 of the BHC Act.\1577\

---------------------------------------------------------------------------

\1577\ See, e.g., Occupy.

---------------------------------------------------------------------------

Commenters were in disagreement as to the extent and timing of

disclosure that should be required under the rule. Some commenters

stated the disclosure provisions would slow trading, and suggested the

rule require only one-time disclosure at the inception of the business

relationship \1578\ or periodic disclosures to address ongoing

conflicts.\1579\ One of these commenters noted that extensive trade-by-

trade disclosure requirements create the risk of unintended breaches of

confidentiality.\1580\ Other commenters requested the Agencies provide

additional guidance, such as when transaction-specific disclosure is

necessary,\1581\ whether disclosure should be written,\1582\ and what

constitutes ``reasonable detail.'' \1583\

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\1578\ See ISDA (Apr. 2012); Arnold & Porter.

\1579\ See SIFMA et al. (Prop. Trading) (Feb. 2012); ISDA (Apr.

2012).

\1580\ See ISDA (Apr. 2012).

\1581\ See SIFMA et al. (Prop. Trading) (Feb. 2012);

\1582\ See Sens. Merkley & Levin (Feb. 2012); ICFR (questioning

the effectiveness of enforcement mechanisms if oral disclosure

permitted under the rule); Occupy.

\1583\ See ICFR.

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[[Page 5934]]

In addition, some commenters provided suggestions on whether

parties should be required to acknowledge receipt of disclosures \1584\

or affirmatively consent to the conflict.\1585\ One commenter proposed

allowing a majority of a committee of independent board members to

approve consent to waivers of conflicts of interest.\1586\ One

commenter believed disclosure and consent by a sophisticated investor

ought to be sufficient to serve as a waiver to most types of conflict

of interest.\1587\ In contrast, another commenter asserted general

disclosure or waivers of conflicts should never be allowed, and the

Agencies should not provide any additional guidance as to the extent,

timing, frequency, or scope of disclosure appropriate in any given

situation.\1588\ Similarly, one commenter asserted the Agencies should

not provide guidance on what issues can be addressed by disclosure, as

such guidance would be ``dangerously prescriptive and would introduce

moral hazards.'' \1589\

---------------------------------------------------------------------------

\1584\ See, e.g., Arnold & Porter; Sens. Merkley & Levin (Feb.

2012); Better Markets (Feb. 2012); Public Citizen; AFR et al. (Feb.

2012); Lynda Aiman-Smith.

\1585\ See Public Citizen; Sens. Merkley & Levin (Feb. 2012);

Better Markets (Feb. 2012).

\1586\ See Arnold & Porter.

\1587\ See Arnold & Porter.

\1588\ See Alfred Brock (stating there is no such thing as a

``sophisticated party'').

\1589\ See ICFR.

---------------------------------------------------------------------------

b. Information Barriers

A few commenters addressed the information barriers provision of

the proposed rule. One commenter expressed support for the proposed

approach,\1590\ while three commenters stated this provision was

ineffective.\1591\ A few commenters opposed the information barriers

provision because they believed information barriers would make

conflict mitigation more difficult \1592\ or would effectively mandate

that no single officer be aware of a banking entity's collective

operations.\1593\

---------------------------------------------------------------------------

\1590\ See Alfred Brock.

\1591\ See Better Markets (Feb. 2012); Occupy; Public Citizen.

\1592\ See Occupy.

\1593\ See Public Citizen (contending that this would undermine

the Dodd-Frank Act's requirement to promote sound management, ensure

financial stability, and reduce systemic risk).

---------------------------------------------------------------------------

A few commenters also requested the Agencies provide guidance

regarding the use of information barriers. One commenter requested the

Agencies specify the type and nature of information barriers and where

they are practical to implement.\1594\ Another commenter believed that

the Agencies should view information barriers favorably. This commenter

stated that information barriers should be permitted for addressing

conflicts of interest unless the banking entity knows, or should

reasonably know, that the information barrier would not be effective in

restricting the spread of information that could lead to the

conflict.\1595\ To provide greater clarity, another commenter

recommended the Agencies provide guidance on certain elements that may

be used to determine the reasonableness of information barriers, such

as memorialization of procedures and documentation of actions taken

pursuant to such procedures.\1596\

---------------------------------------------------------------------------

\1594\ See AFR et al. (Feb. 2012).

\1595\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\1596\ See ISDA (Apr. 2012) (arguing that its suggested guidance

was derived from prior SEC and self-regulatory organization guidance

on information barriers).

---------------------------------------------------------------------------

3. Final Rule

After considering carefully comments received on the proposal as

well as the purpose and language of section 13 of the BHC Act, the

Agencies have adopted the final rule largely as proposed. Under the

final rule, a banking entity that 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 the transaction,

class of transactions, or activity, must address and mitigate the

conflict of interest, where possible, through either timely and

effective disclosure or informational barriers.\1597\ This requirement

is in addition to, and does not supplant, any limitations or

prohibitions contained in other laws. For example, a material

misrepresentation by a banking entity to its client, customer, or

counterparty in connection with market-making activities may involve

fraud and is generally illegal under a variety of Federal and State

regulatory schemes (e.g., the Federal securities laws) \1598\ as well

as being prohibited under section 13 of the BHC Act.

---------------------------------------------------------------------------

\1597\ The Agencies note that the definition of material

conflict of interest and the disclosure provisions related to that

definition apply solely for purposes of the 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).

\1598\ See 12 U.S.C. 1851(g)(3).

---------------------------------------------------------------------------

The Agencies believe that certain of commenters' suggested

modifications to the proposed rule are outside the scope of the

Agencies' statutory authority. For example, the Agencies do not believe

section 13 of the BHC Act provides statutory authority to directly

impose limits on the size of banking entities \1599\ or to implement

specific fiduciary standards on banking entities.\1600\ In addition,

the Agencies do not believe it is appropriate to expand the definition

of ``customer'' to include individuals and entities that solely make

use of the bank's traditional banking services because section 13 is

focused on the trading activities and investment in which banking

entities may be involved.\1601\

---------------------------------------------------------------------------

\1599\ See Occupy.

\1600\ See Occupy.

\1601\ See Occupy.

---------------------------------------------------------------------------

The final rule recognizes that a banking entity may address or

substantially mitigate a potential conflict of interest by making

adequate disclosures or creating and enforcing informational barriers.

Some commenters argued that the legislative history of the Dodd-Frank

Act suggests that disclosure or informational barriers are not adequate

to address a material conflict of interest.\1602\ However, section 13

of the BHC Act directs the Agencies to define ``material conflict of

interest'' and gives the Agencies discretion to determine how to define

this term for purposes of the rule. Under the final rule, a material

conflict of interest exists when the banking entity engages in

transactions or activities that cause its interests to be materially

adverse to the interests of its client, customer, or counterparty. At

the same time, the final rule provides banking entities the opportunity

to take certain actions to address the conflict, such that the conflict

does not have a materially adverse effect on that client, customer, or

counterparty. Under the final rule, a banking entity may address a

conflict by establishing, maintaining, and enforcing information

barriers reasonably designed to avoid a conflict's materially adverse

effect, or by disclosing the conflict in a manner that allows the

client, customer, or counterparty to substantially mitigate or negate

any materially adverse effect created by the conflict of interest. The

Agencies believe that, to the extent the materially adverse effect of a

conflict has been substantially mitigated, negated, or avoided, it is

appropriate to allow the

[[Page 5935]]

transaction, class of transaction, or activity under the final rule.

Continuing to view the conflict as a material conflict of interest

under these circumstances would not appear to benefit the banking

entity's client, customer, or counterparty. The disclosure standard

under the final rule requires clear and meaningful information be

provided to the client, customer, or counterparty in a manner that

provides such party the opportunity to negate or substantially

mitigate, any materially adverse effects on such party created by the

conflict.

---------------------------------------------------------------------------

\1602\ See Public Citizen; Sens. Merkley & Levin (Feb. 2012);

Occupy; AFR et al. (Feb. 2012).

---------------------------------------------------------------------------

Some commenters suggested that obtaining consent to or waiver of

disclosed conflicts should be sufficient to comply with the rule.\1603\

The Agencies do not believe that consent or waivers alone are

sufficient to address material conflicts of interest, and continue to

believe that any banking entity using disclosure to address a conflict

of interest should be required to provide any client, customer, or

counterparty with whom the banking entity has a conflict with the

opportunity to negate or substantially mitigate the materially adverse

effect of the conflict on the client, customer, or counterparty. The

Agencies believe this approach, which applies equally to all types of

clients, customers, or counterparties, will reduce the potential for

unintended or differing impacts on certain types of clients, customers,

or counterparties. In response to one commenter's suggestion that the

final rules require full negation of the materially adverse effect on

the client, customer, or counterparty, the Agencies continue to believe

it is appropriate to allow a transaction or activity to continue if the

client, customer, or counterparty is provided an opportunity to

substantially mitigate the materially adverse effect.\1604\ The

Agencies are concerned that requiring the conflict's impact to be fully

negated under all circumstances could prevent a banking entity from

providing a service to a particular customer despite that customer's

knowledge of the conflict and ability to substantially reduce the

effect of the conflict on that customer.

---------------------------------------------------------------------------

\1603\ See, e.g., Arnold & Porter.

\1604\ See Occupy.

---------------------------------------------------------------------------

With regards to commenters' statements that information barriers

and disclosure will not work to address the harm caused by conflicts,

the Agencies emphasize that under the final rule, like the proposed

rule, a banking entity may use disclosure or information barriers to

address a conflict only in those instances where the disclosure

provides the client, customer, or counterparty with the opportunity to

negate or substantially mitigate any materially adverse effect of the

conflict on that entity or the information barriers are reasonably

designed to prevent the conflict of interest from involving or

resulting in a materially adverse effect on a client, customer, or

counterparty. If the banking entity is unable to effectively use

disclosure or information barriers in a way that meets the rule's

requirements, then the banking entity is prohibited from engaging in

the conflicted transaction, class of transaction, or activity.

Additionally, the Agencies note that the material conflict of interest

provisions in the final rule do not preempt any duties owed to parties

outside the transaction, including any duty of confidentiality.\1605\

---------------------------------------------------------------------------

\1605\ See ISDA (Apr. 2012).

---------------------------------------------------------------------------

In response to commenters' statements that the volume of

information included in a disclosure or the manner in which the

disclosure is presented may make it difficult for a customer to

identify and understand the relevant information regarding the

conflict,\1606\ the Agencies note that the final rule requires

disclosure of the conflict or potential conflict be clear, timely, and

effective and that the disclosure includes any other necessary

information. Disclosure is also required 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.\1607\ Thus, disclosure that is only general or generic, 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, or that is hidden in a large volume of needless

information would not meet this standard. The Agencies believe these

provisions of the final rule are designed to ensure that customers

receive sufficient information about the conflict of interest so that

they are well informed and, as required by the rule, able to negate or

substantially mitigate any materially adverse effect of the conflict.

---------------------------------------------------------------------------

\1606\ See Better Markets (Feb. 2012) (suggesting that a

disclosure regime can facilitate abuse by enabling market

participants to point to obscure and meaningless disclosure as a

shield against liability); Occupy (arguing that a large volume of

disclosed information can be difficult to understand or can serve to

hide relevant information).

\1607\ See final rule Sec. 75.7(b)(1)(i) and final rule Sec.

75.16(b)(1)(i).

---------------------------------------------------------------------------

In addition to requiring that customers are provided with detailed

information about the conflict, the final rule, like the proposal,

requires that disclosure is made prior to effecting the specific

transaction or class or type of transactions, or engaging in the

specific activity, for which a conflict may arise and is otherwise

timely. As a result, under Sec. 75.7(b)(2)(i), disclosure must 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 take steps that would negate or substantially

mitigate the conflict. This approach is similar to the approach

permitted by a variety of consumer protection statutes and regulations

for addressing potential conflicts of interest in consumer

transactions.\1608\

---------------------------------------------------------------------------

\1608\ See, e.g., 15 U.S.C. 78c(a)(4)(B)(i)(I)--(IV) (finding

that disclosure and physical separation of personnel and activities

addresses the potential that consumers might be misled by the

broker-dealer activities of banks); 15 U.S.C. 80b-6(3) (``It shall

be unlawful for any investment adviser, by use of the mails or any

means or instrumentality of interstate commerce, directly or

indirectly . . . acting as principal for his own account, knowingly

to sell any security to or purchase any security from a client, or

acting as broker for a person other than such client, knowingly to

effect any sale or purchase of any security for the account of such

client, without disclosing to such client in writing before the

completion of such transaction the capacity in which he is acting

and obtaining the consent of the client to such transaction.''). See

also Form ADV, the form used by investment advisers to register with

the Securities and Exchange Commission and state securities

authorities, and, in particular, Form ADV Part 2: Uniform

Requirements for the Investment Adviser Brochure and Brochure

Supplements. A registered investment adviser generally must deliver

the Form ADV brochure, which contains disclosure about conflicts of

interest, to its prospective and existing clients. See 17 CFR

275.204-3; Amendments to Form ADV, Investment Advisers Act Release

No. 3060 (July 28, 2010) 75 FR 49234 (Aug. 12, 2010) (``We are

adopting a requirement that investment advisers registered with us

provide prospective and existing clients with a narrative brochure

written in plain English . . . We believe these amendments will

greatly improve the ability of clients and prospective clients to

evaluate firms offering advisory services and the firms' personnel,

and to understand relevant conflicts of interest that the firms and

their personnel face and their potential effect on the firms'

services.'').

---------------------------------------------------------------------------

Some commenters requested that the final rule permit a conflict to

be negated or substantially mitigated through generic or periodic

disclosures, such as at the beginning of a trading relationship or on

an annual basis. Other commenters stated that some conflicts, such as

anticipated future conflicts or those that arise in the context of

block trading, may require the banking entity to provide disclosure in

advance of the actual conflict in order to allow the client, customer,

or counterparty the opportunity to mitigate the materially adverse

effect.\1609\ The

[[Page 5936]]

Agencies emphasize, however, that disclosure provided far in advance of

a particular transaction, such that the client, customer, or

counterparty is unlikely to take that disclosure into account when

evaluating the transaction, would not suffice. At the same time,

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 be

permissible disclosure under the final rules. The Agencies believe

that, in considering the effectiveness of disclosures, the type, timing

and frequency of disclosures depends significantly on the customer

relationship, the type of transaction, and the matter that creates the

potential conflict. Therefore, while written disclosures may be

appropriate in certain circumstances, the Agencies are not requiring

banking entities to provide written disclosure,\1610\ or obtain

documentation showing that disclosure was received,\1611\ because the

Agencies believe it is more important that disclosure is timely than

documented. For example, if disclosure were required to be in writing,

this might slow a banking entity's ability to provide the disclosure to

the relevant customer, which could impede the customer's ability to

consider the disclosed information and take steps to negate or

substantially mitigate the conflict's effect on the customer. The

Agencies further note that the final rule does 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.

---------------------------------------------------------------------------

\1609\ See Public Citizen; see also AFR et al. (Feb. 2012).

\1610\ See Sens. Merkley & Levin (Feb. 2012); ICFR; Occupy;

Alfred Brock.

\1611\ See, e.g., Arnold & Porter; Sens. Merkley & Levin (Feb.

2012); Better Markets (Feb. 2012); Public Citizen; AFR et al. (Feb.

2012); Lynda Aiman-Smith.

---------------------------------------------------------------------------

As noted above, one commenter expressed concern about the burdens

of disclosing inherent conflicts and stated such disclosure is

unnecessary because market participants understand inherent conflicts

of interest.\1612\ As noted in the proposal, certain inherent

conflicts, such as 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

permitted activities.\1613\

---------------------------------------------------------------------------

\1612\ See SIFMA et al. (Prop. Trading) (Feb. 2012); but see

Occupy.

\1613\ See Joint Proposal, 76 FR at 68893. Thus, the Agencies

are not adopting one commenter's suggestion that the final rule

consider all transactions by a banking entity to involve a material

conflict of interest because the banking entity is necessarily on

the opposite side of a transaction with its client, customer, or

counterparty. See Occupy.

---------------------------------------------------------------------------

The Agencies continue to believe that information barriers can be

an effective means of addressing conflicts of interest that may arise

through, for example, the spread of information among trading desks

engaged in different trading activities that may result in potentially

inappropriate informational advantage. The Agencies are not adopting

one commenter's suggestion that the final rule specify the particular

types of scenarios where information barriers may be effective \1614\

because, as discussed below, the Agencies believe banking entities are

better positioned to determine when information barriers may be

effective given their trading activities and business structure.\1615\

In response to one commenter's concern that information barriers may

result in the banking entity's management not being aware of the firm's

collective operations,\1616\ the Agencies note that information

barriers do not require this result. Rather, information barriers would

be established between relevant personnel or functions while other

personnel, including senior managers, internal auditors, and compliance

personnel, would have access to each group separated by the barrier.

---------------------------------------------------------------------------

\1614\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\1615\ The Agencies note examples of information barriers that

may address or substantially mitigate a material conflict of

interest include restrictions on information sharing, limits on

types of trading, prohibitions on common officers or employees

between functions. Such information barriers have been recognized in

Federal securities laws as a means to address or mitigate potential

conflicts of interest or other inappropriate activities. See, e.g.,

17 U.S.C. 78o(g).

\1616\ See Public Citizen.

---------------------------------------------------------------------------

The final rule continues to recognize that a banking entity may

address or substantially mitigate a conflict of interest through use of

information barriers. In order to address and mitigate a conflict of

interest through the use of the information barriers, a banking entity

is 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.\1617\ Importantly, the final 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 complied with the requirements of Sec.

75.7(b)(2)(i).\1618\

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\1617\ The Agencies note that a banking entity subject to

Appendix B of the final rule 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. 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. See Part VI.C.2.e., infra.

\1618\ 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.

---------------------------------------------------------------------------

While some commenters requested that the final rule include

additional limitations as part of implementing the material conflict of

interest provisions in section 13(d)(2), the Agencies do not believe

additional restrictions are appropriate at this time. 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.\1619\ In all cases, the question

of whether a material conflict of interest exists will depend on an

evaluation of the specific facts and circumstances. For example,

certain

[[Page 5937]]

simple transactions may implicate conflicts of interest that cannot be

mitigated by disclosure or restricted by information barriers. On the

other hand, certain highly structured and complex transactions may

involve conflicts of interest that can be mitigated by disclosure or

restricted by information barriers.

---------------------------------------------------------------------------

\1619\ 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.

---------------------------------------------------------------------------

The Agencies believe that conflicts of interest must be determined

and addressed in accordance with the specific facts and circumstances

presented. One commenter suggested that the proposed rule be modified

so that a banking entity could conclusively rely on information

barriers unless it knows or has reason to know that policies,

procedures, and controls establishing barriers would not be effective

in restricting the spread of information.\1620\ By focusing on whether

a banking entity knows or has reason to know that its policies and

procedures would not be effective, rather than on what the banking

entity knows or should reasonably know about a conflict of interest

that may involve or result in a material adverse effect on a client,

customer, or counterparty, the commenter's suggestion has the potential

to allow a banking entity to engage in transactions that involve a

material conflict of interest. Therefore, the Agencies have determined

not to adopt the commenter's suggested approach. Similarly, the

Agencies are rejecting some commenters' suggestions that the final rule

prescribe the method, scope, or specific content of disclosures.\1621\

The Agencies believe that specific guidance on disclosure may provide

an incentive for banking entities to consider the form of disclosure

provided, rather than whether disclosure can address the substance of

the conflict as determined by the specific facts and circumstances at

hand. Moreover, the Agencies believe banking entities are in the best

position to identify and evaluate the conflicts present in their

business as well as the most effective method of disclosing such

conflicts. Banking entities must tailor their compliance programs to

identify, monitor, and evaluate potential conflicts based on their

business structure and specific activities and customer

relationships.\1622\

---------------------------------------------------------------------------

\1620\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\1621\ See Occupy; ISDA (Apr. 2012); Better Markets (Feb. 2012);

SIFMA et al. (Prop. Trading) (Feb. 2012); ICFR; Alfred Brock; Public

Citizen; AFR et al. (Feb. 2012); Arnold & Porter; Sens. Merkley &

Levin (Feb. 2012).

\1622\ For a full discussion of the final rule's compliance

requirements, including a discussion of the specific compliance

requirements applicable to different banking entities, see Part

VI.C. of this SUPPLEMENTARY INFORMATION, infra.

---------------------------------------------------------------------------

Finally, some commenters requested that the final rule specifically

address the conflict of interest provisions related to asset-backed

securitizations contained in section 621 of the Dodd-Frank Act. As

explained below in Part VI.B.1., some securitizations are subject to

the final rule, and others such as securitizations of loans are not

subject to section 13 of the BHC Act. For any securitization that meets

the definition of covered fund under the final rule, relationships with

and transactions by a banking entity involving those securitizations

remain subject to the requirements of section 13, including the

requirements of section 13(d)(2). In addition, the banking entity would

be subject to the limitations contained in section 621 of the Dodd-

Frank Act and any rules regarding conflicts of interest relating to

securitizations implemented under that section. The final rule in no

way limits the application of section 621 of that Act with respect to

an asset-backed security that is subject to that section.

b. Definition of ``High-Risk Asset'' and ``High-Risk Trading Strategy''

1. Proposed Rule

Section 75.8(c) of the proposed rule defined ``high-risk asset''

and ``high-risk trading strategy'' for purposes of the proposed

limitations on permitted trading activities. Proposed Sec. 75.8(c)(1)

defined 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. Proposed Sec. 75.8(c)(2) defined 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.\1623\

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\1623\ See Joint Proposal, 76 FR at 68894. The Agencies noted

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). See Joint

Proposal, 76 FR at 68894 n.215.

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2. Comments on Proposed Limitations on High-Risk Assets and Trading

Strategies

With respect to the prohibition on transactions or activities that

expose banking entities to high-risk assets or high-risk trading

strategies, one commenter stated the provisions were effective,\1624\

while other commenters stated the proposed rule was too vague \1625\

and implied that banking entities may be required to exit positions in

periods of market stress, further reducing liquidity.\1626\ A few

commenters suggested the Agencies identify and prohibit certain types

of high-risk assets or high-risk trading strategies under the

rule.\1627\ In contrast, one commenter asserted the Agencies should not

specify certain classes of assets or trading strategies as ``high

risk.'' \1628\ A few commenters requested greater clarity on the

proposed definitions and suggested the Agencies provide additional

guidance.\1629\ One of these commenters suggested the Agencies simplify

compliance by establishing safe harbors, setting pre-determined risk

limits within risk-based approaches, or allowing individual banking

entities to set practical risk-based standards that the Agencies can

review.\1630\

---------------------------------------------------------------------------

\1624\ See Alfred Brock.

\1625\ See AFR et al. (Feb. 2012); Japanese Bankers Ass'n.;

Investure; AllianceBernstein; Comm. on Capital Markets Regulation.

\1626\ See Obaid Syed.

\1627\ See Sens. Merkley & Levin (Feb. 2012); Johnson & Prof.

Stiglitz; Occupy.

\1628\ See Alfred Brock.

\1629\ See Japanese Bankers Ass'n.; Sens. Merkley & Levin (Feb.

2012); Occupy; Public Citizen.

\1630\ See Japanese Bankers Ass'n.

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One commenter suggested integrating the ban on high-risk activities

throughout the rule and stated that, given the evolving nature of

financial markets, regulators should have the flexibility to update

criteria for identifying high-risk assets or high-risk trading

strategies.\1631\ This commenter stated the definition of high-risk

trading strategies was appropriately broad and flexible, but suggested

improving the rule by encompassing trading strategies that are so

complex the risk or value thereof cannot be reliably and objectively

determined.\1632\ The commenter also suggested that the quantitative

measurements collected under proposed Appendix A could be utilized to

help inform whether a high-risk asset or trading strategy exists.\1633\

---------------------------------------------------------------------------

\1631\ See Sens. Merkley & Levin (Feb. 2012).

\1632\ See Sens. Merkley & Levin (Feb. 2012).

\1633\ See Sens. Merkley & Levin (Feb. 2012).

---------------------------------------------------------------------------

One commenter stated that in large concentrations, all assets can

be high risk. This commenter suggested evaluating transactions on a

case-by-case basis and believed all activity exempted under section

13(d)(1) of the BHC Act should be viewed as ``high-risk'' absent prior

regulatory approval. This commenter further suggested that high-risk

assets or trading strategies be defined to include any asset or trading

strategy that would have forced a

[[Page 5938]]

banking entity to exit the market during the 2008 financial crisis, and

that leverage, rehypothecation, concentration limits, and high

frequency trading should be viewed as indicia of high-risk trading

strategies. Finally, this commenter suggested the Agencies require

banking entity CEOs to certify that their institution's activities do

not result in a material exposure to high-risk assets or high-risk

trading strategies.\1634\

---------------------------------------------------------------------------

\1634\ See Occupy.

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3. Final rule

After considering carefully the comments received, the Agencies

have modified the final rule to provide that a high-risk asset means an

asset or group of assets that would, if held by a banking entity,

significantly increase the likelihood that the banking entity would

incur a substantial financial loss or would pose a threat to the

financial stability of the United States. Similarly, the final rule

defines high-risk trading strategy to include any strategy that would,

if engaged in by a banking entity, significantly increase the

likelihood that the banking entity would incur a substantial financial

loss or would pose a threat to the financial stability of the United

States.

Importantly, under the final rule, banking entities that engage in

activities pursuant to an exemption must have a reasonably designed

compliance program in place to monitor and understand whether it is

exposed to high-risk assets or trading strategies. For instance, any

banking entity engaged in activity pursuant to the market-making

exemption in Sec. 75.4(b) must, as part of its compliance program,

have reasonably designed written policies and procedures, internal

controls, analysis and independent testing regarding the limits for

each trading desk, including limits on the level of exposures to

relevant risk factors that the trading desk may incur. These policies

and procedure and any activity conducted pursuant to the final rule

will be evaluated by the Agencies, as appropriate, as part of ensuring

the safety and soundness of banking entities and monitoring for

exposures to high-risk activities or assets.

While some commenters stated that the definition of high risk asset

or trading strategy should be more clearly defined, the Agencies

believe that it is appropriate to include a broad definition of these

terms that accounts for different facts and circumstances that may

impact whether a particular asset or trading strategy is high-risk with

respect to a banking entity. As stated by commenters, this framework is

effective and flexible enough to be utilized by the Agencies in a

variety of contexts. For instance, a trading strategy or asset may be

high-risk to one banking entity but not another, or may be high-risk to

a banking entity under some market conditions but not others. As part

of evaluating whether a banking entity is exposed to a high-risk asset

or trading strategy, the Agencies expect that a variety of factors will

be considered, such as the presence of excess leverage, rehypothecation

or excessively high concentration of assets, or unsafe and unsound

trading strategies.

We believe an approach limiting this provision's applicability to

certain permitted activities or creating a safe harbor for certain

assets or trading strategies would be inconsistent with the statutory

language, which prohibits any permitted activity that involves or

results in a material exposure to a high-risk asset or high-risk

trading strategy.\1635\ In addition, the Agencies decline to identify

any particular assets or trading strategies as per se high-risk because

a determination of the specific risk posed to a banking entity depends

on the facts and circumstances.\1636\ Certain facts and circumstances

may include, but are not limited to, the amount of capital at risk in a

transaction, whether or not the transaction can be hedged, the amount

of leverage present in the transaction, and the general financial

condition of the banking entity engaging in the transaction. In

response to one commenter's recommendation that the Agencies adopt a

CEO certification requirement specific to the high-risk

provisions,\1637\ the Agencies believe such a requirement is

unnecessary in light of the required management framework in the

compliance program provision of Sec. 75.20 of the final rule, as well

as the CEO certification requirement included in the final rule.\1638\

---------------------------------------------------------------------------

\1635\ See BDA (Feb. 2012); Japanese Bankers Ass'n.

\1636\ See Occupy.

\1637\ See Occupy.

\1638\ See Sec. 75.20 and Appendix B of the final rule, also

discussed in Part VI.C., infra.

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c. Limitations on Permitted Activities That Pose a Threat to Safety and

Soundness of the Banking Entity or the Financial Stability of the

United States

Finally, as the Agencies did not receive any comments on the

proposed rule's limitations on permitted activities that pose a threat

to the safety and soundness of the banking entity or to the financial

stability of the United States and the proposed approach mirrored the

statutory language, the Agencies have determined no changes to final

rule are necessary.

B. Subpart C--Covered Fund Activities and Investments

As noted above and except as otherwise permitted, section

13(a)(1)(B) of the BHC Act generally prohibits a banking entity from

acquiring or retaining any ownership in, or acting as sponsor to, a

covered fund.\1639\ Section 13(d) of the BHC Act contains certain

exemptions to this prohibition. Subpart C of the final rule implements

these and other provisions of section 13 related to covered funds.

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

final rule, as well as Appendix B, to the extent applicable.

---------------------------------------------------------------------------

\1639\ See 12 U.S.C. 1851(a)(1)(B).

---------------------------------------------------------------------------

1. Section 75.10: Prohibition on Acquisition or Retention of Ownership

Interests in, and Certain Relationships With, a Covered Fund

Section 75.10 of the final rule defines the scope of the

prohibition on the acquisition and retention of ownership interests in,

and certain relationships with, a covered fund. It also defines a

number of key terms, including the definition of covered fund.

The term ``covered fund'' specifies the types of entities to which

the prohibition contained in Sec. 75.10(a) applies, unless the

activity is specifically permitted under an available exemption

contained in subpart C of the final rule.\1640\ The final rule modifies

the proposed definition of covered fund in a number of key aspects. The

Agencies have defined the term ``covered fund'' with reference to

sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940

(``Investment Company Act'') with some additions and subject to a

number of exclusions, several of which have been modified from

permitted activity exemptions included in the proposal.

---------------------------------------------------------------------------

\1640\ See final rule Sec. Sec. 75.10(b)-(c). The term banking

entity is defined in final rule Sec. 75.2(c).

---------------------------------------------------------------------------

The Agencies have tailored the final definition to include entities

of the type that the Agencies believe Congress intended to capture in

its definition of private equity fund and hedge fund in section

13(h)(2) of the BHC Act by reference to section 3(c)(1) and 3(c)(7) of

[[Page 5939]]

the Investment Company Act. Thus, the final definition focuses on the

types of entities formed for the purpose of investing in securities or

derivatives for resale or otherwise trading in securities or

derivatives, and that are offered and sold in offerings that do not

involve a public offering, but typically involve offerings to

institutional investors and high-net worth individuals (rather than to

retail investors). These types of funds are not subject to all of the

securities law protections applicable with respect to funds that are

registered with the SEC as investment companies, and the Agencies

therefore believe that these types of entities may be more likely to

engage in risky investment strategies. At the same time, the Agencies

have tailored the definition to exclude entities that have more general

corporate purposes and do not present the same risks for banking

entities as those associated with the funds described above, as well as

certain other entities as further discussed below.

The final rule also contains a revised version of the proposal's

treatment of certain foreign funds as covered funds, which has been

modified from the proposal and tailored to include only the types of

foreign funds that the Agencies believe are intended to be the focus of

the statute, such as certain foreign funds that are established by U.S.

banking entities and not otherwise subject to the Investment Company

Act.

The Agencies have not included all commodity pools within the

definition of covered fund as proposed. Instead, and as discussed in

more detail below, the Agencies have included only commodity pools for

which the commodity pool operator has claimed exempt pool status under

section 4.7 of the CFTC's regulations or that could qualify as exempt

pools and which have not been publicly offered \1641\ to persons who

are not qualified eligible persons under section 4.7 of the CFTC's

regulations.\1642\ Qualified eligible persons are typically

institutional investors, banking entities and high net worth

individuals (rather than retail investors). This more tailored

approach, together with the various exclusions from the covered fund

definition in the final rule, is designed to include as covered funds

those commodity pools that are similar to funds that rely on section

3(c)(1) or 3(c)(7) while not also including as covered funds entities,

like commercial end-users or registered investment companies, whose

activities do not implicate the concerns that section 13 was designed

to address.

---------------------------------------------------------------------------

\1641\ See infra note 1726 and accompanying text regarding the

meaning of the term ``offer'' as used in the final rule's inclusion

of certain commodity pools as covered funds.

\1642\ See final rule Sec. 75.10(b)(1)(ii).

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Finally, other related terms, including ``ownership interest,''

``resident of the United States,'' ``sponsor,'' and ``trustee,'' are

also defined in Sec. 75.10(d) of the final rule.\1643\ As explained

below, these terms are largely defined in the same manner as in the

proposal although with certain changes, including changes to help

clarify the scope of these definitions as requested by commenters. Some

of these terms and related provisions also have been reorganized to

improve clarity. As explained in more detail below, the Agencies

received a number of comments relating to some of the terms defined in

Sec. 75.10. Some comments directly relate to the scope of the proposed

rule and the economic effects associated with the prohibitions on

covered funds activities and investments, some of which commenters

argued did not further the purposes of section 13.\1644\ The Agencies

have carefully considered these and other comments when defining the

key terms used in the statute and in providing certain exclusions to

the definition of the term covered fund. The Agencies also have sought

to provide guidance below, where appropriate, on how these key terms

would operate in order to better enable banking entities to understand

their obligations under section 13 and the final rule.

---------------------------------------------------------------------------

\1643\ See final rule Sec. 75.10(d)(6), (8), (9), and (10).

\1644\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012); BoA;

Goldman (Covered Funds); Rep. Himes; SVB; Scale.

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a. Prohibition Regarding Covered Fund Activities and Investments

Section 75.10(a) of the final rule implements section 13(a)(1)(B)

of the BHC Act and prohibits a banking entity from, directly or

indirectly, acquiring or retaining as principal an equity, partnership,

or other ownership interest in, or acting as sponsor to, a covered

fund, unless otherwise permitted under subpart C of the final

rule.\1645\ This provision of the rule reflects the statutory

prohibition.

---------------------------------------------------------------------------

\1645\ See final rule Sec. 75.10(a).

---------------------------------------------------------------------------

The general prohibition in Sec. 75.10(a) of the proposed rule

applied solely to the acquisition or retention of an ownership interest

in, or acting as sponsor to, a covered fund, ``as principal.'' \1646\

Commenters generally supported this approach, arguing that applying the

prohibition related to covered fund activities and investments by a

banking entity only to instances where the banking entity acts as

principal is consistent with the statutory focus on principal

activity.\1647\ The final rule takes this approach as discussed below.

---------------------------------------------------------------------------

\1646\ See proposed rule Sec. 75.10(a); see also Joint

Proposal, 76 FR at 68896.

\1647\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012);

SIFMA et al. (Mar. 2012).

---------------------------------------------------------------------------

The proposed rule and preamble accompanying it described potential

exemptions from the definition of ownership interest for a variety of

interests, including interests related to employee benefit plans,

interests held in the ordinary course of collecting a debt previously

contracted, positions as trustee, or interests acquired as agent,

broker or custodian. Commenters provided information on each of these

types of ownership interests, and generally supported excluding each of

these from the section's prohibition on acquiring or retaining an

ownership interest in a covered fund.

A significant number of commenters focused on employee benefit

plans. Commenters generally argued that the prohibition in section

13(a) of the BHC Act did not encompass interests held on behalf of

employees through an employee benefit plan. While the proposed rule did

not explicitly cover certain ``qualified plans'' under the Internal

Revenue Code, a number of commenters argued that the prohibition should

not cover activity or investments related to other types of employee

benefit plans that are not a ``qualified plan'' under the Internal

Revenue Code.\1648\ A significant number of commenters urged exclusion

of interests in and relationships with foreign employee benefit

plans.\1649\ Commenters argued that the risks of investments made

through employee benefit plans are borne by the employee beneficiaries

of these plans, and any decision to cover employee benefit plans or

investments made by these plans under the prohibitions in section 13 of

the BHC Act would eliminate or severely restrict the availability of

employee programs that are widely offered, regulated and endorsed under

a system of Federal, state and foreign laws.\1650\

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\1648\ See Credit Suisse (Williams); Arnold & Porter; UBS; Hong

Kong Inv. Funds Ass'n.

\1649\ See, e.g., Credit Suisse (Williams); Arnold & Porter;

UBS; NAB; Hong Kong Inv. Funds Ass'n; Australian Bankers Ass'n.

(Feb. 2012).

\1650\ See, e.g., Arnold & Porter.

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Commenters also supported the exemption under the proposed rule for

holdings in satisfaction of a debt previously contracted in good

faith.\1651\

[[Page 5940]]

This provision of the proposal recognized that banking entities may

acquire an ownership interest in or relationship with a covered fund as

a result of a counterparty's failure to repay a bona fide debt and

without an intent to engage in those activities as principal.\1652\

---------------------------------------------------------------------------

\1651\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012); LSTA

(Feb. 2012).

\1652\ See proposed rule Sec. 75.14(b).

---------------------------------------------------------------------------

Several commenters urged revision to the proposal to add a specific

exclusion for investments held by a banking entity in the capacity of

trustee (including as trustee for a charitable trust).\1653\ These

commenters argued that failing to recognize and exempt these types of

activities in the final rule would prevent banking entities that act as

trustees from effectively meeting their trust and fiduciary obligations

and from providing these services to customers. Commenters also argued

that the exemption for trust activities should not be dependent on the

duration of the trust because the law governing the duration of trusts

is changing and varies across jurisdictions.\1654\

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\1653\ See, e.g., ABA (Keating).

\1654\ See, e.g., ABA (Keating); Arnold & Porter; NAB.

---------------------------------------------------------------------------

As with the proposed rule, the prohibition in Sec. 75.10(a) of the

final rule applies only to the acquisition or retention of an ownership

interest in, or sponsorship of, a covered fund as principal. The

Agencies continue to believe section 13 of the BHC Act was designed to

address the risks attendant to principal activity and not those that

are borne by customers of the banking entity or for which the banking

entity lacks design or intent to take a proprietary interest as

principal.

In order to address commenter concerns regarding the types of

activity that are subject to the prohibition, the Agencies have

modified and reorganized the final rule to make the scope of acting

``as principal'' clear and more consistent with the proprietary trading

restrictions under the final rule.\1655\ The final rule provides that

the prohibition does not include acquiring or retaining an ownership

interest in a covered fund by a banking entity: (1) Acting solely as

agent, broker, or custodian, so long as the activity is conducted for

the account of, or on behalf of, a customer, and the banking entity and

its affiliates do not have or retain beneficial ownership of the

ownership interest; \1656\ (2) through a deferred compensation, stock-

bonus, profit-sharing, or pension plan of the banking entity (or an

affiliate thereof) that is established and administered in accordance

with the law of the United States or a foreign sovereign, if the

ownership interest is held or controlled directly or indirectly by a

banking entity as trustee for the benefit of people who are or were

employees of the banking entity (or an affiliate thereof); \1657\ (3)

in the ordinary course of collecting a debt previously contracted in

good faith, provided that the banking entity divests the ownership

interest as soon as practicable, and in no event may the banking entity

retain such instrument for longer than such period permitted by the

appropriate agency; or (4) on behalf of customers as trustee or in a

similar fiduciary capacity for a customer that is not a covered fund,

so long as the activity is conducted for the account of, or on behalf

of, the customer, and the banking entity and its affiliates do not have

or retain beneficial ownership of such ownership interest.\1658\

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\1655\ See final rule Sec. 75.3(d)(7)-(9).

\1656\ A banking entity acting as agent, broker, or custodian is

not acting ``as principal'' under the final rule so long as the

activity is conducted for the account of, or on behalf of, a

customer and the banking entity does not have or retain beneficial

ownership of such ownership interest, as noted above. This provision

is consistent with the final rule's treatment of banking entities

acting on behalf of customers as trustee or in a fiduciary capacity.

\1657\ The Agencies note that this provision does not permit

joint investments between the banking entity and its employees.

Rather, this provision is intended to enable banking entities to

maintain deferred compensation and other similar plans formed for

the benefit of employees. The Agencies recognize that, since it is

possible an employee may forfeit its interest in such a plan, the

banking entity may have a residual or reversionary interest in the

assets referenced under the plan. However, other than such residual

or reversionary interests, a banking entity may not rely on this

provision to invest in a covered fund.

\1658\ See final rule Sec. 75.10(a)(2). For instance, as part

of engaging in its traditional trust company functions, a bank or

savings association typically may act through an entity that is

excluded from the definition of investment company under section

3(c)(3) or 3(c)(11). This would be included within the scope of

acting on behalf of customers as trustee or in a similar fiduciary

capacity, provided that it meets the applicable requirements of the

exclusion under the final rule.

---------------------------------------------------------------------------

Because these activities do not involve the banking entity engaging

in an activity intended or designed to take ownership interests in a

covered fund as principal, they do not appear to be the types of

activities that section 13 of the BHC Act was designed to address.

However, the Agencies note that in order to prevent a banking entity

from evading the requirements of section 13 and the final rule, the

exclusions for these activities do not permit a banking entity to

engage in establishing, organizing and offering, or acting as sponsor

to a covered fund in a manner other than as permitted elsewhere in the

final rule. The Agencies intend to monitor these activities and

investments for efforts to evade the restrictions in section 13 of the

BHC Act and the final rule on banking entities' investments in and

relationships with covered funds.

b. ``Covered Fund'' Definition

Section 13(h)(2) of the BHC Act defines hedge fund and private

equity fund to mean an issuer that would be an investment company, but

for section 3(c)(1) or 3(c)(7) of the Investment Company Act, or ``such

similar funds'' as the Agencies determine by rule.\1659\ Given that the

statute defines ``hedge fund'' and ``private equity fund'' without

differentiation, the proposed rule and the final rule combine the terms

into the definition of a ``covered fund.'' Sections 3(c)(1) and 3(c)(7)

of the Investment Company Act are exclusions 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.\1660\ The

proposal included as a covered fund any entity that would be an

investment company but for the exclusion from that definition contained

in section 3(c)(1) or 3(c)(7) of the Investment Company Act, any

foreign entity that would also be an investment company but for those

same exclusions were the foreign entity to be organized or offered in

the United States, and a commodity pool as defined in section 1a(10) of

the Commodity Exchange Act.\1661\ The preamble to the proposal

recognized that this definition was broad and specifically requested

comment on whether and how the definition of covered fund should be

modified for purposes of the final rule.

---------------------------------------------------------------------------

\1659\ See 12 U.S.C. 1851(h)(2).

\1660\ 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: (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 propose to make a public

offering of such securities. See 15 U.S.C. 80a-3(c)(1) and (c)(7).

\1661\ See proposed rule Sec. 75.10(b)(1).

---------------------------------------------------------------------------

Commenters contended that the definition of covered fund should not

focus exclusively on whether an entity relies on section 3(c)(1) or

3(c)(7) of the Investment Company Act. Commenters argued that sections

3(c)(1) and 3(c)(7) of the Investment Company Act are exclusions

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. Under the Investment Company Act, any entity that holds

investment securities (i.e.,

[[Page 5941]]

generally all securities other than U.S. government securities)

representing at least 40 percent of the entity's total assets would be

an investment company.\1662\ According to commenters, this definition

and the accompanying exclusions are part of a securities law and

regulatory framework designed for purposes different than the

prudential purpose that underlies section 13 of the BHC Act.\1663\

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\1662\ 15 U.S.C. 80a-3(a)(1)(A) and (C). The definition of

securities is very broad under the Investment Company Act and has

been interpreted to include instruments such as loans, that would

not be regarded as securities under the Securities Act of 1933 and

the Securities Exchange Act of 1934. In addition, the determination

of what constitutes an ``investment security'' under the Investment

Company Act requires complex analysis and consideration of a broad

set of facts and circumstances.

\1663\ See, e.g., NVCA.

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A number of comments received on the proposal argued that the

proposed definition of covered fund was overly broad and would lead to

anomalous results inconsistent with the words, structure, and purpose

of section 13.\1664\ For instance, many commenters asserted that the

proposed rule's definition of covered fund would cause a number of

commonly used corporate entities that are not traditionally thought of

as hedge funds or private equity funds, such as wholly-owned

subsidiaries, joint ventures, and acquisition vehicles, to be subject

to the covered fund restrictions of section 13. These commenters argued

that this interpretation of section 13 would cause a disruption to the

operations of banking entities and their closely related affiliates

that does not relate to the intent of section 13 and therefore cause an

unnecessary burden on banking entities. Commenters argued that the

words, structure and purpose of section 13 allow the Agencies to adopt

a more tailored definition of covered fund that focuses on vehicles

used for investment purposes that were the target of section 13's

restrictions.

---------------------------------------------------------------------------

\1664\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012);

BlackRock; AHIC; Sen. Carper et al.; Rep. Garrett et al.

---------------------------------------------------------------------------

In particular, commenters requested that the final rule exclude at

least the following from the definition of covered fund: U.S.

registered investment companies (including mutual funds); the foreign

equivalent of U.S. registered investment companies; business

development companies; wholly-owned subsidiaries; joint ventures;

acquisition vehicles; financial market utilities; foreign pension or

retirement funds; insurance company separate accounts; loan

securitizations, including asset-backed commercial paper conduits; cash

management vehicles or cash collateral pools; credit funds; real estate

investment trusts; various securitization vehicles; tender option bond

programs; and venture capital funds.\1665\ Commenters requested some of

these exclusions in order to mitigate the impact of the proposal's

inclusion of commodity pools as part of the definition of covered

fund.\1666\

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\1665\ See ABA (Keating); ABA (Abernathy); SIFMA et al. (Covered

Funds) (Feb. 2012); Allen & Overy (on behalf of Foreign Bank Group);

Allen & Overy (on behalf of Canadian Banks); Deutsche Bank

(Repackaging Transactions); ICI (Feb. 2012); Putnam; JPMC; GE (Feb.

2012); Chamber (Feb. 2012); Rep. Himes; BOK; Ass'n. of Institutional

Investors (Feb. 2012); Wells Fargo (Covered Funds); BoA; NAIB et

al.; PNC; SunTrust; Nationwide; STANY; BNY Mellon et al.; RMA;

Goldman (Covered Funds); Japanese Bankers Ass'n; IRSG; ISDA (Feb.

2012); IIB/EBF; Citigroup (Jan. 2012); SSgA (Feb. 2012); State

Street (Feb. 2012); Eaton Vance; Fidelity; SBIA; River Cities;

Ashurst; Sen. Hagan; Sen. Bennet.

\1666\ As discussed below, the Agencies have modified the final

rule to include only certain commodity pools within the definition

of covered fund.

---------------------------------------------------------------------------

Some commenters argued that the proposal failed to distinguish

between different types of investment funds.\1667\ These commenters

expressed the view that the statute provides the Agencies with the

discretion to distinguish between investment funds generally and a

subset of funds--hedge funds and private equity funds--that may engage

in particularly risky trading and investment activities. For example,

several commenters argued that the proposed rule's restrictions on

covered fund investments should not cover venture capital funds that

provide investment capital to new businesses.\1668\ Others argued an

exclusion for securitization vehicles such as securitizations that are

backed, in whole or in part, by assets that are not loans, including

corporate debt repackagings,\1669\ CLOs,\1670\ ABCP conduits,\1671\

insurance-linked securities,\1672\ and synthetic securitizations backed

by derivatives.\1673\

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\1667\ See NVCA; see also SIFMA et al. (Covered Funds) (Feb.

2012); ABA (Keating).

\1668\ See, e.g., ABA (Keating); ABA (Abernathy); Canaan

(Young); Canaan (Ahrens); Canaan (Kamra); Growth Managers; River

Cities; SVB; EVCA.

\1669\ See AFME et al.; Allen & Overy (on behalf of Foreign Bank

Group); ASF (Feb. 2012); Cleary Gottlieb; Deutsche Bank (Repackaging

Transactions); SIFMA (Securitization) (Feb. 2012).

\1670\ See SIFMA (Securitization) (Feb. 2012); Allen & Overy (on

behalf of Foreign Bank Group); ASF (Feb. 2012); Cleary Gottlieb;

Credit Suisse (Williams); JPMC; LSTA (Feb. 2012).

\1671\ See Allen & Overy (on behalf of Foreign Bank Group); ASF

(Feb. 2012); Credit Suisse (Williams); Eaton Vance; Fidelity; GE

(Feb. 2012); GE (Aug. 2012); ICI (Feb. 2012); IIB/EBF; JPMC; PNC;

RBC; SIFMA (Securitization) (Feb. 2012); AFME et al.

\1672\ See AFME et al.; SIFMA (Securitization) (Feb. 2012).

\1673\ See AFME et al.; ASF (Feb. 2012); Cleary Gottlieb; Credit

Suisse (Williams); SIFMA (Securitization) (Feb. 2012); ABA

(Keating).

---------------------------------------------------------------------------

As a potential solution to some of these concerns, a number of

commenters argued that the Agencies should define covered fund by

reference to characteristics that are designed to distinguish hedge

funds and private equity funds from other types of entities that rely

on section 3(c)(1) or 3(c)(7) of the Investment Company Act.\1674\

Commenters believed this approach would help exclude some of the

corporate vehicles and funds mentioned above that they did not believe

were intended by Congress to be included as hedge funds and private

equity funds and therefore reduce costs that, in the commenters' view,

did not further the purposes of section 13.\1675\

---------------------------------------------------------------------------

\1674\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012);

BlackRock; Credit Suisse (Williams); SSgA (Feb. 2012); State Street

(Feb. 2012); Deutsche Bank (Repackaging Transactions); Allen & Overy

(on behalf of Foreign Bank Group).

\1675\ See SIFMA et al. (Covered Funds) (Feb. 2012); AFME et

al.; Allen & Overy (on behalf of Foreign Bank Group); ASF (Feb.

2012); Ashurst; Barclays; BDA (Feb. 2012); Credit Suisse (Williams);

Commercial Real Estate Fin. Council; Fidelity; ICI (Feb. 2012); ISDA

(Feb. 2012); JPMC; Nuveen Asset Mgmt.; PNC; RBC; SIFMA et al.

(Covered Funds) (Feb. 2012); SIFMA (Municipal Securities) (Feb.

2012); SSgA (Feb. 2012); State Street (Feb. 2012); Vanguard; Wells

Fargo (Covered Funds).

---------------------------------------------------------------------------

These commenters proposed a number of different potential types of

characteristics for defining hedge fund and private equity fund. Some

commenters focused on certain structural or investment characteristics

found in traditional private equity funds and hedge funds, such as

investor redemption rights, performance compensation fees, leverage and

the use of short-selling.\1676\ Another commenter argued that the

characteristics used to define a covered fund should focus on the types

of speculative behavior that the statute was intended to address,

citing characteristics such as volatility of asset performance and high

leverage.\1677\

---------------------------------------------------------------------------

\1676\ See Ass'n. of Institutional Investors (Feb. 2012);

Barclays; JPMC; SIFMA et al. (Covered Funds) (Feb. 2012); see also

FSOC study at 62-63 (suggesting a characteristics-based approach

considering compensation structure; trading/investment strategy; use

of leverage; investor composition); ABA (Keating); BNY Mellon et

al.; Northern Trust, SSgA (Feb. 2012); State Street (Feb. 2012);

Deutsche Bank (Repackaging Transactions); T. Rowe Price; RMA

(suggesting use of characteristics derived from the SEC's Form PF

for registration of investment advisers of private funds).

\1677\ See RBC (citing FSOC study).

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In contrast to the majority of the commenters, one commenter urged

that characteristics be used to expand the proposed definition to

include any

[[Page 5942]]

issuer that exhibits characteristics of proprietary trading that the

statute prohibits to be done by a banking entity.\1678\ According to

this commenter, any fund engaging in more than minimal proprietary

trading should be a covered fund and subject to the requirements of

section 13.

---------------------------------------------------------------------------

\1678\ See Occupy.

---------------------------------------------------------------------------

However, not all commenters supported a characteristics-based

definition. One commenter opposed a characteristics-based definition,

suggesting that the final rule rely only on the statutory reference to

the Investment Company Act, and arguing that using characteristics to

define a covered fund (e.g., leverage) could create opportunities for

circumvention of the rule.\1679\ Commenters that generally supported

the proposed definition argued that its broad scope prevented

circumvention.\1680\

---------------------------------------------------------------------------

\1679\ See AFR et al. (Feb. 2012).

\1680\ See Sens. Merkley & Levin (Feb. 2012); AFR et al. (Feb.

2012); Alfred Brock.

---------------------------------------------------------------------------

One commenter argued in favor of broadening the definition of

covered fund to include entities that rely on an exclusion from the

definition of investment company other than those contained in section

3(c)(1) and 3(c)(7), such as section 3(c)(2) (which provides an

exclusion for underwriters and brokers) or 3(c)(6) (which provides an

exclusion for entities engaged in a business other than investing in

securities).\1681\ By contrast, other commenters argued that an entity

should not be considered a covered fund if the entity relies on an

exclusion or exemption contained in the Investment Company Act other

than an exclusion contained in section 3(c)(1) or 3(c)(7) under that

Act, such as the exclusion contained in section 3(c)(3) for bank

collective investment funds.\1682\

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\1681\ See Occupy (also arguing in favor of including entities

that rely on rule 3a-1 (which provides an exemption for issuers that

hold less than 45% of their assets in securities excluding

government securities) or 3a-6 (which provides an exemption for

foreign banks and insurance companies) to avoid being regulated as

investment companies under the Investment Company Act).

\1682\ See, e.g., ABA (Keating).

---------------------------------------------------------------------------

The Agencies have carefully considered all of the comments related

to the definition of covered fund. While the Agencies believe that the

proposal reflected a reasonable interpretation of the statutory

provision, on further review and in light of the comments the Agencies

have determined to adopt a different approach. The Agencies have

revised the final rule to address many of the concerns raised by

commenters regarding the scope of the original proposal in a manner the

Agencies believe is a better reading of the statutory provision because

it is both consistent with the language, purpose and structure of

section 13 and avoids unintended consequences of the less precise

definitional approach of the proposal.

In the final rule, the Agencies have joined the definitions of

``hedge fund'' and ``private equity fund'' into a single definition

``covered fund'' (as in the statute) and have defined this term as 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 with a

number of express exclusions and additions (explained below) as

determined by the Agencies. Thus, for example, an entity that invests

in securities and relies on any exclusion or exemption from the

definition of ``investment company'' under the Investment Company Act

other than the exclusion contained in section 3(c)(1) or 3(c)(7) of

that Act would not be considered a covered fund so long as it satisfies

the conditions of another Investment Company Act exclusion or

exemption.\1683\ Such an entity would not be an investment company but

for section 3(c)(1) or 3(c)(7), and the Agencies have modified the

final rule to explicitly exclude such an entity.\1684\

---------------------------------------------------------------------------

\1683\ For instance, bank common trust and collective funds that

qualify for the exclusion from the definition of investment company

pursuant to section 3(c)(3) or 3(c)(11) of the Investment Company

Act are not covered funds. See 15 U.S.C. 78a-3(c)(3) and (c)(11).

These funds are subject to supervision and regulation by a Federal

banking agency, thus helping to distinguish them from traditional

hedge funds and private equity funds which are generally not

themselves subject to such supervision or regulation.

\1684\ See final rule Sec. 75.10(c)(12).

---------------------------------------------------------------------------

The Agencies believe this definition is consistent with the words,

structure, purpose and legislative history of section 13 of the BHC

Act. As noted above, section 13(h)(2) provides that the terms ``hedge

fund'' and ``private equity fund'' mean an issuer that would be an

investment company as defined in the Investment Company Act (15 U.S.C.

80a-1 et seq.), but for section 3(c)(1) or 3(c)(7) of that Act, or such

similar funds as the Agencies may, by rule, as provided in subsection

(b)(2), determine.\1685\ The statutory provision contains two parts: A

first part that refers to any issuer that is ``an investment company,

as defined in the Investment Company Act, but for section 3(c)(1) and

3(c)(7) of the Act''; and a second part that covers ``such similar

funds as the [Agencies] may, by rule . . . determine.'' The proposed

rule offered a reading of this provision as a simple concurrent

definition with two self-contained, supplementary parts. Under this

approach, all entities covered by part one of the definition would be

included in the definitions of ``hedge fund'' and ``private equity

fund,'' and the role of the Agencies under the second part was limited

to considering whether and how to augment the scope of the primary

statutory definition.

---------------------------------------------------------------------------

\1685\ See 12 U.S.C. 1851(h)(2) (emphasis added).

---------------------------------------------------------------------------

As noted above, commenters argued that this interpretation led to

unintended consequences that were not consistent with other provisions

of section 13 or the purposes of section 13, and that other

interpretations of the definition of covered fund were consistent with

both the words and the purpose of the statute. Also as explained above,

commenters offered multiple alternative interpretations of the

definition of, the scope of the prohibition on ownership interests in,

and relationships with, a covered fund.\1686\

---------------------------------------------------------------------------

\1686\ In addition to the readings described above, one

commenter argued that the section could be read to provide that both

the reference to issuers covered by section 3(c)(1) or 3(c)(7) of

the Investment Company Act in the first part of section 13(h)(2) and

the reference to similar funds in the second part of the section

should be read as qualified by the clause ``as the Agencies may by

rule. . . determine.'' Under this reading, Congress granted the

Agencies authority to determine by rule whether an entity described

by the first part would be covered and whether an issuer would be

deemed to be a similar fund under the second part. See SIFMA et al.

(Covered Funds) (Feb. 2012).

---------------------------------------------------------------------------

The Agencies believe that the language of section 13(h)(2) can best

be interpreted to provide two alternative definitions of the entities

to be covered by the statutory terms ``hedge fund'' and ``private

equity fund.'' Under this reading, the first part of section 13(h)(2)

contains a base definition that references the noted exclusions under

the Investment Company Act (the ``default definition''), while the

second part grants the Agencies the authority to adopt an alternate

definition that is triggered by agency action (the ``tailored

definition''). Thus, if the Agencies do not act by rule, the definition

is set by reference to the Investment Company Act and the relevant

exclusions alone; if the Agencies act by rule, the definitions are set

by the Agencies under that rule. As noted above, the Agencies have

determined to exercise the authority under the second part of the

statute to define ``hedge fund'' and ``private equity fund'' in the

final rule.

Relying on the Agencies' authority to adopt an alternative,

tailored definition of ``hedge fund'' and ``private equity fund,'' the

final rule references funds that are similar to the funds in the base

[[Page 5943]]

alternative provided in the first alternative definition--that is, an

issuer that would be an investment company under the Investment Company

Act but for section 3(c)(1) or 3(c)(7) of that Act. The additions and

exclusions from that definition represent further determinations by the

Agencies regarding the scope of that definition that were made in the

course of a rulemaking conducted in accordance with section 13(b)(2) of

the BHC Act.

The Agencies believe that this reading of the statutory provision

is consistent with the purpose of section 13. That purpose appears to

be to limit the involvement of banking entities in high-risk

proprietary trading, as well as their investment in, sponsorship of,

and other connections with, entities that engage in investment

activities for the benefit of banking entities, institutional investors

and high-net worth individuals.\1687\ Further, the Agencies believe

that the provision permits them to tailor the scope of the definition

to funds that engage in the investment activities contemplated by

section 13 (as opposed, for example, to vehicles that merely serve to

facilitate corporate structures); doing so allows the Agencies to avoid

the unintended results, some of which commenters identified, that might

follow from a definition that is inappropriately imprecise.\1688\

---------------------------------------------------------------------------

\1687\ See 156 Cong. Reg. S.5894-5895 (daily ed. July 15, 2010)

(statement of Sen. Merkley).

\1688\ The Agencies believe that the choice of the tailored

definition is supported by the legislative history that suggests

that Congress may have foreseen that its base definition could lead

to unintended results and might be overly broad, too narrow, or

otherwise off the mark. Part two of the statutory definition was not

originally included in the bill reported by the Senate Committee on

April 30, 2010. While the addition of part two did not receive

specific comment, Rep. Frank, a co-sponsor and principal architect

of the Dodd-Frank Act, noted that the default definition ``could

technically apply to lots of corporate structures, and not just the

hedge funds and private equity funds'' and confirmed that ``[w]e do

not want these overdone.'' See 156 Cong. Rec. H5226 (daily ed. June

30, 2010) (statement of Reps. Himes and Frank) (noting intent that

subsidiaries or joint ventures not be included within the definition

of covered fund); 156 Cong. Rec. S5904-05 (daily ed. July 15, 2010)

(statement of Sens. Boxer and Dodd) (noting broad definition of

hedge fund and private equity fund and recommending that the

Agencies take steps to ensure definition is reasonably tailored).

---------------------------------------------------------------------------

The Agencies also note that nothing in the structure or history of

the Dodd-Frank Act suggests that the definition of hedge fund and

private equity fund was intended to necessitate a fundamental

restructuring of banking entities by disallowing investments in common

corporate vehicles such as intermediate holding companies, joint

operating companies, acquisition vehicles and similar entities that do

not engage in the types of investment activities contemplated by

section 13. Moreover, other provisions of the Dodd-Frank Act and

existing banking laws and regulations would be undermined or vitiated

by a reading that restricts investments in these types of corporate

vehicles and structures.\1689\

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\1689\ For example, the Dodd-Frank Act requires banking entities

to serve as a source of financial strength to their insured

depository institutions and requires certain banking entities to

form intermediate holding companies to separate their financial and

non-financial activities. See Sections 167, 616(d) & 626 of the

Dodd-Frank Act. These provisions would be severely undermined if the

prohibitions on investments and activities contained in section 13

were applied to ownership of intermediate holding companies. For

instance, a bank holding company would not be able to serve as a

source of strength to an intermediate holding company (or any

subsidiary thereof) that is a covered fund due to the transaction

restrictions contained in section 13(f). See 12 U.S.C. 1851(f). As

another example, the Agencies have made certain modifications to the

final rule to make clear that it will not affect the resolution

authority of the Federal Deposit Insurance Corporation, including by

excluding from the covered fund definition issuers formed by or on

behalf of the Corporation for the purpose of facilitating the

disposal of assets acquired in the Corporation's capacity as

conservator or receiver. See Sec. 75.10(c)(13).

---------------------------------------------------------------------------

Based on the interpretive and policy considerations raised by

commenters, the language of section 13(h)(2), and the language,

structure, and purpose of the Dodd-Frank Act, the Agencies have adopted

a tailored definition of covered fund in the final rule that covers

issuers of the type that would be investment companies but for section

3(c)(1) or 3(c)(7) of the Investment Company Act with exclusions for

certain specific types of issuers in order to focus the covered fund

definition on vehicles used for the investment purposes that were the

target of section 13. The definition of covered fund under the final

rule also includes certain funds organized and offered outside of the

United States in order to address foreign fund structures and certain

commodity pools that might otherwise allow circumvention of the

restrictions of section 13. The Agencies also expect to exercise the

statutory anti-evasion authority provided in section 13(e) of the BHC

Act and other prudential authorities in order to address instances of

evasion.\1690\

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\1690\ As discussed in Part VI.C.1 of this SUPPLEMENTARY

INFORMATION regarding the compliance program requirements of the

final rule, the Agencies will consider information maintained and

provided by banking entities under the compliance program mandate to

help monitor potential evasions of the prohibitions and restrictions

of section 13. Additionally and consistent with the statute, the

final rule permits the Agencies to jointly determine to include

within the definition of covered fund any fund excluded from that

definition. The Agencies expect that this authority may be used to

help address situations of evasion.

---------------------------------------------------------------------------

As discussed above, an alternative approach to defining a covered

fund would be to reference fund characteristics. Commenters arguing for

a characteristics-based approach stated that it would more precisely

tailor the final rule to the intent of section 13 and limit the

potential for undue burden on banking entities. A characteristics-based

definition, however, could be less effective than the approach taken in

the final rule as a means to prohibit banking entities, either directly

or indirectly, from engaging in the covered fund activities limited or

proscribed by section 13. A characteristics-based approach also could

require more analysis by banking entities to apply those

characteristics to every potential covered fund on a case-by-case

basis, and create greater opportunity for evasion. As discussed below,

the Agencies have sought to address some of the concerns raised by

commenters suggesting a characteristics-based approach by tailoring the

definition of covered fund to provide exclusions for certain entities

that rely on section 3(c)(1) or 3(c)(7) of the Investment Company Act

and otherwise would be treated as covered funds.

Some commenters discussed the potential cost to banking entities to

analyze the covered fund status of certain entities if the Agencies

were to define the term covered fund by reference to sections 3(c)(1)

and 3(c)(7), arguing that this analysis would be costly.\1691\ A

characteristics-based approach could mitigate the costs associated with

an investment company analysis but, depending on the characteristics,

could result in additional compliance costs in some cases to the extent

banking entities would be required to implement policies and procedures

to prevent potential covered funds from having characteristics that

would bring them within the covered fund definition. Furthermore,

banking entities may currently rely on section 3(c)(1) and 3(c)(7) of

the Investment Company Act to avoid registering various entities under

the Investment Company Act, and the costs to analyze the status of

these entities under a statutory-based definition of covered fund are

generally already included as part of the fund formation process and

the costs of determining covered fund status may thus be mitigated,

especially given the exclusions provided in the final rule.

---------------------------------------------------------------------------

\1691\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012).

---------------------------------------------------------------------------

The entities excluded from the definition of covered fund are

described in detail in section (c) below.

[[Page 5944]]

1. Foreign Covered Funds

In order to prevent evasion of the prohibition and purposes of

section 13, the proposal included within the definition of covered fund

any issuer organized or offered outside of the United States (``foreign

covered fund'') that would be a covered fund were it organized or

offered in the United States.\1692\

---------------------------------------------------------------------------

\1692\ See proposed rule Sec. 75.10(b)(1)(iii).

---------------------------------------------------------------------------

Commenters expressed concern that the proposed treatment of foreign

covered funds was overly broad, exceeded the Agencies' statutory

authority, was not consistent with principles of national treatment,

and violated international treaties.\1693\ Commenters expressed concern

about the difficulties of applying Investment Company Act concepts to

foreign funds that are structured to comply with regulatory schemes

under local laws outside the United States. They also argued that it

would be burdensome and costly to require foreign banking entities to

interpret and apply U.S. securities laws to foreign structures that are

designed primarily to be offered and sold outside the United

States.\1694\ Commenters also contended that foreign mutual fund

equivalents, such as retail Undertakings for Collective Investments in

Transferable Securities (``UCITS''),\1695\ would be treated as covered

funds under the proposal even though they generally are similar to U.S.

registered investment companies, which are not covered funds, meaning

that under the proposal the scope of foreign funds captured was broader

than the scope of domestic funds.\1696\ These commenters argued that a

foreign fund organized and offered outside of the United States should

not be treated as a covered fund simply because the foreign fund may

(or could) rely on the exclusion under section 3(c)(1) or 3(c)(7) of

the Investment Company Act were it to be offered in the United

States.\1697\

---------------------------------------------------------------------------

\1693\ See SIFMA et al. (Covered Funds) (Feb. 2012); BNY Mellon

et al.; BlackRock; ABA (Keating); AFTI; AFG; ICI Global; Ass'n. of

Institutional Investors (Feb. 2012); ICI (Feb. 2012); SSgA (Feb.

2012); State Street (Feb. 2012); JPMC; BoA; Goldman (Covered Funds);

Bank of Montreal et al. (Jan. 2012); AGC; Cadwalader (on behalf of

Thai Banks); ALFI; BVI; EBF; British Bankers Ass'n.; French ACP;

AFME et al.; F&C; IIF; ICSA; IMA; EFAMA; UKRCBC; AIMA; AFMA;

Australian Bankers Ass'n. (Feb. 2012); Allen & Overy (on behalf of

Foreign Bank Group); IFIC; Allen & Overy (on behalf of Canadian

Banks); RBC; French Treasury et al.; Hong Kong Inv. Funds Ass'n.;

TCW; Govt. of Japan/Bank of Japan.

\1694\ See JPMC; see also Cadwalader (on behalf of Thai Banks);

Cadwalader (on behalf of Singapore Banks); Ass'n. of Banks in

Malaysia; Govt. of Japan/Bank of Japan.

\1695\ UCITS are public limited companies that, under a series

of directives issued by the EU Commission, coordinate distribution

and management of unit trusts or collective investment schemes in

financial instruments on a cross-border basis throughout the

European Union on the basis of the authorization of a single member

state.

\1696\ See Allen & Overy (on behalf of Foreign Bank Group); ABA

(Keating); AFG; AFTI; BoA; French Banking Fed'n.; SIFMA et al.

(Covered Funds) (Feb. 2012); see also BNY Mellon et al.; BlackRock;

ICI Global; Ass'n. of Institutional Investors (Feb. 2012); ICI (Feb.

2012); SSgA (Feb. 2012); State Street (Feb. 2012); JPMC; BoA;

Goldman (Covered Funds); Bank of Montreal et al. (Jan. 2012); AGC;

Cadwalader (on behalf of Thai Banks); ALFI; BVI; EBF; British

Bankers Ass'n.; French ACP; AFME et al.; F&C; IIF; ICSA; IMA; EFAMA;

UKRCBC; AIMA; AFMA; Australian Bankers Ass'n. (Feb. 2012); Allen &

Overy (on behalf of Foreign Bank Group); IFIC; Allen & Overy (on

behalf of Canadian Banks); RBC; French Treasury et al.; Hong Kong

Inv. Funds Ass'n.; HSBC Life; ICSA Ass'n. of Banks in Malaysia

(arguing that foreign banking organization would have to determine

how a fund would be regulated under U.S. law before making

investments in funds in their home markets).

\1697\ See Allen & Overy (on behalf of Foreign Bank Group); ABA

(Keating); SSgA (Feb. 2012); BoA; Goldman (Covered Funds).

---------------------------------------------------------------------------

Some commenters argued that the proposal did not clearly identify

which foreign funds would be covered, thereby creating uncertainty

about the scope of funds to which section 13 would apply.\1698\ Several

commenters argued that the proposal's foreign covered fund definition

could be read to include a foreign fund, even if its securities were

never offered and sold to U.S. persons, because the fund could

theoretically be offered in the United States in reliance on section

3(c)(1) or 3(c)(7).\1699\ Commenters argued that the definition of

foreign covered fund should be tailored.\1700\ Some commenters argued

that foreign funds that are not made available for sale in the U.S. or

actively marketed to U.S. investors should be specifically excluded

from the definition of covered fund.\1701\ Several other commenters

supported narrowing the definition of foreign covered fund to those

foreign funds with characteristics similar to domestic hedge funds or

private equity funds.\1702\

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\1698\ See Australian Bankers Ass'n. (Feb. 2012); BlackRock.

\1699\ See BlackRock; SIFMA et al. (Covered Funds) (Feb. 2012);

JPMC; ABA (Keating); IIB/EBF. These commenters argued that the

proposed definition of a covered fund could result in virtually

every foreign fund being considered a covered fund, regardless of

whether the fund is similar to a hedge fund or private equity fund.

\1700\ See, e.g., AGC; Ass'n. of Institutional Investors (Feb.

2012); ABA (Keating); Goldman (Covered Funds); BoA; GE (Feb. 2012);

Japanese Bankers Ass'n.; EBF.

\1701\ See Australian Bankers Ass'n. (Feb. 2012); AFG; BNY

Mellon et al.; BlackRock; Goldman (Covered Funds); IIB/EBF.

\1702\ See SIFMA et al. (Covered Funds) (Feb. 2012); JPMC;

Goldman (Covered Funds); Credit Suisse (Williams); ABA (Keating);

IIB/EBF; Barclays; BoA; GE (Feb. 2012) (discussing the uncertainty

with respect to foreign-based loan and securitization programs and

whether they would be deemed covered funds).

---------------------------------------------------------------------------

After considering the comments in light of the statutory provisions

and purpose of section 13, the Agencies have modified the final rule to

more effectively tailor the scope of foreign funds that would be

covered funds under the rule and better implement the language and

purpose of section 13. As noted above, section 13 of the BHC Act

applies to the global operations of U.S. banking entities, and one of

the purposes of section 13 is to reduce the risk to the U.S. financial

system of activities with and investments in covered funds. The

Agencies proposed to include foreign funds within the definition of

covered fund in order to more effectively accomplish the purpose of

section 13. In particular, the Agencies were concerned that a

definition of covered fund that did not include foreign funds would

allow U.S. banking entities to be exposed to risks and engage in

covered fund activities outside the United States that are specifically

prohibited in the United States. This result would undermine section 13

and pose risks to U.S. banking entities and the stability of the U.S.

financial system that section 13 was designed to prevent.

At the same time, section 13 includes other provisions that

explicitly limit its extra-territorial application to the activities of

foreign banks outside the United States. As explained below, section 13

specifically exempts certain activities in covered funds conducted by

foreign banking entities solely outside of the United States.

Based on these considerations and the information provided by

commenters, the Agencies have revised the definition of covered fund in

the final rule to include certain foreign funds under certain

circumstances. The final rule provides that a foreign fund is included

within the definition of covered fund only for any banking entity that

is, or is controlled directly or indirectly by a banking entity that

is, located in or organized or established under the laws of the United

States or of any State. Under this definition a foreign fund becomes a

covered fund only with respect to the U.S. banking entity (or foreign

affiliate of a U.S. banking entity) that acts as a sponsor to the

foreign fund or has an ownership interest in the foreign fund. Under

the rule, a foreign fund is any entity that: (i) Is organized or

established outside the United States and the ownership interests of

which are offered and sold solely outside the United States; (ii) is,

or holds itself out as being, an entity or arrangement that raises

money from investors primarily for the purpose of investing in

securities for resale or other disposition or

[[Page 5945]]

otherwise trading in securities; and (iii) has as its sponsor the U.S.

banking entity (or an affiliate thereof) or has issued an ownership

interest that is owned directly or indirectly by the U.S. banking

entity (or an affiliate thereof).\1703\ A foreign fund therefore may be

a covered fund with respect to the U.S. banking entity that sponsors

the fund, but not be a covered fund with respect to a foreign bank that

invests in the fund solely outside the United States.

---------------------------------------------------------------------------

\1703\ See final rule Sec. 75.10(b)(1)(iii).

---------------------------------------------------------------------------

This approach is designed to include within the definition of

covered fund only foreign entities that would pose risks to U.S.

banking entities of the type section 13 was designed to address. The

Agencies note that any foreign fund, including a foreign fund sponsored

or owned by a foreign banking entity, that is offered or sold in the

United States in reliance on the exclusions in section 3(c)(1) or

3(c)(7) of the Investment Company Act would be included in the

definition of covered fund under Sec. 75.10(b)(1)(i) of the final rule

unless it meets the requirements of an exclusion from that definition

as discussed below.\1704\ Thus, the rule is designed to provide

parity--and no competitive advantages or disadvantages--between U.S.

and non-U.S. funds sold within the United States.

---------------------------------------------------------------------------

\1704\ See also Goodwin, Procter & Hoar LLP, SEC Staff No-Action

Letter (Feb. 28, 1997); Touche Remnant & Co., SEC Staff No-Action

Letter (Aug. 27, 1984).

---------------------------------------------------------------------------

To further ensure that this approach to foreign funds is consistent

with the scope of coverage applied within the United States, the final

rule excludes from the definition of covered fund any foreign issuer

that, were it subject to U.S. securities laws, would be able to rely on

an exclusion or exemption from the definition of investment company

other than the exclusions contained in section 3(c)(1) or 3(c)(7) of

the Investment Company Act.\1705\

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\1705\ See final rule Sec. 75.10(b)(2). Because any issuer that

offers its securities under the U.S. securities laws that may rely

on an exclusion or exemption from the definition of investment

company other than the exclusions contained in section 3(c)(1) or

3(c)(7) of the Investment Company Act would not be a covered fund,

this exclusion is designed to provide equivalent treatment for

foreign covered funds.

---------------------------------------------------------------------------

As explained below, the final rule also contains an exclusion for

foreign public funds.\1706\ This is designed to prevent the extension

of the definition of covered fund from including foreign funds that are

similar to U.S. registered investment companies, which are by statute

not covered by section 13.

---------------------------------------------------------------------------

\1706\ See Sec. 75.10(c)(1).

---------------------------------------------------------------------------

2. Commodity Pools

Under the proposal, the Agencies proposed to use their authority to

expand the definition of covered fund to include a commodity pool as

defined in section 1a(10) of the Commodity Exchange Act.\1707\ A

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.\1708\ The Agencies

proposed to include commodity pools in the definition of covered fund

because some commodity pools are managed and structured in a manner

similar to a covered fund.

---------------------------------------------------------------------------

\1707\ See proposal rule Sec. 75.10(b)(1)(ii).

\1708\ Commodity interests include: (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)

leveraged transaction authorized under section 23 of the Commodity

Exchange Act. See Joint Proposal, 76 FR at 68897 n.224 and

accompanying text.

---------------------------------------------------------------------------

Some commenters objected to this expansion of the definition of

covered fund as beyond the scope of section 13. Commenters argued that

covering commodity pools would extend section 13 of the BHC Act to any

entity that engages in a single commodity, futures or swap transaction,

including entities that share few, if any, of the characteristics or

risk associated with private equity funds or hedge funds.\1709\ For

example, some commenters argued that many non-bank businesses that are

not investment companies but that hedge risks using commodity interests

would be treated as covered funds if all commodity pools were

covered.\1710\ In addition, registered mutual funds, pension funds, and

many investment companies that rely on exclusions or exceptions other

than section 3(c)(1) or 3(c)(7) of the Investment Company Act would be

covered as commodity pools. Commenters argued that the CFTC has ample

authority to regulate the activities of commodity pools and commodity

pool operators, and nothing in section 13 indicates that Congress

intended section 13 to govern commodity pool activities or investments

in commodity pools.\1711\ Commenters also argued that expanding the

definition of covered fund to include commodity pools would have the

unintended consequence of limiting all covered transactions between a

banking entity sponsor or investor in a commodity pool and the

commodity pool itself.\1712\ If a commercial end user is a commodity

pool for example, this restriction could limit access to credit for

that entity.

---------------------------------------------------------------------------

\1709\ See, e.g., ABA (Keating) (citing see, e.g., CFTC

Interpretative Letter No. 86-22, Comm. Fut. L. Rep. (CCH) ] 23,280

(Sept. 19, 1986)); SIFMA et al. (Covered Funds) (Feb. 2012); ICI

(Feb. 2012); BlackRock; Goldman (Covered Funds); Wells Fargo

(Covered Funds); BoA; EFAMA; TCW; ISDA (Feb. 2012); Arnold & Porter;

BNY Mellon et al.; SSgA (Feb. 2012); State Street (Feb. 2012);

Credit Suisse (Williams); RMA; IIB/EBF.

\1710\ See Goldman (Covered Funds); TCW; IIB/EBF.

\1711\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012); ICI

(Feb. 2012); BlackRock.

\1712\ See, e.g., BoA.

---------------------------------------------------------------------------

Commenters that opposed the proposal's inclusion of commodity pools

generally asserted that, if commodity pools were nonetheless included

as covered funds under the final rule, the definition of commodity pool

should be modified so that it would include only those pools that

engage ``primarily'' or ``principally'' in commodities trading and

exhibit characteristics similar to those of conventional hedge funds

and private equity funds.\1713\ Other commenters urged the Agencies to

incorporate the exemptions from the commodity pool operator

registration requirements under the Commodity Exchange Act (such as

rule 4.13(a)(4)).\1714\

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\1713\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012);

Goldman (Covered Funds); BlackRock; Wells Fargo (Covered Funds); BNY

Mellon, et al.; SSgA (Feb. 2012); State Street (Feb. 2012); Credit

Suisse (Williams); ABA (Keating); FIA; IIB/EBF; BoA.

\1714\ See Credit Suisse (Williams).

---------------------------------------------------------------------------

Some commenters supported including commodity pools within the

definition of covered fund,\1715\ with some suggesting that this

approach would be consistent with the goals of the statute.\1716\ One

commenter asserted that including commodity pools would be necessary to

prevent banking entities from indirectly engaging in prohibited

proprietary trading through commodity pools.\1717\ Another commenter

asserted that the inclusion of commodity pools was advisable because

the CFTC has in the past viewed many commodity pools as similar to

hedge funds.\1718\

---------------------------------------------------------------------------

\1715\ See AFR et al. (Feb. 2012); Alfred Brock; Occupy; Sens.

Merkley & Levin (Feb. 2012).

\1716\ See Sens. Merkley & Levin (Feb. 2012); Occupy; AFR et al.

(Feb. 2012); Alfred Brock.

\1717\ See Sens. Merkley & Levin (Feb. 2012).

\1718\ See Occupy.

---------------------------------------------------------------------------

After carefully considering these comments, the Agencies have

determined not to include all commodity pools as covered funds as

proposed. Instead, and taking into account commenters' concerns, the

Agencies have taken a more tailored approach that is designed to more

accurately identify those commodity pools that are similar to issuers

that would be investment companies as defined the Investment Company

Act of 1940 but for section 3(c)(1) or 3(c)(7) of

[[Page 5946]]

that Act, consistent with section 13(h)(2) of the BHC Act.

Under the final rule, as a threshold matter, a collective

investment vehicle must determine whether it is a ``commodity pool'' as

that term is defined in section 1a(10) of the Commodity Exchange

Act.\1719\ The Agencies note that collective investment vehicles need

to make this determination for purposes of complying with the Commodity

Exchange Act regardless of whether commodity pools are covered funds.

Under section 1a(10), a commodity pool is ``any investment trust,

syndicate, or similar form of enterprise operated for the purpose of

trading commodity interests.'' \1720\ If a collective investment

vehicle meets that definition, the commodity pool would be considered a

covered fund provided it meets one of two alternative tests and does

not also qualify for an exclusion from the covered fund definition

(e.g., the exclusion for registered investment companies).

---------------------------------------------------------------------------

\1719\ See 7 U.S.C. 1a(10).

\1720\ Id. The CFTC and its divisions have provided

interpretative guidance with respect to the meaning of the

definition of commodity pool. See, e.g., 46 FR 26004, 26005 (May 8,

1981) (adopting the CFTC's regulatory definition of commodity pool

in 17 CFR 4.10(d), which is substantively identical to the

definition in section 1a(10) of the Commodity Exchange Act); 77 FR

11252, 11258 (Feb. 24, 2012) (explaining the need for swaps to be

included in the de minimis exclusion and exemption in 17 CFR 4.5 and

4.13); CFTC Staff Letter 12-13 (Oct. 11, 2012) (providing

interpretative guidance to equity real estate investment trusts);

and CFTC Staff Letters Nos. 12-14 (Oct. 11, 2012) and 12-45 (Dec. 7,

2012) (providing interpretative relief that certain securitization

vehicles are not commodity pools).

---------------------------------------------------------------------------

First, a commodity pool will be a covered fund if it is an ``exempt

pool'' under section 4.7(a)(1)(iii) of the CFTC's regulations,\1721\

meaning that it is a commodity pool for which a registered commodity

pool operator has elected to claim the exemption provided by section

4.7 of the CFTC's regulations. The Agencies believe that such commodity

pools are appropriately considered covered funds because, like funds

that rely on section 3(c)(1) or 3(c)(7), these commodity pools sell

their participation units in restricted offerings that are not

registered under the Securities Act of 1933 and are offered only to

investors who meet certain heightened qualification standards, as

discussed above.\1722\ The Agencies therefore have determined that they

properly are considered ``such similar funds'' as specified in section

13(h)(2) of the BHC Act.

---------------------------------------------------------------------------

\1721\ 17 CFR 4.7(a)(1)(iii).

\1722\ Although section 3(c)(1) itself does not limit the types

of investors who may invest in a fund relying on that exclusion,

section 3(c)(1) provides that the fund may not conduct a public

offering. A fund relying on section 3(c)(1) therefore must offer and

sell its interests in offerings that are not registered under the

Securities Act of 1933, which offerings generally are limited to

persons who meet certain qualification standards.

---------------------------------------------------------------------------

Alternatively, a commodity pool for which exempt pool status under

section 4.7 of the CFTC's regulations has not been elected may also be

a covered fund if the pool features certain elements that make the pool

substantively similar to exempt pools under section 4.7. The Agencies

are including the alternative definition of commodity pools that are

covered funds because, if the Agencies had included only pools for

which exempt pool status had been elected, covered fund status for

pools in which banking entities are invested could easily be avoided

merely by not electing exempt pool status under section 4.7. The

following is a description of the elements of a pool that would cause a

pool that is not an exempt pool under section 4.7 to be a covered fund.

The first element is that a commodity pool operator for the pool is

registered pursuant to the Commodity Exchange Act in connection with

the operation of that commodity pool. This element is present for all

pools that are exempt pools under section 4.7 because exempt pool

status can only be elected by registered commodity pool operators. This

element excludes from the definition of covered fund an entity that is

a commodity pool, but for which the pool operator has been either

exempted from registration as a commodity pool operator or excluded

from the definition of commodity pool operator under the CFTC's

regulations or pursuant to a no-action letter issued by CFTC

staff.\1723\

---------------------------------------------------------------------------

\1723\ See, e.g., CFTC regulations 3.10(c) and 4.13 and CFTC

Staff Letters Nos. 12-37 (Nov. 29, 2012) (relief from registration

for operators of certain types of family office pools), 12-40 (Dec.

4, 2012) (relief from registration for operators of business

development companies that meet certain conditions) and 12-44 (Dec.

7, 2012) (relief from registration for operators of mortgage real

estate investment trusts that meet certain conditions). See also

supra note 1720.

---------------------------------------------------------------------------

The second element under the alternative definition is that

substantially all of the commodity pool's participation units are owned

only by qualified eligible persons under section 4.7(a)(2) and

(a)(3).\1724\ This element is consistent with the requirement under

section 4.7 that exempt pool status can only be claimed if the

participation units in the pool are only offered or sold to qualified

eligible persons.\1725\ Moreover, the inclusion of this element aligns

the elements of the alternative test with features that define funds

that rely on sections 3(c)(1) and 3(c)(7) of the Investment Company Act

of 1940.

---------------------------------------------------------------------------

\1724\ 17 CFR 4.7(a)(2) and (a)(3).

\1725\ Although section 4.7 requires that all participation

units be owned by qualified eligible persons, this element of the

final rule has been modified to include pools for which

``substantially all'' participation units are owned by qualified

eligible persons to prevent avoidance of covered fund status by

distributing a small number of participation units to persons who

are not qualified eligible persons.

---------------------------------------------------------------------------

The assessment as to whether the commodity pool in question

satisfies this condition must be made at the time that the banking

entity is required to make the following determinations: whether it can

obtain new participation units in the commodity pool, whether it can

retain previously purchased participation units in the commodity pool,

and whether it can act as the commodity pool's sponsor. The Agencies

believe this to be appropriate because it would require the banking

entity to consider current information regarding the commodity pool and

its participants rather than assess the composition of the pool's

participants over time even though its investments in or relationships

with the pool do not change, which could be difficult depending upon

the length of time that the pool has been in operation and the records

available at the time of determination.

Finally, the third element under the alternative definition is that

the commodity pool participation units have not been publicly offered

to persons other than qualified eligible persons. Consistent with CFTC

regulations addressing the meaning of ``offer'' in the context of the

CFTC's regulations, the term ``offer'' as used in Sec.

75.10(b)(1)(ii)(B) ``has the same meaning as in contract law, such

that, if accepted the terms of the offer would form a binding

contract.'' \1726\ This aspect of the alternative definition is

intended to limit the ability for commodity pools to avoid

classification as covered funds through an offer, either in the past or

currently ongoing, to non-qualified eligible persons ``in name only''

where there is no actual offer to non-qualified eligible persons.

---------------------------------------------------------------------------

\1726\ See 77 FR 9734, 9741 (Feb. 17, 2012) (describing the

meaning of the term ``offer'' in the context of the business conduct

standards for swap dealers and major swap participants with

counterparties adopted by the CFTC). The term ``offered'' as used in

this section of the final rule is not intended to denote an

``offer'' for purposes of the Securities Act of 1933.

---------------------------------------------------------------------------

Accordingly, unless the pool operator can show that the pool's

participation units have been actively and publicly offered to non-

affiliated parties that are not qualified eligible persons whereby such

non-qualified eligible persons could in fact purchase a participation

unit in the commodity pool, a pool that features the other elements

listed in the

[[Page 5947]]

alternative definition would be a covered fund. Such a showing will not

turn solely on whether the commodity pool has filed a registration

statement to offer its participation units under the Securities Act of

1933 or whether the commodity pool operator has prepared a disclosure

document consistent with the provisions of section 4.24 of the CFTC's

regulations.\1727\ Rather, the pool operator would need to show that a

reasonably active effort, based on the facts and circumstances, has

been undertaken by brokers and other sales personnel to publicly offer

the pool's participation units to non-affiliated parties that are not

qualified eligible persons.

---------------------------------------------------------------------------

\1727\ 17 CFR 4.24 (2013).

---------------------------------------------------------------------------

In taking this more tailored approach to commodity pools that will

be covered funds, the Agencies are more closely aligning the types of

commodity pools that will be covered funds under the final rule with

section 13's definition of a hedge fund and private equity fund by

reference to section 3(c)(1) or section 3(c)(7), and addressing

concerns of commenters that the proposal was overly broad and would

lead to outcomes inconsistent with the words, structure, and purpose of

section 13.\1728\ The Agencies believe that the types of commodity

pools described above generally are similar to funds that rely on

section 3(c)(1) and 3(c)(7) in that, like funds that rely on section

3(c)(1) or 3(c)(7), these commodity pools may be owned only by

investors who meet certain heightened qualification standards, as

discussed above.\1729\ Further, the Agencies believe that the final

rule's identification of the elements of a commodity pool that is a

covered fund are clearly established and readily ascertainable such

that once it is determined whether an entity is a commodity pool, an

assessment that is already necessary to comply with the Commodity

Exchange Act, then the further determination of whether an entity that

is a commodity pool is also a covered fund can be made based on readily

ascertainable information.

---------------------------------------------------------------------------

\1728\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012);

BlackRock; AHIC; Sen. Carper et al.; Rep. Garrett et al.

\1729\ Funds relying on section 3(c)(7) must be owned

exclusively by qualified purchasers, as defined in the Investment

Company Act. The Agencies note in this regard that section 4.7 of

the CFTC's regulations use substantially the same definition of a

qualified purchaser in defining the term qualified eligible person.

---------------------------------------------------------------------------

In adopting this approach, the Agencies also are utilizing the

current regulatory structure promulgated by the CFTC under the CEA. As

the CFTC regulates commodity pools, commodity pool operators, and

commodity trading advisors that advise commodity pools, the Agencies

believe that it is beneficial to utilize an already established set of

rules, regulations, and guidance. The Agencies considered alternative

approaches provided by the commenters, but have adopted the approach

taken in the final rule for the reasons discussed above and because the

Agencies believe that the final rule, by incorporating concepts with

which commodity pools and their operators are familiar, more clearly

delineates the commodity pools that are covered funds.\1730\

---------------------------------------------------------------------------

\1730\ Operators of commodity pools currently must consider

whether they are required to register with the CFTC as commodity

pool operators, and whether the pools have the characteristics that

would make it possible for the operator to claim an exemption under

section 4.7. These concepts thus should be familiar to commodity

pools and their operators, and including these concepts in the final

rule should allow banking entities more easily to determine if a

particular commodity pools is a covered fund than if the Agencies

were to develop new concepts solely for purposes of the final rule.

---------------------------------------------------------------------------

The Agencies believe that the final rule's tailored approach to

commodity pools includes in the definition of covered fund commodity

pools that are similar to funds that rely on section 3(c)(1) and

3(c)(7). The Agencies also note in this regard that a commodity pool

that would be a covered fund even under this tailored approach will not

be a covered fund if the pool also qualifies for an exclusion from the

covered fund definition, including the exclusion for registered

investments companies. Accordingly, this approach excludes from covered

funds entities like commercial end users and registered investment

companies, whose activities do not implicate the concerns section 13

was designed to address. Rather, the final rule limits the commodity

pools that will be included as covered funds to those that are similar

to other covered funds except that they are not generally subject to

the Investment Company Act of 1940 due to the instruments in which they

invest. For all of these reasons, the Agencies believe that the final

rule's approach to commodity pools addresses both the Agencies'

concerns about the potential for evasion and commenters' concerns about

the breadth of the proposed rule, and provides that the commodity pools

captured as covered funds are ``such similar funds,'' consistent with

section 13(h)(2) of the BHC Act.

The Agencies acknowledge that as a result of including certain

commodity pools in the definition of covered fund, the prohibitions

under section 13(f) and Sec. 75.14 may result in certain structural

changes in the industry. The Agencies note that these changes (e.g.,

bank-affiliated FCMs may not be able to lend money in certain clearing

transactions to affiliated commodity pools that are covered funds) may

result in certain changes in the way related entities do business with

each other. However, the Agencies believe that because the industry is

competitive with a significant number of alternative non-affiliate

competitors, the changes would not result in a less competitive

landscape for investors in commodity pools.

3. Entities Regulated Under the Investment Company Act

The proposed rule did not specifically include registered

investment companies (including mutual funds) or business development

companies within the definition of covered fund.\1731\ As explained

above, the statute references funds that rely on section 3(c)(1) or

3(c)(7) of the Investment Company Act. Registered investment companies

and business development companies do not rely on either section

3(c)(1) or 3(c)(7) of the Investment Company Act and are instead

registered or regulated in accordance with the Investment Company Act.

---------------------------------------------------------------------------

\1731\ See proposed rule Sec. 75.10(b)(1).

---------------------------------------------------------------------------

Many commenters argued that registered investment companies and

business development companies would be treated as covered funds under

the proposed definition if commodity pools are treated as covered

funds.\1732\ A few commenters argued that the final rule should

specifically provide that all SEC-registered funds are excluded from

the definition of covered fund (and the definition of banking entity)

to avoid any uncertainty about whether section 13 applies to these

types of funds.\1733\

---------------------------------------------------------------------------

\1732\ See, e.g., Arnold & Porter; BoA; Goldman (Covered Funds);

ICI (Feb. 2012); Putnam; TCW; Vanguard. According to these

commenters, a registered investment company may use security or

commodity futures, swaps, or other commodity interests in various

ways to manage its investment portfolio and be swept into the broad

definition of ``commodity pool'' contained in the Commodity Exchange

Act.

\1733\ See Arnold & Porter; Goldman (Covered Funds); see also

SIFMA et al. (Covered Funds) (Feb. 2012); SIFMA et al. (Mar. 2012);

ABA (Keating); BoA; ICI (Feb. 2012); JPMC; (requesting clarification

that registered investment companies are not banking entities); TCW.

---------------------------------------------------------------------------

Commenters also requested that the final rule exclude from the

definition of covered fund entities formed to establish registered

investment companies during the seeding period. These commenters

contended that, during the early stages of forming and seeding a

registered investment company, an entity relying on section 3(c)(1) or

(3)(c)(7) may be created to

[[Page 5948]]

facilitate the development of a track record for the registered

investment company so that it may be marketed to unaffiliated

investors.\1734\

---------------------------------------------------------------------------

\1734\ See ICI (Feb. 2012); TCW.

---------------------------------------------------------------------------

The Agencies did not intend to include registered investment

companies and business development companies as covered funds under the

proposal. Section 13's definition of private equity fund and hedge fund

by reference to section 3(c)(1) and 3(c)(7) of the Investment Company

Act appears to reflect Congress' concerns about banking entities'

exposure to and relationships with investment funds that explicitly are

excluded from SEC regulation as investment companies. The Agencies do

not believe it would be appropriate to treat as a covered fund

registered investment companies and business development companies,

which are regulated by the SEC as investment companies. The Agencies

believe that the proposed rule's inclusion of commodity pools would

have resulted in some registered investment companies and business

development companies being covered funds, a result the Agencies did

not intend. The Agencies, in addition to narrowing the commodity pools

that will be included as covered funds as discussed above, have also

modified the final rule to exclude SEC-registered investment companies

and business development companies from the definition of covered

fund.\1735\

---------------------------------------------------------------------------

\1735\ See final rule Sec. 75.10(c)(12).

---------------------------------------------------------------------------

The Agencies also recognize that an entity that becomes a

registered investment company or business development company might,

during its seeding period, rely on section 3(c)(1) or 3(c)(7). The

Agencies have determined to exclude these seeding vehicles from the

covered fund definition for the same reasons the Agencies determined to

exclude entities that are operating as registered investment companies

or business development companies as discussed in more detail below in

Part VI.B.1.c.12 of this SUPPLEMENTARY INFORMATION.

The Agencies also understand that registered investment companies

may establish and hold subsidiary entities that rely on section 3(c)(1)

or 3(c)(7) in order to trade in various financial instruments for the

registered investment company parent. If a registered investment

company were itself a banking entity, section 13 and the final rule

would prohibit the registered investment company from sponsoring or

investing in such an investment subsidiary. But a registered investment

company would only itself be a banking entity if it is an affiliate of

an insured depository institution. As explained in the proposal, a

registered investment company, such as a mutual fund or exchange traded

fund, or an entity that has made an effective election to be regulated

as a business development company, would not be an affiliate of a

banking entity for purposes of section 13 of that Act solely by virtue

of being advised, or organized, sponsored and managed by a banking

entity in accordance with the BHC Act (including section 13) and the

Board's Regulation Y.\1736\

---------------------------------------------------------------------------

\1736\ See Joint Proposal, 76 FR at 68856.

---------------------------------------------------------------------------

Under the BHC Act, an entity (including a registered investment

company) would generally be considered an affiliate of a banking

entity, and therefore a banking entity itself, if it controls, is

controlled by, or is under common control with an insured depository

institution.\1737\ Pursuant to the BHC Act, a company controls another

company if: (i) The company directly or indirectly or acting through

one or more other persons owns, controls, or has power to vote 25 per

cent or more of any class of voting securities of the company; (ii) the

company controls in any manner the election of a majority of the

directors of trustees of the other company; or (iii) the Board

determines, after notice and opportunity for hearing, that the company

directly or indirectly exercises a controlling influence over the

management or policies of the company.\1738\

---------------------------------------------------------------------------

\1737\ See final rule Sec. 75.2(a) (defining ``affiliate'' for

purposes of the final rule).

\1738\ See 12 U.S.C. 1841(a)(2); 12 CFR 225.2(e).

---------------------------------------------------------------------------

The Board's regulations and orders have long recognized that a bank

holding company may organize, sponsor, and manage a mutual fund such as

a registered investment company, including by serving as investment

adviser to registered investment company, without controlling the

registered investment company for purposes of the BHC Act.\1739\ For

example, the Board has permitted a bank holding company to own up to 5

percent of the voting shares of a registered investment company for

which the bank holding company provides investment advisory,

administrative, and other services, and has a number of director and

officer interlocks, without finding that the bank holding company

controls the fund.\1740\ The Board has also permitted a bank holding

company to own less than 25 percent of the voting shares of a

registered investment company and provide similar services without

finding that the bank holding company controls the fund, so long as the

fund limits its investments to those permissible for the holding

company to make itself.\1741\

---------------------------------------------------------------------------

\1739\ See, e.g., 12 CFR 211.10(a)(11); 225.28(b)(6)(i);

225.86(b)(3); Unicredito, 86 Fed. Res. Bull. 825 (2000); Societe

Generale, 84 Fed. Res. Bull. 680 (1998); Commerzbank AG, 83 Fed.

Res. Bull. 678 (1997); The Governor and Company of the Bank of

Ireland, 82 Fed. Res. Bull. 1129 (1996); Mellon Bank Corp., 79 Fed.

Res. Bull. 626 (1993); Bayerische Vereinsbank AG, 73 Fed. Res. Bull.

155 (1987).

\1740\ See, e.g., Societe Generale, 84 Fed. Res. Bull. 680

(1998) (finding that a bank holding company does not control a

mutual fund for which it holds up to 5 percent of the voting shares

and also provides investment advisory, administrative and other

services, has directors or employees who comprise less than 25

percent of the board of directors of the fund (including the

chairman of the board), and has three senior officer interlocks and

a number of junior officer interlocks).

\1741\ See letter dated June 24, 1999, to H. Rodgin Cohen, Esq.,

Sullivan & Cromwell (First Union Corp.), from Jennifer J. Johnson,

Secretary of the Board of Governors of the Federal Reserve System

(finding that a bank holding company does not control a mutual fund

for which it provides investment advisory and other services and

that complies with the limitations of section 4(c)(7) of the BHC Act

(12 U.S.C. 1843(c)(7)), so long as (i) the bank holding company

reduces its interest in the fund to less than 25 percent of the

fund's voting shares after a six-month period, and (ii) a majority

of the fund's directors are independent of the bank holding company

and the bank holding company cannot select a majority of the board)

(``First Union Letter''); H.R. Rep. No. 106-434 at 153 (1999) (Conf.

Rep.) (noting that the Act permits a financial holding company to

sponsor and distribute all types of mutual funds and investment

companies); see also 12 U.S.C. 1843(k)(1), (6).

---------------------------------------------------------------------------

The BHC Act, as amended by the Gramm-Leach-Bliley Act, and the

Board's Regulation Y authorize a bank holding company that qualifies as

a financial holding company to engage in a broader set of activities,

and to have a broader range of relationships or investments with

entities, than bank holding companies.\1742\ For instance, a financial

holding company may engage in, or acquire shares of any company engaged

in, any activity that is financial in nature or incidental to such

financial activity, including any activity that a bank holding company

is permitted to engage in or acquire by regulation or order.\1743\ In

light of the foregoing, for purposes of section 13 of the BHC Act a

financial holding company may own more than 5 percent (and less than 25

percent) of the voting shares of a registered investment company for

which the holding company provides investment advisory, administrative,

and other services and has a number of director and officer interlocks,

without

[[Page 5949]]

controlling the fund for purposes of the BHC Act.\1744\

---------------------------------------------------------------------------

\1742\ See, e.g., H.R. Rep. No. 106-434 at 153 (1999) (Conf.

Rep.) (noting that the Act permits a financial holding company to

sponsor and distribute all types of mutual funds and investment

companies).

\1743\ See 12 U.S.C. 1843(k)(1); 12 CFR 225.86.

\1744\ See First Union Letter (June 24, 1999); see also 12 CFR

225.86(b)(3) (authorizing a financial holding company to organize,

sponsor, and manage a mutual fund so long as (i) the fund does not

exercise managerial control over the entities in which the fund

invests, and (ii) the financial holding company reduces its

ownership in the fund, if any, to less than 25 percent of the equity

of the fund within one year of sponsoring the fund or such

additional period as the Board permits).

---------------------------------------------------------------------------

So long as a bank holding company or financial holding company

complies with these limitations, it would not, absent other facts and

circumstances, control a registered investment company and the

registered investment company for purposes of section 13 (and any

subsidiary thereof) would not itself be a banking entity subject to the

restrictions of section 13 of the BHC Act and any final implementing

rules (unless the registered investment company itself otherwise

controls an insured depository institution). Also consistent with the

Board's precedent regarding bank holding company control of and

relationships with funds, a seeding vehicle that will become a

registered investment company or SEC-regulated business development

company would not itself be viewed as violating the requirements of

section 13 during the seeding period so long as the banking entity that

establishes the seeding vehicle operates the vehicle pursuant to a

written plan, developed in accordance with the banking entity's

compliance program, that reflects the banking entity's determination

that the vehicle will become a registered investment company or SEC-

regulated business development company within the time period provided

by section 13(d)(4) and Sec. 75.12 for seeding a covered fund.\1745\

---------------------------------------------------------------------------

\1745\ See final rule Sec. Sec. 75.10(c)(12) and 75.20(e).

Under the final rule, these seeding vehicles also must comply with

the limitations on leverage under the Investment Company Act that

apply to registered investment companies and SEC-regulated business

development companies. See final rule Sec. 75.10(c)(12).

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c. Entities Excluded From Definition of Covered Fund

As noted above, the final rule excludes a number of entities from

the definition of covered fund.\1746\ As discussed in more detail

below, these exclusions more effectively tailor the definition of

covered fund to those types of entities that section 13 was designed to

focus on. The exclusions thus are designed to provide certainty,

mitigate compliance costs and other burdens, and address the potential

over-breadth of the covered fund definition and related requirements

without such exclusions by permitting banking entities to invest in and

have other relationships with entities that do not relate to the

statutory purpose of section 13. These exclusions, described in more

detail below, take account of information provided by many commenters

regarding entities that would likely be included within the proposed

definition of a covered fund, but that are not traditionally thought of

as hedge funds or private equity funds.\1747\ Finally, the Agencies

note that providing exclusions from the covered fund definition, rather

than providing permitted activity exemptions as proposed in some cases,

aligns the final rule with the statute in applying the restrictions

imposed by section 13(f) on transactions with covered funds only to

transactions with issuers that are defined as covered funds and thus

raise the concerns section 13 was designed to address.

---------------------------------------------------------------------------

\1746\ See final rule Sec. 75.10(c).

\1747\ See 156 Cong. Rec. H5226 (daily ed. June 30, 2010)

(statement of Reps. Himes and Frank) (noting intent that

subsidiaries or joint ventures not be included within the definition

of covered fund); 156 Cong. Rec. S5904-05 (daily ed. July 15, 2010)

(statement of Sens. Boxer and Dodd) (noting broad definition of

hedge fund and private equity fund and recommending that the

Agencies take steps to ensure definition is reasonably tailored);

see also FSOC study at 61-63.

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The Agencies recognize, however, that the final rule's definition

of covered fund does not include certain pooled investment vehicles.

For example, the definition of covered fund excludes business

development companies, entities that rely on section 3(c)(5)(C),

3(c)(3), or 3(c)(11) of the Investment Company Act, and certain foreign

public funds that are subject to home-country regulation. The Agencies

expect that the types of pooled investment vehicles sponsored by the

financial services industry will continue to evolve, including in

response to the final rule, and the Agencies will be monitoring this

evolution to determine whether excluding these and other types of

entities remains appropriate. The Agencies will also monitor use of the

exclusions for attempts to evade the requirements of section 13 and

intend to use their authority where appropriate to prevent evasions of

the rule.

1. Foreign Public Funds

As discussed above, under the proposal a covered fund was defined

to include the foreign equivalent of any covered fund in order to

address the potential for circumvention. Many commenters argued that

the proposed definition could capture non-U.S. public retail funds,

such as UCITS.\1748\ These commenters contended that non-U.S. public

retail funds should be excluded from the definition of covered fund

because they are regulated in their home jurisdiction; commenters noted

that similar funds registered in the United States, such as mutual

funds, are not covered funds.\1749\

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\1748\ As discussed above, the proposed rule generally included

in the covered fund definition a foreign fund that, were it

organized or offered under the laws of the United States or offered

to U.S. residents, would meet the definition of a domestic covered

fund (i.e., would need to rely section 3(c)(1) or 3(c)(7) of the

Investment Company Act). Many commenters argued that this definition

is too broad and could include as covered funds various types of

foreign funds, like UCITS, that commenters argued should not be

included. See, e.g., JPMC; BlackRock.

\1749\ See SIFMA et al. (Covered Funds) (Feb. 2012); Hong Kong

Inv. Funds Ass'n.; UBS; ICI Global; BlackRock; TCW; State Street

(Feb. 2012); SSgA (Feb. 2012); IAA; JPMC; Goldman (Covered Funds);

BoA; Credit Suisse (Williams); BNY Mellon, et al.; Union Asset;

EFAMA; BVI; IRSG, SEB; IIB/EBF; GE (Feb. 2012) (commenting on the

overbreadth of the definition because of the effect on foreign

issuers of asset-backed securities); Allen & Overy (on behalf of

Foreign Bank Group).

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Some commenters were concerned that the proposed definition could

inadvertently capture exchange-traded funds trading in foreign

jurisdictions,\1750\ separate accounts set up to fund foreign pension

plans,\1751\ non-U.S. issuers of asset-backed securities,\1752\ and

non-U.S. regulated funds specifically designed for institutional

investors.\1753\ Commenters also provided several potential effects of

capturing foreign public funds under the covered fund definition: U.S.

banking entities would incur unnecessary and substantial costs to

rebrand and restructure their non-U.S. regulated funds,\1754\ banking

entities could be eliminated from the potential pool of counterparties,

thereby affecting pricing and efficiency,\1755\ U.S. banking entities

may exit the UCITS market and lose competitiveness,\1756\ the growth of

mutual fund formation in foreign countries could be limited,\1757\ and

market liquidity in foreign jurisdictions could be impaired.\1758\

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\1750\ See BlackRock; Vanguard.

\1751\ See BlackRock.

\1752\ See ASF (Feb. 2012).

\1753\ See Union Asset; EFAMA; BVI.

\1754\ See Goldman (Covered Funds).

\1755\ See AFMA.

\1756\ See BoA.

\1757\ See BVI.

\1758\ See Goldman (Covered Funds).

See AFMA.

See BoA.

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Some commenters supported excluding any foreign public fund that is

organized or formed under non-U.S. law, authorized for public sale in

the jurisdiction in which it is organized or formed, and regulated as a

public investment company in that

[[Page 5950]]

jurisdiction.\1759\ In light of the proposal's broad definition of

covered fund, some commenters recommended explicitly excluding non-U.S.

regulated funds based on characteristics to distinguish the foreign

funds that should be treated as covered funds.\1760\ Several commenters

recommended excluding non-U.S. funds based upon whether the funds are

subject to a regulatory framework comparable to that which is imposed

on SEC-registered funds; \1761\ one commenter specifically identified

European UCITS, Canadian mutual funds, Australian unit trusts, and

Japanese investment trusts as examples of regulated funds to be

excluded.\1762\

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\1759\ See ICI Global; ICI (Feb. 2012); SSgA (Feb. 2012); BNY

Mellon et al.

\1760\ See UBS; ICI Global; ICI (Feb. 2012); Allen & Overy (on

behalf of Foreign Bank Group); T. Rowe Price; HSBC Life; Union

Asset; EFAMA; BVI; EBF; Hong Kong Inv. Funds Ass'n.; IMA; Ass'n. of

Institutional Investors (Feb. 2012); Katten (on behalf of Int'l

Clients); Credit Suisse (Williams).

\1761\ See T. Rowe Price; Credit Suisse (Williams); SSgA (Feb.

2012); BNY Mellon et al.

\1762\ See T. Rowe Price.

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To address these concerns, the final rule generally excludes from

the definition of covered fund any issuer that is organized or

established outside of the United States and the ownership interests of

which are authorized to be offered and sold to retail investors in the

issuer's home jurisdiction and are sold predominantly through one or

more public offerings outside of the United States.\1763\ Foreign funds

that meet these requirements will not be covered funds, except that an

additional condition applies to U.S. banking entities \1764\ with

respect to the foreign public funds they sponsor. The foreign public

fund exclusion is only available to a U.S. banking entity with respect

to a foreign fund sponsored by the U.S. banking entity if, in addition

to the requirements discussed above, the fund's ownership interests are

sold predominantly to persons other than the sponsoring banking entity,

affiliates of the issuer and the sponsoring banking entity, and

employees and directors of such entities.

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\1763\ See final rule Sec. 75.10(c)(1).

\1764\ Although the discussion of this condition generally

refers to U.S. banking entities for ease of reading, the condition

also applies to foreign affiliates of a U.S. banking entity. See

final rule Sec. 75.10(c)(1)(ii) (applying this limitation ``[w]ith

respect to a banking entity that is, or is controlled directly or

indirectly by a banking entity that is, located in or organized

under the laws of the United States or of any State and any issuer

for which such banking entity acts as sponsor'').

---------------------------------------------------------------------------

For purposes of this exclusion, the Agencies note that the

reference to retail investors, while not defined, should be construed

to refer to members of the general public who do not possess the level

of sophistication and investment experience typically found among

institutional investors, professional investors or high net worth

investors who may be permitted to invest in complex investments or

private placements in various jurisdictions. Retail investors would

therefore be expected to be entitled to the full protection of

securities laws in the home jurisdiction of the fund, and the Agencies

would expect a fund authorized to sell ownership interests to such

retail investors to be of a type that is more similar to a U.S.

registered investment company rather than to a U.S. covered fund.

In order to help maintain this distinction and to avoid

circumstances that could result in an evasion of section 13 and the

final rule, the ownership interests of the fund must be sold

predominantly in one or more public offerings outside of the United

States to qualify for the exclusion. Given this restriction, a U.S.

banking entity therefore could not rely on this exclusion to set up a

foreign public fund for the purpose of selling a significant amount of

ownership interests in the fund through one or more offerings conducted

on an unregistered basis (whether in a foreign jurisdiction or in the

United States). The Agencies generally expect that an offering is made

predominantly outside of the United States if 85 percent or more of the

fund's interests are sold to investors that are not residents of the

United States.

The requirements that a foreign public fund both be authorized for

sale to retail investors and sold predominantly in public offerings

outside of the United States are based in part on the Agencies' view

that foreign funds that meet these requirements generally will be

sufficiently similar to U.S. registered investment companies such that

it is appropriate to exclude these foreign funds from the covered fund

definition. A foreign fund authorized for sale to retail investors that

is also publicly offered may, for example, provide greater information

than funds that are sold through private offerings like funds that rely

on section 3(c)(1) or 3(c)(7). Such foreign funds also may be subject

to various restrictions, as deemed appropriate by foreign regulators in

light of local conditions and practices, that exceed those applicable

to privately offered funds. Foreign regulators may apply these or other

enhanced restrictions or other requirements to funds that are offered

on a broad basis to the general public for the protection of investors

in those jurisdictions.

A foreign fund that purports to publicly offer its shares but in

fact offers them on a more limited basis, however, may be less likely

to resemble a registered investment company in these and other

respects. In order to limit the foreign public fund exclusion to funds

that publicly offer their shares on a sufficiently broad basis, the

final rule defines the term ``public offering'' for purposes of this

exclusion to mean a ``distribution'' (as defined in Sec. 75.4(a)(3) of

subpart B) of securities in any jurisdiction outside the United States

to investors, including retail investors, provided that (i) the

distribution complies with all applicable requirements in the

jurisdiction in which such distribution is being made; (ii) the

distribution does not restrict availability to investors having a

minimum level of net worth or net investment assets; and (iii) the

issuer has filed or submitted, with the appropriate regulatory

authority in such jurisdiction, offering disclosure documents that are

publicly available.\1765\

---------------------------------------------------------------------------

\1765\ See final rule Sec. 75.10(c)(1)(iii).

---------------------------------------------------------------------------

Under the final rule, therefore, a foreign fund's distribution

would not be a public offering for purposes of the foreign public fund

exclusion if the distribution imposes investor restrictions based on a

required minimum level of net worth or net investment assets. This

would not be affected by any suitability requirements that may be

imposed under applicable local law. In addition, the final rule

requires that, in connection with a public offering by a foreign public

fund, the offering disclosure documents must be ``publicly available.''

This requirement will provide assurance regarding the transparency for

such an offering and will generally be satisfied where the documents

are made accessible to all persons in such jurisdiction. Disclosure

documents may be made publicly available in a variety of means, such as

through a public filing with a regulatory agency or through a Web site

that provides broad accessibility to persons in such jurisdiction.

In addition and as discussed above, the final rule also places an

additional condition on a U.S. banking entity's ability to rely on the

foreign public fund exclusion with respect to the foreign public funds

it sponsors. For a U.S. banking entity to rely on the foreign public

fund exclusion with respect to a foreign public fund it sponsors, the

ownership interests in the fund must be sold predominantly to persons

other than the sponsoring U.S. banking entity

[[Page 5951]]

and certain persons connected to that banking entity. Consistent with

the Agencies' view concerning whether a foreign public fund has been

sold predominantly outside of the United States, the Agencies generally

expect that a foreign public fund will satisfy this additional

condition if 85 percent or more of the fund's interests are sold to

persons other than the sponsoring U.S. banking entity and certain

persons connected to that banking entity.

This additional condition reflects the Agencies' view that the

foreign public fund exclusion is designed to treat foreign public funds

consistently with similar U.S. funds and to limit the extraterritorial

application of section 13 of the BHC Act, including by permitting U.S.

banking entities and their foreign affiliates to carry on traditional

asset management businesses outside of the United States. The exclusion

is not intended to permit a U.S. banking entity to establish a foreign

fund for the purpose of investing in the fund as a means of avoiding

the restrictions imposed by section 13. Permitting a U.S. banking

entity to invest in a foreign public fund under this exclusion only

when that fund is sold predominantly to persons other than the

sponsoring U.S. banking entity and certain persons connected to that

banking entity permits U.S. banking entities to continue their asset

management businesses outside of the United States while also limiting

the opportunity for evasion of section 13 as discussed below.

This additional condition only applies to U.S. banking entities

with respect to the foreign public funds they sponsor because the

Agencies believe that a foreign public fund sponsored by a U.S. banking

entity may present heightened risks of evasion. Absent the additional

condition, a U.S. banking entity could establish a foreign public fund

for the purpose of itself investing substantially in that fund and,

through the fund, making investments that the banking entity could not

make directly under section 13. The Agencies believe it is less likely

that a U.S. banking entity effectively could evade section 13 by

investing in third-party foreign public funds that the banking entity

does not sponsor. In those cases it is less likely that the U.S.

banking entity would be able to control the investments of the fund,

and the fund thus likely would be a less effective means for the

banking entity to engage in proprietary trading through the fund. The

Agencies therefore have declined to apply this additional condition

with respect to any foreign public fund in which a U.S. banking entity

invests but does not act as sponsor.

The Agencies note that the foreign public fund exclusion is not

intended to permit a banking entity to sponsor a foreign fund for the

purpose of selling ownership interests to any banking entity

(affiliated or unaffiliated) that is, or is controlled directly or

indirectly by a banking entity that is, located in or organized under

the laws of the United States or of any State (or to a limited group of

such banking entities). The Agencies intend to monitor banking

entities' investments in foreign public funds to ensure that banking

entities do not use the exclusion for foreign public funds in a manner

that functions as an evasion of section 13 in this or any other way.

The Agencies expect that one area of focus for such monitoring would be

significant investments in a foreign public fund, including a fund that

is unaffiliated with any banking entity located in or organized under

the laws of the United States or of any State, where such investments

represent a substantial percentage of the ownership interests in such

fund.

In order to conduct this monitoring more effectively, the Agencies

also are adopting certain documentation requirements concerning U.S.

banking entities' investments in foreign public funds, as discussed in

more detail below in Part VI.C.1 of this SUPPLEMENTARY INFORMATION.

Under the final rule, a U.S. banking entity with more than $10 billion

in total consolidated assets will be required to document its

investments in foreign public funds, broken out by each foreign public

fund and each foreign jurisdiction in which any foreign public fund is

organized, if the U.S. banking entity and its affiliates' ownership

interests in foreign public funds exceed $50 million at the end of two

or more consecutive calendar quarters. This requirement thus is

tailored to apply only to U.S. banking entities above a certain size

that also have substantial investments in foreign public funds.\1766\

The Agencies believe this approach appropriately balances the Agencies'

evasion concerns and the burdens that documentation requirements

impose.

---------------------------------------------------------------------------

\1766\ See final rule Sec. 75.20(e).

---------------------------------------------------------------------------

For all of the reasons discussed above, the Agencies believe that

the final rule's approach to foreign public funds is consistent with

the final rule's exclusion of registered or otherwise exempt (without

reliance on the exemptions in section 3(c)(1) or 3(c)(7)) funds in the

United States. It also limits the extraterritorial application of

section 13 of the BHC Act and reduces the potential economic and other

burdens commenters argued would result for banking entities. The

Agencies believe that this exclusion represents an appropriate

balancing of considerations that should not significantly increase the

risks to the U.S. financial system that section 13 was designed to

limit.

2. Wholly-Owned Subsidiaries

Under the proposed rule, a banking entity would have been permitted

to invest in or sponsor a wholly-owned subsidiary that relies on the

exclusion contained in section 3(c)(1) or 3(c)(7) of the Investment

Company Act to avoid being an investment company under that Act if the

subsidiary was carried on the balance sheet of its parent and was

engaged principally in performing bona fide liquidity management

activities.\1767\

---------------------------------------------------------------------------

\1767\ See proposed rule Sec. 75.14(a)(2)(iv); Joint Proposal,

76 FR at 68913.

---------------------------------------------------------------------------

Commenters argued that, instead of providing a permitted activity

exemption for banking entities to invest in or sponsor certain wholly-

owned subsidiaries as proposed, all wholly-owned subsidiaries should be

excluded from the definition of covered fund under the final rule

because wholly-owned subsidiaries are typically used for organizational

convenience and generally do not have the characteristics, risks, or

purpose of a hedge fund or private equity fund, which involves

unaffiliated investors owning interests in the structure for the

purpose of sharing in the profits and losses from investment

activities.\1768\ Commenters explained that publicly traded companies

often establish wholly-owned intermediate companies for the purpose of

holding securities of operating entities or other corporate vehicles

necessary to the business of the entity. Because these intermediate

companies invest entirely (or substantially) in the securities of other

entities, these intermediate companies may be investment companies for

purposes of the Investment Company Act but for the exclusion provided

by section 3(c)(1) or 3(c)(7) of the Investment Company Act.\1769\

---------------------------------------------------------------------------

\1768\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012),

JPMC; Goldman (Covered Funds), NAIB et al.; GE (Feb. 2012); BoA;

Chamber (Feb. 2012); Wells Fargo (Covered Funds); ABA (Keating);

Ass'n. of Institutional Investors (Feb. 2012); Credit Suisse

(Williams); Rep. Himes; BOK.

\1769\ See 15 U.S.C. 80a-3(a)(1)(A) & (C).

---------------------------------------------------------------------------

Commenters contended that requiring banking entities to divest

their interests in wholly-owned subsidiaries and cease certain

intercompany transactions would have a material adverse effect on the

safety, soundness, efficiency and stability of the U.S. and global

financial systems, which could in turn have a material adverse effect

on the wider

[[Page 5952]]

economy in terms of reduced credit, increased unemployment and reduced

output.\1770\ Commenters also argued that an exclusion for wholly-owned

subsidiaries is necessary in order to avoid a conflict with other

important requirements in the Dodd-Frank Act. For example, commenters

alleged that including wholly-owned subsidiaries within the definition

of covered fund for purposes of section 13 would create a conflict with

the requirement that a banking entity that is a bank holding company

serve as a source of strength to its subsidiaries because the

prohibition in section 13(f) on transactions between a banking entity

and covered funds owned or sponsored by the banking entity would

effectively prohibit the banking entity from providing financial

resources to wholly-owned intermediate holding companies and their

subsidiaries.\1771\ Other commenters argued that banking entities would

bear extensive compliance costs and operational burdens and likely

would be restricted from structuring themselves effectively.\1772\

---------------------------------------------------------------------------

\1770\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012).

\1771\ See SIFMA et al. (Covered Funds) (Feb. 2012); BoA; Rep.

Himes.

\1772\ See, e.g., Goldman (Covered Funds); BoA.

---------------------------------------------------------------------------

Commenters proposed several alternatives to address these concerns.

For instance, commenters recommended that the final rule exclude all

wholly-owned subsidiaries from the definition of covered fund.\1773\

Commenters also urged that the final rule include ownership interests

held by employees of a banking entity with any ownership interests held

directly by the banking entity for purposes of qualifying for any

exclusion granted by the rule for wholly-owned subsidiaries.\1774\

Another commenter recommended the exclusion of subsidiaries, wholly

owned or not, that engage in bona fide liquidity management.\1775\

---------------------------------------------------------------------------

\1773\ See Rep. Himes; Fin. Services Roundtable (June 14, 2011);

SIFMA et al. (Covered Funds) (Feb. 2012); BOK; Chamber (Feb. 2012);

ABA (Keating); GE (Feb. 2012); Wells Fargo (Covered Funds); Goldman

(Covered Funds); Ass'n. of Institutional Investors (Feb. 2012); BoA;

NAIB et al.

\1774\ See Wells Fargo (Covered Funds); Credit Suisse

(Williams).

\1775\ See Credit Suisse (Williams).

---------------------------------------------------------------------------

In light of these comments and consistent with the purposes of

section 13 and the terms of the Dodd-Frank Act as discussed in more

detail above, the Agencies have revised the final rule to exclude

wholly-owned subsidiaries from the definition of covered fund,

including those not engaged in liquidity management.\1776\ A wholly-

owned subsidiary, as defined in the final rule, is an entity, all of

the outstanding ownership interests of which are owned directly or

indirectly by the banking entity (or an affiliate thereof), except that

(i) up to five percent of the entity's ownership interests may be owned

by directors, employees, and certain former directors and employees of

the banking entity (or an affiliate thereof); and (ii) within the five

percent ownership interests described in clause (i), up to 0.5 percent

of the entity's outstanding ownership interests may be held by a third

party if the ownership interest is held by the third party for the

purpose of establishing corporate separateness or addressing

bankruptcy, insolvency, or similar concerns.\1777\

---------------------------------------------------------------------------

\1776\ Although not a condition of the exclusion, banking

entities may use wholly-owned subsidiaries to engage in bona fide

liquidity management. As discussed below, however, a wholly-owned

subsidiary is itself a banking entity, and thus is subject to all of

the requirements that apply to banking entities, including the

requirements applicable to a banking entity's liquidity management

activities under Sec. 75.3(d)(3).

\1777\ See final rule Sec. 75.10(c)(2).

---------------------------------------------------------------------------

Although the final rule includes ownership interests held by

certain former directors and employees for purposes of qualifying for

the exclusion, the exclusion requires that an interest held by a former

(or current) director or employee must actually be held by that person

(or by the banking entity) and must have been acquired while employed

by or in the service of the banking entity. For example, if a former

employee subsequently transfers his/her interest to a third party

(other than to immediate family members of the employee or through

intestacy of the employee), then the ownership interest would no longer

be held by the banking entity or persons whose ownership interests may

be aggregated with interests held by the banking entity for purposes of

the exclusion for wholly-owned subsidiaries under the final rule.

The final rule also permits up to 0.5 percent of the ownership

interest of a wholly-owned subsidiary to be held by a third party if

the interest is held by the third party for the purpose of establishing

corporate separateness or addressing bankruptcy, insolvency, or similar

concerns, and the ownership interest is included when calculating the

five percent cap on employee and director ownership. The Agencies

understand that it is often important, or in certain circumstances

required, under the laws of various jurisdictions for a parent company

to establish corporate separation of a subsidiary through the issuance

of a small amount of ownership interest to a third party.

The Agencies believe that permitting limited employee and director

ownership of a vehicle and accommodating the foreign law requirements

discussed above is consistent with a vehicle's treatment as a wholly-

owned subsidiary. Under the final rule, the banking entity (or an

affiliate thereof) will control the vehicle because it must, as

principal, own at least 95% of the vehicle.\1778\ These conditions are

designed to exclude from the covered fund definition vehicles that are

formed for corporate and organizational convenience, as discussed

above, and that thus do not engage in the investment activities

prohibited by section 13. The exclusion also should reduce the

disruption to the operations of banking entities that commenters

asserted would result from the proposed rule.\1779\

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\1778\ Cf. Section 2(a)(43) of the Investment Company Act

(defining a ``wholly-owned subsidiary'' of a person to mean ``a

company 95 per centum or more of the outstanding voting securities

of which are owned by such person, or by a company which, within the

meaning of this paragraph, is a wholly-owned subsidiary of such

person'').

\1779\ The Agencies also note that depositors for asset-backed

securities offerings are important to the process of securitization.

See, e.g., ASF (July 2012) (noting that a depositor, as used in a

securitization structure, is an entity that generally acts only as a

conduit to transfer the loans from the originating bank to the

issuing entity for the purpose of facilitating a securitization

transaction and engages in no discretionary investment or securities

issuance activities). See also, Rule 191 under the Securities Act of

1933 (17 CFR 230.191) (depositor as issuer for registered asset-

backed securities offerings). Commenters raised a question about the

treatment of depositors under the Investment Company Act, and

therefore, whether they would technically fall within the definition

of covered fund. See ASF (July 2012); GE (Aug. 2012). For purposes

of the covered fund prohibitions, the Agencies note that depositors

may fall within the wholly-owned subsidiary exclusion from the

covered fund definition.

---------------------------------------------------------------------------

Importantly, the Agencies note that a wholly-owned subsidiary of a

banking entity--although excluded from the definition of covered fund--

still would itself be a banking entity, and therefore remain subject to

the prohibitions and other provisions of section 13 of the BHC Act and

the final rule.\1780\ Accordingly, a wholly-owned subsidiary of a

banking entity would remain subject to the restrictions of section 13

and the final rule (including the ban on proprietary trading) and may

not engage in activity in violation of the prohibitions of section 13

and the final rule.

---------------------------------------------------------------------------

\1780\ See 12 U.S.C. 1851(h)(1) (defining banking entity to

include any affiliate or subsidiary of a banking entity).

---------------------------------------------------------------------------

3. Joint Ventures

The proposed rule would have permitted a banking entity to invest

in or manage a joint venture between the banking entity and any other

person,

[[Page 5953]]

provided that the joint venture was an operating company and did not

engage in any activity or any investment not permitted under the

proposed rule. As noted in the proposal, many joint ventures rely on

the exclusion contained in section 3(c)(1) or 3(c)(7) of the Investment

Company Act.\1781\ Joint ventures are a common form of business,

especially for firms seeking to enter new lines of business or new

markets, or seeking to share complementary business expertise.

---------------------------------------------------------------------------

\1781\ See Joint Proposal, 76 FR at 68913.

---------------------------------------------------------------------------

Commenters supported this aspect of the proposal and argued that

joint ventures do not share the same characteristics as a hedge fund or

private equity fund. However, they expressed concern that joint

ventures were defined too narrowly under the proposal because the

exclusion was limited to joint ventures that were operating

companies.\1782\ Some commenters criticized the lack of guidance

regarding the meaning of operating company.\1783\ One commenter

proposed defining operating company as any company engaged in

activities that are permissible for a financial holding company under

sections 3 or 4 of the BHC Act, other than a company engaged

exclusively in investing in securities of other companies for resale or

other disposition.\1784\

---------------------------------------------------------------------------

\1782\ See,, e.g., ABA (Keating); Chamber (Feb. 2012); SIFMA et

al. (Covered Funds) (Feb. 2012); GE (Aug. 2012); Goldman (Covered

Funds); NAIB et al.; Rep Himes; Sen. Bennet; see also 156 Cong Rec.

H5226 (daily ed. June 30, 2010) (statement of Rep. Himes).

\1783\ See, e.g., ABA (Keating); NAIB et al.; GE (Aug. 2012);

Chamber (Feb. 2012); SIFMA et al. (Covered Funds) (Feb. 2012); Wells

Fargo (Covered Funds); Credit Suisse (Williams); Goldman (Covered

Funds).

\1784\ See SIFMA et al. (Covered Funds) (Feb. 2012).

---------------------------------------------------------------------------

Another commenter argued that joint ventures are often used to

share risk from non-performing loans, credit card receivables, consumer

loans, commercial real estate loans or automobile loans.\1785\

According to this commenter, these joint ventures, while not generally

viewed as operating companies, promote safety and soundness by allowing

a banking entity to limit the size of its exposure to permissible

investments or to more efficiently transfer the risk of existing assets

to a small number of partners. Commenters stated that banking entities

often employ similar types of non-operating company joint ventures to

engage in merchant banking activities or other permissible banking

activities, and that the final rule should not prevent a banking entity

from sharing the risk of a portfolio company investment with third

parties.\1786\ A number of commenters argued that treating joint

ventures as covered funds would create the same inconsistencies with

other provisions and principles embodied in the Dodd-Frank Act noted

for wholly-owned subsidiaries, were they to be treated as covered

funds.\1787\ Several commenters argued that the proposed exemption, as

drafted, was unworkable because it did not appear to provide an

exception to the intercompany limitations on transactions under section

13(f), which prohibits transactions between a banking entity and a

related covered fund.\1788\

---------------------------------------------------------------------------

\1785\ See Goldman (Covered Funds).

\1786\ See ABA (Keating); SIFMA et al. (Covered Funds) (Feb.

2012).

\1787\ See SIFMA et al. (Covered Funds) (Feb. 2012); Goldman

(Covered Funds); ABA (Keating); Chamber (Feb. 2012).

\1788\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012);

Goldman (Covered Funds); ABA (Keating); GE (Feb. 2012); Chamber

(Feb. 2012).

---------------------------------------------------------------------------

Commenters proposed several alternatives to address these issues.

Several commenters recommended that the final rule eliminate the

operating company condition under the proposed exemption.\1789\ Other

commenters recommended excluding joint ventures that have an

unspecified but limited number of partners (such as five or fewer joint

venture partners).\1790\ One commenter recommended excluding all

``controlled joint ventures'' but did not provide an explanation of how

to define that term.\1791\ Another commenter suggested defining a joint

venture in one of the following ways: (1) Any company with a limited

number of co-venturers that is managed pursuant to a shareholders'

agreement, as opposed to managed by a general partner; \1792\ or (2) a

joint venture in which: (a) There are a limited number of unaffiliated

partners; (b) the parties operate the venture on a joint basis or in

proportion to their relative ownership, including pursuant to a

shareholders' agreement; (c) material decisions are made by one party

(for example, a general partner); and (d) the joint venture does not

engage in any activity or investment not permitted under section 13,

other than activities or investments incidental to its permissible

business.\1793\

---------------------------------------------------------------------------

\1789\ See SIFMA et al. (Covered Funds) (Feb. 2012); ABA

(Keating); Credit Suisse (Williams).

\1790\ See SIFMA et al. (Covered Funds) (Feb. 2012); Credit

Suisse (Williams); GE (Feb. 2012).

\1791\ See Goldman (Covered Funds).

\1792\ See ABA (Keating); Credit Suisse (Williams); SIFMA et al.

(Covered Funds) (Feb. 2012); SIFMA et al. (Mar. 2012); see also GE

(Feb. 2012); NAIB et al.

\1793\ See Goldman (Covered Funds).

---------------------------------------------------------------------------

In response to commenter concerns, the final rule excludes joint

ventures from the definition of covered fund with some modifications

from the proposal to more clearly identify entities that are excluded.

Under the final rule, a joint venture is excluded from the definition

of covered fund if the joint venture is between the banking entity or

any of its affiliates and no more than 10 unaffiliated co-venturers, is

in the business of engaging in activities that are permissible for the

banking entity other than investing in securities for resale or other

disposition, and is not, and does not hold itself out as being, an

entity or arrangement that raises money from investors primarily for

the purpose of investing in securities for resale or other disposition

or otherwise trading in securities.\1794\ Banking entities, therefore,

will continue to be able to share the risk and cost of financing their

banking activities through these types of entities which, as noted by

commenters as discussed above, may allow banking entities to more

efficiently manage the risk of their operations.

---------------------------------------------------------------------------

\1794\ See final rule Sec. 75.10(c)(3).

---------------------------------------------------------------------------

The Agencies have specified a limit on the number of joint venture

partners at the request of many commenters that suggested such a limit

be added (though typically without suggesting the specific number of

partners). The Agencies believe that a limit of 10 partners allows

flexibility in structuring larger business ventures without involving

such a large number of partners as to suggest the venture is in reality

a hedge fund or private equity fund established for investment

purposes. The Agencies will monitor joint ventures--and other excluded

entities--to ensure that they are not used by banking entities to evade

the provisions of section 13.

The final rule's requirement that a joint venture not be an entity

or arrangement that raises money from investors primarily for the

purpose of investing in securities for resale or other disposition or

otherwise trading in securities prevents a banking entity from relying

on this exclusion to evade section 13 of the BHC Act by owning or

sponsoring what is or will become a covered fund. Consistent with this

restriction and to prevent evasion of section 13, a banking entity may

not use a joint venture to engage in merchant banking activities

because that involves acquiring or retaining shares, assets, or

ownership interests for the purpose of ultimate resale or disposition

of the investment.\1795\

---------------------------------------------------------------------------

\1795\ See 12 U.S.C. 1843(k)(4)(H).

---------------------------------------------------------------------------

As with wholly-owned subsidiaries, if a banking entity owns 25

percent or more of the voting securities of the joint venture or

otherwise controls an entity

[[Page 5954]]

that qualifies for the joint venture exclusion, the joint venture would

then itself be a banking entity and would remain subject to the

restrictions of section 13 and the final rule (including the ban on

proprietary trading).

The Agencies note that the statute defines banking entity to

include not only insured depository institutions and bank holding

companies, but also their affiliates. In the context of a company that

owns an insured depository institution but is not a bank holding

company or savings and loan holding company, the insured depository

institution's affiliates may engage in commercial activities

impermissible for banks and bank holding companies. However, section 13

of the BHC Act and the final rule do not authorize a banking entity to

engage in otherwise impermissible activities. Because of this, the

scope of activities in which a joint venture may engage under the final

rule will depend on the status and identity of its co-venturers. For

instance, a joint venture between a bank holding company and

unaffiliated companies may not engage in commercial activities

impermissible for a bank holding company.

4. Acquisition Vehicles

Similar to wholly-owned subsidiaries and joint ventures, the

proposed rule would have permitted a banking entity to invest in or

sponsor an acquisition vehicle provided that the sole purpose and

effect of the acquisition vehicle was to effectuate a transaction

involving the acquisition or merger of an entity with or into the

banking entity or one of its affiliates. As noted in the proposal,

banking entities often form corporate vehicles for the purpose of

accomplishing a corporate merger or asset acquisition.\1796\ Because of

the way they are structured, acquisition vehicles may rely on section

3(c)(1) or 3(c)(7) of the Investment Company Act.\1797\

---------------------------------------------------------------------------

\1796\ Cf. Joint Proposal, 76 FR at 68897.

\1797\ See Joint Proposal, 76 FR at 68913; SIFMA et al. (Covered

Funds) (Feb. 2012).

---------------------------------------------------------------------------

Commenters supported the exclusion of acquisition vehicles from the

restrictions governing covered funds, and argued that acquisition

vehicles do not share the same characteristics as a hedge fund or

private equity fund.\1798\ However, similar to concerns articulated

above with respect to wholly-owned subsidiaries and joint ventures,

commenters argued that the proposed rule, as drafted, left uncertain

how other provisions of section 13 would apply to these vehicles.\1799\

---------------------------------------------------------------------------

\1798\ See, e.g., JPMC; SIFMA et al. (Covered Funds) (Feb.

2012); GE (Feb. 2012); Sen. Bennet; Sen. Carper et al.

\1799\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012);

JPMC; GE (Feb. 2012).

---------------------------------------------------------------------------

In light of the comments, the final rule has been modified to

exclude acquisition vehicles from the definition of covered fund,

rather than provide a permitted activity exemption for banking entities

to invest in or sponsor the vehicles, so long as the vehicle is formed

solely for the purpose of engaging in a bona fide merger or acquisition

transaction and the vehicle exists only for such period as necessary to

effectuate the transaction.\1800\ The final rule thus reflects

modifications from the exemption for acquisition vehicles in the

proposal, which was available for acquisition vehicles where the sole

purpose and effect of the entity was to effectuate a transaction

involving the acquisition or merger of one entity with or into the

banking entity.\1801\ The Agencies modified the conditions in the final

rule, as discussed above, to more clearly reflect the limited

activities in which an excluded acquisition vehicle may engage and to

exclude acquisition vehicles from the definition of covered fund,

rather than only permit banking entities to invest in or sponsor them

pursuant to an exemption.

---------------------------------------------------------------------------

\1800\ See final rule Sec. 75.10(c)(4).

\1801\ The proposed rule contained an exemption for investments

in acquisition vehicles, provided that the ``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.'' See proposed rule Sec.

75.14(a)(2)(ii). The final rule excludes an acquisition vehicle,

which is defined as an issuer that is ``[f]ormed solely for the

purpose of engaging in a bona fide merger or acquisition

transaction'' and that ``exists only for such period as necessary to

effectuate the transaction.'' See final rule Sec. 75.10(c)(4).

---------------------------------------------------------------------------

The Agencies also note that an acquisition vehicle that survives a

transaction would likely be excluded from the definition of covered

fund under the separate exclusion for either joint ventures or wholly-

owned subsidiaries described above. An acquisition vehicle that is

controlled by a banking entity would be a banking entity itself and

would be subject to the restrictions of section 13 and the final rule

that apply to a banking entity.

5. Foreign Pension or Retirement Funds

Under the proposed rule, a foreign pension plan that relied on

section 3(c)(1) or 3(c)(7) of the Investment Company Act to avoid being

an investment company (or that was a commodity pool), would have been a

covered fund. Commenters argued that including pension funds within the

definition of covered fund would produce many unexpected results for

pension plans as well as plan participants.\1802\

---------------------------------------------------------------------------

\1802\ As explained above, commenters also argued that a foreign

pension plan should not be considered a banking entity if the plan

is sponsored by a banking entity or is established for the benefit

of employees of the banking entity. If deemed a banking entity, the

pension plan could become subject to the limits on section 13 on

investing in covered funds. See Allen & Overy (on behalf of Canadian

Banks); Arnold & Porter; Credit Suisse (Williams). The final rule

addresses these comments with the exclusions described above.

---------------------------------------------------------------------------

Commenters generally argued that foreign pension or retirement

funds are established by a foreign company or foreign sovereign for the

purpose of providing a specific group of foreign persons with income

during retirement or when they reach a certain age or meet certain

predetermined criteria and are typically eligible for preferential tax

treatment, and are not formed for the same purposes as hedge funds or

private equity funds.\1803\ Commenters argued that the definition of

covered fund should not include certain foreign pension or retirement

funds, including managed investment arrangements and wrap platforms,

such as so-called ``superannuation funds,'' that are managed by foreign

banks as part of providing retirement or pension schemes to foreign

citizens pursuant to foreign law and are generally not available for

sale to U.S. citizens. Commenters asserted that many foreign banking

entities act as sponsor to and organize and offer foreign pension funds

abroad as part of a foreign sovereign program to provide retirement,

pension, or similar benefits to its citizens or workforce.\1804\ These

commenters contended that a foreign pension plan might itself rely on

the exclusion in section 3(c)(1) or 3(c)(7) in order to avoid being an

investment company if it is offered to citizens of the foreign

sovereign present in the United States.\1805\

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\1803\ See, e.g., Allen & Overy (on behalf of Canadian Banks).

\1804\ See Allen & Overy (on behalf of Canadian Banks); Arnold &

Porter; UBS; Hong Kong Inv. Funds Ass'n.

\1805\ See Allen & Overy (on behalf of Canadian Banks); Arnold &

Porter; UBS; Hong Kong Inv. Funds Ass'n.; Credit Suisse (Williams).

---------------------------------------------------------------------------

Several commenters argued that foreign pension and retirement plans

should be excluded from the definition of covered fund on the same

basis as U.S. pension and retirement funds that are ERISA-qualified

funds that rely on the exclusion from the definition of investment

company provided under section 3(c)(11) of the Investment Company

Act.\1806\ Commenters alleged that without an exclusion for foreign

[[Page 5955]]

pension or retirement funds, section 13 of the BHC Act would have an

extra-territorial effect on pension or retirement benefits abroad that

would be severe and beyond what was contemplated by section 13 of the

BHC Act.

---------------------------------------------------------------------------

\1806\ See Arnold & Porter; UBS; Hong Kong Inv. Funds Ass'n.;

Credit Suisse (Williams).

---------------------------------------------------------------------------

In light of comments received on the proposal, the final rule

excludes from the definition of covered fund a plan, fund, or program

providing pension, retirement, or similar benefits that is: (i)

Organized and administered outside of the United States; (ii) a broad-

based plan for employees or citizens that is subject to regulation as a

pension, retirement, or similar plan under the laws of the jurisdiction

in which the plan, fund, or program is organized and administered; and

(iii) established for the benefit of citizens or residents of one or

more foreign sovereign or any political subdivision thereof.\1807\ This

is similar to the treatment provided to U.S. pension funds by virtue of

the exclusion from the definition of investment company under the

Investment Company Act for certain broad-based employee benefit plans

provided by section 3(c)(11) of that Act. The exclusion from the

covered fund definition for foreign plans would be available for bona

fide plans established for the benefit of employees or citizens outside

the U.S. even if some of the beneficiaries of the fund reside in the

U.S. or subsequently become U.S. residents.

---------------------------------------------------------------------------

\1807\ See final rule Sec. 75.10(c)(5).

---------------------------------------------------------------------------

The Agencies believe this exclusion is appropriate in order to

facilitate parallel treatment of domestic and foreign pension and

retirement funds to the extent possible and to assist in ensuring that

section 13 of the BHC Act does not apply to foreign pension,

retirement, or similar benefits programs.\1808\

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\1808\ Additionally and as discussed above, the prohibitions of

section 13 and the final rule do not apply to an ownership interest

that is acquired or retained by a banking entity through a deferred

compensation, stock-bonus, profit-sharing, or pension plan of the

banking entity that is established and administered in accordance

with the law of the United States or a foreign sovereign, if the

ownership interest is held or controlled directly or indirectly by a

banking entity as trustee for the benefit of persons who are or were

employees of the banking entity.

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6. Insurance Company Separate Accounts

Under the proposed rule, insurance company separate accounts would

have been covered funds to the extent that the separate accounts relied

on section 3(c)(1) or 3(c)(7). Such reliance would generally occur in

circumstances where policies funded by the separate account are

distributed in an unregistered securities offering solely to qualified

purchasers or on a limited basis to accredited investors. While the

proposed rule did not generally exclude insurance company separate

accounts from the definition of covered fund, the proposed rule did

provide a limited exemption for investing in or acting as sponsor to

separate accounts that were used for the purpose of allowing a banking

entity to purchase bank owned life insurance (``BOLI''), subject to

certain restrictions.\1809\

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\1809\ See proposed rule Sec. 75.14(a)(1).

---------------------------------------------------------------------------

Various state or foreign laws allow regulated insurance companies

to create separate accounts that are generally not separate legal

entities but represent a segregated pool of assets on the balance sheet

of the insurance company that support a specific policy claim on the

insurance company. These accounts have assets and obligations that are

separate from the general account of the insurance company. Insurance

companies often utilize these separate accounts to allow policyholders

of variable annuity and variable life insurance to allocate premium

amounts for the purpose of engaging in various investment strategies

that are tailored to the requirements of the individual policyholder.

The policyholder, and not the insurance company, primarily benefits

from the results of investments in the separate account. These separate

accounts are generally investment companies for purposes of the

Investment Company Act, unless an exclusion from that definition is

applicable,\1810\ and, as noted above, may rely on the exclusion

contained in section 3(c)(1) or 3(c)(7) of the Investment Company Act.

---------------------------------------------------------------------------

\1810\ See In re The Prudential Ins. Co. of Am., 41 S.E.C. 335,

345 (1963), aff'd, The Prudential Ins. Co. of Am. v. SEC, 326 F.2d

383 (3d Cir.), cert. denied, 377 U.S. 953 (1964).

---------------------------------------------------------------------------

While most commenters supported the proposal's recognition that

interests in BOLI separate accounts should be permitted, commenters

generally argued that the final rule should also provide a broader

exclusion from the definition of covered fund for all insurance company

separate accounts. Commenters argued that covering separate accounts

could lead to unintended consequences and was inconsistent with the

statutory recognition that the business of insurance should continue to

be accommodated.\1811\ These commenters argued that covering separate

accounts within the definition of covered fund would disrupt a

substantial portion of customer-driven insurance or retirement planning

activity and pose a burden on insurance companies and holders of

insurance policies funded by separate accounts, a result commenters

alleged Congress did not intend.\1812\

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\1811\ See ACLI (Jan. 2012); Nationwide; Sutherland (on behalf

of Comm. of Annuity Insurers); see also STANY.

\1812\ See ACLI (Jan. 2012); Nationwide; Sutherland (on behalf

of Comm. of Annuity Insurers); see also STANY.

---------------------------------------------------------------------------

In response to commenter concerns and in order to more

appropriately accommodate the business of insurance in a regulated

insurance company, the final rule excludes an insurance company

separate account from the definition of covered fund under certain

circumstances. To prevent this exclusion from being used to evade the

restrictions on investments and sponsorship of covered funds by a

banking entity, the final rule provides that no banking entity other

than the insurance company that establishes the separate account may

participate in the account's profits and losses.\1813\ In this manner,

the final rule appropriately accommodates the business of insurance by

permitting an insurance company that is a banking entity to continue to

provide its customers with a variety of insurance products through

separate account structures in accordance with applicable insurance

laws while protecting against the use of separate accounts as a means

by which banking entities might take a proprietary or beneficial

interest in an account that engages in prohibited proprietary trading

and thereby evade the requirements of section 13 of the BHC Act. The

exclusion of insurance company separate accounts from the definition of

covered fund therefore is designed to reduce the potential burden of

the final rule on insurance companies and holders of insurance policies

funded by separate accounts while also continuing to prohibit banking

entities from taking ownership interests in, and sponsoring or having

certain relationships with, entities that engage in investment and

trading activities prohibited by section 13.

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\1813\ See final rule Sec. 75.10(c)(6).

---------------------------------------------------------------------------

7. Bank Owned Life Insurance Separate Accounts

As explained above, bank owned life insurance (``BOLI'') is

generally offered through a separate account held by an insurance

company. In recognition of the fact that banking entities have for many

years invested in life insurance policies that covered key employees,

in accordance with supervisory policies established by the Federal

banking agencies, the proposal contained a provision that would permit

banking

[[Page 5956]]

entities to invest in and sponsor BOLI separate accounts.\1814\

---------------------------------------------------------------------------

\1814\ See proposed rule Sec. 75.14(a)(1).

---------------------------------------------------------------------------

Many commenters supported the exemption in the proposal for BOLI

separate accounts, arguing that permitting this kind of activity was

appropriate and consistent with safety and soundness as well as

financial stability.\1815\ Conversely, one commenter objected to the

proposed rule's exemption for investments in BOLI separate accounts,

contending that such an exemption did not promote and protect the

safety and soundness of banking entities or the financial stability of

the United States.\1816\

---------------------------------------------------------------------------

\1815\ See ACLI (Jan. 2012); Mass. Mutual; Jones of

Northwestern; AALU; BBVA; BoA; Chris Barnard; Clark Consulting (Feb.

7, 2012); Clark Consulting (Feb. 13, 2012); Gagnon of GW Financial.

\1816\ See Occupy.

---------------------------------------------------------------------------

After considering comments received on the proposal, the final rule

excludes BOLI separate accounts from the definition of covered fund but

maintains the substance of the conditions from the proposal designed to

ensure that BOLI investments are not conducted in a manner that raises

the concerns that section 13 of the BHC Act was designed to address. In

particular, in order for a separate account to qualify for the BOLI

exclusion from the definition of covered fund, the final rule requires

that the separate account be used solely for the purpose of allowing

one or more banking entities (which by definition includes their

affiliates) to purchase a life insurance policy for which such banking

entity(ies) is a beneficiary.\1817\ Additionally, if the banking entity

is relying on this exclusion, the banking entity that purchases the

insurance policy (i) must not control the investment decisions

regarding the underlying assets or holdings of the separate

account,\1818\ and (ii) must participate in the profits and losses of

the separate account in compliance with applicable supervisory guidance

regarding BOLI.\1819\

---------------------------------------------------------------------------

\1817\ See final rule Sec. 75.10(c)(7).

\1818\ This requirement is not intended to preclude a banking

entity from purchasing a life insurance policy from an affiliated

insurance company.

\1819\ See, e.g., Bank Owned Life Insurance, Interagency

Statement on the Purchase and Risk Management of Life Insurance

(Dec. 7, 2004).

---------------------------------------------------------------------------

When made in the normal course, investments by banking entities in

BOLI separate accounts do not involve the types of speculative risks

section 13 of the BHC Act was designed to address. Rather, these

accounts permit the banking entity to effectively hedge and cover costs

of providing benefits to employees through insurance policies related

to key employees. Moreover, applying the prohibitions of section 13 to

investments in these accounts would eliminate an investment that helps

banking entities to efficiently reduce their costs of providing

employee benefits, and therefore potentially introduce a burden to

banking entities that would not further the statutory purpose of

section 13. The Agencies expect this exclusion to be used by banking

entities in a manner consistent with safety and soundness.

8. Exclusion for Loan Securitizations and Definition of Loan

a. Definition of Loan

The proposal defined the term ``loan'' for purposes of the

restrictions on proprietary trading and the covered funds provisions

and, as discussed in more detail below, provided an exemption for loan

securitizations in two separate sections of the proposed rule. As

proposed, loan was defined as ``any loan, lease, extension of credit,

or secured or unsecured receivable.'' \1820\ The definition of loan in

the proposed rule was expansive, and included a broad array of loans

and similar credit transactions, but did not include any asset-backed

security issued in connection with a loan securitization or otherwise

backed by loans.

---------------------------------------------------------------------------

\1820\ See proposed rule Sec. 75.2(q).

---------------------------------------------------------------------------

Some commenters requested that the Agencies narrow the proposed

definition of ``loan.'' \1821\ One of these commenters was concerned

that the proposed definition could apply to any banking activity and

argued that the definition of loan for purposes of the final rule

should not include securities.\1822\ Another commenter, citing a

statement made by Senator Merkley, asserted that Congress did not

intend the rule of construction for the sale and securitization of

loans in section 13(g)(2) to include ``loans that become financial

instruments traded to capture the change in their market value.''

\1823\

---------------------------------------------------------------------------

\1821\ See AFR et al. (Feb. 2012); Occupy; Public Citizen.

\1822\ See Public Citizen. This commenter argued that the loan

definition should be limited to the plain meaning of the term

``loan'' and noted that a loan is not a security. Id.

\1823\ See Occupy (citing 156 Cong. Rec. S5895 (daily ed. July

15, 2010)).

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Other commenters requested that the Agencies expand the proposed

definition of ``loan'' to capture many traditional extensions of credit

that the proposal would otherwise exclude.\1824\ Examples of

traditional credit extensions that commenters requested be specifically

included within the definition of ``loan'' included loan

participations,\1825\ variable funding notes or certificates,\1826\

note purchase facilities,\1827\ certain forms of revolving credit

lines,\1828\ corporate bonds,\1829\ municipal securities,\1830\

securities lending agreements and reverse repurchase agreements,\1831\

auto lease securitizations,\1832\ and any other type of credit

extension that banking entities traditionally have been permitted to

issue under their lending authority.\1833\

---------------------------------------------------------------------------

\1824\ See Allen & Overy (on behalf of Foreign Bank Group); ASF

(Feb. 2012); Credit Suisse (Williams); GE (Feb. 2012); Goldman

(Covered Funds); ICI (Feb. 2012); Japanese Bankers Ass'n.; JPMC;

LSTA (Feb. 2012); RBC; SIFMA et al. (Covered Funds) (Feb. 2012);

SIFMA (Securitization) (Feb. 2012). One individual commenter

supported the proposed definition of loan. See Alfred Brock. For

example, one commenter requested that definition of ``loan'' be

revised to include ``(i) any loan, lease (including any lease

residual), extension [of] credit, or secured or unsecured

receivables, (ii) any note, bond or security collateralized and

payable from pools of loans, leases (including Lease residuals),

extensions of credit or secured or unsecured receivables, and (iii)

any contractual rights arising from, or security interests or liens,

assets, property guarantees, insurance policies, letters of credit,

or supporting obligations underlying or relating to any of the

foregoing.'' See RBC. Another commenter requested that the

definition of ``loan'' be revised to include ``any type of credit

extension (including bonds, other [banking entity-eligible] debt

securities, asset-backed securities [as defined in their letter],

variable funding notes and securities lending agreements, repurchase

agreements, reverse repurchase agreements and other similar

extensions of credit) that a banking entity could hold or deal in.''

See SIFMA (Securitization) (Feb. 2012).

\1825\ See JPMC.

\1826\ See ASF (Feb. 2012); Credit Suisse (Williams); JPMC

(arguing that such notes operate in economic substance as loans);

SIFMA (Securitization) (Feb. 2012).

\1827\ See ASF (Feb. 2012). This commenter asserted that a note

purchase facility is negotiated by the asset-backed commercial paper

conduit and allows the asset-backed commercial paper conduit to

purchase asset-backed securities issued by an intermediate special

purpose vehicle and backed by loans or asset-backed securities

backed by loans. Id.

\1828\ See ASF (Feb. 2012).

\1829\ See Allen & Overy (on behalf of Foreign Bank Group); ASF

(Feb. 2012); Credit Suisse (Williams); JPMC.

\1830\ See ASF (Feb. 2012). This commenter argued that certain

municipal securities may be ABS, including revenue bonds that

involve the issuance of senior and subordinate bonds. Id.

\1831\ See Credit Suisse (Williams); SIFMA (Securitization)

(Feb. 2012).

\1832\ See SIFMA (Securitization) (Feb. 2012). This commenter

contended that because securitization transactions have been viewed

by the Agencies and courts as `legally transparent' (i.e., as simply

another way for banking entities to buy and sell the loans or other

assets underlying such securities), auto lease securitizations

supported by a beneficial interest in a titling trust should be

treated as securitizations of the underlying auto leases and should

fall within the loan securitization exemption. This commenter also

argued that if the definition of ``loan'' is not expanded to include

securities, then banking entities could not act as sponsors for auto

lease securitizations (including resecuritizations) supported by a

beneficial interest in a titling trust.

\1833\ See Credit Suisse (Williams); Goldman (Covered Funds);

SIFMA et al. (Covered Funds) (Feb. 2012); SIFMA (Securitization)

(Feb. 2012).

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The definition of ``loan'' in the final rule applies both in the

context of the

[[Page 5957]]

proprietary trading restrictions as well as in determining the scope of

the exclusion of loan securitizations and asset-backed commercial paper

conduits from the definition of covered fund. The final rule modifies

the proposed definition and defines ``loan'' as ``any loan, lease,

extension of credit, or secured or unsecured receivable that is not a

security or derivative.'' \1834\ The definition of loan in the final

rule specifically excludes loans that are securities or derivatives

because trading in these instruments is expressly included in the

statute's definition of proprietary trading.\1835\ In addition, the

Agencies believe these instruments, if not excluded from the definition

of loan, could be used to circumvent the restrictions on proprietary

trading.

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\1834\ See final rule Sec. 75.2(s).

\1835\ 12 U.S.C. 1851(h)(4).

---------------------------------------------------------------------------

The definition of loan in the final rule excludes loans that are

securities or derivatives, including securities or derivatives of or

based on such instruments. The definition of ``loan'' does not specify

the type, nature or structure of loans included within the definition,

other than by excluding securities and derivatives. In addition, the

definition of loan does not limit the scope of parties that may be

lenders or borrowers for purposes of the definition. The Agencies note

that the parties' characterization of an instrument as a loan is not

dispositive of its treatment under the Federal securities laws or

Federal laws applicable to derivatives. The determination of whether a

loan is a security or a derivative for purposes of the loan definition

is based on the Federal securities laws and the Commodity Exchange Act.

Whether a loan is a ``note'' or ``evidence of indebtedness'' and

therefore a security under the Federal securities laws will depend on

the particular facts and circumstances, including the economic terms of

the loan.\1836\ For example, loans that are structured to provide

payments or returns based on, or tied to, the performance of an asset,

index or commodity or provide synthetic exposure to the credit of an

underlying borrower or an underlying security or index may be

securities or derivatives depending on their terms and the

circumstances of their creation, use, and distribution.\1837\

Regardless of whether a party characterizes the instrument as a loan,

these kinds of instruments, which may be called ``structured loans,''

must be evaluated based on the standards associated with evaluating

derivatives and securities in order to prevent evasion of the

restrictions on proprietary trading and ownership interests in covered

funds.

---------------------------------------------------------------------------

\1836\ See 15 U.S.C. 77b(a)(1) and 15 U.S.C. 78c(a)(10); Reves

v. Ernst & Young, 494 U.S. 56 (1990) ; Trust Company of Louisiana v.

N.N.P. Inc., 104 F.3d 1478 (5th Cir. 1997); Pollack v. Laidlaw

Holdings, 27 F.3d 808 (2d Cir. 1994); but see Marine Bank v. Weaver,

455 U.S. 551 (1982); Banco Espanol de Credito v. Security Pacific

National Bank, 973 F.2d 51 (2d Cir. 1992); Bass v. Janney Montgomery

Scott, Inc., 210 F.3d 577 (6th Cir. 2000); Piaubert v. Sefrioui,

2000 WL 194140 (9th Cir. 2000).

\1837\ Id.

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b. Loan Securitizations

An exemption for loan securitizations was contained in two separate

sections of the proposed rule. The first, in section 75.13(a), was

proposed as part of ``other permitted covered fund activities and

investments.'' The second, in Sec. 75.14(d), was proposed as part of

``covered fund activities determined to be permissible.'' These

proposed provisions would have acted in concert to permit a banking

entity to acquire and retain an ownership interest in, or act as

sponsor to, a loan securitization regardless of the relationship that

the banking entity had with the securitization. The Agencies have

evaluated all comments received on securitizations. These sections of

the proposed rule were intended to implement the rule of construction

contained in 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 that is

otherwise permitted by law.\1838\ The language of the proposed

exemption for loan securitizations would have permitted 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 were solely comprised of: (i) Loans (as defined); (ii) 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 rights or

assets and (B) are used for hedging purposes with respect to the

securitization structure.\1839\ The proposed rule in Sec. 75.13(d) was

further augmented by the proposed rule in Sec. 75.14(a)(2) so that a

banking entity would be permitted to purchase loan securitizations and

engage in the sale and securitization of loans. This was accomplished

through the authorization in proposed section 75.14(a)(2) of a banking

entity's acquisition or retention of an ownership interest in such

securitization vehicles that the banking entity did not organize and

offer, or for which it did not act as sponsor, provided that the assets

or holdings of such vehicles were solely comprised of the instruments

or obligations identified in the proposed exemption.

---------------------------------------------------------------------------

\1838\ See 12 U.S.C. 1851(g)(2).

\1839\ See proposed rule Sec. 75.13(d); Joint Proposal, 76 FR

at 68912.

---------------------------------------------------------------------------

The proposed rules would have allowed 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 be a

covered fund for purposes of the proposed rules) that the banking

entity organized and offered, or acted as sponsor to, without being

subject to the ownership and sponsor limitations contained in the

proposed rule.\1840\ As noted in the proposing release, the Agencies

recognized that by defining ``covered fund'' broadly, and, in

particular, by reference to sections 3(c)(1) and 3(c)(7) of the

Investment Company Act, securitization vehicles may be affected by the

restrictions and requirements of the proposed rule. The Agencies

attempted to mitigate the potential adverse impact on the

securitization market by excluding loan securitizations from the

restrictions on sponsoring or acquiring and retaining ownership

interests in covered funds, consistent with the rule of construction

contained in section 13(g)(2) of the BHC Act.\1841\ As a result, under

the proposal, loan securitizations would not be limited or restricted

because banking entities would be able to find investors or buyers for

their loans or loan securitizations. The proposing release included

several requests for comment on the proposed loan securitization

exemption and the application of the covered fund prohibitions to

securitizations.

---------------------------------------------------------------------------

\1840\ Id.

\1841\ See Joint Proposal, 76 FR at 68931.

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Some commenters supported a narrow exemption for loan

securitizations and in some cases suggested that the proposed exemption

could be narrowed even further. For example, one commenter argued that

the definition of ``loan'' for purposes of the exemption could include

any extension of credit and any banking activity.\1842\ Also, in

response to the

[[Page 5958]]

proposing release,\1843\ some commenters suggested that any exemption

for securitizations should seek to prevent evasion of the covered fund

prohibitions by issuers with ``hedge-fund or private equity fund-like

characteristics'' or issuers with ``hidden proprietary trading

operations.'' \1844\

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\1842\ See, e.g., Public Citizen. This commenter argued that any

exemption should prevent evasion, should ensure that each exempted

securitization reduces risk and should be designed to only serve

client needs. A different commenter recommended a safe harbor

available only to a particular pre-specified, transparent and

standardized securitization structure, where Agencies would need to

justify why the specified structure protects against the systemic

risks associated with securitization. See AFR (Nov. 2012).

\1843\ See Request for Comment No. 231 in the Proposing Release

(noting that 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) and requesting comment on how to prevent

hedge funds or private equity funds from structuring around an

exemption for asset-backed securities from the covered fund

prohibitions).

\1844\ See, e.g., AFR et al. (Feb. 2012); Occupy; Public

Citizen. But see Credit Suisse (Williams) (arguing it would be

difficult to use the typical structure and operation of

securitizations to avoid the prohibition on proprietary trading

because the structures are not set up to engage in the kind of

proprietary trading about which Congress was concerned).

---------------------------------------------------------------------------

On the other hand, many commenters believed that the proposed

exemption from the covered fund prohibitions for loan securitizations

should be expanded to cover securitizations generally and not just loan

securitizations. These commenters provided various arguments for their

request to exempt all securitizations from the covered fund

prohibitions, including that the regulation of securitizations was

addressed in other areas of the Dodd-Frank Act,\1845\ that

securitization is essentially a lending activity,\1846\ and that

securitizations have ``long been recognized as permissible activities

for banking entities.'' \1847\

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\1845\ See AFME et al.; Ass'n. of German Banks; Cleary

Glottlieb; Credit Suisse (Williams); GE (Feb. 2012); IIB/EBF; RBC;

SIFMA (Securitization) (Feb. 2012).

\1846\ See, e.g., Credit Suisse (Williams).

\1847\ See Credit Suisse (Williams); JPMC. These commenters

cited the sponsoring of asset-backed commercial paper conduits as an

example of permissible bank securitization activity.

---------------------------------------------------------------------------

Commenters recommending a broader exclusion for securitizations

also provided a wide variety of specific suggestions or concerns. Some

commenters suggested that permissible assets for a loan securitization

include assets other than loans acquired in the course of collecting a

debt previously contracted, restructuring a loan, during a loan work

out or during the disposition of a loan or other similar

situation.\1848\ Commenters noted that, for example, rules 2a-7 and 3a-

7 under the Investment Company Act define eligible assets for a

securitization as not only including financial assets but also ``any

rights or other assets designed to assure the servicing or timely

distribution of proceeds to security holders.'' \1849\ Commenters

requested that various additional rights or assets be added to the list

of permissible assets held by a loan securitization such as cash and

cash accounts,\1850\ cash equivalents,\1851\ and various other high

quality short term investments, liquidity agreements or credit

enhancements, certain beneficial interests in titling trusts used in

lease securitizations or lease residuals.\1852\ One commenter suggested

that a loan securitization be permitted to include ``any contractual

rights arising from or supporting obligations underlying or relating to

the loans.'' \1853\

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\1848\ See Allen & Overy (on behalf of Foreign Bank Group);

Credit Suisse (Williams); JPMC.

\1849\ See GE (Feb. 2012); GE (Aug. 2012); ICI (Feb. 2012).

\1850\ See Allen & Overy (on behalf of Foreign Bank Group); ASF

(Feb. 2012); Cleary Gottlieb; Credit Suisse (Williams) (including

cash that did not arise directly from the underlying loans); JPMC;

LSTA (Feb. 2012); LSTA (July 2012); RBC; SIFMA (Securitization)

(Feb. 2012).

\1851\ See Cleary Gottlieb; Credit Suisse (Williams).

\1852\ See JPMC (requesting high quality, highly liquid

investments, including Treasury securities and highly rated

commercial paper); LSTA (Feb. 2012); LSTA (July 2012) (requesting

short-term highly liquid investments such as obligations backed by

the full faith and credit of the United States, deposits insured by

the Federal Deposit Insurance Corporation, various obligations of

U.S. financial institutions and investments in money market funds);

ASF (Feb. 2012); Commercial Real Estate Fin. Council; RBC

(requesting short-term, high quality investments); Allen & Overy (on

behalf of Foreign Bank Group) (requesting short-term eligible

investments); Credit Suisse (Williams) (requesting government

guaranteed securities, money market funds and other highly credit-

worthy and liquid investments); Cleary Gottlieb (requesting money-

market interests; SIFMA (Securitization) (Feb. 2012) (requesting

associated investments which are customarily employed in

securitization transactions). One commenter further noted that such

investments are required by securitization documents. See Commercial

Real Estate Fin. Council.

\1853\ RBC. This commenter argued that the loan securitization

exemptions as proposed would not permit ``traditional

securitizations and securitizations with the characteristics of

traditional securitizations'' and ``would effectively eliminate a

substantial portion of the very securitization activities carried on

by banks that the [loan securitization exemptions] are designed to

preserve.''

---------------------------------------------------------------------------

Others requested that loan securitizations also be permitted to

hold repurchase agreements or unlimited amounts of various forms of

securities, including municipal securities, asset-backed securities,

credit-linked notes, trust certificates and ``equity like-rights.''

\1854\ Some commenters requested that loan securitizations be permitted

to hold a limited amount of certain rights such as securities.\1855\

Commenters also had suggestions about the types of derivatives that an

exempted securitization vehicle be permitted to hold.\1856\ For

example, one industry association requested that the loan

securitization exemption include securitizations where up to 10 percent

of the assets are held in the form of synthetic risk exposure that

references ``loans that could otherwise be held directly'' under the

proposal in order to achieve risk diversification.\1857\ This commenter

stated its belief that the rule of construction requires that synthetic

exposures be permitted because they are used in certain types of loan

securitizations.

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\1854\ See Allen & Overy (on behalf of Foreign Bank Group); ASF

(Feb. 2012); Credit Suisse (Williams); GE (Feb. 2012); JPMC; RBC;

SIFMA et al. (Covered Funds) (Feb. 2012); SIFMA (Securitization)

(Feb. 2012).

\1855\ See, e.g., ASF (Feb. 2012); Cleary Gottlieb; LSTA (Feb.

2012). LSTA (Feb. 2012) specifically requested that entities issuing

collateralized loan obligations that are primarily backed by loans

or loan participations also be permitted to hold a limited amount of

corporate credit obligations. This commenter provided

recommendations about such limitations--if the amount of such

corporate credit obligations exceeded 10 percent, a CLO would not be

able to purchase any assets other than senior, secured syndicated

loans and temporary investments (as defined in the letter). If the

amount of such assets exceeded 30 percent, the entity should not be

able to purchase any assets other than loans.

\1856\ See AFME et al.; Allen & Overy (on behalf of Foreign Bank

Group); Credit Suisse (Williams); Japanese Bankers Ass'n.; LSTA

(Feb. 2012); SIFMA (Securitization) (Feb. 2012).

\1857\ See ASF (Feb. 2012). Permissible synthetic exposure would

include ``credit default swaps, total return swaps or other

agreements referencing corporate loans or corporate bonds pursuant

to which the issuer is the seller of credit protection or otherwise

`long' the credit exposure of the reference corporate loan or bond,

and receives a yield derived from the yield on the reference

corporate loan or bond.''

---------------------------------------------------------------------------

In addition to requests that specific types of underlying assets be

permitted under the loan securitization exemption, the Agencies also

received comments about specific types of asset classes or structures.

Some commenters suggested certain asset classes or structures should be

an excluded securitization from the covered fund prohibitions including

insurance-linked securities, collateralized loan obligations, tender

option bonds, asset-backed commercial paper conduits (ABCP conduits),

resecuritizations of asset-backed securities, and corporate debt re-

packagings.\1858\ In some cases, commenters believed that the Agencies

should use their authority under section 13(d)(1)(J) of the BHC Act to

exempt these types of vehicles. Some commenters identified other

vehicles such as credit funds and issuers of covered bonds that they

believed should be excluded from the covered fund

[[Page 5959]]

prohibitions.\1859\ On the other hand, the Agencies also received

comment letters that argued that certain securitizations should not be

exempted from the covered fund prohibitions, including

resecuritizations, CDO-squared, and CDO-cubed securitizations because

of concern about their complexity and lack of reliable performance data

or ability to value those securities.\1860\

---------------------------------------------------------------------------

\1858\ See AFME et al.; ASF (July 2012); GE (Aug. 2012); Capital

Group; Goldman (Covered Funds); LSTA (Feb. 2012); SIFMA et al.

(Covered Funds) (Feb. 2012).

\1859\ See Goldman (Covered Funds) (requesting exclusion for

credit funds). AFME et al. (requesting exclusion for covered bonds);

FSA (Apr. 2012) (requesting exclusion for covered bonds); UKRCBC

(requesting exclusion for covered bonds).

\1860\ See Sens. Merkley & Levin (Feb. 2012). These commenters

argued that there should be increased capital charges in line with

the complexity of a securitization and using the ``high risk asset

limitations on permitted activities to bar any securitization by a

bank from using complex structures, re-securitization techniques,

synthetic features, or other elements that may increase risk or make

a risk analysis less reliable.''

---------------------------------------------------------------------------

Because a loan securitization could still be a covered fund,

several commenters expressed concern that the proposed loan

securitization exemption, as drafted, did not exempt loan

securitizations from the prohibitions of section 13(f) of the BHC Act.

As a result, one commenter noted that the proposed loan securitization

exemptions would not have their intended result of excluding loan

securitizations from the BHC Act restrictions applicable to covered

funds.\1861\

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\1861\ See AFME et al.; SIFMA (May 2012) (arguing that because

of the narrowness of the proposed exemption and because it would not

exempt securitizations from prohibitions on covered transactions

imposed by section 13(f), the rule as proposed ``will effectively

prevent banking entities from sponsoring and owning a large variety

of asset-backed securities, in contravention of the rule of

construction.'')

---------------------------------------------------------------------------

Certain securitization transactions may involve the issuance of an

intermediate asset-backed security that supports the asset-backed

securities that are issued to investors, such as in auto lease

securitizations and ABCP conduits. Commenters suggested that the

Agencies should look through intermediate securitizations to the assets

that support the intermediate asset-backed security to determine if

those assets would satisfy the definition of ``loan'' for purposes of

the loan securitization exemption. If those assets are loans, these

commenters suggested that the entire securitization transaction should

be deemed a loan securitization, even if the assets supporting the

asset-backed securities issued to investors are not loans.\1862\

However, some commenters argued that each step in a multi-step

securitization should be viewed separately to ensure compliance with

the specific restrictions in the proposal because otherwise a multi-

step securitization could include impermissible assets.\1863\ Some

commenters also raised question about whether depositors would fall

within the definition of ``investment company'' under the Investment

Company Act and, therefore, may fall within the proposed definition of

covered fund.\1864\

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\1862\ See AFME et al.; ASF (Feb. 2012); SIFMA (Securitization)

(Feb. 2012).

\1863\ See Occupy; Public Citizen. Occupy contended that the

structured security issued in a multi-step securitization can hide

underlying risks under layers of structured complexity. See Occupy.

Public Citizen argued that prohibiting such activity would ensure

that securitizations do not become proprietary trading vehicles for

banking entities that are effectively off-balance sheet. See Public

Citizen. See infra Part VI.B.1.c.8.b.iv. of this SUPPLEMENTARY

INFORMATION.

\1864\ A depositor, as used in a securitization structure, is an

entity that generally acts only as a conduit to transfer the loans

from the originating bank to the issuing entity for the purpose of

facilitating a securitization transaction and engages in no

discretionary investment or securities issuance activities. See ASF

(July 2012); GE (Aug. 2012). For purposes of this rule, the Agencies

believe the wholly owned subsidiary exclusion is available for

depositors. See supra note 1779.

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After considering carefully the comments received on sections of

the proposed rule, the Agencies have determined to adopt a single

section in the final provision relating to loan securitizations that

would exclude loan securitizations that meet certain criteria contained

in the rule from the definition of covered fund. The rule, as adopted,

takes into account comments received on each of the conditions

specified in the two loan securitization sections of the proposed

provisions and has adopted those conditions with some clarifying

changes from the proposed language. In addition, in response to

comments, as discussed more fully below, the Agencies are adopting

additional exclusions from the definition of covered fund for certain

types of vehicles if they are backed by the same types of assets as the

assets that are permitted to be held in the loan securitization

exclusion. These additional exclusions are tailored to vehicles that

are very similar to loan securitizations but have particular structural

issues, which are described in more detail below.

In light of the comments received on the proposal, the final rule

was revised to exclude from the definition of covered fund an issuing

entity of asset-backed securities, as defined in Section 3(a)(79) of

the Exchange Act,\1865\ if the underlying assets or holdings are

comprised solely of: (A) loans, (B) any rights or other assets (i)

designed to assure the servicing or timely distribution of proceeds to

security holders or (ii) related or incidental to purchasing or

otherwise acquiring, and holding the loans, (C) certain interest rate

or foreign exchange derivatives, and (D) certain special units of

beneficial interests and collateral certificates (together, ``loan

securitizations'').\1866\ In addition, as discussed below, the Agencies

are adopting specific exclusions for certain vehicles that issue short

term asset-backed securities and for pools of assets that are part of

covered bond transactions which pools also meet the conditions

delineated above.\1867\

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\1865\ 15 U.S.C. 78c(a)(79). This definition was added by

Section 941 of the Dodd-Frank Act.

\1866\ See final rule Sec. 75.10(c)(8). Consistent with the

proposal, certain securitizations, regardless of asset composition,

would not be considered covered funds because the securitization

issuer is deemed not to be an investment company under Investment

Company Act exclusions other than section 3(c)(1) or 3(c)(7) of the

Investment Company Act. For example, this would include issuers that

meet the requirements of section 3(c)(5) or rule 3a-7 of the

Investment Company Act, and the asset-backed securities of such

issuers may be offered in transactions registered under the

Securities Act.

\1867\ As discussed below, the Agencies are adopting an

exclusion from the definition of covered funds for the pools of

assets that are involved in the covered bond financings. Although

the cover pools must satisfy the same criteria as the excluded loan

securitizations, a separate exclusion is needed because the

securities involved in the covered bond issuance are not asset-

backed securities.

---------------------------------------------------------------------------

Although commenters argued that various types of assets should be

included within the definition of loan or otherwise permitted to be

held under the loan securitization exclusion, the loan securitization

exclusion in the final rule has not been expanded to be a broad

exclusion for all securitization vehicles. Although one commenter

suggested that any securitization is essentially a lending

activity,\1868\ the Agencies believe such an expansion of the exclusion

would not be consistent with the rule of construction in section

13(g)(2) of the BHC Act, which specifically refers to the ``sale and

securitization of loans.'' The Agencies believe that a broad definition

of loan and therefore a broad exemption for transactions that are

structured as securitizations of pooled financial assets could

undermine the restrictions Congress intended to impose on banking

entities' covered fund activities, which could enable market

participants to use securitization structures to engage in activities

that otherwise are constrained for covered funds. The Agencies believe

the purpose underlying section 13 is not to expand the scope of assets

in an excluded loan securitization beyond loans as defined in the final

rule and the other assets that the Agencies are specifically permitting

in a loan securitization.

---------------------------------------------------------------------------

\1868\ See, e.g., Credit Suisse (Williams).

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[[Page 5960]]

While not expanding the permitted assets under the loan

securitization exclusion, the Agencies have made modifications in

response to commenters to ensure that the provisions of the final rule

appropriately accommodate the need, in administering a loan

securitization transaction on an ongoing basis, to hold various assets

other than the loans that support the asset-backed securities.

Moreover, the Agencies do not believe that the assets permitted under

the loan securitization need to be narrowed further to prevent evasion

and hidden proprietary trading as requested by certain commenters

because the Agencies believe that the potential for evasion has been

adequately addressed through modifications to the definition of loan

and more specific limitations on the types of securities and

derivatives permitted in an excluded loan securitization. The Agencies

have revised the scope of the loan securitization exclusion to

accommodate existing market practice for securitizations as discussed

by commenters while limiting the availability of the exclusion for

these particular types of securitization transactions to issuers of

asset-backed securities supported by loans.

The Agencies are not adopting specific exclusions for other

securitization vehicles identified by commenters, including insurance-

linked securities, collateralized loan obligations, and corporate debt

re-packagings.\1869\ The Agencies believe that providing such

exclusions would not be consistent with the rule of construction in

section 13(g)(2) of the BHC Act, which specifically refers to the

``sale and securitization of loans.'' These other types of

securitization vehicles referenced by commenters are used to securitize

exposures to instruments which are not included in the definition of

loan as adopted by the final rule. Moreover, the Agencies note in

response to commenters that resecuritizations of asset-backed

securities and CDO-squared and CDO-cubed securitizations could be used

as a means of evading the prohibition on the investment in the

ownership interests of covered funds.

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\1869\ Commenters' concerns regarding credit funds are discussed

below in Part VI.B.1.d.6. of this SUPPLEMENTARY INFORMATION.

---------------------------------------------------------------------------

As with the proposed rules, the Agencies are excluding certain loan

securitizations from the definition of covered fund and therefore the

prohibitions applicable to banking entities' involvement in covered

funds in order to implement Congressional intent expressed in the rule

of construction in section 13(g)(2) of the BHC Act.\1870\ The Agencies

believe that, as reflected in the rule of construction, the continued

ability of banking entities to participate in loan securitizations is

important to enable banks of all sizes to be able to continue to

provide financing to loan borrowers at competitive prices. Loan

securitizations provide an important avenue for banking entities to

obtain investor financing for existing loans, which allows such banks

greater capacity to continuously provide financing and lending to their

customers. The Agencies also believe that loan securitizations that

meet the conditions of the rule as adopted do not raise the same types

of concerns as other types of securitization vehicles that could be

used to circumvent the restrictions on proprietary trading and

prohibitions in section 13(f) of the BHC Act.

---------------------------------------------------------------------------

\1870\ As discussed below, the Agencies are excluding those loan

securitizations that hold only loans (and certain other assets

identified in the final rule), consistent with the rule of

construction in section 13(g)(2) of the BHC Act.

---------------------------------------------------------------------------

Under the rule as adopted, loan securitizations that meet the

conditions of the rule as adopted are excluded from the definition of

covered fund and, consequently, banking entities are not restricted as

to their ownership of such entities or their ongoing relationships with

such entities by the final rule. As the Agencies stated in the

proposal, permitting banking entities to acquire or retain an ownership

interest in these loan securitizations will allow for 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 the

continued availability of funding to individuals and small businesses,

as well as provide an efficient allocation of capital and sharing of

risk. The Agencies believe that excluding these loan securitizations

from the definition of covered fund is consistent with the terms and

the purpose of section 13 of the BHC Act, including the rule of

construction regarding loan securitizations.\1871\

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\1871\ The Agencies note that the loan securitization and other

securitization exclusions apply only to the definition of covered

fund, and therefore the covered fund-related provisions of the rule,

and not to its prohibition on proprietary trading. The Agencies

recognize that trading in loans is not subject to the proprietary

trading restrictions.

---------------------------------------------------------------------------

i. Loans

The first condition of the loan securitization exclusion from the

definition of covered fund is that the underlying assets or holdings

are comprised of loans. In the proposal, ``loan'' was a defined term

for purposes of the restrictions on proprietary trading and the covered

funds provisions. As proposed, a loan was defined as a loan, lease,

extension of credit, or secured or unsecured receivable.\1872\ The

definition of loan in the proposed rule was expansive, and included a

broad array of loans and similar credit transactions, but did not

include any asset-backed security that is issued in connection with a

loan securitization or otherwise backed by loans.

---------------------------------------------------------------------------

\1872\ See proposed rule Sec. 75.2(q).

---------------------------------------------------------------------------

As discussed above under ``Definition of Loan,'' the Agencies

received comments regarding the loan definition in the securitization

context. In particular, one commenter, citing a statement made by

Senator Merkley, argued that Congress did not intend the loan

securitization exemption to include ``loans that become financial

instruments traded to capture the change in their market value.''

\1873\

---------------------------------------------------------------------------

\1873\ See Occupy (citing 156 Cong. Rec. S5895 (daily ed. July

15, 2010)).

---------------------------------------------------------------------------

The Agencies, after considering carefully the comments received,

have adopted a definition of loan that is revised from the proposed

definition. The final rule defines ``loan'' as ``any loan, lease,

extension of credit, or secured or unsecured receivable that is not a

security or derivative.'' \1874\ The definition of loan in the final

rule specifically excludes loans that are securities or derivatives

because trading in these instruments is expressly included in the

statute's definition of proprietary trading.\1875\ In addition, the

Agencies believe these instruments, if not excluded from the definition

of loan, could be used to circumvent the restrictions on proprietary

trading. Further, for purposes of the loan securitization exclusion,

the loan securitization must own the loan directly; a synthetic

exposure to a loan, such as through holding a derivative, such as a

credit default swap, will not satisfy the conditions for the loan

securitization exclusion.\1876\ As such, a securitization that owns a

tranche of another loan securitization is not itself a loan

securitization, even if the ownership of such tranche by a banking

entity would otherwise be permissible under the final rule.

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\1874\ See Sec. 75.2(r).

\1875\ 12 U.S.C. 1851(h)(4).

\1876\ Under the final provision, the issuing entity for the

SUBIs and collateral certificate may rely on the loan securitization

exclusion because of the separate provisions allowing such a

holding.

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As discussed above under ``Definition of Loan,'' the definition of

loan in the final rule has not been expanded as requested by some

commenters but has

[[Page 5961]]

been clarified in some respects in response to comments. The final rule

explicitly excludes securities or derivatives.\1877\ In addition, the

definition of loan has not been modified to include repurchase

agreements or reverse repurchase agreements regardless of the character

of the underlying asset. The Agencies are concerned that parties, under

the guise of a ``loan'' might instead create instruments that provide

the same exposures to securities and derivatives that otherwise are

prohibited by section 13 and might attempt to use the loan

securitization exclusion to acquire ownership interests in covered

funds holding those types of instruments, counter to the terms and the

purpose of section 13 of the BHC Act. As the Agencies have noted

previously, the rules relating to covered funds and to proprietary

trading are not intended to interfere with traditional lending

practices or with securitizations of loans generated as a result of

such activities. Although the Agencies have revised the definition of

loan in response to commenters' concerns as discussed above, the

Agencies are not adopting a separate definition of loan for

securitization transactions as requested by commenters. The Agencies

believe that the definition of loan adopted in the final rule

appropriately encompasses the financial instruments that result from

lending money to customers.

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\1877\ The determination of whether an instrument falls outside

the definition of loan because it is a security or a derivative is

based on the Federal securities laws and the Commodity Exchange Act.

Whether a loan, lease, extension of credit, or secured or unsecured

receivable is a note or evidence of indebtedness that is defined as

a security under the Federal securities laws will depend on the

particular facts and circumstances, including the economic terms of

the transaction. See supra note 1836 and accompanying text.

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ii. Contractual Rights or Assets

Under the proposed loan securitization definition, a covered fund

that is an issuer of asset-backed securities would have been permitted

to hold contractual rights or assets directly arising from those loans

supporting the asset-backed securities.\1878\ The proposal did not

identify or describe such contractual rights or assets.

---------------------------------------------------------------------------

\1878\ See proposed rule Sec. 75.13(d).

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Commenters requested that the Agencies expand the list of

contractual rights and assets that an issuer of asset-backed securities

would be permitted to hold under the proposed loan securitization

exemption.\1879\ Examples of the additional rights and assets requested

by commenters include cash and cash accounts; \1880\ cash

equivalents;\1881\ liquidity agreements, including asset purchase

agreements, program support facilities and support commitments; \1882\

credit enhancements: \1883\ asset-backed securities; \1884\ municipal

securities; \1885\ repurchase agreements; \1886\ credit-linked notes;

\1887\ trust certificates; \1888\ lease residuals; \1889\ debt

securities; \1890\ and derivatives.\1891\ As an alternative, commenters

requested that an issuer of asset-backed securities be permitted to

hold under the proposed loan securitization exemption certain of such

additional rights and/or assets up to a threshold, such as a specified

[[Page 5962]]

percentage of the assets of such covered fund.\1892\

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\1879\ See Allen & Overy (on behalf of Foreign Bank Group); AFME

et al.; ASF (Feb. 2012); Cleary Gottlieb; Credit Suisse (Williams);

Commercial Real Estate Fin. Council; GE (Feb. 2012); GE (Aug. 2012);

ICI (Feb. 2012); Japanese Bankers Ass'n.; JPMC; LSTA (Feb. 2012);

LSTA (July 2012); RBC; SIFMA et al. (Covered Funds) (Feb. 2012);

SIFMA (Securitization) (Feb. 2012); Vanguard.

\1880\ See Allen & Overy (on behalf of Foreign Bank Group); ASF

(Feb. 2012); Cleary Gottlieb; Credit Suisse (Williams).

\1881\ See Allen & Overy (on behalf of Foreign Bank Group); ASF

(Feb. 2012); Cleary Gottlieb; Credit Suisse (Williams); Commercial

Real Estate Fin. Council; JPMC; LSTA (Feb. 2012); LSTA (July 2012);

RBC; SIFMA (Securitization) (Feb. 2012). Commenters requested

inclusion of the following examples of cash equivalents: government

guaranteed securities, money market funds, and ``other highly

credit-worthy and liquid investments'' (Credit Suisse (Williams));

and high quality, highly liquid investments, including Treasury

securities and highly rated commercial paper (JPMC). In addition,

LSTA (Feb. 2012) requested inclusion of the following: (i) short-

term highly liquid investments; (ii) direct obligations of, and

obligations fully guaranteed as to full and timely payment by, the

United States (or by any agency thereof to the extent such

obligations are backed by the full faith and credit of the United

States); (iii) demand deposits, time deposits or certificates of

deposit that are fully insured by the Federal Deposit Insurance

Corporation; (iv) corporate, non-extendable commercial paper; (v)

notes that are payable on demand or bankers' acceptances issued by

regulated U.S. financial institutions; (vi) investments in money

market funds or other regulated investment companies; time deposits

having maturities of not more than 90 days; (vii) repurchase

obligations with respect to direct obligations and guaranteed

obligations of the U.S. entered into with a regulated U.S. financial

institution; and (viii) other investments with a maturity one year

or less, with the requirement that each of the investments listed

have, at the time of the securitization's investment or contractual

commitment to invest therein, a rating of the highest required

investment category.

\1882\ See Allen & Overy (on behalf of Foreign Bank Group); ASF

(Feb. 2012); GE (Feb. 2012); JPMC; RBC; SIFMA (Securitization) (Feb.

2012).

\1883\ See Allen & Overy (on behalf of Foreign Bank Group); ASF

(Feb. 2012); GE (Feb. 2012); JPMC; RBC; SIFMA (Securitization) (Feb.

2012). For example, SIFMA (Securitization) (Feb. 2012) requested

inclusion of third party credit enhancements such as guarantees and

letters of credit. Commenters requested inclusion of the following

examples of credit enhancements: (i) external credit support of

borrower obligations under such loans, including a credit support

facilities, third party or parent guarantee, insurance policy,

letter of credit or other contractual commitment to make payments or

perform other obligations of the borrower under the loans (ASF (Feb.

2012)); and (ii) property guarantees, insurance policies, letters of

credit, or supporting obligations underlying or relating to any of

the loans (RBC).

\1884\ See Allen & Overy (on behalf of Foreign Bank Group); AFME

et al.; ASF (Feb. 2012); Credit Suisse (Williams); GE (Feb. 2012);

GE (Aug. 2012); ICI (Feb. 2012); JPMC; RBC; SIFMA et al. (Covered

Funds) (Feb. 2012); SIFMA (Securitization) (Feb. 2012). Commenters

requested inclusion of the following examples of asset-backed

securities: (i) SUBI certificates (beneficial interests in titling

trusts typically used in lease securitizations) (AFME et al.; ASF

(Feb. 2012); GE (Aug. 2012); SIFMA (Securitization) (Feb. 2012));

(ii) ownership interests and bonds issued by CLOs (JPMC); a broad

array of receivables that support asset-backed commercial paper (ICI

(Feb. 2012)); certain notes, certificates or other instruments

backed by loans or financial assets that are negotiated by the

purchasing asset-backed commercial paper conduit (ASF (Feb. 2012);

GE (Feb. 2012)); municipal securities that are technically ABS,

including revenue bonds that involve the issuance of senior and

subordinate bonds (ASF (Feb. 2012)); ownership interests in credit

funds (as defined in their letter) (SIFMA et al. (Covered Funds)

(Feb. 2012)); any note, bond or security collateralized and payable

from pools of loans, leases (including lease residuals), extensions

of credit or secured or unsecured receivables (RBC); asset-backed

securities issued by intermediate vehicles in a securitization

collateralized predominantly by loans and financial assets, and

other similar instruments (Credit Suisse (Williams)); and asset-

backed securities backed by loans or receivables that are originated

by or owned by the sponsor of such securitization or which are

issued by an entity that is organized under the direction of the

same sponsor as the issuer of the covered fund (ASF (Feb. 2012)).

\1885\ See ICI (Feb. 2012); Vanguard.

\1886\ See Credit Suisse (Williams); SIFMA (Securitization)

(Feb. 2012).

\1887\ See Allen & Overy (on behalf of Foreign Bank Group).

\1888\ See Credit Suisse (Williams).

\1889\ See ASF (Feb. 2012); GE (Feb. 2012); GE (Aug. 2012); RBC.

\1890\ See GE (Aug. 2012).

\1891\ See Allen & Overy (on behalf of Foreign Bank Group);

Credit Suisse (Williams); Japanese Bankers Ass'n.; LSTA (Feb. 2012);

SIFMA (Securitization) (Feb. 2012). Commenters requested inclusion

of the following examples of derivatives: (i) credit derivatives

(without explanation) as a means of diversifying the portfolio

(Japanese Bankers Association); (ii) synthetic securities that

reference corporate credits or other debt (Credit Suisse (Covered

Fund)); (iii) credit instruments or other obligations that the

banking entity could originate or invest or deal in directly,

including tranched or untranched credit linked notes exposed to the

credit risk of such reference assets through a credit default swap

or other credit derivative entered into by the related ABS Issuer

(SIFMA (Securitization) (Feb. 2012)); (iv) any derivatives

structured as part of the securitization of loans (without

explanation) (Allen & Overy (on behalf of Foreign Bank Group)); (v)

hedge agreements (Credit Suisse (Williams)); and (vi) any

derivative, including a credit default swap, as and to the extent a

banking entity could use such derivative in managing its own

investment portfolio (SIFMA (Securitization) (Feb. 2012)).

\1892\ See ASF (Feb. 2012); Cleary Gottlieb; Credit Suisse

(Williams); GE (Feb. 2012); GE (Aug. 2012); LSTA (Feb. 2012); LSTA

(July 2012).

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In response to comments, the final rule modifies the loan

securitization exclusion from the proposal to identify the types of

contractual rights or assets directly arising from those loans

supporting the asset-backed securities that a loan securitization

relying on such exclusion may hold. Under the final rule, a loan

securitization which is eligible for the loan securitization exclusion

may hold contractual rights or assets (i) designed to assure the

servicing or timely distribution of proceeds to security holders or

(ii) related or incidental to purchasing or otherwise acquiring, and

holding the loans (``servicing assets'').\1893\ The servicing assets

are permissible in an excluded loan securitization transaction only to

the extent that they arise from the structure of the loan

securitization or from the loans supporting a loan securitization. If

such servicing assets are sold and securitized in a separate

transaction, they will not qualify as permissible holdings for the loan

securitization exclusion.\1894\

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\1893\ See final rule Sec. 75.10(c)(8)(i)(B). The use of the

term ``servicing assets'' is not meant to imply that servicing

assets are limited to those contractual rights or assets related to

the servicer and the performance of the servicer's obligations.

\1894\ For example, under the final rule, mortgage insurance

policies supporting the mortgages in a loan securitization are

servicing assets permissible for purposes of Sec.

75.10(c)(8)(i)(B). However, a separate securitization of the

payments on those mortgage insurance policies would not qualify for

the loan securitization exclusion.

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In adopting this approach, the Agencies considered commenters'

concerns and determined to revise the condition to be more consistent

with the definition and treatment of servicing assets in other asset-

backed securitization regulations, such as the exemption from the

definition of ``investment company'' under rule 3a-7 promulgated under

the Investment Company Act.\1895\

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\1895\ The Agencies believe that for purposes of the final rule,

in the context of securitization, such related or incidental assets

in a loan securitization should support or further, and therefore,

be secondary to the loans held by the securitization vehicle.

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Although the Agencies have revised the proposal in response to

commenters' concerns, the final rule does not permit a loan

securitization to hold as servicing assets a number of instruments

specifically requested by commenters whether in their entirety or as a

percentage of the pool. Under the final rule, servicing assets do not

include securities or derivatives other than as specified in the rule.

Under the final rule, a loan securitization which is eligible for

the loan securitization exclusion may hold securities if those

securities fall into one of three categories.\1896\ First, such loan

securitizations may hold securities that are cash equivalents. For

purposes of the exclusion for loan securitizations, the Agencies

interpret ``cash equivalents'' to mean high quality, highly liquid

short term investments whose maturity corresponds to the

securitization's expected or potential need for funds and whose

currency corresponds to either the underlying loans or the asset-backed

securities.\1897\ Depending on the specific funding needs of a

particular securitization, ``cash equivalents'' might include deposits

insured by the Federal Deposit Insurance Corporation, certificates of

deposit issued by a regulated U.S. financial institution, obligations

backed by the full faith and credit of the United States, investments

in registered money market funds, and commercial paper.\1898\ Second,

such loan securitizations may hold securities received in lieu of debts

previously contracted with respect to the loans supporting the asset-

backed securities. Finally, such loan securitizations may hold

securities that qualify as SUBIs or collateral certificates subject to

the provisions set forth in the rule for such intermediate asset-backed

securities.

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\1896\ See final rule Sec. 75.10(c)(8)(iii).

\1897\ If either the loans supporting the loan securitization or

the asset-backed securities issued by the loan securitization are

denominated in a foreign currency, for purposes of the exclusion a

loan securitization would be permitted to hold foreign currency,

cash equivalents denominated in foreign currency and foreign

exchange derivatives that comply with Sec. 75.10(c)(8)(iv).

\1898\ Servicing assets should not introduce significant

additional risks to the transaction, including foreign currency risk

or maturity risk. For instance, funds on deposit in an account that

is swept on a monthly basis should not be invested in securities

that mature in 90 days.

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The Agencies have specifically limited the types of securities held

as eligible assets in a loan securitization that may be excluded from

the definition of covered fund under the final rule, even in limited

amounts, in order to assure that the types of securities are cash

equivalents or otherwise related to the loan securitization and to

prevent the possible misuse of the loan securitization exclusion to

circumvent the restrictions on proprietary trading, investments in

covered funds and prohibitions in section 13(f) of the BHC Act.\1899\

The Agencies believe that types of securities other than those

specifically included in the final rule could be misused in such

manner, because without limitations on the types of securities in which

an excluded loan securitization may invest, a banking entity could

structure an excluded loan securitization with provisions to engage in

activities that are outside the scope of the definition of loan as

adopted and also to engage in impermissible proprietary trading.

Further, the Agencies do not believe that the use of thresholds with

respect to such other types of securities as an alternative is

appropriate because similarly, such a securitization would then involve

a securitization of non-loan assets, outside the scope of what the

Agencies believe the rule of construction was intended to cover. By

placing restrictions on the securities permitted to be held by an

excluded loan securitization, the potential for evasion is reduced.

Loan securitizations are intended, as contemplated by the rule of

construction, to permit banks to continue to engage in securitizations

of loans. Including all types of securities within the scope of

permitted assets in an excluded loan securitization would expand the

exclusion beyond the scope of the definition of loan in the final rule

that is intended to implement the rule of construction.

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\1899\ Commenters expressed concerns about the use of

securitization vehicles for evasion. See, e.g., AFR et al. (Feb.

2012); Occupy; Public Citizen.

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iii. Derivatives

Under the proposed loan securitization definition, an exempted loan

securitization would be permitted to hold interest rate or foreign

exchange derivatives that materially relate to the terms of any loans

supporting the asset-backed securities and any contractual rights or

assets directly arising from such loans so long as such derivatives are

used for hedging purposes with respect to the securitization

structure.\1900\ The Agencies indicated in the proposing release that

the proposed loan securitization definition would not allow an exempted

loan securitization to use credit default swaps.\1901\

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\1900\ See Joint Proposal, 76 FR at 68912.

\1901\ Id.

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Commenters criticized the proposed limitations on the use of

derivatives included in the proposed loan securitization

definition.\1902\ In particular, one commenter indicated that the use

of credit derivatives such as credit default swaps is important in loan

securitizations to provide diversification

[[Page 5963]]

of assets.\1903\ Another commenter noted the use of such instruments to

manage risks with respect to corporate loan and debt books by accessing

capital from a broad group of capital markets investors and facilitates

making markets.\1904\ In contrast, two commenters generally supported

the limitations on the use of derivatives under the proposed loan

securitization definition and indicated that excluding credit default

swaps from the loan securitization definition was appropriate.\1905\

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\1902\ See AFME et al.; Allen & Overy (on behalf of Foreign Bank

Group); ASF (Feb. 2012) (requesting that an excluded loan

securitization be permitted to hold up to 10% of its assets in the

form of synthetic risk exposure to loans); Credit Suisse (Williams);

Japanese Bankers Ass'n.; LSTA (Feb. 2012) (for CLOs); SIFMA

(Securitization) (Feb. 2012).

\1903\ See Japanese Bankers Ass'n. This commenter indicated that

credit derivatives are important in securitizations to provide

diversification when the desired mix of assets cannot be achieved.

\1904\ See ASF (Feb. 2012). This commenter argued that for some

loan securitizations, investors may seek a broader pool of credit

exposures than the bank has available or can obtain to securitize in

order to achieve risk diversification.

\1905\ See AFR et al. (Feb. 2012); Public Citizen. One of these

commenters stated that the credit default exclusion was appropriate

because ``synthetic securitizations and resecuritizations were a key

contributor to financial contagion during the crisis.'' See AFR et

al. (Feb. 2012). Another commenter argued that the loan

securitization definition should not permit the use of derivatives.

See Occupy. This commenter argued that covered funds should only be

permitted to engage in hedging activity in accordance with the

proposed exemption for hedging activity. This commenter also argued

that the inclusion of derivatives in the loan securitization

definition exceeded the Agencies' statutory authority. Id. Two

senators indicated that ``complex securitizations'' including those

with ``synthetic features'' and ``embedded derivatives'' should not

be allowed to rely on the exclusion for loan securitizations. See

Sens. Merkley & Levin (Feb. 2012).

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With respect to the use of derivatives, the Agencies are adopting

the loan securitization exclusion substantially as proposed with

certain modifications to reflect a restructuring of this provision in

order to more closely align the permissible uses of derivatives under

the loan securitization exclusion with the loans, the asset-backed

securities, or the contractual rights and other assets that a loan

securitization relying on the loan securitization exclusion may hold.

As adopted, for a loan securitization to be eligible for the loan

securitization exclusion, the loan securitization may hold only

interest rate or foreign exchange derivatives that meet the following

requirements: (i) the written terms of the derivatives directly relate

to either the loans or the asset-backed securities that such loan

securitization may hold under the other provisions of the loan

securitization exclusion; and (ii) the derivatives reduce interest rate

and/or foreign exchange risk with respect to risks related to either

such loans, the asset-backed securities or the contractual rights or

other assets that a loan securitization may hold.\1906\

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\1906\ See final rule Sec. 75.10(c)(8)(iv).

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The first requirement that the written terms of the derivatives

``directly relate'' to either the loans or the asset-based securities

themselves is intended to quantitatively and qualitatively limit the

use of derivatives permitted under the loan securitization

exclusion.\1907\ The Agencies would expect that neither the total

notional amount of directly related interest rate derivatives nor the

total notional amount of directly related foreign exchange derivatives

would exceed the greater of either the outstanding principal balance of

the loans supporting the asset-backed securities or the outstanding

principal balance of the asset-backed securities.\1908\ Moreover, under

the loan securitization exclusion, the type of derivatives must be

related to the types of risks associated with the underlying assets and

may not be derivatives designed to supplement income based on general

economic scenarios, income management or unrelated risks.

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\1907\ Under the final rule, the Agencies expect that a loan

securitization relying on the loan securitization exclusion would

not have a significant amount of interest rate and foreign exchange

derivatives with respect to risks arising from contractual rights or

other assets.

\1908\ For example, a $100 million securitization cannot be

hedged using an interest rate hedge with a notional amount of $200

million.

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The second requirement that derivatives reduce the interest rate

and/or foreign exchange risks related to either such loans, contractual

rights or other assets, or such asset-backed securities is intended to

permit the use of derivatives to hedge interest rate and/or foreign

exchange risks that result from a mismatch between the loans and the

asset-backed securities.\1909\

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\1909\ The derivatives permitted in a securitization that may

rely on the loan securitization exclusion would permit a

securitization to hedge the risk resulting from differences between

the income received by the issuing entity and the amounts due under

the terms of the asset-backed securities. For example, fixed rate

loans could support floating rate asset-backed securities; loans

with an interest rate determined by reference to the Prime Rate

could support asset-backed securities with an interest rate

determined by reference to LIBOR; or Euro-denominated loans could

support U.S. Dollar-denominated asset-backed securities.

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The Agencies believe that the statutory rule of construction should

be implemented in a manner that does not limit or restrict the sale and

securitization of loans. The Agencies further believe that the sale and

securitization of credit exposures other than ``loans'' as defined in

the rule, such as through securities or derivatives, could be abused.

The derivatives that may be held in a loan securitization for purposes

of the exclusion may not be used for speculative purposes. Consistent

with the proposal, the loan securitization exclusion does not permit a

loan securitization relying on such exclusion to hold credit default

swaps or other types of derivatives whether or not they are related

either to the underlying loans or the asset-backed securities.\1910\

Under the final rule, a synthetic securitization in which the asset-

backed securities are supported by cash flow from derivatives, such as

credit default swaps and total return swaps, would not be permitted to

rely on the loan securitization exclusion because such derivatives are

excluded from the final rule's definition of loan specifically, as a

derivative. Similarly, a loan securitization that relies on the loan

securitization exclusion would not be permitted to hold a credit

default swap or total return swap that references a loan that is held

by the loan securitization. Under the final rule as adopted, an

excluded loan securitization would not be able to hold derivatives that

would relate to risks to counterparties or issuers of the underlying

assets referenced by these derivatives because the operation of

derivatives, such as these, that expand potential exposures beyond the

loans and other assets, would not in the Agencies' view be consistent

with the limited exclusion contained in the rule of construction under

section 13(g)(2) of the BHC Act, and could be used to circumvent the

restrictions on proprietary trading and prohibitions in section 13(f)

of the BHC Act. The Agencies believe that the use of derivatives by an

issuing entity for asset-backed securities that is excluded from the

definition of covered fund under the loan securitization exclusion

should be narrowly tailored to hedging activities that reduce the

interest rate and/or foreign exchange risks directly related to the

asset-backed securities or the loans supporting the asset-backed

securities because the use of derivatives for purposes other than

reducing interest rate risk and foreign exchange risks would introduce

credit risk without necessarily relating to or involving a reduction of

interest rate risk or foreign exchange risk.

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\1910\ Loan securitizations excluded from the covered fund

definition may only hold certain directly related derivatives as

specified in Sec. 75.11(c)(8)(iv) and as discussed in this Part.

---------------------------------------------------------------------------

On the other hand, while the Agencies are not expanding the types

of permitted derivatives to be held in a loan securitization, the

Agencies in the final rule are not restricting the use of all

derivatives under the loan securitization exclusion as requested by

certain commenters. The Agencies believe that a loan securitization

that is excluded from the definition of covered fund should be allowed

to engage in activities that reduce interest rate and

[[Page 5964]]

foreign exchange risk because the hedging of such risks is consistent

with the prudent risk management of interest rate and currency risk in

a loan portfolio while at the same time avoiding the potential for

additional risk arising from other types of derivatives.\1911\ The

Agencies do not believe that the exemption for hedging activity

applicable to market making and underwriting under the final rule is

the appropriate measure for permitted derivatives in a loan

securitization that would be excluded from definition of covered fund

\1912\ because the hedging exemptions for market making and

underwriting are not tailored to the hedging requirements of a

securitization transaction.\1913\ The Agencies also do not believe that

they lack the statutory authority to permit a loan securitization

relying on the loan securitization exclusion to use derivatives, as

suggested by one commenter,\1914\ because the Agencies believe that the

permitted derivatives relate directly to loans that are permitted and

have limited the quality and quantity of derivatives that an excluded

loan securitization is permitted to hold directly to the reduction of

risks that result from the loans and the loan securitization.

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\1911\ See AFR et al. (Feb. 2012); Occupy; Public Citizen.

\1912\ See Occupy. This commenter argued that covered funds

should only be permitted to engage in hedging activity in accordance

with the proposed exemption for hedging activity.

\1913\ For example, a banking entity may hold an ownership

interest in a covered fund in order to hedge employee compensation

risks. Because securitizations do not have employees, such a hedging

exemption would not be applicable to a securitization structure.

\1914\ See Occupy.

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While loan securitizations that include non-loan assets are not

excluded from the definition of covered fund, banking entities are not

prohibited from owning interests or sponsoring these covered funds

under the final rule. Under the final rule, these securitizations would

be covered funds, and banking entities engaged with these covered funds

would be subject to the limitations on ownership interests and

relationships with these covered funds imposed by section 13 of the BHC

Act.

iv. SUBIs and Collateral Certificates

Commenters also argued that, under the proposed exemption for loan

securitizations, securitizations that are backed by certain

intermediate asset-backed securities would not satisfy the conditions

for the exemption and therefore would be subject to the covered fund

prohibitions.\1915\ For example, commenters noted that, in a

securitization of leases with respect to equipment where a titling

trust is used to hold ownership of the equipment, a titling trust will

typically own the equipment and the right to payment on the leases, and

then will issue a security or other instrument, often referred to as a

special unit of beneficial interest (SUBI), that represents an

ownership interest in the titling trust to the securitization

issuer.\1916\ As another example, certain securitizations frequently

use a master trust structure allowing the trust to issue more than one

series of asset-backed security collectively backed by a common

revolving pool of assets. In such a structure, a master trust may hold

assets (such as loans) and issue a collateral certificate supported by

those assets to an issuing trust that issues asset-backed securities to

investors. The assets held by the master trust are typically a pool of

revolving accounts that may be paid in full each month (e.g., credit

card receivables) or a revolving pool of short-term loans that are

replaced with new loans as they mature (e.g., floor plan loans).\1917\

One commenter opposed the inclusion of securitizations backed by

intermediate asset-backed securities, arguing that each step should be

viewed separately to ensure compliance to prevent the inclusion of

impermissible assets such as prohibited derivatives.\1918\

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\1915\ See AFME et al.; Allen & Overy (on behalf of Foreign Bank

Group); ASF (Feb. 2012); Credit Suisse (Williams); GE (Aug. 2012);

PNC; RBC; SIFMA (Securitization) (Feb. 2012).

\1916\ See SIFMA (Securitization) (Feb. 2012).

\1917\ See, e.g., ASF (Feb. 2012). UK RMBS master trusts also

use a master trust structure. See AFME et al.; ASF (Feb. 2012);

SIFMA (Securitization) (Feb. 2012).

\1918\ See Occupy.

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In response to comments, the Agencies are modifying the proposal to

provide that a securitization backed by certain intermediate asset-

backed securities will qualify for the loan securitization exclusion.

The Agencies recognize that securitization structures that use these

types of intermediate asset-backed securities are essentially loan

securitization transactions, because the intermediate asset-backed

securities in the asset pool are created solely for the purpose of

facilitating a securitization \1919\ and once created, are issued

directly into a securitization vehicle rather than to any third party

investor.

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\1919\ The use of SUBIs, for example, allows the sponsor to

avoid administrative expenses in retitling the physical property

underlying the leases.

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Under the final rule, a loan securitization that is excluded from

the definition of covered fund may include SUBIs or collateral

certificates, provided that four conditions are met.\1920\ First, the

special purpose vehicle issuing the SUBI or collateral certificate

itself must meet the conditions of the loan securitization exclusion,

as adopted in the final rule.\1921\ Under this provision, for example,

the special purpose vehicle, in addition to the issuing entity, may

hold an interest rate or foreign exchange derivative or other assets

only if the derivative or asset is permitted to be held in accordance

with the requirements for derivatives in respect of the loan

securitization exclusion. Second, the SUBI or collateral certificate

must be used for the sole purpose of transferring economic risks and

benefits of the loans (and other permissible assets) \1922\ to the

issuing entity for the securitization and may not directly or

indirectly transfer any interest in any other economic or financial

exposures. Third, the SUBI or collateral certificate must be created

solely to satisfy legal requirements or otherwise facilitate the

structuring of the loan securitization. Fourth, the special purpose

vehicle issuing the SUBI or collateral certificate and the issuing

entity for the excluded loan securitization transaction must be

established under the direction of the same entity that initiated the

loan securitization transaction. The Agencies believe that the fourth

condition will ensure that the resecuritizations of asset-backed

securities purchased in the secondary market, which the Agencies do not

believe would constitute a loan securitization, will not be able to use

these special provisions tailored only for transactions utilizing SUBIs

and collateral certificates in order to fall within the loan

securitization exclusion.

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\1920\ See final rule Sec. 75.10(c)(8)(v).

\1921\ The provision will allow for the existing practice of a

master trust to hold a collateral certificate issued by a legacy

master trust.

\1922\ This would include a collateral certificate issued by a

legacy master trust that meets the requirements of the loan

securitization exclusion.

---------------------------------------------------------------------------

The Agencies believe that these conditions provide that only

securitizations backed by SUBIs and collateral certificates involving

loans--and not other types of securities or other types of assets--will

be able to use the loan securitization exclusion. These conditions are

intended to assure that for purposes of the loan securitization

exclusion that only SUBI and collateral certificates that essentially

represent the underlying loans are included consistent with the terms

and the purpose of section 13 of the BHC Act, while also not adversely

affecting

[[Page 5965]]

securitization of ``loans'' as defined in the final rule.\1923\ The

Agencies believe that the limitation of the types of asset-backed

securities permitted in an excluded loan securitization (only SUBIs and

collateral certificates) and the restrictions placed on those SUBIs and

collateral certificates that are permitted in an excluded loan

securitization will avoid loan securitizations that contain other types

of assets from being excluded from the definition of covered fund.

---------------------------------------------------------------------------

\1923\ See, e.g., rule 190 under the Securities Act. See also,

e.g., ASF (Feb. 2012) (noting that certain rules under the

Securities Act and staff interpretations have carved out SUBIs and

collateral certificates from certain disclosure and other

requirements).

---------------------------------------------------------------------------

v. Impermissible Assets

As discussed above, commenters on the loan securitization proposals

argued that various types of assets should be included within the

definition of loan or otherwise permitted to be held by the loan

securitization that would be entitled to rely on the proposed

exemptions.

After considering comments, the Agencies have determined to retain

the narrower scope of the permitted assets in a loan securitization

that is eligible for the loan securitization exclusion. The Agencies

have revised the language regarding loan securitizations from the

proposal to specify certain types of assets or holdings that a loan

securitization would not be able to hold if it were eligible to rely on

the exclusion from the definition of covered fund for loan

securitizations.\1924\ The Agencies recognize that securitization

structures vary significantly and, accordingly, the loan securitization

exclusion as adopted in the final rule accommodates a wider range of

securitization practices. The Agencies believe that these limitations

provide that only securitizations backed by loans--and not securities,

derivatives or other types of assets--will be able to use the loan

securitization exclusion consistent with the terms and the purpose of

section 13 of the BHC Act.\1925\ The Agencies believe that the

limitation of the types of assets permitted in an excluded loan

securitization will avoid loan securitizations that contain other types

of assets from being excluded from the definition of covered fund.

---------------------------------------------------------------------------

\1924\ See final rule Sec. 75.10(c)(8)(ii).

\1925\ The Agencies discuss earlier in this Part the permissible

assets an excluded loan securitization may hold and the Agencies'

belief that excluding loan securitizations as defined in the final

rule is consistent with the terms and the purpose of section 13 of

the BHC Act, including the rule of construction in section 13(g)(2).

See, e.g., supra note 1871 and accompanying and following text.

---------------------------------------------------------------------------

Under the final rule, in order to be excluded from the definition

of covered fund, a loan securitization may not hold (i) a security,

including an asset-backed security, or an interest in an equity or debt

security (unless specifically permitted, such as with respect to a SUBI

or collateral certificate as described above), (ii) a derivative other

than an interest rate or foreign exchange derivative that meets the

requirements described above,\1926\ or (iii) a commodity forward

contract.\1927\ The Agencies have determined that a loan securitization

relying on the loan securitization exclusion may not include a

commodity forward contract because a commodity forward contract is not

a loan.\1928\

---------------------------------------------------------------------------

\1926\ See final rule Sec. 75.10(c)(8)(iv); see also 7 U.S.C.

27(a)-(b).

\1927\ See the discussion above in Part VI.B.1.c.8 of this

SUPPLEMENTARY INFORMATION.

\1928\ For a discussion of commodity forward contracts, see

Further Definition of ``Swap,'' ``Security-Based Swap,'' and

``Security-Based Swap Agreement''; Mixed Swaps; Security-Based Swap

Agreement Recordkeeping, 77 FR 48208 (Aug. 13, 2012) (Release Nos.

33-9338 and 34-67453, July 18, 2012).

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9. Asset-Backed Commercial Paper Conduits

Under the proposed rule, certain securitization vehicles, including

ABCP conduits, would not have been covered by the loan securitization

exclusion and, therefore, would have been deemed to be a covered

fund.\1929\ ABCP is a type of liability that is typically issued by a

special purpose vehicle (commonly referred to as a ``conduit'')

sponsored by a financial institution or other entity. The short term

asset-backed securities issued by the conduit are supported by a

managed pool of assets, which may change over the life of the entity.

Depending on the type of ABCP conduit, the securitized assets

ultimately supporting the short term asset-backed securities may

consist of a wide range of assets including automobile loans,

commercial loans, trade receivables, credit card receivables, student

loans, and other loans in addition to asset-backed securities supported

by such assets. The term of ABCP typically is short, and the

liabilities are ``rolled'' (i.e., replaced or refinanced) at regular

intervals. Thus, ABCP conduits generally fund longer-term assets with

shorter-term liabilities.\1930\ In this regard, in the proposing

release, the Agencies requested comment on the proposed rule's

definition of ``covered fund'' with respect to asset-backed securities

and/or securitization vehicles \1931\ and received numerous comments

requesting a variety of exemptions for ABCP conduits.\1932\

---------------------------------------------------------------------------

\1929\ See proposed rule Sec. 75.13(d).

\1930\ Structured investment vehicles (``SIVs'') and securities

arbitrage ABCP programs both purchase securities (rather than

receivables and loans). SIVs typically lack liquidity facilities

covering all of these liabilities issued by the SIV, while

securities arbitrage ABCP programs typically have such liquidity

coverage, though the terms are more limited than those of the ABCP

conduits eligible for the exclusion pursuant to the final rule.

\1931\ See Joint Proposal, 76 FR at 68899.

\1932\ See, e.g., ASF (Feb. 2012); BoA; Capital Group; Eaton

Vance; Fidelity; ICI (Feb. 2012); Japanese Bankers Ass'n.; PNC; RBC.

---------------------------------------------------------------------------

A number of commenters requested that the final rule exclude ABCP

conduits from the definition of covered fund \1933\ or that the

Agencies use their authority under section 13(d)(1)(J) of the BHC Act

\1934\ to similar effect.\1935\ One commenter argued that ABCP conduits

do not have the characteristics of a private equity fund or hedge

fund,\1936\ even though they typically rely on the exemptions set forth

in section 3(c)(1) or 3(c)(7) of the Investment Company Act. Another

commenter argued that the proposed rule's definition of covered fund

would negatively impact asset-backed securitizations (including ABCP

conduits), and suggested that the Agencies define covered funds, in

part, as those that both (i) rely on section 3(c)(1) or 3(c)(7) of the

Investment Company Act and (ii) have the traditional characteristics of

private equity funds or hedge funds.\1937\ Another commenter stated

that the rule of construction set forth in section 13(g)(2) of the BHC

Act \1938\ is a clear indication that section 13 of the BHC Act was not

intended to apply to securitization vehicles such as ABCP

conduits.\1939\ Another commenter stated that the lending that occurs

through ABCP conduits is the type of activity that Congress and the

Executive Branch have urged banks to expand in order to support

economic growth and job creation,\1940\ while another commenter stated

that ABCP conduits provide low cost, reliable financing for registered

investment companies, which poses little risk to the safety and

soundness of banks because Federal law requires registered investment

companies to

[[Page 5966]]

maintain prescribed asset coverage in connection with borrowings.\1941\

---------------------------------------------------------------------------

\1933\ See, e.g., ICI (Feb. 2012); PNC et al.; SIFMA (May 2012).

\1934\ See 12 U.S.C. 1851(d)(1)(J).

\1935\ See ICI (Feb. 2012).

\1936\ See PNC.

\1937\ See Barclays.

\1938\ See 12 U.S.C. 1851(g)(2).

\1939\ See ICI (Feb. 2012).

\1940\ See Credit Suisse (Williams).

\1941\ See Eaton Vance.

---------------------------------------------------------------------------

Two commenters contended that, while certain issuers of asset-

backed securities may rely on section 3(c)(5) of the Investment Company

Act or rule 3a-7 thereunder, and, therefore, not be brought under the

proposed rule's definition of covered fund, ABCP conduits typically

cannot rely on this section or rule either because to do so would be

too restrictive (in the case of section 3(c)(5)) or because they cannot

meet the rule's requirements.\1942\

---------------------------------------------------------------------------

\1942\ See RBC; ASF (Feb. 2012).

---------------------------------------------------------------------------

One commenter, employing ABCP conduits as an example, stated that

failing to exempt securitization vehicles from the covered fund

prohibitions would preclude banking entities from engaging in

activities that have long been recognized as permissible activities for

banking entities and that are vital to the normal functioning of the

securitization markets, and will have a significant and negative impact

on the securitization markets and on the ability of banking entities

and other companies to provide credit to their customers.\1943\ This

commenter further stated that ABCP conduits are an efficient and

attractive way for banking entities to lend their own credit-worthiness

to expand the pool of possible lenders willing to finance key economic

activity while maintaining a low cost of funding for consumers, and

because of the liquidity support provided by the sponsoring banking

entity, the sponsoring banking entity to the ABCP conduit has full

exposure to the assets acquired by or securing the amounts lent by the

ABCP conduit and the banking entity subjects those assets and the

obligors to the same analysis as it would engage in if the bank were

lending directly against those assets.\1944\ Another commenter stated

that the provision of credit to companies to finance receivables

through ABCP conduits is an area of traditional banking activity that

should be distinguished from the type of high-risk, conflict-ridden

financial activities that Congress sought to restrict under section 13

of the BHC Act.\1945\

---------------------------------------------------------------------------

\1943\ See Credit Suisse (Williams).

\1944\ Id.

\1945\ See ICI (Feb. 2012). This commenter emphasized the

importance of the ABCP conduit market to money market funds, noting

that as of November 2011, taxable money market funds held $126

billion of the $348.1 billion of securities issued by ABCP conduits

outstanding, which represented approximately 5.4% of taxable money

market funds' total assets. Another commenter noted that

approximately $66.7 billion of automobile loans and leases, $52.1

billion of student loans, $22.3 billion of credit card charges,

$49.4 billion of loans to commercial borrowers and $50.7 billion of

trade receivables were financed by the U.S. ABCP conduit market as

of October 31, 2011, and that the total outstanding amount of

securities sold by ABCP conduits in the U.S. market was $344.5

billion as of January 18, 2012. See ASF (Feb. 2012).

---------------------------------------------------------------------------

To this end, commenters proposed several means to exclude ABCP

conduits from the proposed rule's restrictions and requirements,

including an expansion of the loan securitization exemption to treat

two-step securitization transactions as a single loan

securitization,\1946\ a separate exclusion for ABCP conduits,\1947\ an

expansion of the definition of loan,\1948\ or as part of a broad

exclusion for all issuers of asset-backed securities.\1949\ In order to

allow ABCP conduits to qualify as loan securitizations, commenters

suggested that the loan securitization exclusion should permit a

limited amount of securities purchased in the secondary market.\1950\

Commenters also proposed changes to the permissible assets such as

allowing a loan securitization to hold liquidity and support

commitments, asset-backed securities and certain financial assets in

addition to loans that by their terms convert to cash within a finite

period of time.\1951\ Another commenter argued that the loan

securitization exemption should allow banking entities to sponsor,

control, and invest in ABCP conduits that facilitate the securitization

of customer loans and receivables.\1952\ In contrast, one commenter

supported the restriction of the loan securitization exemption to the

plain meaning of what constitutes a loan and advocated that the

Agencies not include ABCP conduits under the exemption.\1953\

---------------------------------------------------------------------------

\1946\ See AFME et al.; Allen & Overy (on behalf of Foreign Bank

Group); ASF (Feb. 2012); PNC; SIFMA (Securitization) (Feb. 2012).

\1947\ See ASF (Feb. 2012); Capital Group (alleging that ABCP

does not pose the risks that the rule is meant to combat); GE (Feb.

2012). One commenter proposed an exemption for ABCP conduits that

included a requirement of 100% liquidity support from a regulated,

affiliated entity, and such liquidity support may be conditional or

unconditional. See RBC.

\1948\ See Credit Suisse (Williams) (alleging that ABCP conduits

acquire ownership of loans indirectly through the purchase of

variable funding notes, trust certificates, asset-backed securities,

repurchase agreements and other instruments that may be considered

securities, all of which economically are consistent with providing

funding or extensions of credit to customers); ICI (Feb. 2012)

(requesting that the definition of loan include the broad array of

receivables that back ABCP).

\1949\ See AFME et al.; SIFMA (Securitization) (Feb. 2012).

\1950\ See ASF (Feb. 2012) (requesting that ABCP conduits be

permitted to own asset-backed securities purchased on the secondary

market only if the aggregate principal amount of such securities

does not exceed 5% of the aggregate principal or face amount of all

assets held by the ABCP conduit in order to diversify their asset

base and avoid the negative consequences of divestiture of such

assets); RBC (requesting that loan securitizations be permitted to

hold cash equivalents and assets, other than loans, which, by their

terms, convert to cash within a finite period of time so long as

such assets comprise no more than 10% of their total assets based on

book value).

\1951\ See ASF (Feb. 2012) (arguing that the loans, receivables,

leases, or other assets purchased by the ABCP conduit might have fit

the definition of loan in the proposed rules but for the proposal's

express assertion that the definition of loan does not include any

asset-backed security that is issued in connection with a loan

securitization or otherwise backed by loans). See Joint Proposal, 76

FR at 68865; GE (Feb. 2012); RBC.

\1952\ See PNC.

\1953\ See Public Citizen.

---------------------------------------------------------------------------

In addition to the effect the proposed rule's definition of covered

fund would have on ABCP conduits, commenters also noted that section

13(f) of the BHC Act \1954\ would prohibit certain transactions between

a banking entity sponsor and a covered fund securitization.\1955\ Two

commenters requested a specific exemption from Sec. 75.16 of the

proposed rule for ABCP conduits based on the interpretation that the

proposed rule subjects covered funds exempted under the loan

securitization exemption or other exemptions to Sec. 75.16.\1956\

Commenters argued that without liquidity and credit support, ABCP

conduits are not viable,\1957\ cannot effectively operate,\1958\ could

not function,\1959\ or would not be marketable.\1960\ One commenter

argued that prohibiting a banking entity from providing liquidity

facilities to ABCP conduits is tantamount to requiring the banking

entity to wind down the operation of such ABCP conduits.\1961\

---------------------------------------------------------------------------

\1954\ See 12 U.S.C. 1851(f); see also Sec. 75.16 of the

proposed rule.

\1955\ See, e.g., Allen & Overy (on behalf of Foreign Bank

Group); Credit Suisse (Williams); Fidelity; IIB/EBF; JPMC; PNC; RBC;

SIFMA (Securitization) (Feb. 2012).

\1956\ See ICI (Feb. 2012); Fidelity.

\1957\ See JPMC.

\1958\ See ASF (Mar. 2012).

\1959\ See Allen & Overy (on behalf of Foreign Bank Group).

\1960\ See ASF (Feb. 2012); Fidelity.

\1961\ See ASF (Mar. 2012).

---------------------------------------------------------------------------

In response to the comments received and in light of the rule of

construction contained in section 13(g)(2) of the BHC Act, the Agencies

have determined in the final rule to exclude from the definition of

covered fund an ABCP conduit that is a ``qualifying asset-backed

commercial paper conduit'' as defined in the final rule is excluded

from the definition of covered fund.\1962\

---------------------------------------------------------------------------

\1962\ See final rule Sec. 75.10(c)(9)(i). The rule of

construction contained in section 13(g)(2) of the BHC Act 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 that is otherwise permitted by law. As noted above

and explained below, a qualifying asset-backed commercial paper

conduit under the final rule is an ABCP conduit that holds only (i)

loans or other assets that would be permissible in a loan

securitization and (ii) asset-backed securities that are supported

solely by assets permissible for a loan securitization and are

acquired by the conduit as part of an initial issuance directly from

the issuer or directly from an underwriter engaged in the

distribution of the securities.

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[[Page 5967]]

Under the final rule, a qualifying asset-backed commercial paper

conduit is an ABCP conduit that holds only (i) loans or other assets

that would be permissible in a loan securitization \1963\ and (ii)

asset-backed securities that are supported solely by assets permissible

for a loan securitization and are acquired by the conduit as part of an

initial issuance directly from the issuer or directly from an

underwriter engaged in the distribution of the securities.\1964\ In

addition, a qualifying asset-backed commercial paper conduit must issue

only asset-backed securities, comprising of a residual and securities

with a term of 397 days or less and in addition, a ``regulated

liquidity provider,'' as defined in the final rule, must provide a

legally binding commitment to provide full and unconditional liquidity

coverage with respect to all the outstanding short term asset-backed

securities issued by the qualifying asset-backed commercial paper

conduit in the event that funds are required to redeem the maturing

securities.\1965\

---------------------------------------------------------------------------

\1963\ See final rule Sec. 75.10(c)(8).

\1964\ See final rule Sec. 75.10(c)(9)(i)(B).

\1965\ See final rule Sec. 75.10(c)(9)(ii) and (iii).

---------------------------------------------------------------------------

Under the final rule, a regulated liquidity provider is (i) a

depository institution as defined in section 3 of the Federal Deposit

Insurance Act; \1966\ (ii) a bank holding company or a subsidiary

thereof; \1967\ (iii) a savings and loan holding company,\1968\

provided all or substantially all of the holding company's activities

are permissible for a financial holding company,\1969\ or a subsidiary

thereof; (iv) a foreign bank whose home country supervisor as defined

in section 211.21 of the Federal Reserve Board's Regulation K \1970\

has adopted capital standards consistent with the Capital Accord of the

Basel Committee on Banking Supervision, as amended, and that is subject

to such standards, or a subsidiary thereof; or (v) a sovereign

nation.\1971\ In order for a sovereign nation to qualify as a regulated

liquidity provider, the liquidity provided must be unconditionally

guaranteed by the sovereign, which would include its departments and

ministries, including the central bank.

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\1966\ See 12 U.S.C. 1813.

\1967\ See 12 U.S.C. 1841.

\1968\ See 12 U.S.C. 1467a.

\1969\ See 12 U.S.C. 1843(k).

\1970\ See 12 CFR 211.21.

\1971\ See final rule Sec. 75.10(c)(9)(iii).

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In this regard, under the final rule, the exclusion from the

definition of covered fund in respect of ABCP conduits is only

available to an issuer of short-term asset-backed securities supported

by loans and certain asset-backed securities supported by loans that

were issued or initially sold to the ABCP conduit, and the short term

asset-backed securities issued by the ABCP conduit are supported by a

liquidity facility that provides 100 percent liquidity coverage from a

regulated liquidity provider. The exclusion, therefore, is not

available to ABCP conduits that lack 100 percent liquidity coverage.

The liquidity coverage may be provided in the form of a lending

facility, an asset purchase agreement, a repurchase agreement, or

similar arrangement and 100 percent liquidity coverage means that, in

the event the qualifying asset-backed commercial paper conduit is

unable for any reason to repay maturing asset-backed securities issued

by the issuing entity, the total amount for which the regulated

liquidity provider may be obligated is equal to 100 percent of the

amount of asset-backed securities outstanding plus accrued and unpaid

interest. In addition, amounts due pursuant to the required liquidity

coverage may not be subject to the credit performance of the asset-

backed securities held by the qualifying asset-backed commercial paper

conduit or reduced by the amount of credit support provided to the

qualifying asset-backed commercial paper conduit. Under the final rule,

liquidity coverage that only funds an amount determined by reference to

the amount of performing loans, receivables, or asset-backed securities

will not be permitted to satisfy the liquidity requirement for a

qualifying asset-backed commercial paper conduit.

As discussed above, the final rule defines a qualifying asset-

backed commercial paper conduit as having certain elements. First, a

qualifying asset-backed commercial paper conduit must issue only a

residual interest and short-term asset-backed securities. This

requirement distinguishes ABCP conduits from covered funds that issue

partnership interests and mitigates the potential that a qualifying

ABCP conduit would be used for evasion of the covered fund

prohibitions. The Agencies chose a maximum term of 397 days for these

securities because this time frame corresponds to the maximum maturity

of securities allowed to be purchased by money market funds under Rule

2a-7 of the Investment Company Act.

Second, the asset-backed securities issued by the ABCP conduit must

be supported only by loans and certain asset-backed securities that

meet the requirements of the loan securitization exclusion. By placing

restrictions on the assets permitted to be held by an excluded loan

securitization, the potential for evasion of the covered fund

prohibitions is reduced. The exclusion for qualifying ABCP conduits is

intended, as contemplated by the rule of construction in section

13(g)(2) of the BHC Act, to permit banks to continue to engage in

securitizations of loans. Including all types of securities and other

assets within the scope of permitted assets in a qualifying ABCP

conduit, as with loan securitizations, would expand the exclusion

beyond the scope of the definition of loan in the final rule that is

intended to implement the rule of construction.

Third, the asset-backed securities supporting a qualifying asset-

backed commercial paper conduit must be purchased as part of the

initial issuance of such asset-backed securities. Asset-backed

securities purchased by an ABCP conduit in the secondary market will

not be permitted because such a purchase would not be part of an

initial issuance and the banking entity that established and manages

the ABCP conduit would not have participated in the negotiation of the

terms of such asset-backed securities. Without a more direct connection

between the banking entity and the ABCP conduit, the purchase of such

asset-backed securities in the secondary market would resemble

investments in securities.

Fourth, under the final rule, the ABCP conduit exclusion will not

be available to ABCP conduits that lack 100 percent liquidity coverage.

The Agencies believe that the 100 percent liquidity coverage

requirement distinguishes the conduits eligible for the exemption,

which sometimes hold and securitize a customer's loans through an

intervening special-purpose vehicle instead of holding the loans

directly, and are supported by a 100 percent liquidity guarantee, from

other types of conduits with partial liquidity guarantees (such as

structured investment vehicles) that have sometimes been operated by

banking entities for the purpose of financing portfolios of securities

acquired or retained as part of their activities in the securities

markets.

The Agencies recognize that ABCP conduits that do not satisfy the

elements of the ABCP conduit exclusion may be covered funds and

therefore would be subject to section 13(f) of the BHC

[[Page 5968]]

Act.\1972\ As a result of section 13(f) of the BHC Act, which prohibits

certain transactions between banking entities and a covered fund

securitization that the banking entity sponsors or for which it

provides investment management services, the banking entity would be

prohibited from providing liquidity support for the ABCP conduit.

---------------------------------------------------------------------------

\1972\ See 12 U.S.C. 1851(f); see also Sec. 75.16 of the

proposed rule.

---------------------------------------------------------------------------

Similarly, while some commenters requested that the loan

securitization exclusion permit the holding of a limited amount of

securities purchased in the secondary market, the final rule does not

provide for this in the context of ABCP conduits. The Agencies believe

that the limitations on the types of securities that a qualifying

asset-backed commercial paper conduit may invest in are needed to avoid

the possibility that a banking entity could use a qualifying asset-

backed commercial paper conduit to securitize non-loan assets or to

engage in proprietary trading of such securities prohibited under the

final rule. Thus this limitation reduces the potential for evasion of

the covered fund provisions of section 13 of the BHC Act. In developing

the exclusion from the definition of covered fund for qualifying asset-

backed commercial paper conduits in the final rule, the Agencies

considered the factors set forth in sections 13(g)(2) and 13(h)(2) of

the BHC Act. The final rule includes conditions designed to ensure that

an ABCP conduit established and managed by a banking entity serves as a

means of facilitating that banking entity's loan securitization

activity rather than financing that banking entity's capital market

investments. The final rule distinguishes between qualifying asset-

backed commercial paper conduits and other ABCP conduits in order to

adhere to the tenets of section 13 of the BHC Act while accommodating

the market practices discussed by the commenters by facilitating

reasonable access to credit by consumers and businesses through the

issuance of ABCP backed by consumer and business receivables. As

discussed above, the Agencies understand that some existing ABCP

conduits may need to be restructured to conform to the requirements of

the ABCP conduit exclusion.

To the extent that the definition of covered fund, the loan

securitization exclusion and the ABCP conduit exclusion do not

eliminate the applicability of the final rule provisions to certain

covered funds, there may be adverse effects on the provision of capital

to customers,\1973\ to securitization markets,\1974\ and to the

creation of new securitization products to meet investor demands that

Congress may not have contemplated. \1975\ However, financial

institutions that are not banking entities and therefore are not

subject to the restrictions on ownership can continue to engage in

activities relating to securitization, including those securitizations

that fall under the definition of covered fund. Furthermore, new

securitizations may be structured so as to qualify for the loan

securitization exclusion or other exclusions under the final rule. For

these reasons, the impact on securitizations that are not excluded

under the final rule may be mitigated.

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\1973\ See, e.g., ASF (Feb. 2012).

\1974\ See Credit Suisse (Williams) (employing ABCP conduits as

an example); ASF (Feb. 2012) (describing the constriction of the

market for asset-backed securities if banking entities are

restricted from owning debt classes of new asset backed securities).

\1975\ See RBC; ASF (Feb. 2012).

---------------------------------------------------------------------------

The Agencies believe that the final rule excludes from the

definition of covered fund typical structures used in the most common

loan securitizations representing a significant majority of the current

securitization market, such as residential mortgages, commercial

mortgages, student loans, credit card receivables, auto loans, auto

leases and equipment leases. Additionally, the Agencies believe that

esoteric asset classes supported by loans may also be able to rely on

the loan securitization exclusion, such as time share loans, container

leases and servicer advances.

10. Covered Bonds

Several commenters called for covered bond structures to be

excluded from the definition of covered fund.\1976\ They indicated that

the proposed rule may interfere with and restrict non-U.S. banks'

ability to establish or issue covered bonds. As described by several

commenters, covered bonds are full recourse debt instruments typically

issued by a non-U.S. entity that are fully secured or ``covered'' by a

pool of high-quality collateral (e.g., residential or commercial

mortgage loans or public sector loans).\1977\ Certain of these covered

bond structures utilize a special purpose vehicle (``SPV'') that holds

a collateral pool. As such, under the proposed rule, an SPV could be a

covered fund that relies on the exclusion in section 3(c)(1) or 3(c)(7)

of the Investment Company Act.

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\1976\ See Allen & Overy (on behalf of Foreign Bank Group);

UKRCBC; FSA (Apr. 2012); ASF (Feb. 2012).

\1977\ See AFME et al.; Allen & Overy (on behalf of Foreign Bank

Group); ASF (Feb. 2012); FSA (Apr. 2012); UKRCBC.

---------------------------------------------------------------------------

According to one commenter, the majority of covered bonds are

issued under specific legislative frameworks which define permitted

characteristics for covered bond issuances, including the kinds and

quality of collateral that may be included in cover pools, the specific

legal framework for issuance of covered bonds, and the procedures for

resolution in the event that the issuer becomes insolvent.\1978\ Some

commenters expressed concern about the possibility that certain covered

bond structures could fall within the definition of covered fund, as

proposed. In particular, commenters expressed concern about covered

bond structures in the United Kingdom that also would be relevant in

principle with respect to covered bond structures used in other

European Union (``EU'') jurisdictions (e.g., the Netherlands and Italy)

and certain non-EU jurisdictions (e.g., Canada, Australia, and New

Zealand).\1979\ Another commenter indicated that covered bonds issued

by certain French entities that hold a revolving pool of loans may be

impacted by the proposed rule.\1980\

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\1978\ See UKRCBC. For example, a commenter indicated that in

the European Union, Article 52(4) of the EU UCITS Directive sets out

the defining characteristics of covered bonds, and this directive is

implemented by specific legislative frameworks.

\1979\ See UKRCBC; FSA (Apr. 2012). One commenter argued that

there are two main models used for covered bond structures in

Europe--the integrated model (where the collateral pool continues to

be owned directly by the bank issuer and is segregated by special

legislation) and the structured model (where the pool is transferred

to a special purpose vehicle and is segregated by operation of legal

principles). See UKRCBC.

\1980\ See Allen & Overy (on behalf of Foreign Bank Group).

---------------------------------------------------------------------------

Certain commenters argued that in order to achieve the intended

economic effect of providing recourse to both the bank issuing covered

bonds and to the collateral pool, the issuing bank may enter into a

number of agreements with the SPV that holds the collateral. This

includes transactions where the bank takes on credit exposure to the

SPV (e.g., through derivatives and securities lending, provision of

loans, and/or investments in securities of the SPV).\1981\ The issuing

bank typically also provides asset and liability management services to

the SPV and may also repurchase certain assets from the SPV.\1982\

Commenters also contended that under certain legislative frameworks,

the SPV issues the covered bonds and holds the collateral, and a

sponsoring bank lends money to the SPV.\1983\ According to commenters,

the

[[Page 5969]]

broad definition of covered fund in the proposed rule could capture an

SPV that holds the collateral, so transactions between an SPV and the

issuing bank or sponsor bank may be prohibited.\1984\ These commenters

argued that including covered bond structures in the definition of

covered fund is inconsistent with the legislative intent of the rule,

would have a negative and disproportionate effect on foreign banks,

markets and economies and would give rise to potential conflicts with

such foreign legislative frameworks.\1985\

---------------------------------------------------------------------------

\1981\ See FSA (Apr. 2012).

\1982\ See UKRCBC.

\1983\ See Allen & Overy (on behalf of Foreign Bank Group).

\1984\ See Allen & Overy (on behalf of Foreign Bank Group);

UKRCBC; FSA (Apr. 2012).

\1985\ See Allen & Overy (on behalf of Foreign Bank Group);

UKRCBC; FSA (Apr. 2012); ASF (Feb. 2012); AFME et al. For a

discussion of possible economic effects, see FSA (Feb. 2012);

UKRCBC; Allen & Overy (on behalf of Foreign Bank Group).

---------------------------------------------------------------------------

According to certain commenters, SPVs whose sole function is as

part of an offering of covered bonds should be excluded from the

definition of covered fund in the final rule. These commenters provided

that the proposed rule was not clear on whether these SPVs, which

effectively function as collateral devices for the covered bond, would

be excluded from the definition of covered fund.\1986\ One commenter

indicated that the key concern was primarily due to the wide definition

of covered fund in the proposed rule.\1987\ Other commenters indicated

that the final rule should not apply to covered bond transactions

because they are not traditionally recognized or regulated as asset-

backed securities transactions, and they are not the type of

transactions that the rule was intended to address.\1988\

---------------------------------------------------------------------------

\1986\ See ASF (Feb. 2012); AFME et al.; UKRCBC.

\1987\ See UKRCBC.

\1988\ See, e.g., AFME et al.

---------------------------------------------------------------------------

As a result of comments received on covered bond vehicles, the

final rule specifically excludes from the definition of covered fund

certain entities that own or hold a dynamic or fixed pool of assets

that covers the payment obligations of covered bonds. In order to

qualify for the exclusion, the assets or holdings in the cover pool

must satisfy the conditions in the loan securitization exclusion,

except for the requirement that the securities they issue are asset-

backed securities (the ``permitted cover pool'').\1989\ The Agencies

believe this approach is consistent with the rule of construction

contained in section 13(g)(2) of the BHC Act. The rule of construction

in section 13(g)(2) of the BHC Act specifically refers to the ``sale

and securitization of loans'' and the Agencies would not want a banking

entity to use an excluded cover pool to engage in proprietary trading

of such securities prohibited under the final rule. The Agencies

believe this restriction reduces the potential for evasion of the final

rule.

---------------------------------------------------------------------------

\1989\ See final rule Sec. 75.10(c)(10).

---------------------------------------------------------------------------

By placing restrictions on the assets permitted to be held by a

cover pool, the potential for evasion of the covered fund prohibitions

is reduced. The exclusion for cover pools is intended, as contemplated

by the rule of construction in section 13(g)(2) of the BHC Act, to

permit banking entities to continue to engage in lending activities and

the financing those lending activities. Including all types of

securities and other assets within the scope of permitted assets in a

cover pools would expand the exclusion beyond the scope of the

definition of loan in the final rule that is intended to implement the

rule of construction. Additionally, because the exclusion for cover

pools is only available to foreign banking organizations, allowing such

cover pools to hold securities would provide unequal treatment of

covered bonds as compared to a loan securitization sponsored by a U.S.

banking entity.

Under the definition of covered bond in the final rule, the debt

obligation may be issued directly by a foreign banking organization or

by an entity that owns a permitted cover pool. In both cases, the

payment obligations of the debt obligation must be fully and

unconditionally guaranteed. If the debt obligation is issued by a

foreign banking organization, such debt obligation will be a ``covered

bond'' under the final rule if the payment obligations are fully and

unconditionally guaranteed by an entity that owns a permitted cover

pool.\1990\ If the debt obligation is issued by an entity that owns a

permitted cover pool, such debt obligation will be a ``covered bond''

under the final rule if (i) the payment obligations are fully and

unconditionally guaranteed by a foreign banking organization and (ii)

the issuer of the debt obligation is a wholly-owned subsidiary (as

defined) by such foreign banking organization.\1991\ Thus, under the

final rule, a covered bond structure in which an entity holds the cover

pool and issues securities that are fully and unconditionally

guaranteed by a foreign banking organization may also be able to rely

on the loan securitization exclusion if it meets all of the

requirements of that exclusion.

---------------------------------------------------------------------------

\1990\ See final rule Sec. 75.10(c)(10)(ii)(A).

\1991\ See final rule Sec. 75.10(c)(10)(ii)(B). As discussed

above in the section describing the wholly-owned subsidiary

exclusion from the definition of covered fund, the Agencies are

permitting 0.5 of a wholly-owned subsidiary to be owned by an

unaffiliated party for the purpose of establishing corporate

separateness or addressing bankruptcy, insolvency, or similar

concerns.

---------------------------------------------------------------------------

The Agencies recognize that many covered bond programs may involve

foreign covered bond programs (and their related cover pools) that are

permitted by their respective laws to own residential mortgage-backed

securities and other non-loan assets. As a result, the exclusion for

covered bonds in the final rule may not be available to many of the

existing cover pools that support outstanding covered bonds. The

Agencies recognize that this approach may not exclude all foreign

covered bond programs. Although certain commenters argued that

including covered bond structures in the definition of covered fund is

inconsistent with the legislative intent of the rule,\1992\ the

Agencies believe that the exclusion for qualifying covered bonds,

including the limitations on the types of securities that a loan

securitization can hold, is consistent with the rule of construction

contained in section 13(g)(2) of the BHC Act and appropriate for the

reasons discussed directly above and under ``Definition of Loan.'' The

Agencies also recognize that commenters argued that including covered

bonds as covered funds could have a negative and disproportionate

effect on foreign banks, markets and economies and would give rise to

potential conflicts with such foreign legislative frameworks.\1993\ The

Agencies note that, although they do not know the composition of the

cover pools, the Agencies believe that foreign banking organizations

should be able to look at the composition of their cover pools to

evaluate how to meet the requirements of the exclusion -- and thus to

avoid or mitigate the adverse effects commenters asserted would occur--

as they determine appropriate.

---------------------------------------------------------------------------

\1992\ See supra note 1985 and accompanying text.

\1993\ Id.

---------------------------------------------------------------------------

11. Certain Permissible Public Welfare and Similar Funds

Section 13(d)(1)(E) of the BHC Act permits a banking entity to make

and retain: (i) Investments in one or more small business investment

companies (``SBICs''), as defined in section 103(3) of the Small

Business Investment Act of 1958 (SBA) (15 U.S.C. 662) \1994\; (ii)

[[Page 5970]]

investments that are 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); and (iii)

investments that are qualified rehabilitation expenditures with respect

to a qualified rehabilitated 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.\1995\ The proposed

rule permitted banking entities to invest in and act as sponsor \1996\

to these entities, but did not explicitly exclude them from the

definition of covered fund.\1997\

---------------------------------------------------------------------------

\1994\ The Agencies note that section 13(d)(1)(E) of the BHC Act

incorrectly provides that the term ``small business investment

company'' is defined in section 102 of the SBA, while the definition

is in fact contained in section 103(3) of the SBA as codified at 15

U.S.C. 662. The statute includes the correct citation to 15 U.S.C.

662. The Agencies are correcting this technical error in the final

rule by updating the reference to section 102 to section 103(3).

\1995\ See 12 U.S.C. 1851(d)(1)(E).

\1996\ The proposal implemented a proposed determination by the

Agencies under 13(d)(1)(J) ``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.'' Joint Proposal, 76

FR at 68908 n.292.

\1997\ See proposed rule Sec. 75.13(a).

---------------------------------------------------------------------------

Commenters generally supported the proposed exemption for

investments in and sponsorship of funds designed to promote the public

welfare, SBICs, and other tax credit funds given the valuable funding

and assistance these investments provide in facilitating community and

economic priorities and the role these investments play in the ability

of banking entities, especially community and regional banks, to

achieve their financial and Community Reinvestment Act (``CRA'') goals.

However, commenters raised some issues with respect to the proposed

exemption and sought clarification on its application to specific

investments.\1998\ Of primary concern to commenters was the impact of

the prohibition in section 13(f) of the BHC Act on the ability of a

banking entity sponsoring a tax credit fund or its affiliate to

guarantee certain obligations of the fund in order to provide assurance

to investors that the investment has been properly structured to enable

the investor to receive the tax benefits on which the investment are

sold.\1999\ Some commenters noted that failure to address this issue in

the final rule would damage a large segment of this market and

therefore urged the Agencies to exempt these investments from the

application of section 13(f) or, in the alternative, from the

definition of covered fund.\2000\

---------------------------------------------------------------------------

\1998\ See Novogradac (LIHTC); Novogradac (NMTC); Novogradac

(RETC); PNC; Raymond James; SIFMA et al. (Covered Funds) (Feb.

2012); SBIA.

\1999\ See AHIC; Novogradac (LIHTC); Novogradac (NMTC);

Novogradac (RETC); SBIA; Union Bank; U.S. Bancorp.

\2000\ See ABA (Keating); Lone Star; Novogradac (LIHTC);

Novogradac (NMTC); Novogradac (RETC); SVB; U.S. Bancorp.

---------------------------------------------------------------------------

In addition, commenters requested clarification that specific types

of public welfare, SBIC, and other tax credit investments would be

eligible for the exemption, including Low Income Housing Tax Credits,

Renewable Energy Tax Credits, New Markets Tax Credits, and Rural

Business Investment Companies.\2001\ One commenter requested that

applicants for an SBIC license that have received permission from the

Small Business Administration to file a formal SBIC license application

be viewed the same as an SBIC.\2002\ Other commenters sought coverage

of investments in non-SBIC funds that provide capital to small and

middle-market companies,\2003\ investments in any state administered

tax credit program,\2004\ and investments outside the United States

that are of the type permitted under paragraph (11) of section 5136 of

the Revised Statutes of the United States (12 U.S.C. 24).\2005\

---------------------------------------------------------------------------

\2001\ See NCHSA; SBIA; Novogradac (LIHTC); Novogradac (NMTC);

Novogradac (RETC).

\2002\ See SBIA; see also SEC Rule 3c-2.

\2003\ See ABA (Keating); PNC.

\2004\ See USAA.

\2005\ See JPMC; SIFMA et al. (Covered Funds) (Feb. 2012).

---------------------------------------------------------------------------

In light of the comments received, the final rule excludes from the

definition of covered fund an issuer that is an SBIC (or that has

received from the Small Business Administration notice to proceed to

qualify for a license as an SBIC, which notice or license has not been

revoked) or the business of which is to make investments that are: (i)

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 (ii) qualified rehabilitation expenditures with

respect to a qualified rehabilitated 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.\2006\

---------------------------------------------------------------------------

\2006\ See final rule Sec. 75.10(c)(11). This provision would

cover any issuer that engages in the business of making tax credit

investments (e.g., Low Income Housing Tax Credit, New Markets Tax

Credit, Renewable Energy Tax Credit, Rural Business Investment

Company) that are either designed to promote the public welfare of

the type permitted under 12 U.S.C. 24 (Eleventh) or are qualified

rehabilitation expenditures with respect to a qualified

rehabilitated building or certified historic structure, as provided

for under Sec. 75.10(c)(11).

---------------------------------------------------------------------------

By excluding SBICs and other public interest funds from the

definition of covered fund--rather than provide a permitted activity

exemption as proposed--the Agencies addressed commenters' concerns

regarding the burdens imposed by section 13(f). The Agencies believe

that excluding these investments from the definition of covered fund

addresses the issues many commenters raised with respect to the

application of section 13(f) of the BHC Act, and gives effect to the

statutory exemption of these investments in a way that appropriately

facilitates national community and economic development objectives. The

Agencies believe that permitting a banking entity to sponsor and invest

in these types of public interest entities will result in banking

entities being able to provide valuable expertise and services to these

entities and to provide funding and assistance to small businesses and

low- and moderate-income communities. The Agencies believe that

providing the exclusion will also allow banking entities to continue to

provide capital to community-improving projects and in some instances

promote capital formation.

12. Registered Investment Companies and Excluded Entities

The proposed rule did not specifically include registered

investment companies (including mutual funds) or business development

companies within the definition of covered fund.\2007\ As explained

above, the statute references funds that rely on section 3(c)(1) or

3(c)(7) of the Investment Company Act. Registered investment companies

and business development companies do not rely on either section

3(c)(1) or 3(c)(7) of the Investment Company Act and are instead

registered or regulated in accordance with the Investment Company Act.

---------------------------------------------------------------------------

\2007\ See proposed rule Sec. 75.10(b)(1).

---------------------------------------------------------------------------

Many commenters argued that registered investment companies and

business development companies would be treated as covered funds under

the proposed definition if commodity pools are treated as covered

funds.\2008\ A few commenters argued that the final rule should

specifically provide that all SEC-

[[Page 5971]]

registered funds are excluded from the definition of covered fund (and

the definition of banking entity) to avoid any uncertainty about

whether section 13 applies to these types of funds.\2009\

---------------------------------------------------------------------------

\2008\ See, e.g., Arnold & Porter; BoA; Goldman (Covered Funds);

ICI (Feb. 2012); Putnam; TCW; Vanguard. According to these

commenters, a registered investment company may use security or

commodity futures, swaps, or other commodity interests in various

ways to manage its investment portfolio and be swept into the broad

definition of ``commodity pool'' contained in the Commodity Exchange

Act.

\2009\ See Arnold & Porter; Goldman (Covered Funds); see also

SIFMA et al. (Covered Funds) (Feb. 2012); SIFMA et al. (Mar. 2012);

ABA (Keating); BoA; ICI (Feb. 2012); JPMC (requesting clarification

that registered investment companies are not banking entities); TCW.

---------------------------------------------------------------------------

Commenters also requested that the final rule exclude from the

definition of covered fund entities formed to establish registered

investment companies during the seeding period. These commenters

contended that, during the early stages of forming and seeding a

registered investment company, an entity relying on section 3(c)(1) or

(3)(c)(7) may be created to facilitate the development of a track

record for the registered investment company so that it may be marketed

to unaffiliated investors.\2010\

---------------------------------------------------------------------------

\2010\ See ICI (Feb. 2012); TCW.

---------------------------------------------------------------------------

Section 13's definition of private equity fund and hedge fund by

reference to section 3(c)(1) and 3(c)(7) of the Investment Company Act

appears to reflect Congress' concerns about banking entities' exposure

to and relationships with investment funds that explicitly are excluded

from SEC regulation as investment companies. The Agencies do not

believe it would be appropriate to treat as a covered fund registered

investment companies and business development companies, which are

regulated by the SEC as investment companies. The Agencies believe that

the proposed rule's inclusion of commodity pools would have resulted in

some registered investment companies and business development companies

being covered funds, a result the Agencies did not intend. The

Agencies, in addition to narrowing the commodity pools that will be

included as covered funds as discussed above, have also modified the

final rule to exclude SEC-registered investment companies and business

development companies from the definition of covered fund.\2011\

---------------------------------------------------------------------------

\2011\ See final rule Sec. 75.10(c)(12).

---------------------------------------------------------------------------

The Agencies also recognize that an entity that becomes a

registered investment company or business development company might,

during its seeding period, rely on section 3(c)(1) or 3(c)(7). The

Agencies have determined to exclude these seeding vehicles from the

covered fund definition for the same reasons the Agencies determined to

exclude entities that are operating as registered investment companies

or business development companies as discussed above.

In order to prevent banking entities from purporting to use this

exclusion for vehicles that the banking entity does not reasonably

expect to become a registered investment company or business

development company, the exclusion is available only with respect to a

vehicle that the banking entity operates (i) pursuant to a written

plan, developed in accordance with the banking entity's compliance

program, that reflects the banking entity's determination that the

vehicle will become a registered investment company or business

development company within the time period provided by the final rule

for seeding a covered fund; (ii) consistently with the leverage

requirements under the Investment Company Act of 1940 that are

applicable to registered investment companies and SEC-regulated

business development companies.\2012\ A banking entity that seeds a

covered fund for any purpose other than to register it as an investment

company or establish a business development company must comply with

the requirements of section 13(d)(1)(G) of the BHC Act and Sec. 75.11

of the final rule as described above. The Agencies will monitor this

seeding activity for attempts to use this exclusion to evade the

requirements governing the ownership of and relationships with covered

funds under section 13 of the BHC Act and the final rule.\2013\

---------------------------------------------------------------------------

\2012\ See final rule Sec. Sec. 75.10(c)(12)(i);

10(c)(12)(iii); 75.20(e).

\2013\ The Agencies also note that banking entities with more

than $10 billion in total consolidated assets as reported on

December 31 of the previous two calendar years must maintain records

that include, among other things, documentation of the exclusions or

exemptions other than sections 3(c)(1) and 3(c)(7) of the Investment

Company Act of 1940 relied on by each fund sponsored by the banking

entity in determining that such fund is not a covered fund. See

final rule Sec. 75.20(e).

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13. Other Excluded Entities

Section 13(h)(2) permits the Agencies to include similar funds

within the definition of covered fund, but the proposal did not contain

a process for excluding from the definition of covered fund other

entities that do not engage in the investment activities contemplated

by section 13. Many commenters argued that the breadth of entities that

may be required to rely on the exclusions in section 3(c)(1) or 3(c)(7)

of the Investment Company Act could result in additional unidentified

entities becoming subject to the definition of covered fund.\2014\ In

order to ensure that the final rule effectively addresses the full

scope of entities that may inadvertently be included within the

definition of covered fund, a number of commenters urged that the final

rule include a mechanism to exclude other entities from the term

``covered fund'' by rule or order if the Agencies determine such an

exclusion is appropriate.\2015\

---------------------------------------------------------------------------

\2014\ See also FSOC study.

\2015\ See SIFMA et al. (Covered Funds) (Feb. 2012); Credit

Suisse (Williams); GE (Feb. 2012).

---------------------------------------------------------------------------

As evidenced by the extensive comments discussed above identifying

the many types of corporate structures and other vehicles (not just

investment funds) that rely on sections 3(c)(1) and 3(c)(7) but do not

engage in investment activities of the type contemplated by section 13,

the scope of an overly broad definition of covered fund may impose

significant burdens on banking entities that are in conflict with the

purposes of section 13 of the BHC Act. In response to commenters'

concerns and to address the potential that the final rule's definition

of covered fund might encompass entities that do not engage in the

investment activities contemplated by section 13, the final rule

includes a provision that provides that the Agencies may jointly

determine to exclude an issuer from the definition of covered fund if

the exclusion is consistent with the purposes of section 13 of the BHC

Act.\2016\

---------------------------------------------------------------------------

\2016\ See final rule Sec. 75.10(c)(14).

---------------------------------------------------------------------------

As noted above, the statute permits the Agencies to act by rule to

modify the definition of covered fund. After issuing the proposed rule

and receiving comment on it, the final rule provides that the Agencies

may act jointly to provide an exclusion.\2017\ The Agencies are working

to establish a process within which to evaluate requests for exclusions

and expect to provide additional guidance on this matter as the

Agencies gain experience with the final rule.\2018\ As a result, the

definition of covered fund would remain unified and consistent. The

final rule also provides that a determination by the Agencies to

exclude an entity from the definition of covered fund will be promptly

made public in order to ensure that both banking entities and the

public may understand what entities are and are not included within the

definition of covered fund.

---------------------------------------------------------------------------

\2017\ As discussed above, the Agencies also may determine

jointly that an entity excluded from the definition of covered fund

under Sec. 75.10(c) is in fact a covered fund, and consequently

banking entities' investments in and transactions with such fund

would be subject to limitations and/or divestiture. The Agencies

intend to utilize this authority to monitor for and address, as

appropriate, instances of evasion. See, e.g., 12 U.S.C. 1851(e)(2).

\2018\ A joint determination specified under Sec. 75.10(c)(14)

may take a variety of forms.

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[[Page 5972]]

d. Entities Not Specifically Excluded From the Definition of Covered

Fund

In addition to the entities identified above which are excluded

from the definition of covered fund under the final rule, commenters

argued that a number of other entities such as financial market

utilities, venture capital funds, credit funds, cash management

vehicles or cash collateral pools may also be an investment company but

for the exclusion contained in section 3(c)(1) or 3(c)(7) of the

Investment Company Act and requested that these entities expressly be

excluded from the final rule's definition of covered fund. The Agencies

have considered carefully the comments received on each of these

entities but, for the reasons explained below, have declined to provide

a separate exclusion for them from the definition of covered fund at

this time. As discussed below, some of these entities are not covered

funds for various reasons or may, with relatively little cost, conform

to the terms of an exclusion or exemption from the definition of

covered fund. As noted above, to the extent that one of these entities

qualifies for one or more of the other exclusions from the definition

of covered fund, that entity would not be a covered fund under the

final rule. Any entity that would be a covered fund would still be able

to rely on the conformance period in order to come into compliance with

the requirements of section 13 and the final rule.

A number of commenters requested that certain existing covered

funds be either excluded from the definition of covered fund or

grandfathered and not be subject to the limitations of section 13 of

the BHC Act.\2019\ The Agencies note, however, that section 13

specifically addresses a banking entity's preexisting investments in

covered funds by providing a conformance period, which banking entities

may use to bring their activities and investments into compliance with

the requirements of section 13 and the final rule. To the extent that

section 13 could be interpreted to permit the Agencies to take a

different approach, despite addressing banking entities' preexisting

covered fund investments directly, the Agencies believe it would be

inconsistent with the purposes of section 13 to permit banking entities

to continue to hold ownership interests in covered funds beyond the

conformance period provided by the statute. Section 13's prohibition on

banking entities' investments in and relationships with covered funds

and the requirement that banking entities divest or conform these

investments appear to reflect the statutory purpose that banking

entities be limited in their ability to continue to be exposed to these

investments outside of the statutorily-provided conformance period. The

Agencies believe that permitting banking entities to hold ownership

interests indefinitely beyond the conformance period provided by the

statute appears inconsistent with this purpose.

---------------------------------------------------------------------------

\2019\ See, e.g., PNC; SVB; SIFMA (Securitization) (Feb. 2012);

AFME et al.; BoA. See also, e.g., Credit Suisse (Williams).

---------------------------------------------------------------------------

1. Financial Market Utilities

Several commenters contended that financial market utilities

(``FMUs'') could be covered funds because they might rely on section

3(c)(1) or 3(c)(7) for an exclusion from the definition of investment

company under the Investment Company Act and may not qualify for an

alternative exemption.\2020\ These commenters argued that banking

entities have long been investors in domestic and foreign FMUs, such as

securities clearing agencies, derivatives clearing organizations,

securities exchanges, derivatives boards of trade and alternative

trading systems. These commenters expressed concern that, unless FMUs

are expressly excluded from the definition of covered fund, banking

entities could be prohibited from entering into any new covered

transactions with related FMUs and would be required to divest their

investments in FMUs, thereby disrupting the operations of those FMUs

and financial markets generally.

---------------------------------------------------------------------------

\2020\ See SIFMA et al. (Covered Funds) (Feb. 2012); Credit

Suisse (Williams).

---------------------------------------------------------------------------

After carefully considering commenters' concerns, the Agencies

believe that FMUs are not investment vehicles of the type section 13 of

the BHC Act was designed to address, but rather entities that generally

engage in other activities, including acting as central counterparties

that reduce counterparty risk in clearing and settlement activities.

Congress recognized, in the Payment, Clearing, and Settlement

Supervision Act of 2010 (title VIII of the Dodd-Frank Act),\2021\ that

properly designed, operated, and supervised financial market utilities

as defined in that Act mitigate systemic risk and promote financial

stability.\2022\

---------------------------------------------------------------------------

\2021\ 12 USC 5461 et seq.

\2022\ See id.

---------------------------------------------------------------------------

However, the Agencies have not provided an exclusion from the

covered fund definition for FMUs because these kinds of entities do not

generally appear to rely on section 3(c)(1) or 3(c)(7) of the

Investment Company Act, and therefore do not appear to need an

exclusion. For example, section 3(b)(1) of the Investment Company Act

excludes from the definition of investment company--and thus from the

definition of a covered fund--entities primarily engaged in a business

other than that of an investment company.\2023\ If an FMU is primarily

engaged in a business other than those that would make it an investment

company, for example, if the FMU is primarily engaged in transferring,

clearing, or settling payments, securities, or other financial

transactions among or between financial institutions,\2024\ the FMU

could rely on the exclusion to the definition of investment company

provided by section 3(b)(1) and would not need to rely on section

3(c)(1) or 3(c)(7) and, as such, would not be a covered fund.

---------------------------------------------------------------------------

\2023\ Section 3(b)(1) of the Investment Company Act excludes

from the definition of investment company ``[a]ny issuer primarily

engaged, directly or through a wholly-owned subsidiary or

subsidiaries, in a business or businesses other than that of

investing, reinvesting, owning, holding, or trading in securities.''

\2024\ See 12 U.S.C. 1562(6); 12 CFR Part 234.

---------------------------------------------------------------------------

2. Cash Collateral Pools

Some commenters expressed concern that cash collateral pools, which

are part of securities lending programs, could be included in the

definition of covered fund.\2025\ According to these commenters,

banking entities, including bank custodians acting as lending agent for

customer's securities lending activities, typically manage these pools

as fiduciaries for their customers.\2026\ These commenters argued that

collateral pools are part of a banks' traditional custody and advisory

services and have been an integral part of any lending agent's role

(whether custodial or non-custodial) for years.\2027\

---------------------------------------------------------------------------

\2025\ See RMA; State Street (Feb. 2012); see also BNY Mellon et

al.

\2026\ See RMA; State Street (Feb. 2012).

\2027\ See RMA; BNY Mellon et al. (citing Comptroller's

Handbook: Custody Services (Jan. 2002)).

---------------------------------------------------------------------------

Cash collateral pools are typically formed when, as part of a

securities lending program, a customer of a bank authorizes the bank to

take securities from the customer's account and lend them in the open

market. The agent bank then lends those securities and receives

collateral in return from the borrower; a securities lending customer

of a bank typically elects to have cash collateral provided by a

borrower pooled by the agent bank with other cash collateral provided

to other clients.\2028\ These investment pools may exist in the form of

trusts, partnerships, limited liability companies, or separate

[[Page 5973]]

accounts maintained by more than one party and these structures may

rely on sections 3(c)(1) and 3(c)(7) of the Investment Company Act to

avoid being an investment company.\2029\ While their ownership interest

may be nominal in amount, the agent banks may hold a general

partnership, limited liability company membership or trustee interest

in the cash collateral pool.\2030\ As part of these arrangements,

custodian banks routinely offer borrower default indemnifications to

the securities lender in a securities lending transactions.

---------------------------------------------------------------------------

\2028\ See RMA.

\2029\ See RMA.

\2030\ See RMA.

---------------------------------------------------------------------------

Commenters raised concerns that these indemnification agreements

could be considered a covered transaction prohibited by section 13(f)

of the BHC Act.\2031\ Since some cash collateral pools are established

outside of the United States, commenters requested that the final rule

permit banking entities to have interests in and relationships with

both U.S. and non-U.S. cash collateral pools.\2032\ These commenters

suggested that cash collateral pools be excluded from the definition of

covered fund or, in the alternative, that the Agencies make clear that

cash collateral pools managed by agent banks qualify for the exemption

in Sec. 75.11 of the proposed rule for organizing and offering a

covered fund and that the prime brokerage exemption from the

restrictions of section 13(f) would permit the indemnification and

income or settlement services agent banks typically provide to the

pools.\2033\ These commenters also suggested that the Agencies use

their authority under section 13(d)(1)(J) to provide an exemption for

banking entities to continue to have interests in and provide services

to these types of pools.\2034\

---------------------------------------------------------------------------

\2031\ See State Street; RMA. Commenters also argued that as

part of offering pooled cash collateral management, agent banks have

traditionally provided short-term extensions of credit and

contractual income and settlement services to lending clients and

cash collateral pools to facilitate trade settlement and related

cash collateral investment activities. See RMA. One commenter

further argued that if banks are required to ``outsource'' cash

collateral pools and/or the related short-term credit services

provided to the pools, ``participation in securities lending

programs would only be cost effective for the largest lending

clients'' and, as a result, ``many small and intermediate securities

lending clients would be denied the incremental revenue securities

lending can provide''; ``securities lending programs could lose

significant diversification in lending clients, lendable assets,

borrowers and agent banks''; and, as a result of lost revenues,

``the actual costs of [ ] custodial or other services provided to

clients that no longer participate in lending would increase.'' Id.

\2032\ See RMA.

\2033\ See RMA.

\2034\ See RMA.

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After carefully considering comments received, the final rule does

not provide a specific exclusion from the definition of covered fund

for cash collateral pools. The Agencies have determined to provide

specific exclusions for entities that do not function as investment

funds, consistent with the intent of section 13's restrictions, or in

response to other unique considerations (e.g., to provide consistent

treatment for certain foreign and domestic pension plans). These

considerations do not support a separate exclusion for cash collateral

pools.

The Agencies note, however, that some cash collateral pools may not

be covered funds because they rely on an exclusion from the definition

of investment company other than those contained in section 3(c)(1) or

3(c)(7) of the Investment Company Act.\2035\ Banking entities may

determine to register cash collateral pools with the SEC as investment

companies or to operate them as separate accounts to exclude the pools

from the covered fund definition or, if the pools remain covered funds,

to organize and offer them in compliance with the requirements of Sec.

75.11 of the final rule.

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\2035\ For instance, the Agencies understand that a banking

entity may set up a cash collateral pool in reliance on the

exclusion contained in section 3(c)(3) of the Investment Company

Act, or may be able to structure these pools as SEC-registered money

market funds operated in accordance with rule 2a-7 under the

Investment Company Act.

---------------------------------------------------------------------------

In response to comments received on the proposal, the Agencies note

that the provision of a borrower default indemnification by a banking

entity to a lending client in connection with securities lending

transactions involving a covered fund is not a covered transaction

subject to 13(f) or a guarantee of the performance or obligations of a

covered fund prohibited under Sec. 75.11 of the final rule. Those

restrictions apply to transactions with the covered fund or guarantees

of the covered fund's performance. Borrower default indemnifications

are provided to the bank's securities lending customer, not to the cash

collateral pool.

3. Pass-Through REITS

Some banking entities may issue real estate investment trust

(``REIT'') preferred securities to the public directly from a

subsidiary that qualifies for the exclusion in section 3(c)(5) or

section 3(c)(6) of the Investment Company Act. These entities would not

be considered a ``covered fund'' because they may rely on an exclusion

from the definition of an investment company other than the exclusion

in section 3(c)(1) or 3(c)(7) of the Investment Company Act.\2036\

However, in order to meet the demands of customers and avoid

undesirable tax consequences, some banking entities structure their

REIT offerings by using a passive, pass-through statutory trust between

the banking entity and the REIT to issue REIT preferred securities to

the public.\2037\ Because the pass-through trust holds the preferred

securities of the underlying REIT (which would itself not be a covered

fund), as well as provides administrative and ministerial functions for

the REIT (including passing through dividends from the underlying

REIT), the pass-through trust may not itself rely on the exclusion

contained in section 3(c)(5) or 3(c)(6) and, thus, typically relies on

section 3(c)(1) or 3(c)(7).\2038\

---------------------------------------------------------------------------

\2036\ See PNC.

\2037\ See PNC.

\2038\ See ABA (Keating); PNC.

---------------------------------------------------------------------------

Some commenters urged the Agencies to provide an exclusion for

pass-through REITS from the definition of covered fund.\2039\ These

commenters argued that because the pass-through trust exists as a

corporate convenience as part of issuing REIT preferred securities to

the banking entity and its customers, it is not the type of entity that

the covered fund prohibition in section 13 of the BHC Act was intended

to address. These commenters also argued that pass-through REITs enable

banking entities to offer preferable tax treatment to holders of the

REIT preferred securities and that if pass-through REITs were included

as covered funds, because of the limitations on covered transactions

contained in section 13(f), the minority interests in the preferred

securities issued by the REIT would no longer be able to be included in

a banking entity's tier 1 capital, thereby negatively impacting the

safety and soundness of the banking entity.\2040\

---------------------------------------------------------------------------

\2039\ See ABA (Keating); PNC.

\2040\ See PNC; ABA (Keating). These commenters argued that most

REIT preferred securities contain a conditional exchange provision

that allows the primary regulator to direct that the preferred

securities be automatically exchanged for preferred shares of the

bank or parent BHC upon occurrence of a conditional exchange event.

Because this arrangement involves the purchase of securities issued

by an affiliate or the purchase of assets, it would be prohibited

under section 13(f) of the BHC Act if the pass-through REIT were a

covered fund.

---------------------------------------------------------------------------

The Agencies are not providing a specific exclusion from the

definition of covered fund for pass-through REITs because the Agencies

are concerned that such an exclusion could enable banking entities to

structure non-loan securitization transactions using a pass-through

entity in a manner inconsistent with the final rule's treatment of

similar vehicles that invest in securities.

[[Page 5974]]

Furthermore, banking entities have alternative manners in which they

may issue or hold REIT preferred securities, including through REITs

directly, which do not raise the same concerns about evasion.\2041\

---------------------------------------------------------------------------

\2041\ The Agencies recognize that banking entities may have

relied on pass-through REIT structures to issue preferred securities

in the past and prohibiting such transactions may pose

inefficiencies. Furthermore, it may not be possible to unwind or

conform past issuances without significant effort by the banking

entity and negotiation with the holders of the preferred securities.

As noted above, in these circumstances, section 13 provides a

conformance period which banking entities may take advantage of in

order to bring their activities and investments into compliance with

the requirements of section 13 and the final rule.

---------------------------------------------------------------------------

4. Municipal Securities Tender Option Bond Transactions

The Agencies received a number of comments addressing how the final

rule should treat municipal securities tender option bond vehicles. A

number of commenters argued that issuers of municipal securities tender

option bonds would fall under the definition of covered fund in the

proposed rule because these issuers typically rely on the exclusion

contained in section 3(c)(1) or 3(c)(7) of the Investment Company

Act.\2042\ According to commenters, a typical tender option bond

transaction consists of the deposit of a single issue of highly-rated,

long-term municipal bonds in a trust and the issuance by the trust of

two classes of securities: a floating rate, puttable security (the

``floaters''), and an inverse floating rate security (the ``residual'')

with no tranching involved. According to commenters, the holders of the

floaters have the right, generally on a daily or weekly basis, to put

the floaters for purchase at par. The put right is supported by a

liquidity facility delivered by a highly-rated provider (in many cases,

the banking entity sponsoring the trust) and allows the floaters to be

treated as a short-term security. The floaters are in large part

purchased and held by money market mutual funds. The residual is held

by a longer-term investor (in many cases the banking entity sponsoring

the trust, or an insurance company, mutual fund, or hedge fund).

According to commenters, the residual investors take all of the market

and structural risk related to the tender option bonds structure, with

the investors in floaters taking only limited, well-defined insolvency

and default risks associated with the underlying municipal bonds

generally equivalent to the risks associated with investing in the

municipal bonds directly. According to commenters, the structure of

tender option bond transactions is governed by certain provisions of

the Internal Revenue Code in order to preserve the tax-exempt treatment

of the underlying municipal securities.

---------------------------------------------------------------------------

\2042\ See, e.g., Ashurst; SIFMA (Municipal Securities) (Feb.

2012); Citigroup (Jan. 2012); Cadwalader (Municipal Securities);

Vanguard; ICI (Feb. 2012); ASF (Feb. 2012); Fidelity; Wells Fargo

(Covered Funds). Commenters also noted that tender option bond

programs as currently structured may not meet the requirements of

section 3(a)(5) of the Investment Company Act or rule 3a-7

thereunder, or any other exclusion or exemption under the Investment

Company Act. See Ashurst; RBC; ASF (Feb. 2012).

---------------------------------------------------------------------------

Many commenters requested a specific exclusion for municipal tender

option bond vehicles from the definition of a covered fund.\2043\ These

commenters argued that, without an exclusion from the definition of

covered fund, banking entities would be prohibited from owning or

sponsoring tender option bonds and from providing credit enhancement,

liquidity support, remarketing, and other services required in

connection with a tender option bond program.\2044\ Commenters argued

that tender option bond vehicles should be excluded because section

13(d)(1)(A) of the BHC Act already allows banking entities to own and

dispose of municipal securities directly,\2045\ tender option bonds are

economically similar to repurchase agreements, which are expressly

excluded from the proprietary trading restrictions of the proposed

rule, and, because they are safe and low risk are similar to the types

of transactions that the proposed rule would have exempted.\2046\

Commenters also argued that tender option bonds are different from

other covered funds that rely on the exclusion contained in section

3(c)(1) or 3(c)(7) of the Investment Company Act \2047\ and play an

important role in the municipal bond markets.\2048\ Commenters

requested that the Agencies use their authority under section

13(d)(1)(J) of the BHC Act to exclude tender option bonds because they

argued that tender option bonds promote the safety and soundness of

banking entities and the financial stability of the United States by

providing for a deeper, richer pool of potential investors, a larger

and more liquid market for municipal securities that results in lower

borrowing costs for municipalities and other issuers of municipal

securities, and greater efficiency and risk diversification.\2049\

Commenters also suggested a number of other ways to exclude tender

option bonds, including defining ownership interest to exclude any

interest in a tender option bond transaction; \2050\ defining banking

entity to exclude tender option bond issuers; \2051\ expanding the loan

securitization exclusion to include tender option bond issuers; \2052\

and revising the definition of sponsor to exclude sponsors of tender

option bond vehicles.\2053\ One commenter urged the Commission to

consider amending the exemption under rule 3a-7 under the Investment

Company Act or providing formal guidance regarding the status of tender

option bond programs.\2054\ In addition, some commenters requested an

exclusion for tender option bond transactions from the provisions of

section 13(f) of the BHC Act.\2055\

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\2043\ See, e.g., ASF (Feb. 2012); BDA (Feb. 2012); Eaton Vance;

Fidelity; ICI (Feb. 2012); RBC; SIFMA (Municipal Securities) (Feb.

2012); SIFMA (May 2012); State Street (Feb. 2012); Vanguard.

\2044\ See Ashurst; ASF (Feb. 2012).

\2045\ See ASF (Feb. 2012); SIFMA (Municipal Securities) (Feb.

13, 2012); Citigroup (Jan. 2012). See also Cadwalader (Municipal

Securities) (alleging that the legislative history of section 13 of

the BHC Act suggests that the exemption relating to municipal

securities should not be construed to apply only to the section of

the rule pertaining to the proprietary trading prohibitions); BDA

(Feb. 2012) (arguing that any fund or trust the assets of which are

entirely invested in any of the obligations that are excluded from

the proprietary trading prohibitions should also be excluded from

the definition of covered fund).

\2046\ See, e.g., Ashurst; Cadwalader (Municipal Securities);

Eaton Vance; Nuveen Asset Mgmt.; SIFMA (Municipal Securities) (Feb.

13, 2012); State Street (Feb. 2012); Vanguard; Wells Fargo (Covered

Funds); Citigroup (Jan. 2012).

\2047\ See, e.g., ASF (Feb. 2012); State Street (Feb. 2012);

Citigroup (Jan. 2012); Vanguard; Wells Fargo (Covered Funds);

Cadwalader (Municipal Securities); Ashurst.

\2048\ See Cadwalader (Municipal Securities); ICI (Feb. 2012);

Ashurst; ASF (Feb. 2012).

\2049\ See Cadwalader (Municipal Securities).

\2050\ See RBC.

\2051\ See ICI (Feb. 2012).

\2052\ See ASF (Feb. 2012).

\2053\ See RBC.

\2054\ See Ashurst.

\2055\ See, e.g., RBC; ASF (Mar. 2012); ASF (Feb. 2012).

---------------------------------------------------------------------------

After carefully considering the comments received, the final rule

does not provide a specific exclusion from the definition of covered

fund or from the prohibitions and requirements of the final rule for

tender option bond vehicles.\2056\ The Agencies have determined to

provide specific exclusions for entities that they believe fall within

the rule of construction contained in section 13(g)(2) of the BHC Act,

which expressly relates to the sale and securitization of loans,\2057\

do not

[[Page 5975]]

function as investment funds, consistent with the intent of section

13's restrictions, or in response to other unique considerations. The

Agencies do not believe that these considerations support a separate

exclusion for tender option bond vehicles, which have municipal

securities as underlying assets and not loans.

---------------------------------------------------------------------------

\2056\ The Agencies received a variety of requests requesting

specific treatment of tender option bond transactions. See, e.g.,

supra notes 2050-2055. As discussed above, the Agencies believe

that, in light of the comments received, tender option bond vehicles

do not fall within the rule of construction contained in section

13(g)(2) of the BHC Act and, as a result, the final rule does not

provide such treatment.

\2057\ See 12 U.S.C. 1851(g)(2).

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The Agencies recognize commenters' concerns about the treatment of

tender option bonds under the final rule, as discussed above. However,

as there is no corresponding rule of construction in section 13 of the

BHC Act for financial instruments other than loans, the Agencies do not

believe that the resecuritization of municipal debt instruments should

be treated differently than the resecuritization of other debt

instruments.\2058\ Notwithstanding the statutory treatment of municipal

securities for purposes of the proprietary trading restrictions, the

Agencies also do not believe that tender option bond vehicles fall

within the rule of construction contained in section 13(g)(2) of the

BHC Act, because, in light of commenters' descriptions of these

vehicles, tender option bond vehicles are more in the nature of other

types of bond repackaging securitizations and other non-excluded

securitization vehicles.\2059\ The final rule, however, does not

prevent a banking entity from owning or otherwise participating in a

tender option bond vehicle; it requires that these activities be

conducted in the same manner as with other covered funds.

---------------------------------------------------------------------------

\2058\ For these same reasons, and based on the definitions of

sponsor and banking entity in section 13, the Agencies have not

modified those definitions in the final rule to exclude sponsors of

tender options bonds and tender bond issuers, respectively, as some

commenters requested. See supra notes 2051 and 2053 and accompanying

text.

\2059\ Commenters also argued that to the extent tender option

bond programs are not excluded from the definition of covered fund,

the definition of ownership interest should exclude any interest in

a tender option bond program (see RBC) or that where a third party

owns the residual, the banking entity should not be treated as

having an ownership interest, even when it owns a small interest for

tax purposes or becomes the owner through liquidity or remarketing

agreements (see Cadwalader (Municipal Securities)). The definition

of ownership interest in the final rule focuses on the attributes of

the interest, as discussed below, and not the particular type of

covered fund involved. The Agencies are not providing separate

definitions of or exclusions from the ownership interest definition

based on the type of vehicle or financing involved. See infra note

2103 and preceding and following text. Banking entities will need to

evaluate whether the interests they may acquire are ownership

interests as defined under the final rule.

---------------------------------------------------------------------------

In this regard, under the final rule, a banking entity would need

to evaluate whether a tender option bond vehicle is a covered fund as

defined in the final rule. If a tender option bond vehicle is a covered

fund and an exclusion from that definition is not available, then

banking entities sponsoring such a vehicle will be subject to the

prohibitions in Sec. 75.14 of the final rule and the provisions of

section 13(f) of the BHC Act.\2060\

---------------------------------------------------------------------------

\2060\ See 12 U.S.C. 1851(f).

---------------------------------------------------------------------------

As tender option bond vehicles are considered issuers of asset-

backed securities subject to the risk retention requirements of section

15G of the Exchange Act, banking entities may look to the provisions of

the final rule governing the limits applicable to banking entities'

interests in and relationships with those funds. Under the final rule,

as in the statute, a banking entity that conducts the activities

described in section 13(f) of the BHC Act is subject to the

restrictions on transactions with a tender option bond vehicle,

including guaranteeing or insuring the performance of the tender option

bond vehicle, contained in section 13(f) of the BHC Act. As a result, a

banking entity is not permitted to provide credit enhancement,

liquidity support, and other similar services if it serves in a

capacity covered by section 13(f) with the tender option bond

program.\2061\ An unaffiliated third party may provide such services if

it does not have a relationship with the tender option bond vehicle

that triggers application of section 13(f). The extent to which the

final rule causes a disruption to the securitization of, and market

for, municipal tender option bonds may also affect the economic burden

and effects on the municipal bond market and its participants,

including money market mutual funds \2062\ and issuers of municipal

securities. The Agencies recognize that a potential economic burden may

be an increase in financing costs to municipalities as a result of a

decrease in demand for the types of municipal securities customarily

included in municipal tender option bond vehicles \2063\ and therefore

potential effects on the depth and liquidity of the market for certain

types of municipal securities.\2064\

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\2061\ As discussed above, while commenters requested treatment

of municipal tender option bond vehicles that would cause section

13(f) of the BHC Act not to apply to them, the final rule does not

exclude these vehicles from the definition of covered fund or the

prohibitions relating to covered funds. As a result, section 13(f)

of the BHC Act will apply to a banking entity that is sponsoring a

tender option bond vehicle.

\2062\ See ASF (Feb. 2012); Nuveen Asset Mgmt.

\2063\ See Ashurst.

\2064\ See Eaton Vance.

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5. Venture Capital Funds

Some private equity funds that make investments in early-stage

start-up companies or other companies with significant growth potential

(``venture capital funds'') would be investment companies but for the

exclusion contained in section 3(c)(1) or 3(c)(7) of the Investment

Company Act. Venture capital funds would therefore qualify as a covered

fund under the proposal. The proposal specifically requested comment on

whether venture capital funds should be excluded from the definition of

``covered fund.''

Some commenters argued that venture capital funds should be treated

differently than other covered funds and excluded from the definition.

These commenters argued that, unlike conventional hedge funds and

private equity funds, venture capital funds do not possess high

leverage and do not engage in risky trading activities of the type

section 13 of the BHC Act was designed to address.\2065\ These

commenters contended that investments and relationships by banking

entities in venture capital funds would be consistent with safety and

soundness; provide important funding and expertise and other services

to start-up companies; and provide positive benefits to employment,

GDP, growth, and innovation.\2066\ These commenters argued that

restricting banking entities' ability to invest in or sponsor venture

capital funds would have a negative impact on companies and the U.S.

economy generally.\2067\ Some commenters asserted that bank investments

in venture capital funds are important to the success of venture

capital,\2068\ with some citing a consulting firm's data indicating

that approximately 7 percent of all venture capital is provided by

banks.\2069\ One commenter argued, therefore, that ``preventing banks

from investing in venture thus could depress U.S. GDP by roughly 1.5%

(or $215 billion annually) and eliminate nearly 1% of all U.S. private

sector employment over the long term,'' and the funding gap that would

result if banks could not invest in venture capital funds would not be

met

[[Page 5976]]

by other market participants if bank investments in venture capital

were restricted.\2070\ Several commenters recommended that venture

capital funds be excluded if they: (i) Do not fundamentally engage in

proprietary trading; (ii) do not use leverage to increase investment

returns; and (iii) typically invest in high-growth start-up companies

as compared to more mature publicly traded companies.\2071\

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\2065\ See SVB; NVCA; Rep. Eshoo; Sen. Boxer; Rep. Goodlatte;

Rep. Schweikert; Rep. Speier; Rep. Honda; Rep. Lofgren; Rep. Peters

et al.

\2066\ See, e.g., NVCA; SVB; Scale.

\2067\ See, e.g., SVB; Scale; Sen. Boxer; SIFMA et al. (Covered

Funds) (Feb. 2012) (citing a colloquy between Sen. Dodd and Sen.

Boxer supporting an exemption for venture capital funds (156 Cong.

Rec. H5226 (daily ed., June 30, 2010)).

\2068\ See River Cities; Scale. See also Sofinnova; Canaan

(Young); Canaan (Ahrens); Canaan (Kamra); Mohr Davidow; ATV;

BlueRun; Westly; Charles River; Flybridge; SVB.

\2069\ See, e.g., SVB.

\2070\ See SVB.

\2071\ See, e.g., SVB (arguing that the definition of ``venture

capital fund'' in section 203(l)-1 of the Investment Advisers Act

and the SEC's Form PF reporting requirements for investment advisers

to private funds would be instructive for defining an exclusion for

venture capital funds for purposes of section 13 of the BHC Act).

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Conversely, one commenter alleged that there was no credible way to

exclude venture capital funds without providing a means to circumvent

the requirements of section 13 and the final rule.\2072\ Another

commenter argued that venture capital funds do in fact engage in risky

activities and that, instead of making investments in venture capital

funds, banking entities may directly extend credit to start-up

companies in a safe and sound manner.\2073\

---------------------------------------------------------------------------

\2072\ See Occupy.

\2073\ See Sens. Merkley & Levin (Feb. 2012).

---------------------------------------------------------------------------

The final rule does not provide an exclusion for venture capital

funds. The Agencies believe that the statutory language of section 13

does not support providing an exclusion for venture capital funds from

the definition of covered fund. Congress explicitly recognized and

treated venture capital funds as a subset of private equity funds in

various parts of the Dodd-Frank Act and accorded distinct treatment for

venture capital fund advisers by exempting them from registration

requirements under the Investment Advisers Act.\2074\ This indicates

that Congress knew how to distinguish venture capital funds from other

types of private equity funds when it desired to do so.\2075\ No such

distinction appears in section 13 of the BHC Act. Because Congress

chose to distinguish between private equity and venture capital in one

part of the Dodd-Frank Act, but chose not to do so for purposes of

section 13, the Agencies believe it is appropriate to follow this

Congressional determination.

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\2074\ See S. Rep. No. 111-176, at 71-3 (2010) (``S. Rep. No.

111-176''); H. Rep. No. 111-517, at 866 (2010) (``H. Rep. No. 111-

517''). H. Rep. No. 111-517 contains the conference report

accompanying the version of H.R. 4173 that was debated in

conference. See S. Rep. No. 111-176, at 74 (``The Committee believes

that venture capital funds, a subset of private investment funds

specializing in long-term equity investment in small or start-up

businesses, do not present the same risks as the large private funds

whose advisers are required to register with the SEC under this

title.''). Compare Restoring American Financial Stability Act of

2010, S. 3217, 111th Cong. Sec. 408 (2010) (as passed by the Senate)

with The Wall Street Reform and Consumer Protection Act of 2009,

H.R. 4173, 111th Cong. (2009) (as passed by the House) (``H.R.

4173'') and Dodd-Frank Act (2010).

\2075\ But see Rep. Honda.

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In addition to the language of the statute, it appears to the

Agencies that the activities and risk profiles for banking entities

regarding sponsorship of, and investment in, venture capital funds and

private equity funds are not readily distinguishable. Many key

structural and operational characteristics of venture capital funds are

substantially similar to those of hedge funds and private equity funds,

thereby making it difficult to define venture capital funds in a manner

that would not provide banking entities with an opportunity to evade

the restrictions of section 13 of the BHC Act.

For instance, in addition to relying on the same exemptions under

the Securities Act,\2076\ venture capital funds, private equity funds

and hedge funds all rely on the exclusion in section 3(c)(1) or 3(c)(7)

from the definition of investment company under the Investment Company

Act. Moreover, like private equity funds, venture capital funds pool

funds from multiple investors and invest those funds in interests of

portfolio companies for the purpose of profiting from the resale of

those interests. Indeed, funds that are called ``venture capital

funds'' may invest in the very same entities and to the same extent as

do funds that call themselves private equity funds. Venture capital

funds, like private equity funds, also typically charge incentive

compensation to fund investors based on the price appreciation achieved

on the investments held by the fund and provide a return of principal

plus gains at specific times during the limited life of the fund. Not

including venture capital funds in the definition of covered fund,

therefore, could allow banking entities, either directly or indirectly,

to engage in the type of activities section 13 was designed to address.

---------------------------------------------------------------------------

\2076\ These funds all typically offer their shares on an

unregistered basis in reliance on section 4(a)(2) of the Securities

Act of 1933 or Regulation D thereunder (17 CFR 230.500 through

230.508).

---------------------------------------------------------------------------

While the final rule does not provide a separate exclusion for

venture capital funds from the definition of covered fund, the Agencies

recognize that certain venture capital investments by banking entities

provide capital and funding to nascent or early-stage companies and

small businesses and also may provide these companies expertise and

other services.\2077\ Other provisions of the final rule or the statute

may facilitate, or at least not impede, other forms of investing that

may provide the same or similar benefits. For example, in addition to

permitting a banking entity to organize and offer a covered fund in

section 13(d)(1)(G), section 13 of the BHC Act does not prohibit a

banking entity, to the extent otherwise permitted under applicable law,

from making a venture capital-style investment in a company or business

so long as that investment is not through or in a covered fund, such as

through a direct investment made pursuant to merchant banking authority

\2078\ or through business development companies which are not covered

funds and, like venture capital funds, often invest in small, early-

stage companies.\2079\

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\2077\ As noted above, some commenters quantified the importance

of banking entities to the provision of venture capital by providing

information indicating that approximately 7 percent of all venture

capital is provided by banks. See, e.g., SVB (citing ``The Venture

Capital Industry: A Preqin Special Report,'' published by Preqin,

Ltd. (Oct. 2010)). The 7% estimate commenters identified includes

information on investors based in North America, Europe, and Asia;

thus, although potentially indicative of the extent of venture

capital investing by banking entities in venture capital funds, the

estimate does not specifically address the proportion of investment

by banking entities in venture capital funds that are covered funds,

as those terms are defined in the final rule.

\2078\ See 12 U.S.C. 1843(k)(4)(H); 12 CFR 225.170 et seq.

\2079\ See 15 U.S.C. 80a-54. Companies that have elected to be

treated as a business development company are subject to limits

under the Investment Company Act, including: (i) Limits on how much

debt the business development company may incur; (ii) prohibitions

on certain affiliated transactions; (iii) regulation and examination

by the SEC; and (iv) registration and filing requirements.

---------------------------------------------------------------------------

Thus, to the extent that banking entities are required to reduce

their investments in venture capital funds, certain of these

investments may be redirected to the types of entities in which venture

capital funds invest through alternative means. To the extent that

banking entities may reduce their investments in venture capital funds

that are covered funds, the potential funding gap for venture capital

funds may also be offset, in whole or in part, by investments from

firms that are not banking entities and thus not subject to section

13's restrictions.

6. Credit Funds

Several commenters requested that the final rule explicitly exclude

from the definition of covered fund entities that are generally formed

as partnerships with third-party capital and invest in loans or make

loans or otherwise extend the type of credit that banks are

[[Page 5977]]

authorized to undertake on their own balance sheet (``credit

funds'').\2080\ Two commenters contended that the language of section

13(g)(2) indicates that Congress did not intend section 13 of the BHC

Act to limit a banking entity's ability to extend credit.\2081\ They

argued that lending is a fundamental banking activity, whether

accomplished through direct loans or through a fund structure. These

commenters argued that credit funds functioned like syndicated loans

that enable borrowers to secure credit during periods of market

distress and reduce the concentration of risk for both individual

banking entities and the banking system as a whole.

---------------------------------------------------------------------------

\2080\ See, e.g., Goldman (Covered Funds); ABA (Keating); Credit

Suisse (Williams); Comm. on Capital Markets Regulation; Chamber

(Feb. 2012).

\2081\ See ABA (Keating); Goldman (Covered Funds).

---------------------------------------------------------------------------

Commenters suggested different approaches for excluding credit

funds from the definition of covered fund. One commenter recommended

excluding an entity that would otherwise be a covered fund if more than

50 percent of its assets consist of loans.\2082\ Another commenter

proposed defining a credit fund as an entity that met a number of

criteria designed to ensure the entity only held loans or otherwise

engaged in prudent lending activity.\2083\ Another commenter requested

that the Agencies use their authority under section 13(d)(1)(J) to

permit a banking entity to sponsor, invest in, or enter into covered

transactions with related credit funds that are covered funds.\2084\

---------------------------------------------------------------------------

\2082\ See Credit Suisse (Williams).

\2083\ See Goldman (Covered Funds).

\2084\ See SIFMA et al. (Covered Funds) (Feb. 2012); see also.

ABA (Keating); Chamber (Feb. 2012).

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The Agencies, however, are unable effectively to distinguish credit

funds from other types of private equity funds or hedge funds in a

manner that would give effect to the language and purpose of section 13

and not raise concerns about banking entities being able to evade the

requirements of section 13. Moreover, the Agencies also believe that

the final rule largely addresses commenters' concerns in other ways

because some credit funds may be able to rely on another exclusion from

the definition of covered fund in the final rule such as the exclusion

for joint ventures or the exclusion, discussed above, for loan

securitizations. To the extent that a credit fund may rely on another

exclusion from the definition of covered fund, it would not be a

covered fund under section 13 of the BHC Act.

7. Employee Securities Companies

Several commenters argued that employee securities companies

(``ESCs'') should be explicitly excluded from the definition of covered

fund.\2085\ One commenter alleged that, though many ESCs could qualify

for the exemption in section 6(b) of the Investment Company Act, they

often opt to rely on section 3(c)(1) or 3(c)(7) instead due to the fact

that the section 6(b) exemption is available only upon application to

the SEC.\2086\ According to this commenter, the limitations contained

in section 13 on employee investments and intercompany transactions

with covered funds would severely limit the ability of a banking entity

to design competitive employee compensation arrangements.\2087\ This

commenter also argued that an exclusion should be provided for any

investment vehicle that satisfies the definition of an ESC under

section 2(a)(13) of the Investment Company Act.

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\2085\ See, e.g., ABA (Keating), Credit Suisse (Williams),

Arnold & Porter (as it relates to commodity pools). Section 2(a)(13)

of the Investment Company Act generally defines an ESC as ``any

investment company or similar issuer all of the outstanding

securities of which (other than short-term paper) are beneficially

owned'' by employees and certain related persons (e.g., employees'

immediate family members).

\2086\ Section 6(b) of the Investment Company Act provides, in

part, that ``[u]pon application by any employees' security company,

the Commission shall by order exempt such company from the

provisions of this title and of the rules and regulations hereunder,

if and to the extent that such exemption is consistent with the

protection of investors.''

\2087\ See Credit Suisse (Williams).

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After considering carefully the comments received on the proposed

rule, the final rule does not provide a specific exclusion for ESCs

because the Agencies believe that these vehicles may avoid being a

covered fund by either complying with the conditions of another

exclusion from the definition of covered fund or seeking and receiving

an exemption available under section 6(b) of the Investment Company

Act. As such, the Agencies believe a banking entity has a reasonable

alternative to design competitive employee compensation arrangements.

The Agencies recognize that preparing an application under section 6(b)

of the Investment Company Act or modifying an ESC's activities to meet

the terms of another exclusion from the covered fund definition is not

without costs, but have determined to provide specific exclusions for

entities that do not function as investment funds, consistent with the

purpose of section 13, or in response to other unique considerations

(e.g., to provide consistent treatment for certain foreign and domestic

pension plans). These considerations do not support a separate

exclusion for ESCs.

The Agencies also note that non-qualified plans are not exempt from

the Investment Company Act under 3(c)(11) and thus would be covered

funds if they are operating in reliance on section 3(c)(1) or 3(c)(7)

of the Investment Company Act. Some of these non-qualified plans may be

formed as employees' securities companies, however, and could qualify

for an exemption under section 6(b) of the Investment Company Act for

employees' securities companies as discussed above.

e. Definition of ``Ownership Interest''

The proposed rule defined ``ownership interest'' in a covered fund

to mean 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, as well as any derivative of such an

interest.\2088\ This definition focused on the attributes of the

interest and whether it provided a banking entity with economic

exposure to the profits and losses of the covered fund, rather than its

form. The proposal thus would also have included a debt security or

other interest in a covered fund as an ownership interest if it

exhibited 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).\2089\ As described further below, the

proposed rule excluded carried interest (termed ``restricted profit

interest'' in the final rule) from the definition of ownership

interest.

---------------------------------------------------------------------------

\2088\ See proposed rule Sec. 75.10(b)(3).

\2089\ See Joint Proposal, 76 FR at 68897.

---------------------------------------------------------------------------

Many commenters argued that the proposed definition of ownership

interest was too broad and urged excluding one or more types of

interests from the definition. A number of commenters raised concerns

regarding the difficulty of applying the ownership interest definition

to securitization structures and questioned whether the definition of

ownership interest might apply to a debt security issued by, or a debt

interest in, a covered fund that has some characteristics similar to an

equity

[[Page 5978]]

or other ownership interest.\2090\ One commenter argued that the

ownership interest definition should not include debt instruments with

equity features unless the Agencies determine with respect to a

particular debt instrument, after appropriate notice and opportunity

for hearing, that the equity features are so pervasive that the debt

instrument is the functional equivalent of an equity interest or

partnership interest and was structured to evade the prohibitions and

restrictions in the proposal.\2091\ Several commenters argued that the

Agencies should explicitly exclude certain debt instruments with equity

features from the ownership interest definition.\2092\ Finally, certain

commenters argued that, because the application of the ownership

interest definition to securitization structures was problematic,

alternative regulatory treatment was appropriate.\2093\

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\2090\ See AFME et al.; AFR et al. (Feb. 2012); ASF (Feb. 2012);

BoA; Cadwalader (Municipal Securities); Credit Suisse (Williams);

Deutsche Bank (Repackaging Transactions); Occupy; RBC; SIFMA et al.

(Covered Funds) (Feb. 2012); SIFMA (Securitization) (Feb. 2012);

TCW. For example, securitization structures generally provide that

either the most senior or the most junior tranche notes have

controlling voting rights. One commenter argued that under the

proposed ownership interest definition, a banking entity could be

deemed to have an ownership interest in an entity it does not own or

sponsor simply due to its obtaining voting rights. See ASF (Feb.

2012). As a further example, one commenter alleged that

securitization structures generally are not viewed as providing

economic exposure to the profits and losses of the issuer in the

same manner as equity interests in hedge funds and private equity

funds. This commenter argued that the ownership interest definition

should include only those interests that permit the banking entity

to share without limit in the profits and losses or that earn a

return that is based on the performance of the underlying assets.

See SIFMA (Securitization) (Feb. 2012).

\2091\ See SIFMA et al. (Covered Funds) (Feb. 2012).

\2092\ See AFME et al.; ASF (Feb. 2012); BoA; Cadwalader

(Municipal Securities); RBC; SIFMA (Securitization) (Feb. 2012).

These commenters argued that the ownership interest definition

should not include tender option bond programs and other debt asset-

backed securities. Two of these commenters argued that debt asset-

backed securities should not be viewed as ownership interests

because: (i) they are not typically viewed as having economic

exposure to profits and losses of an ABS Issuer; (ii) they have a

limited life, periodic fixed or fluctuating cumulative payments, and

are senior to equity of the issuer should the issuer fail; (iii)

they do not have perpetual life with broad voting rights,

appreciation in the market value of the issuer and non-cumulative

dividends, and subordination to the claims of debt holders if the

issuer fails; and (iv) their limited voting rights (such as the

rights to replace a servicer or manager) and such rights are

protective in nature and similar to voting rights that accompany

securities traditionally classified by the Agencies as debt

securities (including securities formally structured as equity). See

AFME et al.; SIFMA (Securitization) (Feb. 2012). One of these

commenters argued that the ownership interest definition should be

limited to those interests that share in the profits or losses of

the relevant entity on an unlimited basis or that otherwise earn a

return that is specifically based upon the performance of the

underlying assets because the senior tranche in an asset-based

securities transaction often has substantial voting rights and

banking entities should not be penalized for requiring or otherwise

obtaining voting rights that protect their interests. This commenter

also expressed the view that banking entities should not be

restricted from owning debt classes of new asset-backed securities

because ``doing so would substantially constrict the market for

asset-backed securities.'' See ASF (Feb. 2012).

\2093\ See AFR et al. (Feb. 2012); Credit Suisse (Williams);

Occupy. One of these commenters argued that any general statement

about what instruments would be considered an ``ownership interest''

for purposes of securitization structures would be problematic and

easy to evade because transaction documents underlying

securitization structures are not standardized. This commenter

suggested as an alternative using a safe harbor for standardized,

pre-specified securitization structures. See AFR et al. (Feb. 2012).

Another of these commenters argued that ``it is difficult to

characterize holders of ABS securities in most securitization

structures as having `ownership interests' in any common

understanding of the term'' and the concept of ownership interest is

a ``poor fit for the securitization market, underscoring the

benefits of excluding securitization issuers from the definition of

covered fund entirely.'' See Credit Suisse (Williams).

---------------------------------------------------------------------------

One commenter expressed concern over the proposal's inclusion of

``derivatives'' of ownership interests in the definition of ownership

interest and recommended certain derivative interests of ownership

interests in hedge funds and private equity funds not be included

within the definition of ownership interest.\2094\ This commenter also

recommended that the Agencies expressly exclude from the definition of

ownership interest lending arrangements with a covered fund that

contain protective covenants linking the interest rate on the loan to

the profits of the borrowing fund.\2095\

---------------------------------------------------------------------------

\2094\ See Credit Suisse (Williams).

\2095\ See Credit Suisse (Williams) (arguing that such

arrangements are a fundamental part of a bank's lending activities).

---------------------------------------------------------------------------

As discussed in detail below, the Agencies are adopting the

definition of ``ownership interest'' largely as proposed but clarifying

the scope of that definition, including with respect to the inclusion

of interests that are linked to profits and losses of a covered fund

and the exclusion for a restricted profit interest in a covered

fund.\2096\ The definition is centered on equity interests, partnership

interests, membership interests, trust certificates, and similar

interests, and would not generally cover typical extensions of credit

the terms of which provide for payment of stated principal and interest

calculated at a fixed rate or at a floating rate based on an index or

interbank rate. However, as under the proposal, to the extent that a

debt security or other interest in a covered fund exhibits specified

characteristics that are similar to those of equity or other ownership

interests (e.g., provides the holder with the ability to participate in

the election or removal of a party with investment discretion, 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 instrument would be an ownership interest

under the final rule.

---------------------------------------------------------------------------

\2096\ See final rule Sec. 75.10(d)(6). The concept of a

restricted profit share was referred to as ``carried interest'' in

the proposed rule, a term that is often used as a generic reference

to performance-based allocations or compensation. The Agencies have

instead used the term ``restricted profit interest'' in the final

rule to avoid any confusion that could result from using a term that

is also used in other contexts. The final rule focuses only on

whether a profit interest is excluded from the definition of

ownership interest under section 13, and the final rule does not

address in any way the treatment of such profit interests under

other laws, including under Federal income tax law.

---------------------------------------------------------------------------

In response to commenters and in order to provide clarity about the

types of interests that would be considered within the scope of

ownership interest, the Agencies have revised the definition of

``ownership interest'' to define the term more clearly. The Agencies

are not explicitly excluding or including debt securities, instruments

or interests with equity features as requested by some commenters, but

are instead identifying certain specific characteristics that would

cause a particular interest, regardless of the name or legal form of

that interest, to be included within the definition of ownership

interest. The Agencies believe that this elaboration on the

characteristics of an ownership interest will enable parties, including

securitization structures, to more easily analyze whether their

interest is an ownership interest, regardless of the type of legal

entity or the name of the particular interest.

As adopted, the final rule provides that an ownership interest

would be any interest in or security issued by a covered fund that

exhibits any of the following features or characteristics on a current,

future, or contingent basis: \2097\

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\2097\ Each of these factors are designed to clarify the

interests identified in the proposed definition of ownership

interest as noted above.

---------------------------------------------------------------------------

has the right to participate in the selection or removal

of a general partner, managing member, member of the board of directors

or trustees, investment manager, investment adviser, or commodity

trading advisor of the covered fund. For purposes of the rule, this

would not include the rights of a creditor to exercise remedies upon

the occurrence of an event of default or

[[Page 5979]]

similar rights arising due to an acceleration event;

has the right under the terms of the interest to receive a

share of the income, gains or profits of the covered fund. This would

apply regardless of whether the right is pro rata with other owners or

holders of interests; \2098\

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\2098\ This characteristic exists for both multi-class and

single-class covered funds. In the context of an entity that issues

shares, this right could cover, for example, common shares, as well

as preferred shares the dividend payments of which are determined by

reference to the performance of the covered fund.

---------------------------------------------------------------------------

has the right to receive the underlying assets of the

covered fund, after all other interests have been redeemed and/or paid

in full (commonly known as the ``residual'' in securitizations). For

purposes of the rule, this would not include the rights of a creditor

to exercise remedies upon the occurrence of an event of default or

similar rights arising due to an acceleration event;

has the right to receive all or a portion of excess spread

(the positive difference, if any, between the aggregate interest

payments received from the underlying assets of the covered fund and

the aggregate interest paid to the holders of other outstanding

interests); \2099\

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\2099\ The reference to ``all or a portion of excess spread'' is

meant to include within the definition of ownership interest the

right to receive any excess spread which remains after the excess

spread is used to pay expenses, maintain credit enhancement such as

overcollateralization or is otherwise reduced.

---------------------------------------------------------------------------

provides that the amounts payable by the covered fund with

respect to the interest could, under the terms of the interest, be

reduced based on losses arising from the underlying assets of the

covered fund, such as allocation of losses, write-downs or charge-offs

of the outstanding principal balance, or reductions in the amount of

interest due and payable on the interest; \2100\

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\2100\ This characteristic does not refer to any reduction in

the stated claim to principal or interest of a holder of an interest

that occurs either as a result of a bona fide subsequent

renegotiation of the terms of an interest or as a result of a

bankruptcy, insolvency, or similar proceeding.

---------------------------------------------------------------------------

receives income on a pass-through basis from the covered

fund, or has a rate of return that is determined by reference to the

performance of the underlying assets of the covered fund.\2101\ This

provision would not include an interest that is entitled to receive

dividend amounts calculated at a fixed or at a floating rate based on

an index or interbank rate such as LIBOR; or

---------------------------------------------------------------------------

\2101\ This provision is not intended to encompass derivative

transactions entered into in connection with typical prime brokerage

activities of banking entities. However, the activities of banking

entities are subject to the anti-evasion provisions.

---------------------------------------------------------------------------

any synthetic right to have, receive or be allocated any

of the rights above. This provision would not permit banking entities

to obtain synthetic or derivative exposure to any of the

characteristics identified above in order to avoid being considered to

have an ownership interest in the covered fund.

This definition of ``ownership interest'' is intended to address

commenters' concerns regarding the applicability of the ownership

interest definition to different types of interests. The Agencies

believe defining ``ownership interest'' in this way will allow existing

as well as potential holders of interests in covered funds, including

securitizations, to effectively determine whether they have an

ownership interest. As an example, this definition would include

preferred stock, as well as a lending arrangement with a covered fund

in which the interest or other payments are calculated by reference to

the profits of the fund. As a contrasting example, the Agencies believe

that a loan that provides for a step-up in interest rate margin when a

covered fund has fallen below or breached a NAV trigger or other

negotiated covenant would not generally be an ownership interest.

Banking entities will be expected to evaluate the specific terms of

their interests to determine whether any of the specified

characteristics exist. In this manner, the Agencies believe that the

definition of ownership interest in the final rule is clearer than

under the proposal and thus should be less burdensome for banking

entities in their determination of whether certain rights would cause

an interest to be an ownership interest for purposes of compliance with

the rule.

As indicated above, many commenters on securitizations under the

proposed rule made arguments regarding the difficulty of applying the

proposal's definition of ownership interest to securitization

structures, contending that the definition should not include debt

instruments with equity features, or that the final rule should provide

a safe harbor under which the use of a standardized, pre-specified

securitization structure would not give rise to an ownership

interest.\2102\ The Agencies are not adopting a separate definition of

ownership interest for securitization transactions, providing for

differing treatment of financial instruments, or providing a safe

harbor as requested by some commenters. The revised definition of

ownership interest will apply regardless of the type of legal entity or

the name or legal form of the particular interest. The determination of

whether an interest is an ownership interest under the final rule will

depend on the features and characteristics of the particular interest,

including the rights the particular interest provides its holder,

including not only voting rights but also the right to receive a share

of the income, gains, or profits of a covered fund, the right to

receive a residual, the right to receive excess spread, and any

synthetic or derivative that would provide similar rights. While some

commenters argued that securities issued in asset-backed securities

transactions and by tender option bond issuers should not be viewed as

ownership interests due to the nature of the securities issued or the

possible lack of exposure to profits and losses,\2103\ the Agencies do

not believe that the type of covered fund involved or the type of

security issued is an appropriate basis for determining whether there

is an ownership interest for purposes of the restrictions contained in

section 13(a)(1)(B) of the BHC Act. The Agencies believe that making

distinctions in the definition of ownership interest based on the type

of entity or the type of security, in which many of the same rights

exist as for other types of ownership interests, would not be

consistent with the statutory restrictions on ownership. Similarly,

while some commenters argued that including a safe harbor for

standardized securitization structures would be more effective in

identifying an ownership interest in securitizations, the Agencies

believe that the type of interest and the rights associated with the

interest are more appropriate to determine whether an interest is an

ownership interest and is necessary to avoid potential evasion of the

ownership restrictions contained in section 13 of the BHC Act.

---------------------------------------------------------------------------

\2102\ See supra note 2090.

\2103\ See supra note 2092.

---------------------------------------------------------------------------

The Agencies understand that the definition of ownership interest

in the final rule may include interests in a covered fund that might

not be considered an ownership interest or equity interest in other

contexts. For instance, it may include loans with an interest rate

determined by reference to the performance of a covered fund or senior

debt interests issued in a securitization. While the definition of

ownership interest may affect the ability of a banking entity to hold

such interests, whether existing or in the future, the Agencies believe

that the definition of ownership interest as

[[Page 5980]]

adopted in the final rule is more effective in preventing possible

evasion of section 13 by capturing interests that may be characterized

as debt but confer benefits of ownership, including voting rights and/

or the ability to participate in profits or losses of the covered fund.

The definition of ownership interest in the final rule, like the

proposed rule, includes derivatives of the interests described above.

Derivatives of ownership interests provide holders with economic

exposure to the profits and losses of the covered fund or an ability to

earn a return based on the performance of the fund's underlying

holdings or investments in a manner substantially similar to an

ownership interest. The Agencies believe the final rule's approach

appropriately addresses the statutory purpose to limit a banking

entity's economic exposure to covered funds, irrespective of the legal

form, name, or issuer of that ownership interest.

As noted above, the proposed definition of ownership interest did

not include carried interest (termed ``restricted profit interest'' in

the final rule). The proposal recognized that many banking entities

that serve as investment adviser or provide other services to a covered

fund are routinely compensated for services they provide to the fund

through receipt of carried interest. As a result, the proposed rule

provided that an ownership interest with respect to a covered fund did

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) served as

investment manager, investment adviser, or commodity trading advisor,

so long as certain enumerated conditions were met.\2104\

---------------------------------------------------------------------------

\2104\ See proposed rule Sec. 75.10(b)(3)(ii).

---------------------------------------------------------------------------

The enumerated conditions contained in the proposal were designed

to narrow the scope of the exclusion of carried interest from the

definition of ``ownership interest'' so as to distinguish between an

investor's economic risks and a service provider's performance-based

compensation. This was designed to limit the ability of a banking

entity to structure carried interest in a manner that would evade

section 13's restriction on the amount of ownership interests a banking

entity may have as an investment in a covered fund.

Commenters disagreed over whether the definition of ownership

interest should exclude carried interest. For instance, some commenters

did not support excluding carried interest from the definition of

ownership interest, arguing that such an exclusion was too permissive

and inconsistent with the statute because, for instance, carried

interest derives its value in part by tracking gains on price movements

of investments by the fund.\2105\ One commenter argued that, despite

the fact that carried interest is typically provided as compensation

for services provided to a fund, carried interest is a form of

investment and therefore should be included as an ownership

interest.\2106\ Another commenter argued that permitting banking

entities to hold an unrestricted amount of carried interest could

create an indirect and undesirable link between prohibited proprietary

trading and covered fund activities.\2107\ These commenters also argued

that treating carried interest as compensation for providing services

would be inconsistent with the manner in which carried interest is

treated for tax purposes.\2108\

---------------------------------------------------------------------------

\2105\ See, e.g., Occupy; AFR et al. (Feb. 2012).

\2106\ See Public Citizens; see also Occupy.

\2107\ See AFR et al. (Feb. 2012).

\2108\ See Occupy; Public Citizens; AFR et al. (Feb. 2012).

---------------------------------------------------------------------------

Other commenters, however, supported excluding carried interest

from the definition of an ownership interest and argued the exclusion

was consistent with the words and purpose of section 13.\2109\ One

commenter argued that carried interest is readily distinguished from an

investment in a covered fund because carried interest normally does not

expose a banking entity to a covered fund's losses (other than in

limited instances such as when a ``clawback'' provision is

triggered).\2110\ Another commenter argued that permitting a banking

entity to receive carried interest without being subject to the

requirements of section 13 regarding ownership interests better aligns

the interest of the investment manager with that of the fund and its

investors.\2111\ Another commenter supported expanding the definition

of carried interest to include an interest received by a banking entity

in return for qualifying services (e.g., lending, placement,

distribution, or equity financing) provided to the investment manager

of the fund, but not directly provided to the fund itself.\2112\

---------------------------------------------------------------------------

\2109\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012); TCW;

Credit Suisse (Williams); SVB.

\2110\ See Credit Suisse (Williams).

\2111\ See TCW.

\2112\ See Credit Suisse (Williams).

---------------------------------------------------------------------------

The proposal established four criteria that must be met in order

for carried interest to be excluded from the definition of ownership

interest. First, the proposal required that carried interest have the

sole purpose and effect of permitting the banking entity or an employee

thereof to share in the covered fund's profits as performance

compensation for services provided to the fund. While most commenters

did not object to this criterion, one commenter argued that the wording

of this approach would appear to prohibit an employee of the banking

entity from retaining a carried interest after the employee has changed

employment.\2113\ This commenter argued that the determination of the

carried interest's purpose should be made only at the time the interest

is granted, thereby enabling an employee to retain the carried interest

if and when the employee no longer provides investment management,

investment advisory, or similar services to the fund or is no longer

employed at the banking entity.

---------------------------------------------------------------------------

\2113\ See TCW.

---------------------------------------------------------------------------

Second, the proposal required that carried interest, once

allocated, be distributed to the banking entity promptly after it is

earned or, if not so distributed, not share in the subsequent profits

and losses of the covered fund. One commenter urged the Agencies to

allow the ``reserve'' portion of carried interest that for tax purposes

is allocated to the investment manager or investment adviser, but

invested alongside the fund and not formally allocated or distributed

by the fund, also to qualify for the exclusion as carried

interest.\2114\ This commenter also suggested that this criterion

should not affect the common European structure in which allocated

carried interest may share in the subsequent losses, but not the

profits, of the fund.

---------------------------------------------------------------------------

\2114\ See Credit Suisse (Williams).

---------------------------------------------------------------------------

Third, under the proposal a banking entity (including its

affiliates or employees) was not permitted to provide funds to the

covered fund in connection with receiving a carried interest. The

proposal specifically requested comment on whether the exemption for

carried interest, including this requirement, was consistent with the

current tax treatment and requirements of carried interest

arrangements.\2115\ Commenters urged the Agencies to relax or amend

this criterion so that banking entities, including their affiliates and

employees, whether directly or indirectly through a fund vehicle, would

be permitted to make minimal capital contributions to the fund

(typically less than 1 percent) in connection with the receipt of

carried interest to the extent that such contributions provide the

basis for

[[Page 5981]]

treating the interest as carried interest for tax purposes.\2116\

However, these commenters supported the proposal's requirement that any

amount contributed by a banking entity in connection with receiving a

carried interest should be aggregated with the banking entity's

ownership interests for purposes of the 3 percent investment limits.

---------------------------------------------------------------------------

\2115\ Joint Proposal, 76 FR at 68899.

\2116\ See TCW; SIFMA (Covered Funds) (Feb. 2012); Credit Suisse

(Williams).

---------------------------------------------------------------------------

Fourth, the proposal provided that carried interest may not be

transferable by the banking entity (or the affiliate, subsidiary or

employee thereof) except to another affiliate or subsidiary of the

banking entity. Commenters generally urged removing the proposal's

limitations on transferability and argued, among other things, that

this criterion could prevent a banking entity (or its affiliate or

employee) from transferring the carried interest in connection with

selling or otherwise transferring the provision of advisory or other

services that gave rise to the carried interest.\2117\ Similarly, one

commenter argued that the final rule should not require carried

interest to be re-characterized as an ownership interest if it is

transferred among employees, family members of employees or to estate

planning vehicles upon an employee's death.\2118\

---------------------------------------------------------------------------

\2117\ See ASF (Feb. 2012); see also Credit Suisse (Williams);

SVB.

\2118\ See TCW.

---------------------------------------------------------------------------

After considering carefully comments received on the proposal, the

Agencies have determined to retain in the final rule the exclusion from

the definition of ``ownership interest'' for a restricted profit

interest (termed ``carried interest'' in the proposed rule \2119\)

largely as provided in the proposed rule. The final rule, like the

proposal, recognizes that banking entities that serve as investment

adviser or provide other services to a covered fund are routinely

compensated for such services through receipt of a restricted profit

interest. The final rule, also like the proposal, generally excludes

restricted profit interest from the definition of ownership interest

subject to conditions designed to distinguish restricted profit

interest, which serves as a form of compensation, from an investment in

the fund prohibited (or limited) by section 13. As explained in detail

below, the definition of restricted profit interest in the final rule

has been modified from the proposal in several aspects to respond to

commenters' concerns and to more effectively capture the types of

compensation that is often granted in exchange for services provided to

a fund. However, like the proposal, the final rule continues to contain

a number of requirements designed to ensure that restricted profit

interest functions as compensation for providing certain services to a

covered fund and does not permit a banking entity to evade the

investment limitations or other requirements of section 13.

---------------------------------------------------------------------------

\2119\ See supra note 2096 and accompanying text.

---------------------------------------------------------------------------

Under the final rule, restricted profit interest is defined to

include an interest held by an entity (or employee or former employee

thereof) that serves as investment manager, investment adviser,

commodity trading advisor, or other service provider so long as: (i)

The sole purpose and effect of the interest is to allow the entity (or

an employee or former employee thereof) to share in the profits of the

covered fund as performance compensation for the investment management,

investment advisory, commodity trading advisory, or other services

provided to the covered fund by the entity (or employee or former

employee thereof), provided that the entity (or employee or former

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 entity (or employee or former employee

thereof) promptly after being earned or, if not so distributed, is

retained by the covered fund for the sole purpose of establishing a

reserve amount to satisfy contractual obligations with respect to

subsequent losses of the covered fund and such undistributed profit of

the entity (or employee or former employee thereof) does not share in

subsequent investment gains of the covered fund; (iii) any amounts

invested in the covered fund, including any amounts paid by the entity

(or employee or former employee thereof) in connection with obtaining

the restricted profit interest, are within the investment limitations

of Sec. 75.12; and (iv) the interest is not transferable by the entity

(or employee or former employee thereof) except to an affiliate thereof

(or an employee of the banking entity or affiliate), to immediate

family members, or through the intestacy of the employee or former

employee, or in connection with a sale of the business that gave rise

to the restricted profit interest by the entity (or employee or former

employee thereof) to an unaffiliated party that provides investment

management, investment advisory, commodity trading advisory, or other

services to the fund.\2120\ The final rule, like the proposal, permits

any entity (or the affiliate or employee thereof) to receive or hold

restricted profit interest if the entity (or the affiliate or employee

thereof) serves as investment manager, investment adviser, commodity

trading advisor, or other service provider to the covered fund. For

example, an entity that provides services to the covered fund in a

capacity as sub-adviser or placement agent would be eligible to receive

or hold restricted profit interest.

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\2120\ See final rule Sec. 75.10(d)(6)(ii).

---------------------------------------------------------------------------

As requested by commenters, the first condition in the final rule,

in contrast to the proposal, permits an employee or former employee to

retain a restricted profit interest after a change in employment status

so long as the restricted profit interest was originally received as

compensation for qualifying services provided to the covered fund.

Also in response to issues raised by commenters, the second

condition in the final rule has been modified to permit so-called

``clawback'' features whereby restricted profit interest that has been

provided to an investment manager, investment adviser, commodity

trading advisor, or similar service provider may be taken back if

certain subsequent events occur, such as if the fund fails to achieve a

specified preferred rate of return or if liabilities or subsequent

losses are incurred by the fund. Under these circumstances, the

Agencies believe it is appropriate to allow the allocated but

undistributed profits to be clawed back from the service provider's

performance compensation, and the final rule has been amended to allow

this practice. The final rule makes clear, however, that the

undistributed profits may only be held in the fund in connection with

such a clawback arrangement. Undistributed profits that remain in the

covered fund after they have been allocated without connection to such

an arrangement would be deemed to be an investment in the fund and

would be an ownership interest under the final rule. Importantly, the

final rule also retains the limitation in the proposal that

undistributed profit may not share in subsequent investment gains of

the covered fund. This limitation (together with the limited

circumstances under which the undistributed profit may be retained in

the fund) appears necessary in order to distinguish restricted profit

interest, which functions as performance compensation and is not

intended to be a form of investment, from an ownership interest, which

is designed to be an investment. The Agencies believe that this

approach achieves an appropriate balance between accommodating receipt

of restricted profit interest, including such

[[Page 5982]]

amounts held in ``reserve,'' \2121\ and limiting the ability of a

banking entity to evade the investment limitations of section 13. The

Agencies expect to review restricted profit interests to ensure banking

entities do not use the exclusion for restricted profit interest in a

manner that functions as an evasion of section 13.

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\2121\ The Agencies believe that this addresses a commenter's

concern regarding the ``reserve'' portion of carried interest

discussed above; however such amounts may not share in subsequent

investment gains of the covered fund for the reasons also discussed

above.

---------------------------------------------------------------------------

As noted above, the Agencies understand that entities that provide

investment management, investment advisory, commodity trading advisory

or other services to a covered fund may, in connection with receiving

restricted profit interest, be required to hold a small amount of

ownership interests in a fund to provide the basis for desired tax

treatment of restricted profit interest. Accordingly, the third

condition of the final rule allows an entity that provides qualifying

services to a fund to contribute funds to, and have an ownership

interest in, the fund in connection with receiving restricted profit

interest. As under the proposal, the amount of the contribution must be

counted toward the investment limits under section 13(d)(4) and Sec.

75.12 of the final rule. This would include attribution to the banking

entity of sums invested by employees in connection with obtaining a

restricted profit interest. Thus, the final rule permits a banking

entity that provides investment management, investment advisory, or

commodity trading advisory services to have both an ownership interest

in, and receive restricted profit interest from, the covered fund, so

long as the aggregate of the sums invested in all ownership interests

acquired or retained by the banking entity (including a general

partnership interest), either in connection with receiving the

restricted profit interest or as an investment, are within the

investment limitations in section 13(d)(4) and Sec. 75.12 of the final

rule. The Agencies believe this more appropriately implements the

requirements of section 13 of the BHC Act by permitting banking

entities to continue to provide customer-driven investment management

services through organizing and offering covered funds, while also

abiding by the investment limitations of section 13.

In response to comments, the fourth condition of the final rule

permits the transfer of a restricted profit interest in connection with

a sale to an unaffiliated party that provides investment management,

investment advisory, commodity trading advisory, or other services to

the fund. In response to comments, the final rule also permits the

transfer of a restricted profit interest to immediate family members of

the banking entity's employees or former employees that provide

investment management, investment advisory, commodity trading advisory,

or other services to the covered fund, or in connection with the death

of such employee. Also in response to comments, the final rule permits

the transfer of a restricted profit interest to an affiliate or

employee that provides investment management, investment advisory,

commodity trading advisory, or other services to the covered fund.

However, the final rule, like the proposed rule, would treat a

restricted profit interest as an ownership interest if the restricted

profit interest is otherwise transferable. This remaining restriction

recognizes that a freely transferable restricted profit interest has

the same economic benefits as an ownership interest and is essential to

differentiating a restricted profit interest from an ownership

interest.

f. Definition of ``Resident of the United States''

Section 13(d)(1)(I) of the BHC Act provides that a foreign banking

entity may acquire or retain an ownership interest in or act as sponsor

to a covered fund, but only if that activity is conducted according to

the requirements of the statute, including that no ownership interest

in the covered fund is offered for sale or sold to a ``resident of the

United States.'' The statute does not define this term.

Under the proposed rule, the term ``resident of the United States''

was used in the context of the exemptions for covered trading and

covered fund activities. As proposed, the definition of resident of the

United States was similar, but not identical, to the SEC's definition

of U.S. person in Regulation S, which governs offerings of securities

outside of the United States.\2122\ The Agencies proposed this approach

in order to promote consistency and understanding among market

participants that have experience with the concept from the SEC's

Regulation S.

---------------------------------------------------------------------------

\2122\ See proposed rule Sec. 75.2(t); 17 CFR 230.901--230.905.

---------------------------------------------------------------------------

Some commenters supported the proposed definition of resident of

the United States.\2123\ One commenter suggested that the proposed rule

defined resident of the United States too broadly and inappropriately

precluded investments in U.S. funds by foreign banking entities.\2124\

---------------------------------------------------------------------------

\2123\ See, e.g., Occupy.

\2124\ See Sens. Merkley & Levin (Feb. 2012) (citing 156 Cong.

Rec. S5897 (daily ed. July 15, 2010) (statement of Sen. Merkley)).

---------------------------------------------------------------------------

Other commenters generally argued that the final rule should adopt

the definition of ``U.S. person'' under the SEC's Regulation S without

the modifications in the proposed rule.\2125\ According to many

commenters, market participants are familiar with and rely upon the

body of law interpreting U.S. Person under Regulation S.\2126\ They

argued that, to the extent that the definitions of ``resident of the

United States'' under section 13 and ``U.S. person'' under Regulation S

differ, this would create unnecessary uncertainty and increase

compliance burdens associated with monitoring multiple

definitions.\2127\ Other commenters urged the Agencies not to depart

from the treatment of international parties and organizations (e.g.,

the International Monetary Fund and the World Bank) under the SEC's

Regulation S.\2128\

---------------------------------------------------------------------------

\2125\ See, e.g., Union Asset; EFAMA; BVI; AFME et al.; IIB/EBF;

Credit Suisse (Williams); Hong Kong Inv. Funds Ass'n.; PEGCC; UBS;

Allen & Overy (on behalf of Canadian Banks); Allen & Overy (on

behalf of Foreign Bank Group); AFG.

\2126\ See PEGCC; Allen & Overy (on behalf of Canadian Banks);

Allen & Overy (on behalf of Foreign Bank Group); ICI (Feb. 2012);

Credit Suisse (Williams).

\2127\ See IIB/EBF; Credit Suisse (Williams); ICI (Feb. 2012);

ICI Global; PEGCC.

\2128\ See IIB/EBF; ICI Global; Credit Suisse (Williams).

---------------------------------------------------------------------------

Many commenters contended that, because the definition of resident

of the United States in the proposal was generally broader than the

definition of U.S. person under Regulation S, many additional types of

persons, entities and investors would be deemed residents of the United

States for purposes of the foreign activity exemptions. Commenters

argued that this would limit the potential for foreign banking entities

to effectively use those statutorily provided exemptions. A few

commenters noted that using a definition in the foreign fund exemption

that differs from the definition in Regulation S loses the advantage of

using a term that is already understood by market participants and that

avoids confusion and limits compliance costs.\2129\

---------------------------------------------------------------------------

\2129\ See Allen & Overy (on behalf of Foreign Bank Group); IIB/

EBF; PEGCC; Union Asset.

---------------------------------------------------------------------------

Other commenters suggested that defining resident of the United

States as proposed presented problems for investment funds managed by

U.S. investment advisers, even those without U.S. investors.\2130\ Some

commenters argued that, under the proposed

[[Page 5983]]

definition, a foreign fund managed by a U.S. investment adviser or sub-

adviser that is not otherwise subject to section 13 might be deemed a

resident of the United States, thereby disqualifying the fund from

relying on the foreign funds exemption, a result inconsistent with the

purpose of section 13 and the statutory exemption in section

13(d)(1)(I).\2131\

---------------------------------------------------------------------------

\2130\ See, e.g., MFA; TCW.

\2131\ See AFG; BVI. See also MFA; TCW. Similarly, these

commenters argued that although treated as a non-U.S. person under

Regulation S, a non-U.S. fund organized as a trust in accordance

with local law with a limited number of U.S. investors would have

been a resident of the United States. Under the proposal, this

foreign fund could not invest in another foreign covered fund

seeking to rely on the exemption for covered fund activities or

investments that occur solely outside of the United States.

---------------------------------------------------------------------------

Commenters also argued that the proposed definition raised issues

for compensation plans of international organizations that are subject

to section 13 of the BHC Act. Several commenters argued that U.S.

employees of a foreign banking entity should not be considered

residents of the United States if they invest in a non-U.S. covered

fund pursuant to a bona fide employee investment, retirement or

compensation program.\2132\ The Agencies have carefully considered the

comments received on the definition of resident of the United States,

and have determined to modify the final rule as discussed below. The

term ``resident of the United States'' is not defined in the statute

and is used by the statute to clarify when foreign activity or

investment of a foreign banking entity qualifies for the foreign funds

exemption in section 13(d)(1)(I). The purpose of this exemption is to

enable foreign banking entities to continue to engage in foreign funds

activities and investments that do not have a sufficient nexus to the

United States so as to present risk to U.S. investors or the U.S.

financial system.\2133\ The purpose of Regulation S is to provide a

safe harbor from the registration provisions under the Securities Act

for offerings that take place outside of the United States.\2134\

---------------------------------------------------------------------------

\2132\ See IIB/EBF; Credit Suisse (Williams); UBS; JPMC.

\2133\ See 156 Cong. Reg. S.5894-5895 (daily ed. July 15, 2010)

(statement of Sen. Merkley).

\2134\ Offers and Sales, Securities Act Release No. 6863 (Apr.

24, 1990) 55 FR 18306 (May 2, 1990).

---------------------------------------------------------------------------

The Agencies believe that, because the covered funds provisions of

the final rule involve sponsoring covered funds and offering and

selling securities issued by funds (as compared to counterparty

transactional relationships), the securities law framework reflected in

Regulation S would most effectively achieve the purpose of the foreign

funds exemption. As noted by commenters and discussed above, market

participants are familiar with and rely upon the body of law

interpreting U.S. Person under Regulation S, and differing definitions

under section 13 and Regulation S could create uncertainty and increase

compliance burdens associated with monitoring multiple definitions. The

Agencies therefore have defined the term ``resident of the United

States'' in the final rule to mean a ``U.S. person'' as defined in

Regulation S.\2135\

---------------------------------------------------------------------------

\2135\ See final rule Sec. 75.10(d)(8).

---------------------------------------------------------------------------

In addition, as explained in detail below in Part VI.B.4.b.3. of

this SUPPLEMENTARY INFORMATION, the final rule provides that an

ownership interest is offered for sale or sold to a resident of the

United States if it is sold in an offering that ``targets'' residents

of the United States.\2136\ As explained in more detail in that

section, this approach is consistent with Regulation S.

---------------------------------------------------------------------------

\2136\ See infra Part VI.B.4.b.3.

---------------------------------------------------------------------------

g. Definition of ``Sponsor''

Section 13(h)(5) of the BHC Act defines ``sponsor'' to mean: (i)

serving as a general partner, managing member, or trustee of a covered

fund; (ii) in any manner selecting or controlling (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)

sharing with a covered fund, for corporate, marketing, promotional, or

other purposes, the same name or a variation of the same name.\2137\

Sponsor is a key definition because it defines, in part, the scope of

activities to which the prohibition in section 13(a)(1) applies.\2138\

---------------------------------------------------------------------------

\2137\ See 12 U.S.C. 1851(h)(5).

\2138\ See 12 U.S.C. 1851(a)(1).

---------------------------------------------------------------------------

Under the proposal, the term sponsor would have been defined

largely as in the statute.\2139\ Nearly all commenters who addressed

the definition of sponsor argued that the definition was too broad and

suggested various ways to narrow or limit the definition.\2140\

Commenters generally expressed concerns that a sponsor to a covered

fund became subject to the restrictions of section 13(f), limiting the

relationships of the banking entity with the covered fund. Commenters

argued this would prevent banking entities from providing many

customary services to covered funds.\2141\

---------------------------------------------------------------------------

\2139\ See proposed rule 75.10(b)(5).

\2140\ A number of comments received regarding the definition of

sponsor relate to securitization structures and are addressed below.

There also were a few comments urging that insurance companies not

be considered to sponsor their separate accounts. See Sutherland (on

behalf of Comm. of Annuity Insurers); Nationwide. The Agencies

believe these concerns should be addressed by the exclusion of

separate accounts from the definition of covered fund, as discussed

in Part VI.B.1.c.6. of this SUPPLEMENTARY INFORMATION.

\2141\ See, e.g., ASF (Feb. 2012); BNY Mellon et al.; Credit

Suisse (Williams).

---------------------------------------------------------------------------

The proposal excluded from the definition of ``trustee'' as used in

the term sponsor 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 (``ERISA'') (29 U.S.C. 1103(a)(1)).\2142\ On the other

hand, the proposal provided that any banking entity that directs a

directed trustee, or that possesses authority and discretion to manage

and control the assets of a covered fund for which a directed trustee

serves as trustee, would be considered a trustee of the covered fund.

---------------------------------------------------------------------------

\2142\ See proposed rule Sec. 75.10(b)(6); see also 29 U.S.C.

1103(a)(1).

---------------------------------------------------------------------------

Commenters generally supported the exception for directed trustees

in the proposed rule but argued that the exception was too narrow

because it only referred to directed trustees under section 403(a)(1)

of the ERISA and did not include other similar custodial or

administrative arrangements that may not meet those requirements or be

subject to ERISA.\2143\ These commenters argued that banking entities

that serve as trustees or custodians of covered funds may provide a

limited range of ministerial services or exercise limited fiduciary

duties that, while not subject to ERISA or beyond those permitted for a

directed trustee under ERISA, nevertheless do not involve the exercise

of investment discretion or control over the operations of the covered

fund in the same manner as a general partner or managing member. Some

of these commenters advocated defining ``directed trustee'' more

expansively to include any situation in which a banking entity serves

solely in a directed, fiduciary, or administrative role where a third-

party and not the banking entity exercises investment discretion.

---------------------------------------------------------------------------

\2143\ See, e.g., Arnold & Porter; Ass'n. of Global Custodians;

BNY Mellon et al.; SIFMA et al. (Covered Funds) (Feb. 2012); State

Street (Feb. 2012); see also Fin. Services Roundtable (June 14,

2011) (recommending the definition of directed trustee under the

Board's Regulation R be used, which defines directed trustee to mean

``a trustee that does not exercise investment discretion with

respect to the account'').

---------------------------------------------------------------------------

In particular, some commenters also argued that a trustee should

not be viewed as having investment discretion, and therefore should not

be treated as a sponsor, if it possesses only the authority to

terminate an investment adviser to a covered fund and to appoint

another unaffiliated investment adviser

[[Page 5984]]

in order to fulfill a demonstrable legal or contractual obligation of

the trustee, or the formal but unexercised power to make investment

decisions for a covered fund in circumstances where one or more

unaffiliated investment advisers have been appointed to manage fund

assets. Some commenters argued in favor of excluding trustees serving

under non-U.S. trust arrangements pursuant to which they may have legal

or contractual authority to, but in fact do not, exercise investment

discretion (i.e., the entity has the formal authority to appoint an

investment adviser to a trust but does so only in extraordinary

circumstances such as appointing a successor investment adviser).\2144\

---------------------------------------------------------------------------

\2144\ See BNY Mellon et al. (providing proposed rule text or

suggesting in the alternative clarification regarding the phrase

``exercise investment discretion'' in the final rule preamble);

Ass'n. of Global Custodians; ICI Global; State Street (Feb. 2012).

---------------------------------------------------------------------------

A few commenters requested confirmation that a banking entity

acting as a custodian should not be considered a sponsor of a covered

fund.\2145\ One commenter argued that traditional client trust accounts

for which a bank serves as discretionary trustee should not, by

implication, themselves become ``covered funds'' that are ``sponsored''

by the bank.\2146\

---------------------------------------------------------------------------

\2145\ See Ass'n. of Global Custodians; SIFMA et al. (Covered

Funds) (Feb. 2012); ABA (Keating); AFG; AFTI; BNY Mellon et al.;

EFAMA; IMA; State Street (Feb. 2012).

\2146\ See Arnold & Porter. To the extent that a client trust

account would not be an investment company but for the exclusion

contained in section 3(c)(1) or 3(c)(7) of the Investment Company

Act, such as the exclusion for common trust funds under section

3(c)(3) of that Act, it would not be a covered fund regardless of

whether a banking entity acts as trustee.

---------------------------------------------------------------------------

One commenter argued that any person performing similar functions

to a directed trustee (such as a fund management company established

under Irish law), regardless of its formal title or position, also

should be excluded if the person does not exercise investment

discretion.\2147\ Some commenters argued more generally for an

exclusion from the definition of trustee (and therefore from the

definition of sponsor) for entities that act as service providers (such

as custodians, trustees, or administrators) to non-U.S. regulated

funds, arguing that European laws already impose significant

obligations on entities serving in these roles.\2148\

---------------------------------------------------------------------------

\2147\ See BNY Mellon et al.

\2148\ See EFAMA; F&C; IRSG; Union Asset.

---------------------------------------------------------------------------

Under both section 13 of the BHC Act and the proposal, the

definition of sponsor also included the ability to select or control

(or to have employees, officers, directors, or agents who constitute) a

majority of the directors, trustees or management of a covered fund.

Some commenters argued that an entity should not be treated as a

sponsor of a covered fund when it selects a majority of the initial

directors, trustees or management of a covered fund that are

independent of the banking entity, so long as the banking entity may

not remove or replace the directors, trustees, or management and

directors are subsequently either chosen by others or self-

perpetuating.\2149\ One of these commenters argued similarly that a

banking entity should not be deemed to sponsor a covered fund if it

selects an independent general partner, managing member or trustee of a

new fund, so long as the general partner, managing member or trustee

may not be terminated and replaced by the banking entity.\2150\

Commenters argued that initial selection of these parties was

inherently part of, and necessary to allow, the formation of a covered

fund and would not provide a banking entity with ongoing control over

the fund to a degree that the banking entity should be considered to be

a sponsor.

---------------------------------------------------------------------------

\2149\ See SIFMA et al. (Covered Funds) (Feb. 2012)

(recommending the Agencies adopt independence guidelines similar to

the FDIC's guidelines for determining whether audit committee

members of insured depository institutions are ``independent'' of

management); Credit Suisse (Williams).

\2150\ See Credit Suisse (Williams) (arguing that such an

approach would be consistent with the existing BHC Act concept of

control with respect to funds).

---------------------------------------------------------------------------

The statute and proposed rule also defined the term sponsor to

include an entity that shares, for corporate, marketing, promotional,

or other purposes, the same name or a variation of the same name, with

a covered fund. One commenter argued in favor of a narrower

interpretation of this statutory provision.\2151\ This commenter argued

that a covered fund should be permitted to share the name of the asset

manager that advises the fund without the asset manager becoming a

sponsor so long as the asset manager does not share the same name as an

affiliated insured depository institution or the ultimate parent of an

affiliated insured depository institution.\2152\ Another commenter

argued that the proposal would put U.S. banking entities at a

competitive disadvantage relative to non-banking entities and foreign

banks.\2153\ These commenters argued that the costs of rebranding

covered funds or an asset manager would far outweigh any potential

benefit in terms of reducing the risk that a banking entity may be

pressured to ``bail out'' a covered fund with a name similar to its

investment manager.\2154\ One commenter also requested clarification

that the name sharing prohibition does not apply in the context of

offering documents that carry the names of the manager, sponsor,

distributor, as well as the name of the fund itself.\2155\ This

commenter also advocated that, because of the costs associated with

changing a fund name, the Agencies give specific guidance regarding how

similar a name may be so as not to be a ``variation of the same name''

for purposes of the definition of sponsor and the activities permitted

under section 13(d)(1)(G) and Sec. 75.11 of the rule.

---------------------------------------------------------------------------

\2151\ A number of comments were also received regarding the

restriction on name sharing that is one of the requirements of

section 13(d)(1)(G) and Sec. 75.11 of the proposed rule. These

comments are discussed in Part VI.B.2.a.5. of this SUPPLEMENTARY

INFORMATION.

\2152\ See Credit Suisse (Williams); see also ABA (Keating);

BlackRock; Goldman (Covered Funds); SIFMA et al. (Covered Funds)

(Feb. 2012); TCW (proposing similarly to limit the name-sharing

restriction to the insured depository institution in context of

section 13(d)(1)(G)).

\2153\ See Goldman (Covered Funds).

\2154\ See Credit Suisse (Williams); see also Goldman (Covered

Funds).

\2155\ See Credit Suisse (Williams).

---------------------------------------------------------------------------

The Agencies have carefully considered comments received in light

of the terms of the statute. Section 13(h)(5) of the BHC Act

specifically defines the term ``sponsor'' for purposes of section 13.

The Agencies recognize that the broad definition of sponsor in the

statute will result in some of the effects commenters identified, as

discussed above.

The final rule generally retains the definition of ``sponsor'' in

the statute and the proposed rule, although with certain modifications

and clarifications to respond to comments received regarding the

exclusion for ``directed trustees.'' As in the proposed rule, the

definition of sponsor in the final rule covers an entity that (i)

serves as general partner, managing member, or trustee of a covered

fund, or that serves as a commodity pool operator of a covered fund as

defined in Sec. 75.10(b)(1)(ii) of the final rule, (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

corporate, marketing, promotional, or other purposes, the same name or

a variation of the same name.\2156\

---------------------------------------------------------------------------

\2156\ See final rule Sec. 75.10(d)(9). Some commenters

asserted that custodians and service providers should not treated as

sponsors under the final rule. The Agencies note, however, that a

banking entity is not a sponsor under the final rule unless it

serves in one or more of the capacities specified in the definition;

controls or makes up the fund's board of directors or management as

described in the final rule; or shares the same name or a variation

of the same name with the fund as described in the final rule. See,

e.g., supra note 2156 and accompanying text. See also infra note

2160.

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[[Page 5985]]

While commenters urged the Agencies to provide an exemption from

the definition of sponsor for a banking entity that selects the initial

directors, trustees, or management of a fund,\2157\ the final rule has

not been modified in this manner because the initial selection of the

directors, trustees or management of a fund is an action characteristic

of a sponsor and is essential to the creation of a covered fund. The

Agencies note, however, that the statute and the final rule allow

banking entities to sponsor covered funds, including selecting the

initial board of directors, trustees and management, so long as the

banking entity observes certain requirements and conforms any initial

investment in the covered fund to the limits in the statute and

regulation during the relevant conformance period as discussed in Part

VI.B.3.b. of this SUPPLEMENTARY INFORMATION.\2158\ Moreover, a banking

entity that does not continue to select or control a majority of the

board of directors would not be considered to be a sponsor under this

part of the definition once that role or control terminates. In the

case of a covered fund that will have a self-perpetuating board of

directors or a board selected by the fund's shareholders, this would

not be considered to have occurred until the board has held its first

re-selection of directors or first shareholder vote on directors

without selection or control by the banking entity.

---------------------------------------------------------------------------

\2157\ See supra note 2149 and accompanying text.

\2158\ Similarly, a banking entity may share the same name or a

variation of the same name with a covered fund so long as the

banking entity does not organize and offer the covered fund in

accordance with section 13(d)(1)(G) and Sec. 75.11.

---------------------------------------------------------------------------

As explained below, the Agencies believe that, in context, the term

trustee in the definition of the term sponsor refers to a trustee with

investment discretion. Consistent with this view, commenters urged the

Agencies to exclude from the definition of sponsor certain trustees and

parties commenters asserted acted in a similar capacity, as discussed

above.\2159\ The final rule therefore has been modified to exclude from

the definition of trustee: (i) a trustee that does not exercise

investment discretion with respect to a covered fund, including a

trustee that is subject to the direction of an unaffiliated named

fiduciary who is not a trustee pursuant to section 403(a)(1) of the

Employee's Retirement Income Security Act (29 U.S.C. 1103(a)(1)); or

(ii) a trustee that is subject to fiduciary standards imposed under

foreign law that are substantially equivalent to those described in

paragraph (i).\2160\ Under the final rule, a trustee would be excluded

if the trustee does not have any investment discretion, but is required

to ensure that the underlying assets are appropriately segregated for

the benefit of the trust. Similarly, a trustee would be excluded if the

trustee has no investment discretion but is authorized to replace an

investment adviser with an unaffiliated party when the investment

adviser resigns. With respect to an issuing entity of asset-backed

securities and as explained below, a directed trustee excluded from the

definition of sponsor would include a person that conducts their

actions solely in accordance with directions prepared by an

unaffiliated party.

---------------------------------------------------------------------------

\2159\ See, e.g., supra notes 2143-2144 and accompanying text.

See also supra note 2156.

\2160\ See final rule Sec. 75.10(d)(10). With respect to the

concept of a ``directed trustee'' under foreign law, commenters

generally requested changes only if non-U.S. mutual fund equivalents

were not excluded from the definition of covered fund. As discussed

above, the final rule explicitly excludes foreign public funds from

the definition of covered fund, which should address these

commenters concerns. See final rule Sec. 75.10(c)(1).

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The Agencies believe that this exclusion is appropriate because the

relevant prong of the definition of sponsor (i.e., serving as general

partner, managing member, or trustee) specifies entities that have the

ongoing ability to exercise control over a fund; directed trustees

excluded from definition of sponsor in the final rule do not appear to

have this ability and thus do not appear to be the type of entity that

this prong of the definition of sponsor was intended to capture. If a

trustee were itself to assume the role of investment adviser, or have

the ability to exercise investment discretion with respect to the

covered fund, the trustee would not qualify for this exclusion. The

final rule does not include within the definition of sponsor custodians

or administrators of covered funds unless they otherwise meet the

definitional qualifications set forth in section 13 and the final rule.

The definition of sponsor will continue to cover entities that

share the same name or variation of the same name of a covered fund for

corporate, marketing, promotional, or other purposes, consistent with

the definition of sponsor in section 13(h)(5). The Agencies recognize

that some commenters urged the Agencies to modify this aspect of the

definition of sponsor, and that the name-sharing prohibition included

in the definition of sponsor (and in the conditions for the organize

and offer exemption) will require some banking entities to rebrand

their covered funds, which may prove expensive and will limit the

extent to which banking entities may continue to benefit from brand

equity they have developed.\2161\ The costs a banking entity would

incur to rebrand its covered funds would depend on the cost to rebrand

the banking entity's current funds, as well as the banking entity's

ability to attract new investor capital to its current and future

covered funds. The total burden per banking entity, therefore, would

depend on the brand equity as well as the number of covered funds that

share a similar name.\2162\ One commenter argued that, as a result,

banking entities subject to section 13 may be at a competitive

disadvantage to other firms that are not subject to these or similar

restrictions.\2163\ The Agencies believe that the final rule addresses

some commenters' concerns to an extent by adopting a more tailored

definition of covered, including a focused definition of foreign funds

that will be covered funds and an exclusion for foreign public

funds.\2164\ In addition, to the extent that a banking entity would

otherwise come under pressure for reputational reasons to directly or

indirectly assist a covered fund under distress that bears the banking

entity's name, the name-sharing prohibition could reduce the risk to

the banking entity this assistance could pose.

---------------------------------------------------------------------------

\2161\ See supra notes 2151-2155 and accompanying text.

\2162\ See infra note 2164.

\2163\ See supra note 2153 and accompanying text.

\2164\ For example, one commenter argued that it would need to

rebrand approximately 500 established funds under the rule proposal

if the final rule was not modified to exclude established and

regulated funds in foreign jurisdictions. See Goldman (Covered

Funds).

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1. Definition of Sponsor With Respect to Securitizations

Commenters on the definition of sponsor in the context of

securitization vehicles generally argued that the proposed definition

of sponsor was too broad and requested clarification that various roles

that banking entities might serve within a securitization structure

would be excluded from the definition of sponsor, including servicers;

\2165\ backup servicers and master servicers; \2166\ collateral agents

and

[[Page 5986]]

administrators; \2167\ custodians; \2168\ indenture trustees; \2169\

underwriters, distributors, placement agents; \2170\ arrangers,

structuring agents; \2171\ originators, depositors, securitizers;

\2172\ ``sponsors'' under the SEC's Regulation AB; \2173\

administrative agents; \2174\ and securities administrators and

remarketing agents.\2175\ Commenters argued that these parties should

not be included in the definition of sponsor because such parties have

clearly defined and extremely limited authority and discretion,\2176\

do not have the right to control the decision-making and operational

functions of the issuer,\2177\ and would not have ``control'' under BHC

Act control precedent.\2178\ Conversely, one commentator supported

defining sponsor under the proposed rule to include the Regulation AB

sponsor, the servicer and the investment manager.\2179\ Commenters also

made arguments regarding the potential detrimental effects to

securitization and credit markets if banking entities are prohibited

from acting as sponsors of securitizations.\2180\

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\2165\ See Allen & Overy (on behalf of Foreign Bank Group); ASF

(Feb. 2012); Credit Suisse (Williams); SIFMA (Securitization) (Feb.

2012); Wells Fargo (Covered Funds). One of these commenters argued

that servicers will not have the right to control the decision-

making and operational functions of the issuer. See SIFMA

(Securitization) (Feb. 2012). Another commenter stated that

servicers do not have the authority to select assets or make

investment decisions on behalf of investors. See PNC.

\2166\ See ASF (Feb. 2012).

\2167\ Id.

\2168\ See Allen & Overy (on behalf of Foreign Bank Group); ASF

(Feb. 2012).

\2169\ Id.

\2170\ See Cleary Gottlieb; Credit Suisse (Williams); SIFMA

(Securitization) (Feb. 2012); Wells Fargo (Covered Funds). One of

these commentators argued that placement agents and underwriters

will not have the right to control the decision-making and

operational functions of the issuer. See SIFMA (Securitization)

(Feb. 2012).

\2171\ See Cleary Gottlieb (``party that structures the asset-

backed securities''); SIFMA (Securitization) (Feb. 2012).

\2172\ See Credit Suisse (Williams); Wells Fargo (Covered

Funds).

\2173\ See SIFMA (Securitization) (Feb. 2012) (arguing that

Regulation AB sponsors will not have the right to control the

decision-making and operational functions of the issuer after they

deposit the assets).

\2174\ See Credit Suisse (Williams).

\2175\ See ASF (Feb. 2012); Wells Fargo (Covered Funds).

\2176\ See Allen & Overy (on behalf of Foreign Bank Group).

\2177\ See SIFMA (Securitization) (Feb. 2012).

\2178\ See Credit Suisse (Williams).

\2179\ See Occupy.

\2180\ See ASF (Feb. 2012); Credit Suisse (Williams).

---------------------------------------------------------------------------

Commenters disagreed as to whether or not a sponsor under the final

rule should include a party with any investment discretion, some

investment discretion or complete investment discretion. Some

commenters argued that certain parties should not be considered a

sponsor because they were not an investment advisor or did not have

investment discretion.\2181\ Other commenters argued that an entity

should not be considered a sponsor even though it has limited

investment discretion,\2182\ while others argued that investment

advisers and parties with investment discretion should not be included

in the definition of sponsor.\2183\

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\2181\ See ASF (Feb. 2012) (arguing that service providers,

including trustees, custodians, collateral agents, servicers, master

servicers, backup servicers, securities administrators, remarketing

agents and collateral administrators, should not be considered the

sponsor or investment manager of a fund under section 13 of the BHC

Act because they have roles that are principally ministerial in

nature and do not generally involve investment discretion or

management and control activities); PNC (arguing that a banking

entity should not be deemed a sponsor simply by serving as

underwriter, distributor, placement agent, originator, depositor,

investment adviser, servicer, administrative agent, securitizer or

similar role because these parties do not have the authority to

select assets or make investment decisions on behalf of investors).

\2182\ See Allen & Overy (on behalf of Foreign Bank Group); ASF

(Feb. 2012); SIFMA (Securitization) (Feb. 2012). One commenter

argued that the limited discretion that a servicer, trustee or

custodian may have to either invest funds within certain parameters,

liquidate assets following a default on the asset or the

securitization default, or mitigate losses subject to a servicing

standard, should not be considered a sponsor because these entities

do not exercise the level of management and control exercised by the

general partner or managing member of a hedge fund or private equity

fund. Another commenter argued that to the extent that any of these

parties exercises discretion, such discretion (A) involves decisions

made after another party defaults (e.g., post-event of default

collateral sale), (B) prescribed by the transaction documents (e.g.,

choosing among a limited number of eligible investments) and (C)

governed by standards of care (e.g., the servicing standards). See

ASF (Feb. 2012). Another commenter requested clarification that the

exclusion of trustees that do not exercise investment discretion

would also cover trustees that (A) direct investment of amounts in

accordance with the applicable transaction documents, (B) act as

servicer pending the appointment of a successor or (C) liquidate

collateral. See SIFMA (Securitization) (Feb. 2012). One commenter

argued that the definition of sponsor should not include an

investment manager unless the investment manager (A) serves in one

of the capacities designated in the definition of sponsor and can be

replaced at the discretion of one or more entities serving in such

capacity or with or without cause by the security holders or (B) has

the ``discretion to acquire or dispose of assets in the

securitization for the primary purpose of recognizing gains or

decreasing losses resulting from market value changes.'' Id.

\2183\ See Credit Suisse (Williams); SIFMA (Securitization)

(Feb. 2012); TCW (arguing that the investment manager is typically

unaffiliated with the general partner or equivalent of such fund,

does not control the board of directors, is not responsible for the

operations or books and records of the fund and generally does not

perform any other significant function for the fund, such as acting

as transfer agent).

---------------------------------------------------------------------------

After considering comments received and the language and purpose of

section 13, the Agencies have determined not to adopt a separate

definition of sponsor for issuers of covered funds that are issuers of

an asset-backed security. As described above and consistent with the

statute, the definition of sponsor only includes parties that: (i)

Serve as a general partner, managing member, or trustee (other than a

directed trustee) of a covered fund; (ii) have the right to select or

control a majority of the directors, trustees, or management of a

covered fund; or (iii) share with a covered fund, for corporate,

marketing, promotional, or other purposes, the same name or a variation

of the same name. If the parties that commenters described do not serve

in those capacities for a covered fund, do not have those rights with

respect to a covered fund or do not share a name with a covered fund,

such parties would not be a sponsor for purposes of the final rule,

and, therefore, they would not be subject to the restrictions

applicable to the sponsor of a covered fund, including the restrictions

contained in section 13(f).\2184\

---------------------------------------------------------------------------

\2184\ As discussed above, commenters argued that that various

roles that banking entities might serve within a securitization

structure should be excluded from the definition of sponsor. See

supra notes 2165-2175 and accompanying text.

---------------------------------------------------------------------------

Additionally, the Agencies believe that the exclusion of loan

securitizations from the definition of covered fund under the final

rule addresses many of the commenters' concerns about the sponsor

definition because this exclusion limits the types of securitizations

that are covered funds and subject to the final rule. Similarly, the

exclusion of certain ABCP conduits from the definition of covered fund

will mean that the restrictions under section 13(f) will not apply to

qualifying asset-backed commercial paper conduits.

As with any other covered fund under the final rule, the term

sponsor would include a trustee that has the right to exercise any

investment discretion for the securitization. For issuers of asset-

backed securities, this would generally not include a trustee that

executes decision-making, including investment of funds prior to the

occurrence of an event of default, solely according to the provisions

of a written contract or at the written direction of an unaffiliated

party. In addition, under the rule as adopted a trustee with investment

discretion may avoid characterization as a sponsor if it irrevocably

delegates all of its investment discretion to another unaffiliated

party with respect to the covered fund. The Agencies believe that these

considerations regarding when a trustee is a sponsor responds to

commenters' concerns regarding the roles of trustees in

securitizations.\2185\

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\2185\ The Agencies also note that, while the entities

commenters identified may not fall into the definition of sponsor,

the ability of a banking entity to acquire and retain an interest in

a securitization that is a covered fund will depend on whether it

conducts its activity in a manner permitted under one of the

exemptions contained in section 13(d)(1) of the BHC Act, such as the

exemption for organizing and offering a covered fund.

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[[Page 5987]]

2. Section 75.11: Activities Permitted in Connection With Organizing

and Offering a Covered Fund

Section 13(d)(1)(G) of the BHC Act permits a banking entity to make

investments in and sponsor covered funds within certain limits in

connection with organizing and offering the covered fund.\2186\ Section

75.11 of the final rule implements this statutory exemption, and

includes several changes from the proposed rule in response to concerns

raised by commenters as described in detail below.\2187\

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\2186\ 156 Cong. Rec. S5889 (daily ed. July 15, 2010) (statement

of Sen. Hagan) (arguing that section 13 permits a banking entity to

engage in a certain level of traditional asset management business).

\2187\ See final rule Sec. 75.11; proposed rule Sec. 75.11.

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a. Scope of Exemption

Section 75.11 of the proposed rule described the conditions that

must be met in order to qualify for the exemption provided by section

13(d)(1)(G) for covered fund activities conducted in connection with

organizing and offering a covered fund.\2188\ These conditions

generally mirrored section 13(d)(1)(G) of the statute, and included:

(i) The banking entity must provide bona fide trust, fiduciary,

investment advisory, or commodity trading advisory services; \2189\

(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 in accordance with the limitations on amounts and value of

those interests 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. 75.16 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, may not share the same name or a variation of the

same name with the banking entity (or an affiliate or subsidiary

thereof), and 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; (viii) the

banking entity must 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. 75.11(h) of the proposed

rule; and (ix) the banking entity must 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.\2190\

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\2188\ See proposed rule Sec. Sec. 75.11(a)--(h).

\2189\ While section 13(d)(1)(G) of the BHC Act does not

explicitly mention ``commodity trading advisory services,'' the

Agencies proposed to treat commodity trading advisory services in

the same way as investment advisory services because the proposed

rule would have included commodity pools within the definition of

``covered fund.'' One commenter argued that a covered banking entity

should not be permitted to qualify for the exemption in section

13(d)(1)(G) based on providing commodity trading advisory services.

See Occupy. The Agencies believe that commodity trading advisors

provide services to commodity pools that are similar to the services

an investment adviser provides to a hedge fund or private equity

fund. Because certain commodity pools are included within the

definition of covered fund, banking entities may organize and offer

these commodity pools as a means of providing these services to

customers.

\2190\ See proposed rule Sec. 75.11(a)-(h).

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Commenters raised concern that the proposed rule could be read to

extend the prohibition on covered fund activities beyond the scope

intended by the statute.\2191\ Because the proposed exemption was

applicable to banking entities engaged in ``organizing and offering'' a

covered fund, commenters were concerned that the proposed rule might be

interpreted to prohibit a banking entity from engaging in activities

that are part of organizing and offering a covered fund but that are

not prohibited under the covered fund prohibition. In this regard,

commenters contended that the activity of ``organizing and offering'' a

covered fund would include serving as investment adviser, distributor,

broker, and other activities not prohibited by section 13 of the BHC

Act and not involving the acquisition or retention of an ownership

interest in or sponsorship of a covered fund as those terms are defined

in section 13.\2192\

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\2191\ See, e.g., Arnold & Porter.

\2192\ See Arnold & Porter; F&C.

---------------------------------------------------------------------------

The Agencies have modified the final rule to address this concern,

which reflects a reading of the proposal not intended by the Agencies.

Section 13(d)(1)(G) of the BHC Act by its terms provides an exemption

from section 13(a) of the BHC Act, which prohibits a banking entity

from acquiring or retaining an equity, partnership or other ownership

interest in or sponsoring a covered fund. To the extent that an

activity is not prohibited by section 13(a), no exemption to that

statutory prohibition is needed to conduct that activity. However, it

is common for prohibited and non-prohibited activities to be conducted

together in connection with offering and organizing a covered fund. For

example, an entity that provides investment advisory services to a

covered fund (an activity not itself prohibited by section 13(a)(1)(B)

of the BHC Act) often acquires an ownership interest in a covered fund

and/or appoints a majority of management of the covered fund (which is

included in the definition of sponsor under the statute), both of which

are covered by the statutory prohibition in section 13(a)(1)(B). In

that case, the banking entity may engage in the prohibited activity as

part of organizing and offering a covered fund only if the prohibited

activity is conducted in accordance with the requirements in the

exemption in section 13(d)(1)(G) or some other exemption.

The final rule reflects this view in that it permits a banking

entity to invest in or sponsor a covered fund in connection with

organizing and offering the fund, which may involve activities that are

not prohibited by section 13. Under the final rule, a banking entity

that serves as an investment adviser to a covered fund (including a

sub-adviser), for example, may permissibly invest in the covered fund

to the extent the banking entity complies with the requirements of

section 13(d)(1)(G) of the Act. An entity that serves only as

investment adviser, without making any investment or conducting any

activity covered by the prohibition in section 13(a), would not be

covered by the prohibition in section 13(a) and thus would not need to

rely on section 13(d)(1)(G) and Sec. 75.11 of the final rule to

conduct that investment advisory activity.

As described in more detail below, a number of commenters expressed

concern about applying the requirements of section 13(d)(1)(G) and the

final rule outside of the United States, including with respect to

foreign public funds organized and offered by foreign banking entities,

particularly in situations where requirements in foreign jurisdictions

may conflict with the requirements of section 13 of the BHC Act and

implementing regulations.\2193\

[[Page 5988]]

The Agencies believe that many of the concerns raised with respect to

applying section 13(d)(1)(G) and the proposed rule outside the United

States have been addressed through the revised definition of covered

fund described above and revisions to the exemption provided for

activities conducted solely outside the United States. In particular,

the revised definition of covered fund makes clear that a foreign fund

offered outside the United States is only a covered fund under

specified circumstances with respect to a banking entity that is, or is

controlled directly or indirectly by a banking entity that is, located

in or organized or established under the laws of the United States or

of any State.\2194\ Furthermore, foreign public funds are excluded from

the definition of covered fund in the final rule.\2195\ Consequently, a

foreign banking entity may invest in or organize and offer a variety of

funds outside of the United States without becoming subject to the

requirements of section 13(d)(1)(G) and Sec. 75.11 of the final rule,

such as the name-sharing restriction or limitations on director and

employee investments.

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\2193\ See, e.g., EFAMA; ICI Global; JPMC.

\2194\ See final rule Sec. 75.10(b)(1)(iii).

\2195\ See final rule Sec. 75.10(c)(1).

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1. Fiduciary Services

In order to qualify for the exemption for activities related to

organizing and offering a covered fund, section 13(d)(1)(G) generally

requires that a banking entity provide bona fide trust, fiduciary,

investment advisory, or commodity trading advisory services, that the

covered fund be organized and offered in connection with providing

these services, and that the banking entity providing those services

offer the covered fund only to persons that are customers of those

services of the banking entity.\2196\ These requirements were largely

mirrored in the proposed rule. 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.\2197\

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\2196\ See 12 U.S.C. 1851(d)(1)(G)(i); proposed rule Sec.

75.11(a).

\2197\ See 156 Cong. Rec. at S5897 (daily ed. July 15, 2010)

(statement of Sen. Merkley).

---------------------------------------------------------------------------

As noted in the proposal, section 13(d)(1)(G)(ii) of the BHC Act

does not explicitly require that the customer relationship be pre-

existing. Accordingly, the Agencies explained in the proposal that the

customer relationship 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 requirement is consistent with the manner in which these

services are provided by banking entities. The proposed rule also

required that a banking entity relying on the authority contained in

Sec. 75.11 adopt a credible plan or similar documentation outlining

how the banking entity intended to provide advisory or similar services

to its customers through organizing and offering such fund.

Several commenters indicated support for this customer requirement

and, in particular, the Agencies' view that the customer relationship

need not be a preexisting one.\2198\ A few commenters contended that

the statute required that a banking entity have a pre-existing customer

relationship, and may not solicit investors outside of its existing

asset management customers.\2199\ One of these commenters argued that

this would place banking entities at a competitive disadvantage

compared to investment advisers that are not banking entities (and thus

not subject to the requirements of section 13 and the final rule), but

argued that this is a necessary result of section 13.\2200\

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\2198\ See Ass'n of Institutional Investors (Feb. 2012); SIFMA

et al. (Covered Funds) (Feb. 2012); JPMC.

\2199\ See Sens. Merkley & Levin (Feb. 2012); AFR et al. (Feb.

2012); Occupy; Public Citizen.

\2200\ See Sens. Merkley & Levin.

---------------------------------------------------------------------------

The final rule adopts the language largely as proposed, and the

Agencies continue to believe that the customer relationship required

under section 13(d)(1)(G) and the final rule 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.\2201\ The final rule requires that a covered fund be

organized and offered pursuant to a written plan or similar

documentation outlining how the banking entity (or an affiliate

thereof) intends to provide advisory or similar services to its

customers through organizing and offering the fund. As part of this

requirement, the plan must be credible and indicate that the banking

entity has conducted reasonable analysis to show that the fund is

organized and offered for the purpose of providing bona fide trust,

fiduciary, investment advisory, or commodity trading advisory services

to customers of the banking entity (or an affiliate thereof) and not to

evade the restrictions of section 13 of the BHC Act.

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\2201\ See final rule Sec. 75.11(a)(1)-(2). See Part VI.B.2.b.

below for a discussion of these requirements in the context of a

banking entity that organizes and offers a covered fund that is an

issuing entity of asset-backed securities.

---------------------------------------------------------------------------

The language of the final rule also adopts the statutory

requirements (and modifications related to commodity pools as discussed

above) that the banking entity provide bona fide trust, fiduciary,

investment advisory, or commodity trading advisory services, and that

the covered fund be organized and offered only in connection with the

provision of those services. 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.\2202\ Historically, banking entities have used covered funds

as a method of providing these services to customers in a manner that

is both cost efficient for the customer and allows customers to benefit

from access to advice and services that might not otherwise be

available to them. These benefits apply to long-established customers

as well as individuals or entities that have no pre-existing

relationship with the banking entity but choose to obtain the benefit

of trust, fiduciary, investment advisory, or commodity trading advisory

services through participation in the covered fund. Covered funds also

allow customers to gauge the historical record of the banking entity in

providing these services by reviewing the funds' past performance.

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\2202\ 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. Part 362 (with respect

to a state non-member bank).

---------------------------------------------------------------------------

The statute does not require that a covered fund be offered only to

pre-existing customers of the banking entity, and the Agencies believe

that imposing such a requirement would not improve the quality of the

trust, fiduciary, investment advisory, or commodity trading advisory

service, enhance the safety and soundness of the banking entity, or

reduce the risks to the customers or the banking entity. In each case,

the banking entity provides trust, fiduciary or advisory services to a

covered fund for the benefit of the banking entity's customers, and the

statute recognizes that organizing and offering a covered fund is a

legitimate method for providing that service. In addition, the banking

entity must abide by all the statutory and prudential

[[Page 5989]]

requirements imposed by section 13 and the entity's supervisors on the

provision of those services. The Agencies do not believe that a pre-

existing customer relationship requirement would be meaningful because

it could easily be satisfied by a prospective customer seeking to

invest in a covered fund by first establishing an account with a

banking entity or purchasing another product (e.g., a brokerage account

or shares of a mutual fund).

2. 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 as an

investment.\2203\ Both the proposed rule and the final rule implement

this provision by requiring that a banking entity limit its investments

in a covered fund that the banking entity organizes and offers as

provided in Sec. 75.12.\2204\ Comments received on investment

limitations in the proposed rule, and modifications made to the final

rule implementing these limitations, are described in Part VI.B.3.

below.

---------------------------------------------------------------------------

\2203\ See 12 U.S.C. 1851(d)(1)(G)(iii).

\2204\ See proposed rule and final rule Sec. 75.12.

---------------------------------------------------------------------------

3. Compliance With Section 13(f) of the BHC Act

Section 75.11(d) of the proposed rule required that the banking

entity comply with the limitations on relationships with covered funds

imposed by section 13(f) of the BHC Act.\2205\ The final rule adopts

this requirement and provides that the banking entity (and its

affiliates) must comply with the requirements of Sec. 75.14. Section

13(f) of the BHC Act prohibits certain transactions or relationships

that would be covered by section 23A of the Federal Reserve Act, and

provides that any permitted transaction is subject to section 23B of

the Federal Reserve Act, in each instance as if such banking entity

were a member bank and such covered fund were an affiliate

thereof.\2206\ These limitations apply in several contexts, and are

contained in Sec. 75.14 of the final rule, discussed in detail below

in Part VI.B.5.

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\2205\ 12 U.S.C. 1851(d)(1)(G)(iv); proposed rule Sec.

75.11(d).

\2206\ See Part VI.B.5. below. The comments received on section

13(f) and Sec. 75.16 of the proposed rule are described below.

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4. No Guarantees or Insurance of Fund Performance

Section 75.11(e) of the proposed rule prohibited a banking entity

that organizes and offers a covered fund 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.\2207\ This prong implemented section

13(d)(1)(G)(iv) of the BHC Act and was intended to prevent a banking

entity from engaging in bailouts of a covered fund in which the banking

entity has an interest.\2208\

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\2207\ 12 U.S.C. 1851(d)(1)(G)(v); proposed rule Sec. 75.11(e).

\2208\ See 156 Cong. Rec. S5897 (daily ed. July 15, 2010)

(statement of Sen. Merkley).

---------------------------------------------------------------------------

There were only a few comments received on this aspect of the

proposal. One commenter supported the restriction on guarantees as

effective and consistent with the statute.\2209\

---------------------------------------------------------------------------

\2209\ See Occupy.

---------------------------------------------------------------------------

One commenter argued that the final rule should not prohibit

borrower default indemnification services (i.e., the guarantee of

collateral sufficiency upon a securities borrower's default) provided

to lending clients by agent banks in connection with securities lending

transactions involving a covered fund.\2210\ This commenter argued that

borrower default indemnification services guarantee only the deficit

between the mark to market value of cash collateral received and the

amount of any borrower default, and are therefore different from and

more limited than the type of general investment performance or

obligation guarantee that section 13 was designed to prevent.

---------------------------------------------------------------------------

\2210\ See RMA.

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The Agencies believe that the statute does not permit either full

or partial guarantees of the obligations of a covered fund that the

banking entity organizes and offers. Accordingly, the final rule, like

the proposed rule, continues to mirror the statutory restriction on

direct or indirect guarantees of the obligations or performance of a

covered fund by a banking entity in connection with reliance on the

exemption provided in section 13(d)(1)(G) of the BHC Act. However, in

response to comments received on the proposal, the Agencies note that

the provision of a borrower default indemnification by a banking entity

to a lending client in connection with securities lending transactions

involving a covered fund is not prohibited. This type of

indemnification is not a guarantee of the performance or obligations of

a covered fund because it represents a guarantee to the customer or

borrower of the obligation of the counterparty to perform and not a

guarantee of the performance or underlying obligations of the covered

fund. The requirement of the final rule that a banking entity and its

affiliates not guarantee the obligations or performance of a covered

fund that it organizes and offers therefore does not prohibit a banking

entity from providing borrower default indemnifications to customers.

5. Limitation on Name Sharing With a Covered Fund

Section 75.11(f) of the proposed rule prohibited the covered fund

from sharing the same name or a variation of the same name with the

banking entity that relies on the exemption in section 13(d)(1)(G) of

the BHC Act.\2211\ The proposed rule also prohibited the covered fund

from using the word ``bank'' in its name.\2212\

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\2211\ 12 U.S.C. 1851(d)(1)(G)(vi); proposed rule Sec.

75.11(f).

\2212\ 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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The name-sharing restriction was one of the most commented upon

aspects of Sec. 75.11. A number of commenters on this section

expressed the view that the name-sharing restriction in section

13(d)(1)(G)(vi) of the BHC Act and the proposed rule was too strict. In

particular, a number of commenters argued that the name-sharing

restriction should allow an asset manager to share its name with a

sponsored covered fund so long as the covered fund does not share the

name of the insured depository institution or its affiliated holding

company or use the word ``bank.'' \2213\

---------------------------------------------------------------------------

\2213\ See ABA (Keating); Ass'n of Institutional Investors (Feb.

2012); Blackrock; EFAMA; SIFMA et al. (Covered Funds) (Feb. 2012);

TCW; Katten (on behalf of Int'l Clients); Union Asset.

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Commenters argued that the name-sharing restriction as proposed

would impose significant business and branding burdens on the industry

without providing incremental benefit to the public.\2214\ These

commenters argued that it would be unduly burdensome and costly for

funds currently affiliated with banking entities or managers that are

themselves banking entities to change the name of their affiliated

funds and that many of these funds have developed a reputation in the

marketplace based on the current name of the fund and/or fund manager.

[[Page 5990]]

Some of these commenters argued that the name-sharing restriction would

place asset managers and funds affiliated with banking entities at a

competitive disadvantage to other asset managers and funds.\2215\

---------------------------------------------------------------------------

\2214\ See, e.g., ABA (Keating); Ass'n of Institutional

Investors (Feb. 2012); Blackrock; see also SVB; Katten (on behalf of

Int'l Clients); SIFMA et al. (Covered Funds) (Feb. 2012); UBS.

\2215\ See Ass'n of Institutional Investors (Feb. 2012); Katten

(on behalf of Int'l Clients); SIFMA et al. (Covered Funds) (Feb.

2012).

---------------------------------------------------------------------------

A few commenters argued that the rationale for the name-sharing

restriction (i.e., to discourage bailing out funds) was already

addressed under other restrictions of section 13(d)(1)(G) and the

proposed rule that prohibit a banking entity from, directly or

indirectly, guaranteeing, assuming or otherwise insuring the

obligations or performance of the covered fund or of any covered fund

in which such covered fund invested and that require disclosure that

investments in the covered fund are not insured by the Federal Deposit

Insurance Corporation.\2216\ These commenters questioned the necessity

for the name-sharing restriction when a prohibition on bailing out

funds is already in place and where there is disclosure that investors

bear the risk of loss in the fund. Some of these commenters contended

it was unlikely that investors in a covered fund with an SEC-registered

investment adviser that has a name unrelated to the name of an insured

depository institution would be misled to believe that the fund would

be backed in any way by a related insured depository institution or the

Federal Deposit Insurance Corporation.\2217\ One of these commenters

argued that the name-sharing restriction should not apply to

organizations where insured depository institutions represent a de

minimis component of the organization's operations.\2218\

---------------------------------------------------------------------------

\2216\ See Ass'n of Institutional Investors (Feb. 2012); SIFMA

et al. (Covered Funds) (Feb. 2012); T. Rowe Price; TCW.

\2217\ See TCW; Union Asset.

\2218\ See T. Rowe Price.

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Other commenters recommended that the name-sharing restriction not

be applied to covered funds that rely on the exemption for covered fund

activities and investments that occur solely outside of the United

States.\2219\ A few commenters expressed concern that the name-sharing

restriction could be incompatible with regulatory requirements in

certain foreign jurisdictions that a covered fund's name must indicate

the fund's connection with the fund sponsor.\2220\ One commenter argued

that it is common practice in Germany to disclose the designation of

the sponsoring investment manager in the fund name in order to provide

transparency to investors, while a few commenters contended that

European jurisdictions, including the U.K., require an authorized fund

to have a name representative of the authorized investment manager to

avoid misleading fund investors.\2221\ Commenters also argued that the

name-sharing restriction was inconsistent with the laws of Ireland and

Hong Kong.\2222\ Certain commenters argued that the impact of the name-

sharing restriction would be particularly unfair to non-U.S. retail

funds like European UCITS if such funds are not allowed to use the name

of the bank while U.S. mutual funds would not be subject to the same

restriction.\2223\

---------------------------------------------------------------------------

\2219\ See, e.g., UBS.

\2220\ See Credit Suisse (Williams); EFAMA; JPMC; Katten (on

behalf of Int'l Clients); Union Asset; IAA; ICI Global; UBS; SIFMA

et al. (Covered Funds) (Feb. 2012) (citing Directive 2004/39/EC of

the European Parliament and Council).

\2221\ See BVI; EFAMA; JPMC; UBS; Union Asset; ICI Global; IAA.

\2222\ See UBS; Union Asset; ICI Global.

\2223\ See, e.g., AFG; ICI Global; JPMC.

---------------------------------------------------------------------------

By contrast, some commenters supported the name-sharing

restriction. For example, one commenter indicated that the use of the

word ``bank'' or a shared name in the fund's name was already strongly

discouraged by prior guidance.\2224\ Another commenter supported the

name-sharing restriction but argued it did not go far enough because it

did not apply to funds that a banking entity was permissibly allowed to

sponsor and invest in under other provisions of section 13.\2225\

According to this commenter, covered funds permitted under other

exemptions should not be allowed to share the same name with the

banking entity.\2226\

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\2224\ See Arnold & Porter (citing SEC Division of Investment

Management, Letter to Registrants (May 13, 1993); Memorandum to SEC

Chairman Breeden from Division of Investment Management (May 6,

1993); FDIC, Board, OCC, OTS, Interagency Statement on Retail Sales

of Non-Deposit Investment Products (Feb. 14, 1994)).

\2225\ See Occupy the SEC at 165.

\2226\ See id.

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After carefully considering comments and the express terms of the

statute, the final rule includes the name-sharing restriction as

proposed.\2227\ The name-sharing restriction is imposed by the statute

and prohibits a banking entity from sharing the same name or variation

of the same name with a covered fund. The statute also defines the

scope of the prohibition by defining the term ``banking entity'' to

generally include any affiliate or subsidiary of an insured depository

institution or any company that controls an insured depository

institution.\2228\

---------------------------------------------------------------------------

\2227\ See final rule Sec. 75.11(f).

\2228\ See 12 U.S.C. 1851(d)(1)(G)(vi) and (h)(1).

---------------------------------------------------------------------------

However, the Agencies believe that many of the concerns raised by

commenters with respect to this provision should be addressed through

the revised definition of covered fund in the final rule, and

modifications to the exemption for covered fund activities and

investments that occur solely outside of the United States.\2229\ For

example, as discussed in greater detail above in Part VI.B.1.c.1.,

foreign public funds sold outside the United States are excluded from

the definition of covered fund.\2230\ In addition, pursuant to the

definition of covered fund in the final rule, a foreign fund only

becomes a covered fund with respect to a U.S. banking entity (including

a foreign affiliate of that U.S. banking entity) that acts as sponsor

to, or has an ownership interest in, the fund. Moreover, numerous funds

operate successfully with names that differ from the name of the fund

sponsor or adviser.

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\2229\ For example, one commenter alleged that it would need to

rebrand approximately 500 established funds if the final rule was

not modified to exclude established and regulated funds in foreign

jurisdictions. See Goldman (Covered Funds).

\2230\ See final rule Sec. 75.10(b)(1)(ii) and (c)(1).

---------------------------------------------------------------------------

The Agencies recognize, however, that the statutory name-sharing

restriction may affect some entities that will be covered funds and

that cannot rely on another permitted activity exemption under section

13(d)(1) and the final rule. The name-sharing restriction may result in

certain costs and other economic burdens for banking entities that

advise these funds, as discussed in greater detail in Part VI.B.1.g.

above.\2231\ However, as the Agencies also note above, to the extent

that the restriction results in a banking entity not otherwise coming

under pressure for reputational reasons to directly or indirectly

assist a covered fund under distress that shares the banking entity's

name, the name-sharing prohibition could reduce the risk to the banking

entity that this assistance might pose. The Agencies also expect that

the conformance period, both for compliance with section 13 of the BHC

Act generally and for funds that are illiquid funds, should be

sufficient to allow covered funds to take the steps necessary to comply

with the name-sharing restriction in the statute and final rule.

---------------------------------------------------------------------------

\2231\ See Part VI.B.1.g.

---------------------------------------------------------------------------

6. Limitation on Ownership by Directors and Employees

Section 75.11(g) of the proposed rule implemented section

13(d)(1)(G)(vii) of the BHC Act. That statutory provision prohibits any

director or employee of

[[Page 5991]]

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.\2232\ This allows an individual

employed by a banking entity, who also acts as fund manager or adviser

(for example), to acquire or retain an ownership interest in a covered

fund that aligns the manager or adviser's incentives with those of the

banking entity's customers.\2233\

---------------------------------------------------------------------------

\2232\ See 12 U.S.C. 1851(d)(1)(G)(vii); proposed rule Sec.

75.11(g).

\2233\ See 156 Cong. Rec. S5897 (daily ed. July 15, 2010)

(statement of Sen. Merkley).

---------------------------------------------------------------------------

One commenter argued that only employees or directors who provide

investment advisory services should be allowed to make an investment in

the fund and that the rule should not allow employees or directors who

provide other, unspecified services to invest in a fund.\2234\ This

commenter argued that the proposed rule would allow non-adviser banking

entity employees who have no need to maintain ``skin in the game'' to

earn profit on the fund's performance. According to another commenter,

fiduciary clients of banking organizations often are less interested in

whether the fund manager or other service providers have money in the

fund than whether the client's own account manager, and those

individuals above him/her who are responsible for investment decisions,

have allocated his or her own assets in the same way and into the same

general asset classes and funds as the client's fiduciary account is

being allocated.\2235\

---------------------------------------------------------------------------

\2234\ See Occupy.

\2235\ See Arnold & Porter.

---------------------------------------------------------------------------

The more prevalent view among commenters was that the proposed rule

should be revised and expanded to permit investments in a sponsored

fund by a broader group of banking entity directors, officers, and

employees, directly or indirectly through employee benefit programs or

trust and fiduciary accounts, regardless of whether the individual

provides services to the covered fund.\2236\ Some commenters argued

that narrowly limiting permissible director and employee investments

could put asset managers affiliated with an insured depository

institution at a competitive disadvantage relative to managers that are

not affiliated with an insured depository institution,\2237\ as well as

make it more difficult for banking entities to offer their U.S. and

non-U.S. employees similar choices in retirement plans.\2238\

---------------------------------------------------------------------------

\2236\ See Arnold & Porter; BOK, Credit Suisse (Williams); Fin.

Services Roundtable (Jun. 14, 2011); PEGCC; T. Rowe Price.

\2237\ See Credit Suisse (Williams).

\2238\ See T. Rowe Price.

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Two commenters urged that the supervisors of a fund's portfolio

managers or investment advisers should be permitted to invest.\2239\

These commenters also argued that individuals who provide support

services to the fund, including administrative, oversight and risk

management, legal compliance, regulatory, product structuring, deal

sourcing and origination, deal evaluation and diligence, investor

relations, sales and marketing, tax, accounting, valuation and other

operational support services, should be permitted to invest in the

fund. These commenters also requested confirmation that any director,

including an individual serving on the board or investment committee of

a fund or its manager, should be permitted to invest.\2240\ Another

commenter argued that employees and directors should be permitted to

make their own individual investment decisions independently without

regard to whether they provide services to the covered fund.\2241\ One

commenter contended that a grandfathering approach is necessary to

address situations where a pre-existing covered fund already has

investments from directors and employees who do not directly provide

services to the fund because the fund may be unable to force those

individuals out of the fund.\2242\

---------------------------------------------------------------------------

\2239\ See Credit Suisse (Williams); Fin. Services Roundtable

(Jun. 14, 2011).

\2240\ See Credit Suisse (Williams); Fin. Services Roundtable

(Jun. 14, 2011).

\2241\ See BOK (citing proposed rule at Sec. 75.17); Arnold &

Porter.

\2242\ See SVB.

---------------------------------------------------------------------------

A number of commenters argued that, if defined too narrowly, this

restriction may conflict with the laws of other jurisdictions that

require advisers and/or their directors and employees to invest in the

funds they manage.\2243\ For example, several commenters argued that

this requirement will directly conflict with the European Alternative

Investment Fund Managers Directive.\2244\ Two commenters contended that

certain jurisdictions, including the Netherlands, require directors and

other personnel of fund managers to hold fund units or shares of funds

managed by the fund manager as part of their pensions.\2245\

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\2243\ See EFAMA; BVI; IAA; ICI Global; JPMC; Union Asset.

\2244\ See Annex II para. 1(m). Directive 2011/61/EU of the

European Parliament and the Council of 8 June 2011 on Alternative

Investment Fund Managers.

\2245\ See EFAMA; Union Asset.

---------------------------------------------------------------------------

The final rule retains the requirement limiting the ownership of a

covered fund by directors and employees of a banking entity (or an

affiliate thereof) relying on the exemption in section 13(d)(1)(G) of

the BHC Act.\2246\ This limitation is imposed by statute on banking

entities that rely on this exemption. If a director or employee does

not provide services to the fund, they may not invest in that fund. As

in the statute, the final rule allows employees who provide services to

the fund other than investment advisory services to invest in the fund.

Under the final rule, directors or employees who provide investment

advice or investment management services to the fund may invest in that

fund. Similarly, directors or employees who provide services that

enable the provision of investment advice or investment management,

such as oversight and risk management, deal origination, due diligence,

administrative or other support services, may also invest in the fund.

In response to comments, the final rule has been modified to make clear

that a former director or employee may retain an interest in a covered

fund if the director or employee acquired the interest while serving as

a director or employee of the banking entity and providing investment

advisory or other services to the covered fund.

---------------------------------------------------------------------------

\2246\ See final rule Sec. 75.11(g).

---------------------------------------------------------------------------

The Agencies believe that many of the concerns raised by commenters

regarding the effects of this limitation on foreign funds are addressed

through the scope of foreign funds that will be covered funds, and

revisions to the exemption provided for covered fund activities and

investments that occur solely outside of the United States. Moreover,

the final rule excludes foreign public funds and broad-based foreign

pension funds from the definition of covered fund and they are thus not

subject to the restrictions of section 13 or the final rule.\2247\

---------------------------------------------------------------------------

\2247\ See final rule Sec. Sec. 75.10(c)(1) and 75.10(c)(5).

---------------------------------------------------------------------------

Section 13 clearly contemplates investments by certain employees

and directors of the banking entity.\2248\ However, the Agencies

continue to believe that certain 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 the final rule. In

order to address this concern, the final rule attributes an ownership

interest in a

[[Page 5992]]

covered fund acquired or retained by a director or employee to a

banking entity for purposes of the investment limits in section

13(d)(4) under certain circumstances. This attribution is discussed in

detail below in Part VI.B.3.f.

---------------------------------------------------------------------------

\2248\ See 12 U.S.C. 1851(d)(1)(G)(vii).

---------------------------------------------------------------------------

7. Disclosure Requirements

Section 75.11(h) of the proposed rule required that, in connection

with organizing and offering a covered fund, the banking entity clearly

and conspicuously disclose, in writing, to prospective and actual

investors in the covered fund that any losses in the covered fund will

be borne solely by investors in the covered fund and not by the banking

entity and its affiliates or subsidiaries; and that the banking

entity's and its affiliates' or subsidiaries' losses in the 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. In

addition, the proposed rule required that a banking entity disclose, in

writing: (i) that each 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. The proposed

rule also required banking entities to comply with any additional rules

of the appropriate Agency designed to ensure that losses in any covered

fund are borne solely by the investors in the covered fund and not by

the banking entity.\2249\ In proposing the rule, the Agencies indicated

that a banking entity may satisfy these disclosure requirements by

making the required disclosures in the covered fund's offering

documents.\2250\

---------------------------------------------------------------------------

\2249\ 12 U.S.C. 1851(d)(1)(G)(viii); proposed rule Sec.

75.11(h).

\2250\ 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.

---------------------------------------------------------------------------

A few commenters supported the disclosure requirement as effective

and consistent with the statute.\2251\ One commenter stated that the

disclosures required in section 13(d)(1)(G)(viii) of the Act and the

proposed rule are consistent with disclosures in the banking agencies'

February 1994 ``Interagency Statement on Retail Sales of Non-deposit

Investment Products'' and other FINRA and SEC guidance.\2252\ One

commenter suggested that the rule include a requirement that the

disclosures be issued in plain English.\2253\

---------------------------------------------------------------------------

\2251\ See, e.g., Occupy.

\2252\ See Arnold & Porter.

\2253\ See Occupy.

---------------------------------------------------------------------------

Another commenter argued that the Agencies should revise the

disclosure requirements under the proposal so that offering materials

of non-U.S. funds provided to non-U.S. investors outside the United

States need not include the specified disclosures nor refer to the FDIC

or other specific U.S. agencies.\2254\ This commenter argued that a

non-U.S. person investing in a non-U.S. fund offered or sponsored by a

non-U.S. banking entity has no expectation that the fund or its

interests would be insured by the FDIC. The Agencies believe this

concern is addressed through the revised definition of covered fund,

which generally provides that a foreign fund offered outside of the

United States will only be a covered fund with respect to a U.S.

banking entity (including a foreign affiliate of the U.S. banking

entity) that acts as sponsor to, or invests in, the fund.\2255\

---------------------------------------------------------------------------

\2254\ See Katten (on behalf of Int'l Clients).

\2255\ See final rule Sec. 75.10(b)(1)(iii).

---------------------------------------------------------------------------

The final rule adopts the proposed disclosure requirements

substantially as proposed. As explained above, these disclosures are

largely required by the statute.\2256\ The proposed requirement to

disclose that ownership interests in a 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) is not expressly required by the statute. However, section

13(d)(1)(G)(iii) permits the Agencies to impose additional rules

designed to ensure that losses in a covered fund are borne solely by

investors in the fund and not by a banking entity. The Agencies believe

that requiring a banking entity to make this disclosure as part of

organizing and offering a covered fund furthers this purpose by

removing the potential for misperception that a covered fund sponsored

by a banking entity (which by definition must be affiliated with a

depository institution insured by the FDIC) is guaranteed by that

insured institution or the FDIC. Moreover, as noted above, this

disclosure is already commonly provided by banking entities.

---------------------------------------------------------------------------

\2256\ See 12 U.S.C. 1851(d)(1)(G)(viii).

---------------------------------------------------------------------------

b. Organizing and Offering an Issuing Entity of Asset-Backed Securities

To the extent that an issuing entity of asset-backed securities is

a covered fund, the investment limitations contained in section

13(d)(4) of the BHC Act also would limit the ability of a banking

entity to acquire or retain an investment in that issuer. Section 941

of the Dodd-Frank Act added a new section 15G of the Exchange Act (15

U.S.C. 78o-11) which requires a banking entity to retain and maintain a

certain minimum interest in certain asset-backed securities.\2257\ In

order to give effect to this separate requirement under the Dodd-Frank

Act, Sec. 75.14(a)(2) of the proposed rule permitted a banking entity

that is a ``securitizer'' or ``originator'' under the provisions of

that Act to acquire or retain an ownership interest in an issuer of

asset-backed securities, in an amount (or value of economic interest)

required to comply with the minimum requirements of section 15G of the

Exchange Act and any implementing regulations issued thereunder.\2258\

The proposal also permitted a banking entity to act as sponsor to the

securitization.

---------------------------------------------------------------------------

\2257\ 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). Those agencies recently issued a re-

proposal of the risk-retention requirements. See Credit Risk

Retention, 78 FR 57928 (Sept. 20, 2013).

\2258\ See proposed rule Sec. 75.14(a)(2)(iii).

---------------------------------------------------------------------------

Commenters expressed a variety of views on the treatment of

interests in securitizations held under risk retention pursuant to the

proposed rule. Some commenters argued that the proposal was effective

as written and represented a reasonable way to reconcile the two

sections of the Dodd-Frank Act consistent with the risk-reducing

objective of section 13 of the BHC Act.\2259\ Other commenters also

supported the proposal's recognition that banking entities may be

required to hold a certain amount of risk in a securitization that

would also be a covered fund, but argued that the proposed exemption

was too narrow.\2260\

---------------------------------------------------------------------------

\2259\ See Sens. Merkley & Levin (Feb. 2012); Alfred Brock.

\2260\ See, e.g., AFME et al.; SIFMA (Securitization) (Feb.

2012); JPMC; BoA.

---------------------------------------------------------------------------

After carefully considering the comments received on the proposal,

as well as the language and purpose of section 13 of the BHC Act, the

final rule provides an exemption that permits a banking entity to

organize and offer a

[[Page 5993]]

covered fund that is an issuing entity of asset-backed

securities.\2261\ The Agencies have determined to provide this

exemption in order to address the unique circumstances and ownership

structures presented by securitizations.\2262\ Under the final rule, a

banking entity may permissibly organize and offer a covered fund that

is an issuing entity of asset-backed securities so long as the banking

entity (and its affiliates) comply with all of the requirements of

Sec. 75.11(a)(3) through (a)(8).\2263\ As discussed above, the

requirements of Sec. 75.11(a)(3) through 75.11(a)(8) are that: (i) The

banking entity and its affiliates do not acquire or retain an ownership

interest in the covered fund except as permitted under Sec. 75.12 of

the final rule; \2264\ (ii) the banking entity and its affiliates

comply with the requirements of Sec. 75.14 of the final rule; (iii)

the banking entity and its affiliates do 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; (iv) the covered fund, for corporate, marketing, promotional,

or other purposes, does not share the same name or variation of the

same name with the banking entity (or an affiliate thereof) and does

not use the word ``bank'' in its name; (v) no director or employee of

the banking entity (or an affiliate thereof) takes or retains an

ownership interest in the covered fund except under the limited

circumstances noted in the final rule; and (vi) the banking entity

complies with the disclosure requirements regarding covered funds in

the final rule.

---------------------------------------------------------------------------

\2261\ See final rule Sec. 75.11(b).

\2262\ As used in this SUPPLEMENTARY INFORMATION, the term

``securitization'' means a transaction or series of transactions

that result in the issuance of asset-backed securities.

\2263\ See final rule Sec. 75.11(b) (providing the requirements

for a banking entity that is organizing and offering a covered fund

that is an issuing entity of asset-backed securities by reference to

the requirements of Sec. 75.11(a), as discussed above).

\2264\ As explained in detail below in Part VI.B.3. addressing

the limitations on investments in covered funds by a banking entity,

the final rule permits a banking entity to acquire and retain

ownership interests in a covered fund in order to comply with

section 15G of the Exchange Act (15 U.S.C.78o-11) in an amount that

does not exceed the amount required to comply with the banking

entity's chosen method of compliance under section 15G and the

implementing regulations issued thereunder.

---------------------------------------------------------------------------

The Agencies believe that the requirements of the exemption for

organizing and offering a covered fund that is an issuing entity of

asset-backed securities, which are in most aspects consistent with the

exemption for organizing and offering a covered fund in section

13(d)(1)(G), provide limitations on a banking entity's securitization

activities involving covered funds that are consistent with the

limitations imposed with respect to organizing and offering a covered

fund that is not an issuing entity of asset-backed securities. For

instance, a banking entity may not share the same name as a covered

fund that is an issuing entity of asset-backed securities and is

prohibited from guaranteeing or otherwise ``bailing out'' a covered

fund that is an issuing entity of asset-backed securities, including

being required to comply with section 13(f) of the BHC Act regarding

covered transactions with the covered fund. Furthermore, like a banking

entity's investment in any covered fund, the final rule limits the

ability of a banking entity to invest in a covered fund that is an

issuing entity of asset-backed securities unless it meets the

requirements of Sec. 75.12.

Unlike many other covered funds, the Agencies understand that

banking entities might not act in a fiduciary capacity when they

organize and offer a covered fund that is a securitization vehicle. For

instance, as part of organizing and offering a securitization vehicle,

one or more parties may typically organize and initiate the

securitization by selling or transferring assets, either directly or

indirectly, to an issuing entity of asset-backed securities. An entity

that provides these services typically does so as a service to provide

investors and the entity's customers with the ability to invest in the

assets in a manner and to a degree that they may otherwise be unable to

do. In order to identify certain activities that would be included as

organizing and offering a securitization, the final rule provides that

organizing and offering an issuing entity of asset-backed securities

means acting as the securitizer, as that term is used in section

15G(a)(3) of the Exchange Act, for the issuer, or acquiring or

retaining an ownership interest in the issuer in compliance with the

implementing regulations issued under section 15G of that Act.

The final rule reflects, as discussed above, that one or more

parties that organize and offer an issuing entity of asset-backed

securities may not provide any of the services identified in Sec.

75.11(a)(1). In this case the banking entity is not required to comply

with Sec. 75.11(a)(1) or (a)(2). Section 75.11(b) of the final rule is

designed to address situations where, as discussed above, a banking

entity does not act in a fiduciary capacity when it organizes and

offers a covered fund that is a securitization vehicle. With respect to

any securitization vehicle that retains a collateral manager for

investment advice regarding the assets of the securitization vehicle,

such a collateral manager would be required to comply with all of the

provisions of Sec. 75.11(a) to acquire and retain an ownership

interest in such securitization vehicle.

The final rule therefore both identifies certain activities that

would be included as organizing and offering a securitization and

modifies the requirements of Sec. 75.11 to reflect differences between

securitizations and other types of covered funds, as discussed above.

The Agencies believe, therefore, that the final rule appropriately

addresses the type of activity that is usually associated with

organizing and offering a securitization and also comports with the

manner in which Congress chose to define the type of parties engaged in

activities that merit special attention related to issuing entities of

asset-backed securities in another part of the Dodd-Frank Act.

The Agencies have determined to provide this exemption by using

their authority in section 13(d)(1)(J) of the BHC Act and believe that

this exemption promotes and protects the safety and soundness of

banking entities and the financial stability of the United States. Many

companies and other entities utilize securitization transactions to

efficiently manage, allocate and distribute risks throughout the

markets in a manner consistent with meeting the demands of their

investors. Companies also utilize securitizations in order to help

provide liquidity to certain asset classes or portions of the market

that, absent this liquidity, may experience decreased liquidity and

increased costs of funding. For instance, if banking entities were not

permitted to organize and offer a securitization, the Agencies believe

this would result in increased costs of funding or credit for many

businesses of all sizes that are engaged in activities that section 13

of the BHC Act was not designed to address. Additionally, this

exemption enables banking entities to acquire and retain ownership

interests in a covered fund to comply with section 15G of the Exchange

Act, which requires certain parties to a securitization transaction to

retain a minimum amount of risk in a securitization, a requirement not

applicable to covered funds that are not securitizations. The Agencies

therefore have determined that this exemption will promote and protect

the safety and soundness of banking entities and the financial

stability of the United States by facilitating the benefits

securitizations can provide as discussed above, and also by enabling

banking

[[Page 5994]]

entities to comply with section 15G of the Exchange Act.

The Agencies believe it would not be consistent with the safety and

soundness of banking entities or the financial stability of the United

States to prevent banking entities from acquiring or retaining

ownership interests in securitizations as part of the permitted

activity of organizing and offering securitizations or from meeting any

applicable requirements related to securitizations, including those

imposed under section 15G of the Exchange Act. The Agencies note that

the exemption for organizing and offering a securitization does not

relieve banking entities of any requirements that they may be subject

to with respect to their investments in or relationships with a

securitization, such as any applicable requirements regarding conflicts

of interest relating to certain securitizations under section 27B of

the Securities Act of 1933.

c. Underwriting and Market Making for a Covered Fund

Section 13(d)(1)(B) permits a banking entity to purchase and sell

securities and other instruments described in 13(h)(4) in connection

with certain underwriting or market making-related activities.\2265\

The proposal did not discuss how this exemption applied in the context

of underwriting or market making of ownership interests in covered

funds.

---------------------------------------------------------------------------

\2265\ See 12 U.S.C. 1851(d)(1)(B).

---------------------------------------------------------------------------

Commenters argued that the scope of the permitted activities under

sections 13(d)(1)(B), (D) and (F), which respectively set out permitted

activities of underwriting and market making-related activities,

activities on behalf of customers, and activities by a regulated

insurance company, apply to all of the activities prohibited under

section 13(a), whether those activities would involve proprietary

trading or ownership of or acting as a sponsor to covered funds.\2266\

Commenters argued that the statutory exemption for underwriting and

market making-related activities is applicable to both proprietary

trading and covered fund activities, and recommended that the final

rule allow banking entities to hold ownership interests and other

securities of covered funds for the purpose of underwriting and

engaging in market making-related activities.\2267\ Commenters noted

that many structured finance vehicles rely on sections 3(c)(1) and

3(c)(7) of the Investment Company Act, and argued that, without a

market making exemption for securities of covered funds, banking

entities would be unable to engage in customer-driven underwriting and

market making activity with respect to securities issued by entities

such as collateralized loan obligation issuers and non-U.S. exchange-

traded funds.\2268\

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\2266\ See Cleary Gottlieb et al.; JPMC; Credit Suisse

(Williams).

\2267\ See BoA; Cleary Gottlieb; Credit Suisse (Williams); SIFMA

et al. (Covered Funds) (Feb. 2012); see also Deutsche Bank (Fund-

Linked Products); SIFMA (Securitization) (Feb. 2012). Other

commenters argued that application of Section 13(f) of the BHC Act

would prohibit the underwriting and market making by a banking

entity of the securities of a covered fund that such banking entity

sponsors, organizes and offers or provides investment management

advice or services because Section 13(f) of the BHC Act prohibits

the purchase of securities by a banking entity from such a covered

fund. See, e.g., ASF (Feb. 2012); Cleary Gottlieb; Credit Suisse

(Williams); SIFMA (Securitization) (Feb. 2012); FSA (Feb. 2012).

\2268\ See JPMC; Cleary Gottlieb.

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After careful review of the comments in light of the statutory

provisions, the final rule has been modified to provide a covered fund

specific provision for underwriting and market making-related

activities of ownership interests in covered funds. These underwriting

and market making activities are within the scope of permitted

activities under the final rule so long as:

The banking entity conducts the activities in accordance

with the requirements of Sec. 75.4(a) or Sec. 75.4(b), respectively;

With respect to any banking entity (or an affiliate

thereof) that: acts as a sponsor, investment adviser or commodity

trading advisor to a particular covered fund or otherwise acquires and

retains an ownership interest in such covered fund in reliance on Sec.

75.11(a); acquires and retains an ownership interest in such covered

fund and is either a securitizer, as that term is used in section

15G(a)(3) of the Exchange Act, or is acquiring and retaining an

ownership interest in such covered fund in compliance with section 15G

of that Act and the implementing regulations issued thereunder each as

permitted by Sec. 75.11(b); or, directly or indirectly, guarantees,

assumes, or otherwise insures the obligations or performance of the

covered fund or of any covered fund in which such fund invests, then in

each such case any ownership interests acquired or retained by the

banking entity and its affiliates in connection with underwriting and

market making related activities for that particular covered fund are

included in the calculation of ownership interests permitted to be held

by the banking entity and its affiliates under the limitations of Sec.

75.12(a)(2)(ii) and Sec. 75.12(d); and

With respect to any banking entity, the aggregate value of

all ownership interests of the banking entity and its affiliates in all

covered funds acquired and retained under Sec. 75.11, including all

covered funds in which the banking entity holds an ownership interest

in connection with underwriting and market making related activities

under Sec. 75.11(c), are included in the calculation of all ownership

interests under Sec. 75.12(a)(2)(iii) and Sec. 75.12(d).\2269\

---------------------------------------------------------------------------

\2269\ See final rule Sec. 75.11(c).

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The Agencies believe that providing a separate provision relating

to permitted underwriting and market making-related activities for

ownership interests in covered funds is supported by section

13(d)(1)(B) of the BHC Act.\2270\ The exemption for underwriting and

market making-related activities under section 13(d)(1)(B), by its

terms, is a statutorily permitted activity and exemption from the

prohibitions in section 13(a), whether on proprietary trading or on

covered fund activities. Applying the statutory exemption in this

manner accommodates the capital raising activities of covered funds and

other issuers in accordance with the underwriting and market making

provisions under the statute.

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\2270\ A discussion of the implementation of section 13(d)(1)(D)

and (F) with regard to the final rule's limitations on covered fund

investments and activities is provided in the section that relates

to permitted covered fund interests and activities by a regulated

insurance company and Sec. 75.13(c) of the final rule.

---------------------------------------------------------------------------

The final rule provides that a banking entity must include any

ownership interests that it acquires or retains in connection with

underwriting and market making-related activities for a particular

covered fund for purposes of the per-fund limitation under Sec.

75.12(a)(2)(ii) if the banking entity: (i) Acts as a sponsor,

investment adviser or commodity trading advisor to the covered fund;

(ii) otherwise acquires and retains an ownership interest in the

covered fund as permitted under Sec. 75.11(a); (iii) acquires and

retains an ownership interest in the covered fund and is either a

securitizer, as that term is used in section 15G(a)(3) of the Exchange

Act, or is acquiring and retaining an ownership interest in the covered

fund in compliance with section 15G of that Act and the implementing

regulations issued thereunder each as permitted by Sec. 75.11(b); or

(iv) directly or indirectly guarantees, assumes, or otherwise insures

the obligations or performance of the covered fund or of any covered

fund in which such fund invests. This is designed to prevent any

unintended

[[Page 5995]]

expansion of ownership of covered funds by banking entities that are

subject to the per fund limitations under Sec. 75.12.

These banking entities will have a limited ability to engage in

underwriting or market making-related activities for a covered fund for

which the banking entity's investments are subject to the per-fund

limitations in Sec. 75.12 as discussed above. Such a banking entity

will have more flexibility to underwrite and make a market in the

ownership interests of such a covered fund in connection with

organizing and offering the covered fund during the fund's seeding

period, since during the seeding period a banking entity may own in

excess of three percent of the covered fund, subject to the other

requirements in Sec. 75.12.

The final rule also provides that all banking entities that engage

in underwriting and market-making related activities in covered funds

are required to include the aggregate value of all ownership interests

of the banking entity in all covered funds acquired and retained under

Sec. 75.11, including in connection with underwriting and market

making-related activities under Sec. 75.11(c), in the calculation of

the aggregate covered fund ownership interest limitations under Sec.

75.12(a)(2)(iii) (and make the associated deduction from tier one

capital for purposes of calculating compliance with applicable

regulatory capital requirements).\2271\

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\2271\ See final rule Sec. 75.11(c)(3).

---------------------------------------------------------------------------

Some commenters asked that the Agencies permit banking entities to

engage in market making and underwriting in non-sponsored covered fund

interests.\2272\ The final rule permits a banking entity that does not

hold an ownership interest in the covered fund in reliance on

Sec. Sec. 75.11(a) or 75.11(b) of the final rule, is not a sponsor of

the covered fund, is not an investment adviser or commodity trading

advisor to the covered fund, and 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 fund invests

to rely on the market-making and underwriting exemption in Sec.

75.11(c) provided that the banking entity meets all of the requirements

of that exemption. These conditions include the aggregate funds

limitation and the capital deduction contained in Sec. 75.12 after

including all ownership interest held by the banking entity and its

affiliates under Sec. 75.11, including ownership interests acquired or

retained under the exemption for underwriting and market making-related

activities in Sec. 75.11(c). In accordance with section 13(d)(1) of

the BHC Act, the Agencies have determined that these restrictions on

reliance on the market-making and underwriting exemption provided by

section 13(d)(1)(B) are appropriate to address the purposes of section

13 of the BHC Act, which is aimed at assuring that banking entities do

not bail-out a covered fund and maintain sufficient capital against the

risks of ownership of covered funds. The Agencies note, however, that

the guarantee restriction is not intended to prevent a banking entity

from entering into arrangements with a covered fund that are not

entered into for the purpose of guaranteeing the obligations or

performance of the covered fund. For example, this restriction is not

intended to prohibit a banking entity from entering into or providing

liquidity facilities or letters of credit for covered funds; however,

it would apply to arrangements such as a put of the ownership interest

in the covered fund to the banking entity. The determination of whether

an arrangement would fall within this guarantee restriction would

depend on the facts and circumstances.

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\2272\ See Cleary Gottlieb; Credit Suisse (Williams).

---------------------------------------------------------------------------

The Agencies emphasize that any banking entity that engages in

underwriting or market making-related activities in covered funds must

comply with all of the conditions applicable to such activity as set

forth in section Sec. Sec. 75.4(a) and 75.4(b).\2273\ Thus, holdings

of a single covered fund would be subject to limitations on risk as

well as length of holding period, among other applicable limitations

and requirements. These requirements are designed specifically to

address a banking entity's underwriting and market making-related

activities and to prohibit holding exposures in excess of reasonably

expected near term demand of clients, customers and counterparties.

---------------------------------------------------------------------------

\2273\ See final rule Sec. 75.11(c)(1).

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3. Section 75.12: Permitted Investment in a Covered Fund

a. Proposed Rule

Section 75.12 of the proposed rule implemented section 13(d)(4) of

the BHC Act and described the limited circumstances under which a

banking entity may acquire or retain an ownership interest in a covered

fund that the banking entity (which includes its subsidiaries and

affiliates) organizes and offers.\2274\ Section 13(d)(4)(A) 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

for the purpose of: (i) Establishing the 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 fund, subject to several limitations. Section 13(d)(4)(B) of the

BHC Act requires that investments by a banking entity in a covered fund

must, not later than one year after the date of establishment of the

fund, be reduced to an amount that is not more than three percent of

the total outstanding ownership interests of the fund. Consistent with

the statute, Sec. 75.12 of the proposal provided that, after

expiration of the seeding period, a banking entity's investment in a

single covered fund may not represent more than three percent of the

total outstanding ownership interests in the covered fund (the ``per-

fund limitation'').\2275\ In addition, as provided in the statute, the

proposal provided that the total amount invested by a banking entity in

all covered funds may not exceed three percent of the tier 1 capital of

the banking entity (the ``aggregate funds limitation'').\2276\

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\2274\ 12 U.S.C. 1851(d)(4); proposed rule Sec. 75.12.

\2275\ See proposed rule Sec. Sec. 75.12(a)(1)(i);

75.12(a)(2)(i)(A) and (B); 75.12(b).

\2276\ See id. at Sec. Sec. 75.12(a)(1)(ii); 75.12(a)(2)(ii);

75.12(c).

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b. Duration of Seeding Period for New Covered Funds

Commenters argued that it is essential to serving their customers

efficiently that a banking entity be permitted to acquire and retain an

ownership interest in a covered fund that it organizes and offers as a

de minimis investment or for the purpose of establishing the fund. A

number of commenters contended that a banking entity typically invests

a limited amount of its own capital in a fund (``seed capital'') as

part of organizing the fund to produce investment performance as a

record of the fund's investment strategy (``track record'').\2277\ Once

a track record for the fund is established, the banking entity markets

the fund to unaffiliated investors.

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\2277\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012); SSgA

(Feb. 2012); T. Rowe Price; Credit Suisse (Williams); Allen & Overy

(on behalf of Canadian Banks);TCW.

---------------------------------------------------------------------------

Commenters argued that the one-year seeding period provided in the

proposed rule would be too short to establish a track record for many

types of covered funds. Commenters argued that the duration of the

track record investors typically demand before investing in a new fund

depends on a number of factors (e.g., the type of fund,

[[Page 5996]]

investment strategy, and potential investors). According to commenters,

an inability to demonstrate a track record over multiple years may

reduce the allocation of capital by investors who are unable to gain an

understanding of the investment strategy, risk profile, and potential

performance of the fund.\2278\

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\2278\ See et al. (Covered Funds) (Feb. 2012); see also Ass'n of

Institutional Investors (Feb. 2012); Bank of Montreal et al. (Jan.

2012); Allen & Overy (on behalf of Canadian Banks); Credit Suisse

(Williams); Japanese Bankers Ass'n; SSgA (Feb. 2012); T. Rowe Price;

Union Asset. One commenter argued that this limitation would

constrain portfolio composition of a covered fund due to an

inability of a fund to raise sufficient capital to make larger

investments. See Credit Suisse (Williams).

---------------------------------------------------------------------------

Commenters provided alternative suggestions regarding how to define

the start of the seeding period for purposes of applying the statutory

exception for investments during the seeding period. For example, two

commenters recommended that the Agencies treat a private equity fund as

being established on the date on which the fund begins its asset-

acquisition phase and is closed to new investors, and a hedge fund as

established on the date on which the fund has reached its target amount

of funding and begins investing according to the fund's stated

investment objectives.\2279\ Another commenter suggested that the

permitted seeding period begin on the date on which third-party

investors are first admitted to the fund.\2280\

---------------------------------------------------------------------------

\2279\ See AFG; Union Asset.

\2280\ See SIFMA (Mar. 2012); see also Credit Suisse (Williams).

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Several commenters expressed concern that the per-fund limitation

could be subject to evasion unless the Agencies require that the

seeding period begin at the time funds are first invested by the

banking entity in the fund.\2281\ Some of these commenters suggested

the Agencies impose a dollar cap of $10 million on the seed capital

that a banking entity may provide to a newly organized covered fund in

addition to the statutory limits based on the amount of the fund's

shares and the amount of the banking entity's tier 1 capital.\2282\

These commenters argued that an explicit quantitative limit better

accounted for the size of some banking entities, which otherwise made

the potential amount of capital placed in covered funds quite

large.\2283\

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\2281\ See AFR et al. (Feb. 2012); Occupy; Public Citizen; Sens.

Merkley & Levin (Feb. 2012).

\2282\ See Occupy; Sens. Merkley & Levin (Feb. 2012); see also

156 Cong. Rec. S5897 (daily ed. July 15, 2010) (statement of Sen.

Merkley).

\2283\ See, e.g., Public Citizen.

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The Agencies have considered carefully the comments on the proposal

and have made several modifications to the final rule to more clearly

explain how the limitations apply during the seeding period. The final

rule continues to provide that a banking entity may invest in a covered

fund that it organizes and offers either in connection with

establishing the fund, or as a de minimis investment.\2284\

Importantly, the statute does not permit a banking entity to invest in

a covered fund unless the banking entity organizes or offers the

covered fund or qualifies for another exemption. As explained more

fully in the discussion of Sec. 75.11 above, a wide variety of

activities are encompassed in organizing and offering a covered fund.

Under the statute, which generally prohibits investments in covered

funds, a banking entity may invest in a covered fund under the

exemptions provided in section 13(d)(1) of the BHC Act, including

section 13(d)(1)(G) and the provisions of section 13(d)(4), only if the

banking entity engages in one or more of these permitted activities

with regard to that covered fund and complies with all applicable

limitations under the final rule regarding investments in a covered

fund.

---------------------------------------------------------------------------

\2284\ See final rule Sec. 75.12(a)(1).

---------------------------------------------------------------------------

As noted above, the statute allows a banking entity to acquire and

hold all of the ownership interests in a covered fund for the purpose

of establishing the fund and providing the fund with sufficient initial

equity for investment to permit the fund to attract unaffiliated

investors.\2285\ However, the statute also imposes a limit on the

duration of an investment made in connection with seeding a covered

fund. At the end of that period, the investment must conform to the

limits on de minimis investments set by the statute. In keeping with

the terms of the statute, the final rule, like the proposal, allows

banking entities a seeding period of one-year for all covered funds.

The statute also allows the Board to extend that period, upon an

application by a banking entity, for two additional years if the Board

finds an extension to be consistent with safety and soundness and in

the public interest.\2286\ As explained below, the final rule, like the

proposal, incorporates this process and sets forth the factors the

Board will consider when determining whether to allow an extended

seeding period. The Board and the Agencies will monitor these extension

requests to ensure that banking entities do not seek extensions for the

purpose of evading the restrictions on covered funds or to engage in

prohibited proprietary trading.

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\2285\ 12 U.S.C. 1851(d)(4).

\2286\ See id. at 1851(d)(4)(C).

---------------------------------------------------------------------------

As noted above, the proposal did not specify ``date of

establishment,'' and commenters suggested a variety of dates that could

serve as the date of establishment for purposes of determining the

duration of the seeding period and the per-fund limitations on

ownership interests in a covered fund.\2287\ After considering comments

received on the proposal, the Agencies have modified the final rule to

include a definition of ``date of establishment'' for a covered fund.

In general, the date of establishment is the date on which an

investment adviser or similar party begins to make investments that

execute an investment or trading strategy for the covered fund. The

Agencies perceive the act of making investments to execute an

investment or trading strategy as demonstrating that the fund has begun

its existence and is no longer simply a plan or proposal. In order to

account for the unique circumstances and manner in which

securitizations are established, for a covered fund that is an issuing

entity of asset-backed securities, the date of establishment under the

final rule is the date on which the assets are initially transferred

into the issuing entity of the asset-backed securities. This is the

date that the entity is formed and the securities are generally sold

around this time. The Agencies believe this is the appropriate time for

the date of establishment for securitizations because this is the date

that the securitization risks are transferred to the owners of the

securitization vehicle. Once the assets have been transferred, the

securitization has been established and securities of the issuer may

typically be priced in support of organizing and offering the issuer.

Setting a later time, such as when the fund becomes fully subscribed or

the assets have been fully assembled, could permit a banking entity to

engage in prohibited proprietary trading under the guise of waiting for

investors that may never materialize.\2288\

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\2287\ See SIFMA et al. (Mar. 2012); Credit Suisse (Williams);

EFAMA: Hong Kong Inv. Funds Ass'n; AFG; Union Asset.

\2288\ Importantly, the statute recognizes that a banking entity

may need more than the automatic one-year seeding period to build a

track record and/or market its interests to unaffiliated investors;

therefore, a banking entity may apply for an extension of the

seeding period as provided in 75.12(e) of the final rule as

discussed below in Part VI.B.3.h.

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The statute also requires a banking entity to actively seek

unaffiliated investors to reduce or dilute the entity's ownership

interest to the amount permitted under the statute. This requirement is

included in the final

[[Page 5997]]

rule, and underscores the nature of covered fund activities under

section 13(d)(1)(G) as a method to provide investment advisory, trust

and fiduciary services to customers rather than allow the banking

entity to engage in prohibited proprietary trading. To effectuate the

requirements of the statute, under the final rule, banking entities

that organize and offer a covered fund must develop and document a plan

for offering shares in the covered fund to other investors and

conforming the banking entity's investments to the de minimis limits to

help monitor and ensure compliance with this requirement.

While certain commenters requested that the final rule include a

quantitative dollar limit on the amount of funds a banking entity may

use to organize and offer a covered fund, the Agencies have declined to

add this limitation in the final rule. This type of limit is not

required by statute. Moreover, the Agencies believe that imposing a

strict dollar limit may not adequately permit banking entities to

employ trading or investment strategies that will attract unaffiliated

investors, thereby precluding banking entities from meeting the demands

of customers contrary to the purpose of section 13.

c. Limitations on Investments in a Single Covered Fund (``Per-Fund

Limitation'')

Section 13(d)(4)(B) imposes limits on the amount of ownership

interest a banking entity may have in any single covered fund at the

end of the one year period (subject to limited extension) after the

date of establishment of the fund (the ``seeding period''). In

recognition of the fact that a covered fund may have multiple classes

or types of ownership interests with different characteristics or

values, the proposal required that a banking entity apply the limits to

both the total value of and total amount of the banking entity's

ownership interest in a covered fund.

The proposed rule required a banking entity to calculate the per-

fund limitation using two methods. First, a banking entity was required

to calculate the value of its investments and capital contributions

made with respect to any ownership interest in a single covered fund as

a percentage of the value of all investments and capital contributions

made by all persons in that covered fund. Second, a banking entity was

required to determine the total number of ownership interests held by

the banking entity in a single covered fund as a percentage of the

total number of ownership interests held by all persons in that covered

fund.\2289\ Both calculations were required to be done without regard

to committed funds not yet called for investment. The proposed rule

also required the banking entity to calculate the value and amount of

its ownership interest in each covered fund 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.\2290\ These calculations were designed to ensure that the

banking entity's investment in a covered fund could not result in more

than three percent of the losses of the covered fund being allocated to

the banking entity's investment.\2291\

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\2289\ See proposed rule Sec. 75.12(b)(2).

\2290\ See proposed rule Sec. 75.12(b)(4).

\2291\ See Joint Proposal, 76 FR at 68904.

---------------------------------------------------------------------------

Commenters did not generally object to calculating the per-fund

limitation based on both number and value of ownership interests.

Several commenters urged the Agencies to allow a banking entity to

value its investment in a covered fund based on the acquisition cost of

the investment, instead of fair market value, notwithstanding the

manner in which the covered fund accounts for or values investments for

its shareholders generally.\2292\ One commenter suggested that the

Agencies allow a banking entity to choose between acquisition cost and

fair value so long as the chosen valuation method is applied

consistently to both the numerator and denominator when calculating the

per-fund limitation.\2293\

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\2292\ See ABA (Keating); BoA; Arnold & Porter; BOK; Scale; SVB.

\2293\ See ABA (Keating) (alleging that this is similar to the

SEC's approach to the definition of venture capital fund for the

purposes of being exempt from investment advisor registration).

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To the extent that an issuer of an asset-backed security is a

covered fund, the investment limitations contained in section 13(d)(4)

of the BHC Act also would limit the ability of a banking entity to

acquire or retain an investment in that issuer. Section 941 of the

Dodd-Frank Act added a new section 15G of the Exchange Act (15 U.S.C.

78o-11) which requires certain parties to a securitization transaction,

including banking entities, to retain and maintain a certain minimum

interest in certain issuers or asset-backed securities.\2294\ In order

to give effect to this separate requirement under the Dodd-Frank Act,

Sec. 75.14(a)(2) of the proposed rule permitted a banking entity that

is a ``securitizer'' or ``originator'' under that provisions of the Act

to acquire or retain an ownership interest in an issuer of asset-backed

securities, in an amount (or value of economic interest) required to

comply with the minimum requirements of section 15G of the Exchange Act

and any implementing regulations issued thereunder.\2295\ The proposal

also permitted a banking entity to act as sponsor to the

securitization.

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\2294\ 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). Those agencies recently issued a re-

proposal of the risk-retention requirements. See Credit Risk

Retention, 78 FR 57928 (Sept. 20, 2013).

\2295\ See proposed rule Sec. 75.14(a)(2)(iii).

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Commenters expressed a variety of views on the treatment of

interests in securitizations held under risk retention pursuant to the

proposed rule. Some commenters argued that the proposal was effective

as written and represented a reasonable way to reconcile the two

sections of the Dodd-Frank Act consistent with the risk-reducing

objective of section 13 of the BHC Act.\2296\ Other commenters also

supported the proposal's recognition that banking entities may be

required to hold a certain amount of risk in a securitization that

would also be a covered fund, but argued that the proposed exemption

was too narrow.\2297\ Some commenters argued that the exemption should

be broadened to permit a banking entity to hold in excess of the

minimum amount required under section 15G of the Exchange Act instead

of allowing only the minimum amount required by that section.\2298\ One

commenter requested that the final rule permit a banking entity to hold

an amount of risk in a securitization that is commensurate with what

investors demand rather than the minimum required by section 15G.\2299\

Some commenters argued that banking entities may be subject to similar

generally applicable requirements to hold risk in securitizations under

foreign law, such as Article 122a of the Capital Requirements Directive

issued by the European Union, and that the final rule should permit

banking entities to comply with these foreign legal requirements.\2300\

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\2296\ See Sens. Merkley & Levin (Feb. 2012); Alfred Brock.

\2297\ See, e.g., AFME et al.; SIFMA (Securitization) (Feb.

2012); JPMC; BoA.

\2298\ See AFME et al.; SIFMA (Securitization) (Feb. 2012);

JPMC; BoA.

\2299\ See BoA.

\2300\ See AFME et al.; Allen & Overy (on behalf of Foreign Bank

Group); SIFMA (Securitization) (Feb. 2012); BoA.

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Conversely, a few commenters objected to the proposed rule's

exemption for risk-retention as unclear and argued that if the

exemption was

[[Page 5998]]

retained, the Agencies should provide that any amounts held by a

banking entity in a securitization that exceed the minimum required to

satisfy section 15G of the Exchange Act should count towards the

aggregate funds limitation of the banking entity.\2301\ One commenter

argued that the final rule should impose higher capital charges for

interests held in these securitizations due to concerns that

securitizations involve heightened risks due to the complexity of their

ownership structure.\2302\

---------------------------------------------------------------------------

\2301\ See Occupy.

\2302\ See Sens. Merkley & Levin (Feb. 2012).

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The Agencies have carefully considered the comments received and

are adopting the calculation requirements for the per-fund limitation

as proposed with several modifications, including modifications

designed to address the unique characteristics and ownership structure

of securitizations. The final rule, like the proposal, requires that a

banking entity calculate its per-fund investment limit in covered funds

that are not issuing entities of asset-backed securities based on both

the value of its investments and capital contributions in and to each

covered fund and the total number of ownership interests it has in each

covered fund. A banking entity's investment (including investments by

its affiliates) may not exceed either three percent of the value of the

covered fund or three percent of the number of ownership interests in

the covered fund at the end of the seeding period. The Agencies

continue to believe that requiring the per-fund limitation to be

calculated based on these two measures best effectuates the terms and

purpose of the per-fund limitation in the statute. Together, these

measures ensure that a banking entity's exposure to and ownership of

each covered fund is limited. Each measure alone could provide a

distorted view of the banking entity's ownership interest and could be

more easily manipulated, for example by issuing ownership interests

with high value or special governance provisions. As discussed in more

detail below, the final rule contains a separate method for calculating

the value of investments in issuing entities of asset-backed securities

due to the fact that these entities do not have a single class of

security and thus, the valuation of the ownership interests cannot be

made on a per interest or single class basis.

The per-fund limitation on ownership interests must be measured

against the total ownership interests of the covered fund, as defined

in Sec. 75.10 of the final rule and as discussed above in Part

VI.B.1.e. In determining the amount of ownership interests held by the

banking entity and its affiliates, the banking entity must include an

ownership interest permitted under Sec. Sec. 75.4 and 75.11 of the

final rule.\2303\ Additionally, any banking entity that acts as

underwriter or market-maker for ownership interests of a covered fund

must do so in compliance with the limitations of Sec. Sec. 75.4(a) and

75.4(b) of the final rule, including the limits on the amount, types,

and risk of the underwriting position or market-maker inventory as well

as in compliance with the per-fund limitation, as applicable, and the

aggregate funds limitations and capital deduction in the final rule.

The Agencies expect to monitor these activities to ensure that a

banking entity does not engage in underwriting or market making-related

activity in a manner that is inconsistent with the limitations of the

statute and the final rule.\2304\

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\2303\ As discussed above in Part VI.B.2.c., the per-fund

limitation does not apply to ownership interests held by a banking

entity that acts as market maker or underwriter in accordance with

Sec. 75.11(c) of the final rule, so long as the banking entity does

not also organize and offer, or act as sponsor, investment adviser

or commodity trading advisor to, the fund, or, with respect to

ownership interests in issuing entities of asset-backed securities,

is not a securitizer who continues to own ownership interests or is

not an entity that holds ownership interests in compliance with

Section 15G of the Exchange Act and the implementing regulations

adopted thereunder; however, the banking entity that is acting as

market maker or underwriter that is not subject to the per-fund

limitation must still comply with the other requirements set forth

in Sec. Sec. 75.4(a) and 75.4(b), respectively, and any other

applicable requirements set out in Sec. 75.11(c).

\2304\ The Agencies note that if a banking entity acts as

investment adviser or commodity trading advisor to a covered fund

and shares the same name or variation of the same name with the

fund, then that banking entity would be a sponsor and therefore

subject to the limitations of section 13(f).

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The final rule requires that the value of the ownership interests

and contributions made by a banking entity in each covered fund (that

is not an issuing entity of an asset-backed security) be the fair

market value of the interest or contribution. The Agencies have

determined to use fair market value as the measurement of value for the

per-fund value limitation in order to ensure comparability with the

investments made in the covered fund by others and limit the potential

that the valuation measure can be manipulated (for example by altering

the percentage of gains and losses that are associated with a

particular ownership interest). A banking entity should determine fair

market value for purposes of the final rule, including the calculation

of both the per-fund and aggregate funds limitations, in a manner that

is consistent with its determination of the fair market value of its

assets for financial statement purposes and that fair market value

would be determined in a manner consistent with the valuations reported

by the relevant covered fund unless the banking entity determines

otherwise for purposes of its financial statements and documents the

reason for any disparity. If fair market value cannot be determined,

then the value shall be the historical cost basis of all investments

and capital contributions made by the banking entity to the covered

fund. The final rule also requires that, once a valuation method is

chosen, the banking entity calculate the value of its investments and

the investments of all others in the covered fund for purposes of the

per-fund limitation in the same manner and according to the same

standards.\2305\ This approach is intended to ensure that, for purposes

of calculating the per-fund limitation, a banking entity does not

calculate its investment in a covered fund in a manner more favorable

to the banking entity than the method used by the covered fund for

valuing the investments made by others. Under the final rule and as

explained in more detail below, any ownership interest acquired or

retained by an employee or director of the banking entity is attributed

to the banking entity for purposes of the per-fund limitation if the

banking entity financed the purchase of the ownership interest.

Additionally, any amount contributed or paid by a banking entity or its

employee to obtain an ownership interest in connection with obtaining

the restricted profit interest must be included in calculating

compliance with the per-fund and aggregate funds limitations (See Part

VI.B.1.e. above).\2306\

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\2305\ In the context of securitizations, the final rule

similarly provides that the valuation methodology used to calculate

the fair market value of the ownership interests must be the same

for both the ownership interests held by a banking entity and the

ownership interests held by all other investors in the covered fund

in the same manner and according to the same standards.

\2306\ See Part VI.B.1.e.

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In determining the per-fund limitation for purposes of Sec. 75.12

of the final rule, the banking entity should use the same methodology

for valuing its investments and capital contributions as the banking

entity uses to prepare its financial statements and regulatory

reports.\2307\ In particular, the fair market value of a

[[Page 5999]]

banking entity's investments and any capital contributions made to a

covered fund should be the same for purposes of Sec. 75.12 of the

final rule as reported on the banking entity's financial statements and

regulatory reports. Similarly, if fair market value of all investments

in and capital contributions cannot be determined for purposes of Sec.

75.12 of the final rule, then the banking entity should use the same

methodology to calculate the historical cost basis of the investments

and any capital contributions as the banking entity uses to prepare its

financial statements and regulatory reports. The Agencies will review

carefully the methodology that a banking entity uses to calculate the

value of its investments in and capital contributions made to covered

funds as part of the process to monitor compliance with the final rule.

---------------------------------------------------------------------------

\2307\ For example, a depository institution or bank holding

company should use the same methodology as used in the Report of

Condition and Income (Call Report) for depository institutions and

the Consolidated Financial Statements for Holding Companies (FR Y-

9C) for bank holding companies, respectively.

---------------------------------------------------------------------------

The Agencies expect that for the majority of covered funds, the

party that organizes and offers the fund or otherwise exercises control

over the fund will provide a standard methodology for valuing interests

in the fund. However, the Agencies understand that for some covered

funds, including issuing entities of asset backed securities, there may

be multiple parties that organize and offer the fund that each utilize

a different methodology or standard for calculating the value of

ownership interests of the fund. Going forward, the Agencies expect

that in these circumstances the parties that organize and offer the

covered fund will work together or select a responsible party to

determine a single standard by which all ownership interests in the

covered fund will be valued.

One commenter suggested the Agencies count both invested funds and

committed funds not yet called for investment towards the per-fund

limitation.\2308\ This commenter argued that a banking entity has

already contractually allocated committed-yet-uncalled funds to the

covered fund and that depositors face a risk of loss for such funds if

the covered fund fails.

---------------------------------------------------------------------------

\2308\ See Occupy.

---------------------------------------------------------------------------

The final rule, like the proposal, does not count committed-yet-

uncalled funds towards the per-fund limitation; instead, it counts

funds once they are invested. This approach reflects the fact that

these funds may never be called while at the same time ensuring that

the banking entity must comply with the per-fund limitation once the

funds are called. The Agencies note that a banking entity is prohibited

from guaranteeing or bailing out a covered fund that the banking entity

or one of its affiliates organizes and offers by the terms of the

statute and the final rule and, accordingly, would not be permitted to

provide committed funds to a covered fund in a manner inconsistent with

the limitations in the statute and final rule.

After carefully considering the comments received on the proposal,

as well as the language and purpose of section 13 of the BHC Act, the

final rule provides that, for purposes of applying the per-fund

limitation to an investment in a covered fund that is an issuing entity

of an asset-backed security, the ownership interest held by the banking

entity and its affiliates generally may not exceed three percent of the

fair market value of the ownership interests of the fund as measured in

accordance with Sec. 75.12(b)(3), unless a greater percentage is

retained by the banking entity and its affiliates in compliance with

the requirements of section 15G of the Exchange Act and the

implementing regulations issued thereunder, in which case the

investment by the banking entity and its affiliates in the covered fund

may not exceed the amount, number, or value of ownership interests of

the fund required under section 15G of the Exchange Act and the

implementing regulations issued thereunder. A banking entity may rely

on any of the options available to it in order to meet the requirements

of section 15G, but for purposes of section 13 of the BHC Act and this

rule, the amount held by the banking entity may not exceed the amount

required under the chosen option. Under the final rule, if a banking

entity's investment in a covered fund is held pursuant to the

requirements of section 15G of the Exchange Act, the banking entity

must calculate the amount and value of its ownership interest for

purposes of the per-fund limitation as of the date and according to the

same valuation methodology applicable pursuant to the requirements of

that section and the implementing regulations issued thereunder.

While the amount retained in compliance with section 15G of the

Exchange Act and the implementing regulations issued thereunder may

permit a banking entity to own more than three percent of the ownership

interests in a securitization that is a covered fund, this approach is

appropriate to reconcile the competing policies of section 13 of the

BHC Act and section 15G of the Exchange Act which requires that a

securitizer of certain securitizations retain a minimum of five percent

of the risk of the securitization. Congress enacted these two

apparently conflicting provisions in the same Act, and the Agencies

believe the more specific section regarding risk retention in

securitizations was intended to prevail over the more general

restriction on ownership of covered funds (which applies to a broader

range of entities). The Agencies believe that the risk limitation goals

of section 13 of the BHC Act are met by satisfying the minimum

requirement of an applicable option under section 15G of the Exchange

Act as the maximum initial investment limit, and applying the other

limitations discussed in this section governing aggregate investment in

covered funds and capital deductions.

As under the proposal, if a banking entity does not have a minimum

risk retention requirement, that banking entity would remain subject to

the limitations of section 13(d)(4) of the BHC Act and Sec. 75.12 on

the amount of ownership interests it may hold in an issuing entity of

asset-backed securities. A banking entity may not combine the amounts

under these provisions to acquire or retain ownership interests in a

securitization that exceed the aggregate permissible amounts.

Some commenters requested that the Agencies coordinate

implementation of any exemption for risk-retention requirements under

section 13 of the BHC Act with the issuance of rules implementing

section 15G of the Exchange Act. The Agencies note that rules

implementing section 15G have been proposed but not yet finalized, but

the Agencies will review the interaction between the rules promulgated

under section 13 of the BHC Act and section 15G of the Exchange Act

once the rules under section 15G are finalized. Regardless of any

action that may be taken regarding rules implementing section 15G, the

final rule permits banking entities to own ownership interests in and

sponsor covered funds as discussed above.

Some commenters also requested that the final rule provide an

exemption to permit banking entities to comply with any risk retention

requirement imposed under foreign law that is similar to section 15G of

the Exchange Act. The Agencies are not revising the rule to permit

banking entities to own ownership interests required to be retained

pursuant to risk retention-type requirements under foreign law. The

Agencies are providing the exemption for the required ownership arising

from the risk retention provisions under section 15G of the Exchange

Act in order to reconcile the requirements under the Dodd-Frank Act

applicable to ownership of securitization interests; however, the

Agencies do not believe at this time that such reconciliation is

appropriate with respect to foreign law

[[Page 6000]]

risk retention-type requirements and those requirements should not

prevail over the purpose of section 13 of the BHC Act to reduce banking

entities' exposure to risks from investments in covered funds.

The Agencies also note that the definition of covered fund has been

modified to exclude certain foreign public funds and also any foreign

fund that is not owned or sponsored by a U.S. banking entity. Moreover,

the final rule permits foreign banking entities to engage in covered

fund activities and investments that occur solely outside of the United

States without regard to the investment limitations of section 13(d)(4)

of the BHC Act and Sec. 75.12 of the final rule, which may include

retaining risk in a securitization to the extent required under foreign

law. In these manners, the final rule permits foreign banking entities

to comply with requirements under foreign law that govern their

securitization activities or investments abroad. However, as noted

above, section 13 of the BHC Act applies to the global operations of

U.S. banking entities and, as such, U.S. banking entities' investments

in foreign securitizations that are covered funds would remain subject

to the investment limitations of section 13(d)(4) and Sec. 75.12 of

the final rule.

The proposed rule provided that a banking entity must comply with

both measures of the per-fund limitation at all times. The preamble to

the proposal explained that the Agencies expected a banking entity to

calculate its per-fund limitation no less frequently than the frequency

with which the fund performs such calculation or issues or redeems

interests, and in no case less frequently than quarterly.\2309\

---------------------------------------------------------------------------

\2309\ See proposed rule Sec. 75.12(b); Joint Proposal, 76 FR

at 68904.

---------------------------------------------------------------------------

Several commenters requested that the Agencies modify the frequency

of this calculation and monitoring requirement to a standard quarterly

basis.\2310\ These commenters argued that, although some covered funds

may provide daily liquidation and redemption rights to investors,

monitoring the per-fund limitation on a continuous basis would be

costly and burdensome and would not provide a significant offsetting

benefit.

---------------------------------------------------------------------------

\2310\ See, e.g., ABA (Keating); Credit Suisse (Williams); JPMC.

---------------------------------------------------------------------------

The Agencies continue to believe that for covered funds other than

issuing entities of asset-backed securities the per-fund limitations

apply to investments in covered funds at all times following the end of

the seeding period. However, to relieve burden and costs, while also

setting a minimum recordkeeping standard, the final rule has been

modified to require that a banking entity calculate the amount and

value of its ownership interests in covered funds other than issuing

entities of asset-backed securities quarterly.\2311\ The Agencies

believe that this change will assist in reducing unnecessary costs and

burdens in connection with calculating the per-fund limitation,

particularly for smaller banking entities, and will also facilitate

consistency with the calculation for the aggregate funds limitation

(which is also determined on a quarterly basis). Nevertheless, should a

banking entity become aware that it has exceeded the per-fund

limitation for a given fund at any time, the Agencies expect the

banking entity to take steps to ensure that the banking entity complies

promptly with the per-fund limitation.\2312\

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\2311\ See final rule Sec. 75.12(b)(2)(i) and (ii). For covered

funds that are an issuing entity of asset-backed securities,

recalculation of the banking entity's permitted ownership for

purposes of the per-fund limitation is not required unless the

covered fund sells additional securities.

\2312\ See 12 U.S.C. 1851(d)(4)(B)(ii)(I).

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The Agencies have also modified the timing and methodology of the

per-fund limitation as it applies to securitizations to address the

unique circumstances and ownership structure presented by

securitizations, which typically wind down over time. Unlike many other

covered funds, securitizations do not generally experience increases in

the amount of investors or value of ownership interests during the life

of the securitization; rather, they generally experience only a

contraction of the investor base and reduction in the total outstanding

value of ownership interests on an aggregate basis, and may do so at

different rates under the terms of the transaction agreements, meaning

that the percentage of ownership represented by a particular ownership

interest may increase as the fund amortizes but without the banking

entity adding any funds. The manner in which securitizations are

organized and offered, as well as the amortization of securitizations,

differs from many other covered funds; section 15G of the Exchange Act

also requires that certain parties to securitization transactions,

which may include banking entities, retain a minimum amount of risk in

a securitization, a requirement not applicable to covered funds that

are not securitizations. Therefore, for purposes of calculating a

banking entity's per-fund limitation with respect to a securitization,

the calculation of the per-fund limitation shall be based on whether

section 15G applies and the implementing regulations are effective. In

the case of an ownership interest in an issuing entity of an asset-

backed security that is subject to section 15G of the Exchange Act and

for which effective implementing regulations have been issued, the

calculation of the per-fund limitation shall be made as of the date and

pursuant to the methodology applicable pursuant to the requirements of

section 15G of the Exchange Act and the implementing regulations

issued. For securitizations executed after the effective date of the

final rule and prior to the adoption and implementation of the rules

promulgated under section 15G of the Exchange Act and for

securitizations for which a fair valuation calculation is not required

by the implementing rules promulgated under section 15G of the Exchange

Act, the per fund limitation is calculated as of the date on which the

assets are initially transferred into the issuing entity of the asset-

backed securities or such earlier date on which the transferred assets

have been valued for purposes of transfer to the covered fund.\2313\

This calculation for issuers of asset backed securities is only

required to be performed once on the date noted above, and thereafter

only upon the date on which the price of additional securities of the

covered fund to be sold to third parties is determined.

---------------------------------------------------------------------------

\2313\ In addition, although some commenters requested that

banking entities be able to hold more than the minimum required by

section 15G, the Agencies are not revising the per fund limitation

in that manner. One of the purposes of section 13 of the BHC Act is

to reduce banking entities' exposure to risks from investments in

covered funds, and the Agencies believe at this time that permitting

banking entities to retain risk exposure to the covered fund in

excess of the minimum required to be retained would contradict the

purposes of section 13 of the BHC Act.

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As noted above, the per-fund limitations for ownership interests in

issuing entities of asset-backed securities are calculated based only

on the value of the ownership interest in relation to the value of all

ownership interests in the issuing entity of the asset-backed security

and are not calculated on a class by class, or tranche by tranche

basis. For purposes of the valuation, the aggregate value of all the

assets that are transferred to the issuing entity of the asset-backed

securities, and any assets otherwise held by the issuing entity, are

determined based on the valuation methodology used for determining the

value of the assets for financial statement purposes. This valuation

will be the value of the ownership interests in the issuing entity for

purposes of the calculation. A banking entity will need to determine

[[Page 6001]]

its percentage ownership in the issuing entity based on the its

contributions to the entity in relation to the contributions of all

parties and after taking into account the value of any residual

interest in the issuing entity. In addition, for purposes of the final

rule, the asset valuation is as of the date of establishment (the date

of the asset transfer to the issuing entity of the asset-backed

securities).

d. Limitation on Aggregate Permitted Investments in All Covered funds

(``Aggregate Funds Limitation'')

In addition to the per-fund limitation, section 13(d)(4) of the BHC

Act provides that the aggregate of a banking entity's investments in

all covered funds may not exceed three percent of the tier 1 capital of

the banking entity (referred to above as the ``aggregate funds

limitation'').\2314\ To implement this limitation, the proposed rule

required a banking entity to determine the aggregate value of the

banking entity's investments in covered funds by calculating the sum of

the value of each investment in a covered fund, as determined in

accordance with applicable accounting standards. This amount was then

measured as a percentage of the tier 1 capital of the banking entity

for purposes of determining compliance with the aggregate funds

limitation. For purposes of applying the limit, a banking entity that

is subject to regulatory capital requirements was required under the

proposed rule to measure tier 1 capital in accordance with those

regulatory capital requirements; a banking entity that is not a

subsidiary of a reporting banking entity and that is not itself

required to report capital in accordance with the risk-based capital

rules of a Federal banking agency was required by the proposed rule to

calculate its tier 1 capital based on the total amount of shareholders'

equity of the top-tier entity as of the last day of the most recent

calendar quarter, as determined under applicable accounting standards.

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\2314\ See 12 U.S.C. 1851(d)(4)(B)(ii)(II).

---------------------------------------------------------------------------

Commenters expressed a variety of views regarding the aggregate

funds limitation. One commenter argued that basing the aggregate funds

limitation on the size of tier 1 capital of a banking entity provides

an advantage to the largest institutions with large absolute capital

bases and disadvantages smaller banks that are well capitalized but

have a smaller absolute capital base.\2315\ This commenter urged the

Agencies to permit all banking entities to invest in covered funds in

an amount that is, in the aggregate, the greater of $1 billion (subject

to prudential investment limitations and safety and soundness

concerns), or three percent of tier 1 capital.\2316\

---------------------------------------------------------------------------

\2315\ See ABA (Abernathy).

\2316\ See, e.g., ABA (Abernathy).

---------------------------------------------------------------------------

In contrast, other commenters urged the Agencies to decrease the

statutory limit in order to prevent the largest banking entities from

investing amounts that, while within the statutory limit, could be very

large in absolute terms.\2317\ One commenter argued that a loss of

three percent of tier 1 capital would be a material loss reflected in a

change in stock price.\2318\ Another commenter suggested the Agencies

consider whether the investment supports a large flow of management

fees linked to market volatility or has significant embedded

leverage.\2319\

---------------------------------------------------------------------------

\2317\ See AFR et al. (Feb. 2012); Public Citizen.

\2318\ See Public Citizen.

\2319\ See AFR et al. (Feb. 2012).

---------------------------------------------------------------------------

Some commenters argued that the final rule should calculate the

value of covered fund investments based on acquisition cost instead of

fair market value.\2320\ These commenters argued that using fair value

to calculate the aggregate funds limitation penalizes banking entities

for organizing and investing in successful funds and, conversely, would

allow banking entities to increase investments in unsuccessful funds

(the value of which would decline relative to the capital of the

banking entity).

---------------------------------------------------------------------------

\2320\ See ABA(Keating); BoA; Arnold & Porter; BOK; Scale; SVB.

---------------------------------------------------------------------------

In contrast, another commenter argued that valuation of a covered

fund investment should include any mark-to-market increase in a banking

entity's aggregate investments in order to keep pace with increases in

the capital of the banking entity.\2321\

---------------------------------------------------------------------------

\2321\ See Occupy.

---------------------------------------------------------------------------

Some commenters discussing the frequency of the calculation of the

aggregate funds limitation supported determining the aggregate funds

limitation on the last day of each calendar quarter as required in the

proposal.\2322\ Other commenters argued that the statute requires

compliance at all times rather than periodic calculations of

compliance.\2323\

---------------------------------------------------------------------------

\2322\ See ABA (Keating).

\2323\ See AFR et al. (Feb. 2012); Occupy.

---------------------------------------------------------------------------

After consideration of the comments in light of the statutory

provisions, the Agencies have adopted the requirements for calculating

the aggregate funds limitation as proposed with several modifications

as explained below. Under the final rule, the aggregate value is the

sum of all amounts paid or contributed by the banking entity in

connection with acquiring or retaining an ownership interest in each

covered fund (together with any amounts paid by the entity (or employee

thereof) in connection with obtaining a restricted profit interest

under Sec. 75.10(d)(6)(ii)), as measured on a historical cost basis.

This aggregate value is measured against the total applicable tier 1

capital for the banking entity as explained below.

For purposes of determining the aggregate funds limitation, the

final rule requires that the value of investments made by a banking

entity be calculated on a historical cost basis. This approach limits

the aggregate amount of funds a banking entity may provide to covered

funds as a percentage of the banking entity's capital as required by

statute. At the same time, this approach does not permit a banking

entity to increase its exposure to covered funds in the event any

investment in a particular covered fund declines in value as a result

of the fund's investment activities. Permitting a banking entity to

increase its aggregate investments as covered funds lose value would

permit the banking entity both to increase its exposure to covered

funds at the same time the covered funds it already owns are losing

value and to effectively bail-out investors by providing additional

capital to troubled covered funds. Neither of these actions is

consistent with the purposes of section 13 of the BHC Act. Moreover and

as explained below, because the final rule requires that the banking

entity deduct from the entity's capital the greater of historical cost

(plus earnings) or fair market value of its investments in covered

funds, the deduction accounts for any profits resulting from

investments in covered funds.

Historical cost basis means, with respect to a banking entity's

ownership interest in a covered fund, the sum of all amounts paid or

contributed by the banking entity to a covered fund in connection with

acquiring or retaining an ownership interest (together with any amounts

paid by the entity (or employee thereof) in connection with obtaining a

restricted profit interest)), less any amounts received as a

redemption, sale or distribution of such ownership interest or

restricted profit interest. Under the final rule, any reduction of the

historical cost would not generally include gains or losses, fees,

income, expenses or similar items. However, as noted above, the final

rule also requires that a banking entity deduct any earnings from its

tier 1 capital even if it values its ownership interests in a covered

fund pursuant to historical cost.

The concern expressed by commenters that the aggregate funds

[[Page 6002]]

limitation should account for increases in the fair market value of

covered funds is addressed in other ways under the final rule. In

particular, the final rule requires that for purposes of calculating

compliance with regulatory capital requirements the banking entity

deduct from the entity's capital the greater of fair market value (or

historical cost plus earnings) of its investment in each covered fund;

thus, profits resulting from investments in covered funds will not

inflate the capital of the banking entity for regulatory compliance

purposes. Moreover, as explained above, the per-fund limitation is

generally based on fair market value, which maintains the relative

level of a banking entity's investment in each covered fund.

As noted above, the aggregate funds limitation applies to all

investments by a banking entity in a covered fund that the banking

entity or an affiliate thereof holds under Sec. Sec. 75.4 and 75.11 of

the final rule. The limitation would also apply to investments by a

banking entity made or held during the seeding period as part of

organizing and offering a covered fund, including ownership interests

held in order to satisfy the requirements of section 15G of the

Exchange Act, as well as ownership interests held by a banking entity

in the capacity of acting as underwriter or market-maker.

As under the proposal, this calculation must be made as of the last

day of each calendar quarter, consistent with when tier 1 capital is

reported by banking entities to the Agencies. Because compliance with

the aggregate funds limitations is calculated based on tier 1 capital,

the Agencies believe it is more appropriate to require the calculation

to be performed on the same schedule as tier 1 capital is reported.

While the aggregate funds limitation must be calculated on a quarterly

basis, the Agencies expect banking entities to monitor investments in

covered funds regularly and remain in compliance with the limitations

on covered fund investments throughout the quarter. The Agencies

intend, through their respective supervisory processes, to monitor

covered fund investment activity to ensure that a banking entity is not

attempting to evade the requirements of section 13.

The Agencies recognize that banks with large absolute capital bases

will be able to place a greater amount of capital in covered funds

compared to banks with small absolute capital bases. However, the

amount of risk exposure to a covered fund, despite their different

investment strategies, will be relatively similar across banking

entities, which is consistent with the language and risk-limiting

purpose of section 13.

e. Capital Treatment of an Investment in a Covered Fund

Section 13(d)(4)(B)(iii) of the BHC Act provides that, for purposes

of determining compliance with applicable capital standards under

section 13(d)(3) of that Act, the aggregate amount of outstanding

investments by a banking entity under section 13(d)(4), including

retained earnings, must be deducted from the assets and tangible equity

of the banking entity, and the amount of the deduction must increase

commensurate with the leverage of the covered fund.\2324\ Section

13(d)(3) authorizes the Agencies, by rule, to impose additional capital

requirements and quantitative limitations, including diversification

requirements on any of the activities permitted under section 13 of the

BHC Act if the Agencies determine that such additional capital and

quantitative limitations are appropriate to protect the safety and

soundness of banking entities engaged in such activities.\2325\

---------------------------------------------------------------------------

\2324\ See 12 U.S.C. 1851(d)(4)(B)(iii).

\2325\ Id. at 1851(d)(3).

---------------------------------------------------------------------------

The proposed rule implemented the capital deduction provided for

under section 13(d)(4)(B)(iii) of the BHC Act by requiring a banking

entity to deduct the aggregate fair value of its investments in covered

funds, including any attributed profits, from tier 1 capital. As in the

statute, the proposed rule applied the capital deduction to ownership

interests in covered funds held as an investment by a banking entity

pursuant to the provisions of section 13(d)(4) of the BHC Act, and not

to ownership interests acquired under other permitted authorities, such

as a risk-mitigating hedge under section 13 of the BHC Act. The

proposed rule required the deduction to be calculated consistent with

the method for calculating other deductions under the applicable risk-

based capital rules. The proposed rule did not otherwise adopt

additional capital requirements and quantitative limitations under

section 13(d)(3) of the BHC Act.

Some commenters supported the proposed dollar-for-dollar deduction

from tier 1 capital of a banking entity's aggregate investments in

covered funds and asserted it is consistent with the statute.\2326\ One

of these commenters urged the Agencies to rely on their authority under

section 13(d)(3) of the BHC Act to apply the capital deduction to other

permitted ownership interests in covered funds to protect the safety

and soundness of the banking entity.\2327\ In contrast, other

commenters urged the Agencies to eliminate the capital deduction for

investments in covered funds and questioned the Agencies' statutory

authority to impose the capital deduction.\2328\ These commenters

argued that the statute does not authorize or require the Agencies to

require banking entities to deduct their investments in covered funds

for purposes of calculating capital pursuant to the applicable capital

rules. According to these commenters, section 13 only requires

deductions for purposes of determining compliance with applicable

capital standards under section 13 and argued the Agencies did not make

the necessary safety and soundness findings under section 13(d)(3) to

impose additional capital requirements on any activities permitted

under section 13(d)(1).\2329\ One commenter urged the Agencies to make

any capital adjustment as part of the banking agencies' broader efforts

to implement the Basel III capital framework.\2330\ Another commenter

urged the Agencies to apply the capital deduction only for purposes of

determining a banking entity's compliance with the aggregate funds

limitation and not for other regulatory capital purposes.\2331\ This

commenter also argued that a capital deduction is normally not required

for assets reflected on a bank's consolidated balance sheet, and that

the Agencies should not require a deduction for a covered fund

investment that is not consolidated with the banking entity for

financial reporting purposes under GAAP.\2332\ Some commenters urged

the Agencies to apply the capital deduction only to a banking entity's

investment in a covered fund that the banking entity organizes and

offers and not to ownership interests otherwise permitted to be held

under section 13 of the BHC Act.\2333\

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\2326\ See Occupy.

\2327\ See Occupy.

\2328\ See ABA (Keating); BNY Mellon et al.; PNC; SIFMA et al.

(Covered Funds) (Feb. 2012); SVB.

\2329\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012).

\2330\ Id.

\2331\ See ABA (Keating).

\2332\ See ABA (Keating); see also letter from PNC.

\2333\ See Arnold & Porter; SVB.

---------------------------------------------------------------------------

Several commenters addressed the manner for valuing an investment

subject to the deduction. One commenter urged the Agencies to permit a

banking entity to calculate the deduction based on the acquisition

cost, instead of the fair market value, of the banking entity's

ownership interest in

[[Page 6003]]

the covered fund.\2334\ This commenter emphasized that valuing the

investment at fair market value would penalize a banking entity if the

covered fund performs well by reducing the amount of capital available

for additional covered fund investments but reduce the capital charge

against troubled investments. One commenter argued that the Agencies

did not perform an appropriate cost-benefit analysis of the deduction

in the proposed rules.\2335\

---------------------------------------------------------------------------

\2334\ See SIFMA et al. (Covered Funds) (Feb. 2012).

\2335\ Id.

---------------------------------------------------------------------------

Other commenters sought clarification on how the capital deduction

would apply to a foreign banking organization. Several commenters

argued that the capital deduction should not apply to a foreign banking

entity that calculates its tier 1 capital under the standards of its

home country.\2336\ These commenters argued that imposing a capital

deduction requirement on foreign banks would not be consistent with

past practices on the application of U.S. risk-based capital

requirements to foreign banking organizations.

---------------------------------------------------------------------------

\2336\ See IIB/EBF.

---------------------------------------------------------------------------

The Agencies have carefully considered the comments in light of the

statutory provisions requiring a capital deduction. The statute

requires that the aggregate amount of outstanding investments by a

banking entity, including retained earnings, be deducted from the

assets and tangible equity of the banking entity.\2337\ This

requirement is independent of the minimum regulatory capital

requirements in the final capital rule published by the Federal Banking

agencies in 2013 (``regulatory capital rule'').\2338\

---------------------------------------------------------------------------

\2337\ See 12 U.S.C. 1851(d)(4)(B)(iii).

\2338\ See 78 FR 62018, 62072 (Oct. 11, 2013) (Board/OCC/FDIC

Basel III Final Rule); 78 FR 55340, 55391 (Sept. 10, 2013) (FDIC

Basel III interim final rule).

---------------------------------------------------------------------------

The Federal Banking agencies recognize that the regulatory capital

rule imposes risk weights and deductions that do not correspond to the

deduction for covered fund investments imposed by section 13 of the BHC

Act. The Federal Banking agencies intend to review the interaction

between the requirements of this rule and the requirements of the

regulatory capital rule and expect to propose steps to reconcile the

two rules.

At the same time, the Agencies believe that the dollar-for-dollar

deduction of the fair market value of a banking entity's investment in

a covered fund is appropriate to protect the safety and soundness of

the banking entity, as provided in section 13(d) of the BHC Act. This

approach ensures that a banking entity can withstand the failure of a

covered fund without causing the banking entity to breach the minimum

regulatory capital requirements. Consistent with the language and

purpose of section 13 of the BHC Act, this deduction will help provide

that a banking entity has sufficient capital to absorb losses that may

occur from covered fund investments without endangering the safety and

soundness of the banking entity or the financial stability of the

United States.

Accordingly, under the final rule, a banking entity must, for

purposes of determining compliance with applicable regulatory capital

requirements, deduct the greater of (i) the sum of all amounts paid or

contributed by the banking entity in connection with acquiring or

retaining an ownership interest (together with any amounts paid by the

entity (or employee thereof) in connection with obtaining a restricted

profit interest under Sec. 75.10(b)(6)(ii)), on a historical cost

basis, including earnings or (ii) the fair market value of the sum of

all amounts paid or contributed by the banking entity in connection

with acquiring or retaining an ownership interest (together with any

amounts paid by the entity (or employee thereof) in connection with

obtaining a restricted profit interest under Sec. 75.10(b)(6)(ii)), if

the banking entity accounts for the profits (or losses) of the fund

investment in its financial statements.\2339\ This deduction must be

made whenever the banking entity calculates its tier 1 capital, either

quarterly or at such other time at which the appropriate Federal

banking agency may request such a calculation. Requiring a banking

entity to deduct the greater of historical cost or fair market value of

all covered fund investments made by a banking entity from the entity's

tier 1 capital should result in an appropriate deduction that is

consistent with the manner in which the banking entity accounts for its

covered fund investments. For instance, if a banking entity accounts

for its investments in covered funds using fair market value, then any

changes in the fair market value of the banking entity's investment in

a covered fund should similarly be reflected in the banking entity's

tier 1 capital. Thus, this deduction should not unduly penalize banking

entities for making successful investments or allow more investments in

troubled covered funds.

---------------------------------------------------------------------------

\2339\ See 12 CFR part 208, subpart D and appendixes A, B, E,

and F; 12 CFR part 217 (to be codified), and 12 CFR part 225,

appendixes A, D, E, and G; see also 12 CFR 240.15c3-1 (net capital

requirements for brokers or dealers).

---------------------------------------------------------------------------

The final rule does not require a foreign banking entity that makes

a covered fund investment in the United States, either directly or

through a branch or agency, to deduct the aggregate value of the

investment from the foreign bank's tier 1 capital calculated under

applicable home country standards. However, any U.S. subsidiary of a

foreign banking entity that is required to calculate tier 1 capital

under U.S. risk based capital regulations must deduct the aggregate

value of investment held through that subsidiary from its tier 1

capital.

While some commenters requested that additional capital charges be

imposed on banking entity's interests in securitizations, the Agencies

have declined to do so at this time. Under the final rule, the banking

entity must deduct the value of its investment in a securitization that

is a covered fund from its tier 1 capital for purposes of determining

compliance with the applicable regulatory capital requirements. This

requirement already requires the banking entity to adjust its capital

for the possibility of losses on the full amount of its investment. The

Agencies do not believe that it is appropriate to impose additional

capital charges on these securitizations because it would act as a

disincentive to retain risk in securitizations for which the banking

entity acts as issuer or sponsor, a result that would contradict the

purpose of section 15G of the Exchange Act. Additionally and as noted

in the proposal, permitting a banking entity to retain the minimum

level of economic interest and risk in a securitization 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.

The Agencies have also declined to impose additional quantitative

limitations or diversification requirements on covered fund investments

at this time. The Agencies believe that the per-fund and aggregate

funds limitations, as well as the capital deduction required by the

rule, acting together with the other limitations on covered fund

activities, establish an appropriate framework for ensuring that the

covered fund investments and activities of banking entities are

conducted in a manner that is safe and sound and consistent with

financial stability. The Agencies will continue to monitor these

activities and investments

[[Page 6004]]

to determine whether other limitations are appropriate over time.

f. Attribution of Ownership Interests to a Banking Entity

The proposed rule attributed an ownership interest to a banking

entity based on whether or not the banking entity held the interest

through a controlled entity. The proposed rule required that any

ownership interest held by any entity that is controlled, directly or

indirectly, by a banking entity be included in the amount and value of

the banking entity's permitted investments in a single covered fund.

The proposed rule required that the pro rata share of any ownership

interest held by any covered fund that is not controlled 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, be included

in the amount and value of the banking entity's permitted investments

in a single covered fund.

Many commenters expressed concerns regarding the proposed

attribution requirements.\2340\ These commenters argued that the

proposed pro rata attribution requirements are not required or

permitted by the statute, have unintended and inconsistent consequences

for covered fund investments, impose heavy compliance costs on banking

entities, and would impede the ability of funds sponsored by banking

entities to invest in third-party funds for the benefit of clients.

Some commenters argued that the costs and complexity of determining

whether a banking entity ``controls'' another banking entity under the

BHC Act and the Board's precedent are high and urged the Agencies to

adopt a simpler test.\2341\ For example, some commenters urged that

shares of a company be attributed to a banking entity only when the

banking entity maintains ownership of 25 percent or more of voting

shares of the company.\2342\

---------------------------------------------------------------------------

\2340\ See ABA (Keating); Arnold & Porter; SIFMA et al. (Covered

Funds) (Feb. 2012); SSgA (Feb. 2012).

\2341\ See SIFMA et al. (Covered Funds) (Feb. 2012); BlackRock;

Arnold & Porter.

\2342\ See ABA (Keating); Arnold & Porter.

---------------------------------------------------------------------------

Several commenters maintained that applying the attribution

requirements to fund-of-funds structures and parallel or master-feeder

structures would be unworkable.\2343\ Commenters contended that the

proposed attribution rules could result in a banking entity calculating

the per-fund limitation in a way that exceeds the banking entity's

actual loss exposure if the attribution rule for controlled investments

is interpreted to require that 100 percent of all investments made by

controlled entities be attributed to the banking entity.\2344\

---------------------------------------------------------------------------

\2343\ See BoA; SIFMA et al. (Covered Funds) (Feb. 2012); SSgA

(Feb. 2012). These commenters argued that banking entities

traditionally utilize a fund-of-funds structure to offer customers

the opportunity to invest indirectly in a portfolio of other funds

(including some funds sponsored and managed by one or more third

parties) and that these structures provide customers with certain

risk-mitigating benefits and allow customers to gain exposure to a

diverse portfolio without having to satisfy the minimum investment

requirements of each fund directly. They also argued that parallel

and feeder entities are established for a variety of client-driven

reasons, including to accommodate tax needs of clients and that

these entities should be viewed as a single investment program in

which the master fund holds and manages investments in portfolio

assets and the feeder fund typically makes no investments other than

in the master fund.

\2344\ See SIFMA et al. (Covered Funds) (Feb. 2012); BoA; Arnold

& Porter; SSgA (Feb. 2012).

---------------------------------------------------------------------------

In addition, several commenters argued that the pro rata

attribution of investments held through non-controlled structures is

not consistent with the Board's rules and practices for purposes of the

activity and investment limits in other sections of the BHC Act.

Commenters also maintained that this pro rata attribution for non-

controlled entities would be impracticable because a banking entity has

only a limited ability to monitor, direct, or restrain investments of a

covered fund that it does not control.\2345\

---------------------------------------------------------------------------

\2345\ See SIFMA et al. (Covered Funds) (Feb. 2012).

---------------------------------------------------------------------------

Conversely, one commenter supported the pro rata attribution

requirement in the proposal. This commenter argued that this

requirement reduced opportunities for evasion through subsidiaries,

affiliates or related entities.\2346\

---------------------------------------------------------------------------

\2346\ See Occupy.

---------------------------------------------------------------------------

The final rule has been modified in light of the comments. Under

the final rule, a banking entity must account for an investment in a

covered fund for purposes of the per-fund and aggregate funds

limitations only if the investment is made by the banking entity or

another entity controlled by the banking entity. Accordingly, the final

rule does not generally require that a banking entity include the pro

rata share of any ownership interest held by any entity that is not

controlled by the banking entity, and thus reduces the potential

compliance costs of the final rule. The Agencies believe that this

concept of attribution is more consistent with how the Board has

historically applied the concept of ``control'' under the BHC Act for

purposes of determining whether a company subject to that Act is

engaged in an activity or whether to attribute an investment to that

company. Furthermore, because a banking entity does not control a non-

affiliate and typically has less access to information about the

holdings of a non-affiliate, this change is unlikely to present

opportunity for circumvention of the per-fund and aggregate funds

limitations. The Agencies will monitor these limitations for practices

that appear to be attempts to circumvent them.\2347\

---------------------------------------------------------------------------

\2347\ The Agencies note that other provisions of the BHC Act

and Savings and Loan Holding Company Act would prohibit a banking

entity that is a bank holding company or savings and loan holding

company from acquiring 5 percent or more of a covered fund that is

itself a bank holding company or a savings and loan holding company,

respectively, without regulatory approval. See 12 U.S.C. 1842(a); 12

U.S.C. 1467a(e).

---------------------------------------------------------------------------

Whether a banking entity controls another entity under the BHC Act

may vary depending on the type of entity in question. As noted above in

Part VI.B.1.b.3., the Board's regulations and orders have long

recognized that the concept of control is different for funds than for

operating companies.\2348\ In contrast to the proposal, the final rule

incorporates these different concepts of control in part by providing

that, for purposes of section 13 of the BHC Act and the final rule, a

registered investment company, SEC-regulated business development

company, and a foreign public fund as described in Sec. 75.10(c)(1) of

the final rule will not be considered to be an affiliate of the banking

entity if the banking entity owns, controls, or holds with the power to

vote less than 25 percent of the voting shares of the company or fund,

and provides investment advisory, commodity trading advisory,

administrative, and other services to the company or fund only in a

manner that complies with other limitations under applicable

regulation, order, or other authority.\2349\

---------------------------------------------------------------------------

\2348\ See, e.g., First Union Letter.

\2349\ Id. See final rule Sec. 75.12(b)(1)(ii).

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In response to commenter concerns regarding the workability of the

proposed rule, the final rule has been modified to address how

ownership interests would be attributed to a banking entity when those

interests are held in a fund-of-funds or multi-tiered fund structures.

For instance, banking entities may use a variety of structures to

satisfy operational needs or meet the investment needs of customers of

their trust, fiduciary, investment advisory or commodity trading

advisory services.

First, except as explained for purposes of calculating a banking

entity's permitted investment in multi-tier fund structures, the final

rule does not generally attribute to a banking entity ownership

interests held by a covered fund so long as the banking

[[Page 6005]]

entity's investment in the covered fund meets the per-fund limitation

in the final rule.\2350\ Absent unusual circumstances or structures, a

banking entity would not control a covered fund in which the banking

entity has an ownership interest that conforms to the per-fund and

aggregate funds limitations contained in the final rule. Thus, the

interests held by that covered fund would not be attributed to the

banking entity for the reasons discussed above.

---------------------------------------------------------------------------

\2350\ See final rule Sec. 75.12(b)(1)(iii).

---------------------------------------------------------------------------

The final rule also explains how the investment limitations apply

to investments of a banking entity in multi-tier fund structures. The

Agencies believe that master-feeder fund structures typically

constitute a single investment program in which the master fund holds

and manages investments and the feeder funds typically make no

investments other than in the master fund and exist as a convenience

for customers of the trust, fiduciary, investment advisory, or

commodity trading advisory services of the banking entity. Similarly,

trust, fiduciary, or advisory customers of a banking entity may desire

to obtain diversified exposure to a variety of funds or investments

through investing in a fund-of-funds structure that the banking entity

organizes and offers.

In order to meet the demands of these customers, the final rule

provides that if the principal investment strategy of a covered fund

(the ``feeder fund'') is to invest substantially all of its assets in

another single covered fund (the ``master fund''), then for purposes of

the per-fund limitation the banking entity's permitted investment shall

be measured only at the master fund. However, in order to appropriately

capture the banking entity's amount of investment in the master fund, a

banking entity must include in this calculation any investment held by

the banking entity in the master fund, as well as the banking entity's

pro-rata share of any ownership interest of the master fund that is

held through the feeder fund.\2351\

---------------------------------------------------------------------------

\2351\ See final rule Sec. 75.12(b)(34).

---------------------------------------------------------------------------

Similarly, regarding fund-of-funds structures, the final rule

provides that if a banking entity organizes and offers a covered fund

pursuant to Sec. 75.11 for the purpose of investing in other covered

funds (a ``fund of funds'') and that fund of funds itself invests in

another covered fund that the banking entity organizes and offers, then

the banking entity's permitted investment in that other covered fund

shall include any investment held by the banking entity in that other

fund, as well as the banking entity's pro-rata share of any ownership

interest of the other fund that is held through the fund of funds. The

banking entity's investment in the fund of funds must also meet the

investment limitations contained in Sec. 75.12. In these manners, the

final rule permit a banking entity to meet the demands of customers of

their trust, fiduciary, or advisory services while also limiting the

ability of a banking entity to be exposed to more than the amount of

risk of a covered fund contemplated by section 13.

As described above in the discussion of organizing and offering a

covered fund, other provisions of section 13 contemplate investments by

employees and directors of the banking entity that provide qualifying

services to a covered fund.\2352\ The Agencies recognized in the

proposal that employee and director 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 in a covered fund.\2353\ In order to address this concern,

the proposal attributed an ownership interest in a covered fund

acquired or retained by a director or employee to the person's

employing banking entity if the banking entity either extends credit

for the purposes of allowing the director or employee to acquire the

ownership interest, guaranteed the director or employee's purchase, or

guarantees the director or employee against loss on the investment.

---------------------------------------------------------------------------

\2352\ See 12 U.S.C. 1851(d)(1)(G)(vii); final rule Sec.

75.11(g).

\2353\ See Joint Proposal, 76 FR at 68902.

---------------------------------------------------------------------------

One commenter supported the way the proposal addressed evasion

concerns by attributing an ownership interest in a covered fund

acquired or retained by a director or employee to a banking

entity.\2354\ A different commenter urged the Agencies to attribute any

employee investments in a covered fund to the banking entity itself,

regardless of the source of funds.\2355\ Another commenter argued that

the statute prohibits a banking entity from guaranteeing an investment

by an employee or director.\2356\

---------------------------------------------------------------------------

\2354\ See Ass'n. of Institutional Investors (Feb. 2012).

\2355\ See Occupy.

\2356\ See Arnold & Porter.

---------------------------------------------------------------------------

After considering the comments and the language of the statute, the

Agencies have determined to retain the requirement that all director or

employee investments in a covered fund be attributed to the banking

entity for purposes of the per-fund limitation and the aggregate funds

limitation whenever the banking entity provides the employee or

director funding for the purpose of acquiring the ownership interest.

Specifically, under the final rule, an investment by a director or

employee of a banking entity who acquires an ownership interest in his

or her personal capacity in a covered fund sponsored by the banking

entity will be attributed to the banking entity if the banking entity,

directly or indirectly, extends financing for the purpose of enabling

the director or employee to acquire the ownership interest in the fund

and the financing is used to acquire such ownership interest in the

covered fund.\2357\ It is also important to note that the statute

prohibits a banking entity from guaranteeing the obligations or

performance of a covered fund in which it acts as investment adviser,

investment manager or sponsor, or organizes and offers.\2358\

---------------------------------------------------------------------------

\2357\ See final rule Sec. 75.12(b)(1)(iv).

\2358\ See 12 U.S.C. 1851(f)(1).

---------------------------------------------------------------------------

As discussed above in the definition of ownership interest, the

final rule also attributes to the banking entity any amounts

contributed by an employee or director when made in order to receive a

restricted profit interest, whether or not funded or guaranteed by the

banking entity. This approach ensures that all funding provided by the

banking entity--whether directly or through its employees or

directors--and all exposures of the banking entity--whether directly or

through a guarantee provided to or on behalf of an employee or

director--is counted against the limits on exposure contained in the

statute and final rule. At the same time, this approach recognizes that

employees and directors may use their own resources, not protected by

the banking entity, to invest in a covered fund. Employees of

investment advisers in particular often invest their own resources in

covered funds they advise, both by choice and as a method to align

their personal financial interests with those of other investors in the

covered fund. So long as these investments are truly with personal

resources, and are not funded by the banking entity, these personal

investments would not expose the banking entity to loss and would not

be attributed by the final rule to the banking entity. This approach is

also consistent with the terms of the statute, which expressly

contemplates investments by directors or employees of a banking entity

in their individual capacity.\2359\

---------------------------------------------------------------------------

\2359\ See 12 U.S.C. 1851(d)(1)(G)(vii).

---------------------------------------------------------------------------

The Agencies intend to monitor investments by directors and

employees of a banking entity to ensure that employee ownership

interests are not

[[Page 6006]]

used to circumvent the per-fund and aggregate funds limitations in

section 13. Among the factors the Agencies will consider, in addition

to financing and guarantee arrangements, are whether the benefits of

the acquisition and retention, such as dividends, inure to the benefit

of the director or employee and not the banking entity; the voting or

control of the ownership interests is subject to the direction of, or

otherwise controlled by, the banking entity; and the employee or

director, rather than the banking entity, determines whether the

employee or director should make the investment.

The proposed rule contained a provision intended to curb potential

evasion of the per-fund limitation and aggregate limitation through

parallel investments by banking entities that were not otherwise

subject to section 13 of the BHC Act. Specifically, the proposed rule

provided that, to the extent that a banking entity is contractually

obligated to 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 must be included

in the calculation of a banking entity's per-fund limitation.

Several commenters objected to this requirement and argued that it

was not consistent with the statute. These commenters argued that

section 13 of the BHC Act restricts a banking entity's investments in

covered funds, and not direct investments by a banking entity in

individual companies under other authorities, such as the merchant

banking investment authority in section 4(k)(4)(H) of the BHC

Act.\2360\ Some commenters argued that prohibiting or limiting direct

investments could cause a conflict between a banking entity's fiduciary

duty to its clients to manage their covered fund investments and the

banking entity's duty to its shareholders to pursue legitimate merchant

banking investments.\2361\ Some commenters urged the Agencies not to

attribute any parallel co-investment alongside a covered fund to a

banking entity unless there is a pattern of evasion, and some requested

that there be prior notice and an opportunity for a hearing to

determine whether such a pattern has occurred.\2362\ Another commenter

recommended the Agencies provide a safe harbor for situations where a

bank trustee is acting on behalf of customers.\2363\

---------------------------------------------------------------------------

\2360\ See 12 U.S.C. 1843(k)(4)(H); 12 CFR 225.170 et seq. See

ABA (Keating); BoA; BOK; SIFMA et al. (Covered Funds) (Feb. 2012);

SVB.

\2361\ See ABA (Keating).

\2362\ See BOK; SVB; ABA (Keating); BoA; SIFMA et al. (Covered

Funds) (Feb. 2012).

\2363\ See BOK.

---------------------------------------------------------------------------

In contrast, other commenters contended that the risks of direct

investments, such as those made under merchant banking authority, are

similar to those of many investments in covered funds. These commenters

urged the Agencies to restrict direct investments in the underlying

holdings or assets of a covered fund in the same manner as direct

investments in covered funds.\2364\

---------------------------------------------------------------------------

\2364\ See Public Citizen; Sens. Merkley & Levin (Feb. 2012).

---------------------------------------------------------------------------

After carefully considering the comments and the language of the

statute, the Agencies have determined not to adopt the proposed

prohibition on parallel investments in the final rule. As illustrated

by commenters, banking entities rely on a number of investment

authorities and structures to meet the needs of their clients and make

investments under a variety of authorities that are not coordinated

with investments made by covered funds owned or advised by the banking

entity. The Agencies believe that many investments made by banking

entities are made for the purpose of serving the legitimate needs of

customers and shareholders, and not for the purpose of circumventing

the per-fund and aggregate funds limitations in section 13.

Nevertheless, the Agencies continue to believe that the potential

for evasion of these limitations may be present where a banking entity

coordinates its direct investment decisions with the investments of

covered funds that it owns or sponsors. For instance, the Agencies

understand that it is relatively common for the sponsor of a covered

fund in connection with a privately negotiated investment to offer

investors co-investment opportunities when the general partner or

investment manager for the covered fund determines that the covered

fund does not have sufficient capital available to make the entire

investment in the target portfolio company or determines that it would

not be suitable for the covered fund to take the entire available

investment. In such circumstances, a banking entity that sponsors the

covered fund should not itself make any additional side by side co-

investment with the covered fund in a privately negotiated investment

unless the value of such co-investment is less than 3% of the value of

the total amount co-invested by other investors in such investment.

Further, if the co-investment is made through a co-investment vehicle

that is itself a covered fund (a ``co-investment fund''), the sum of

the banking entity's ownership interests in the co-investment fund and

the related covered fund should not exceed 3% of the sum of the

ownership interests held by all investors in the co-investment fund and

related covered fund. Finally, the Agencies note that if a banking

entity makes investments side by side in substantially the same

positions as the covered fund, then the value of such investments shall

be included for purposes of determining the value of the banking

entity's investment in the covered fund.

g. Calculation of Tier 1 Capital

The proposal explained that tier 1 capital is a banking law concept

that, in the United States, is 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 clarified that for purposes of the

aggregate funds limitation in Sec. 75.12, 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'') needed to use 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.

The proposal also recognizes that 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. 75.12(c) of the proposed rule, the proposed rule clarified how

the aggregate funds limitation should 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 was 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

[[Page 6007]]

standards.\2365\ For a banking entity that was not itself required to

report tier 1 capital but was a subsidiary of a reporting banking

entity that is a depository institution (e.g., a subsidiary of a

national bank), the aggregate funds limitation was the amount of tier 1

capital reported by such depository institution.\2366\ For a banking

entity that was not itself required to report tier 1 capital but was 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 was the amount of tier 1 capital reported by

the top-tier affiliate of such banking entity that holds and reports

tier 1 capital under the proposal.\2367\

---------------------------------------------------------------------------

\2365\ See proposed rule Sec. 75.12(c)(2)(ii)(B)(2).

\2366\ See proposed rule Sec. 75.12(c)(2)(ii)(A).

\2367\ See proposed rule Sec. 75.12(c)(1)(B(2)(ii)(B)(1).

---------------------------------------------------------------------------

Commenters did not generally object to the proposed approach for

determining the applicable tier 1 capital for banking entities. One

commenter advocated calculating the aggregate funds limitation based on

the tier 1 capital of the banking entity making the covered fund

investment instead of the tier 1 capital of the consolidated banking

entity.\2368\ In addition, the commenter urged the Agencies to require

banking entities to divest any portions of the investment that exceeds

3 percent of that entity's tier 1 capital.

---------------------------------------------------------------------------

\2368\ See Occupy.

---------------------------------------------------------------------------

The final rule provides that any banking entity that is required to

calculate and report tier 1 capital (a ``reporting banking entity'')

must calculate the aggregate funds limitation using the tier 1 capital

amount reported by the entity as of the last day of the most recent

calendar quarter as reported to the relevant Federal banking agency. A

non-depository institution subsidiary of a reporting banking entity may

rely on the consolidated tier 1 capital of the reporting banking entity

for purposes of calculating compliance with the aggregate funds

limitation. In the case of a depository institution that is itself a

reporting banking entity and that is also a subsidiary or affiliate of

a reporting banking entity, the aggregate of all investments in covered

funds held by the depository institution (including the investments by

its subsidiaries) may not exceed three percent of either the tier 1

capital of the depository institution or of the top-tier reporting

banking entity that controls such depository institution. The final

rule also provides that any 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) may compute compliance with the aggregate funds

limitations using the amount of tier 1 capital reported by such

depository institution.

Several commenters argued that foreign banking organizations should

be permitted to use the consolidated tier 1 capital at the top-tier

foreign banking organization level, as calculated under applicable home

country capital standards, to calculate compliance with the aggregate

funds limitation.\2369\ One commenter noted that the tier 1 capital of

a banking entity may fluctuate based on specific conditions relevant

only to the banking entity, and urged the Agencies to consider an

alternative measure of capital, although this commenter did not suggest

any alternative.\2370\

---------------------------------------------------------------------------

\2369\ See Credit Suisse (Williams); IIB/EBF.

\2370\ See Japanese Bankers Ass'n.

---------------------------------------------------------------------------

After considering the comments received and that purpose and

language of section 13 of the BHC Act, the Agencies have determined

that for foreign banking organizations, the aggregate funds limitation

would be based on the consolidated tier 1 capital of the foreign

banking organization, as calculated under applicable home country

standards. However, a U.S. bank holding company or U.S. savings and

loan holding company that is controlled by a foreign banking entity

must separately meet the per-fund and aggregate funds limitations for

each and all (respectively) covered fund investments made by the U.S.

holding company, based on the tier 1 capital of the U.S. bank holding

company or U.S. savings and loan holding company. The Federal banking

agencies may revisit this approach in light of the manner in which the

Board implements the enhanced prudential standards and early

remediation requirements for foreign banking organizations and foreign

nonbank financial companies, including the proposed U.S. intermediate

holding company requirements under that rule.\2371\

---------------------------------------------------------------------------

\2371\ See Enhanced Prudential Standards and Early Remediation

Requirements for Foreign Banking Organizations and Foreign Nonbank

Financial Companies, 77 FR 76628, 76637 (Dec. 28, 2012).

---------------------------------------------------------------------------

h. Extension of Time To Divest Ownership Interest in a Single Fund

The proposed rule provided that the Board may, upon application by

a banking entity, extend the period of time that a banking entity may

have to conform an investment to the 3 percent per-fund limitation. As

in the statute, the proposed rule permitted the Board to grant up to an

additional two years if the Board finds that an extension would be

consistent with safety and soundness and not detrimental to the public

interest. The proposal required a banking entity to submit an

application for extension to the Board, and set forth the factors that

the Board would consider in reviewing an application for extension,

including a requirement that the Board consult with the primary Federal

supervisory agency for the banking entity prior to acting on an

application.

Some commenters argued that the final rule should be modified to

extend automatically the one-year statutory period for complying with

the per-fund limitation by an additional two years without application

or approval on a case-by-case basis and to apply the extended

conformance period to the aggregate funds limitations.\2372\ Some of

these commenters suggested that Congress explicitly recognized the need

for a banking entity to have a sufficient seeding period following

establishment of a fund, and that funds often require more than one

year to attract enough unaffiliated investors to enable the sponsoring

banking entity to reduce its ownership interests in the fund to the

level required by section 13(d)(4).

---------------------------------------------------------------------------

\2372\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012); SSgA

(Feb. 2012); TCW; Credit Suisse (Williams).

---------------------------------------------------------------------------

Other commenters argued that the amount of a banking entity's own

capital involved in seeding a fund is typically ``small'' and suggested

that, in order to prevent banking entities from engaging in prohibited

proprietary trading through a fund, the Board should condition the

ability of a banking entity to qualify for an extension of the one-year

statutory period on several requirements, including a requirement that

the banking entity not have provided more than $10 million in seed

capital as part of establishing the covered fund.\2373\

---------------------------------------------------------------------------

\2373\ See, e.g., Occupy; Sens. Merkley & Levin (Feb. 2012).

---------------------------------------------------------------------------

The Agencies have carefully considered comments received on the

proposal and have determined instead to adopt the process and standards

governing requests for extensions of time to divest an ownership

interest in a single covered fund largely as proposed. The Agencies

believe that this approach is consistent with the process and standards

set out under the statute.

As under the proposal, the final rule requires any banking entity

that seeks an extension of the conformance period provided for the per-

funds limitation to submit a written request to the Board. Any such

request must be submitted to the Board at least 90 days prior to the

[[Page 6008]]

expiration of the applicable time period and provide the reasons why

the banking entity believes the extension should be granted. In

addition, the request must explain the banking entity's plan for

reducing the permitted investment in a covered fund through redemption,

sale, dilution or other methods to the limits imposed by the final

rule. To allow the Board to assess the factors provided in the statute,

the final rule provides that any extension request by a banking entity

must address: (i) Whether the investment would result, directly or

indirectly, in a material exposure by the banking entity to high-risk

assets or high-risk trading strategies; (ii) the contractual terms

governing the banking entity's interest in the covered fund; (iii) 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 banking entity and the financial stability of the

United States; (iv) the cost to the banking entity of divesting or

disposing of the investment within the applicable period; (v) whether

the investment or the divestiture or conformance of the investment

would involve or result in a material conflict of interest between the

banking entity and unaffiliated parties, including clients, customers

or counterparties to which it owes a duty; (vi) the 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;

(vii) market conditions; and (viii) any other factor that the Board

believes appropriate. In contrast to the proposal, the final rule does

not require information on whether the extension would pose a threat to

safety and soundness of the covered banking entity or to financial

stability of the United States. The categories of information in final

rule have been modified in order to eliminate redundancies.

The final rule continues to permit the Board to impose conditions

on granting any extension granted 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 otherwise unsound practices,

or to otherwise further the purposes of section 13 of the BHC Act and

the final rule. In cases where the banking entity is primarily

supervised by another Agency, the Board will 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. While some commenters requested that the Board

modify the final rule to permit a banking entity to have covered fund

investments in excess of the aggregate funds limitation,\2374\ the

final rule does not contain such a provision. As noted in the release

for the proposed rule, the statutory grant of authority to provide

extensions of time to comply with the investment limits refers

specifically and only to the period for conforming a seeding investment

to the per-fund limitation.\2375\

---------------------------------------------------------------------------

\2374\ See ABA (Keating).

\2375\ See 12 U.S.C. 1851(d)(4)(C).

---------------------------------------------------------------------------

As noted in the proposed rule, the Agencies recognize the potential

for evasion of the restrictions contained in section 13 of the BHC Act

through misuse of requests for extension of the seeding period for

covered funds. Therefore, the Board and the Agencies will monitor

requests for extensions of the seeding period for activity in covered

funds that is inconsistent with the requirements of section 13 of the

BHC Act.

4. Section 75.13: Other Permitted Covered Fund Activities

a. Permitted Risk-Mitigating Hedging Activities

Section 13(d)(1)(C) of the BHC Act provides an exemption for

certain risk-mitigating hedging activities.\2376\ In the context of

covered fund activities, the proposed rule implemented this authority

narrowly and permitted a banking entity to acquire or retain an

ownership interest in a covered fund as a risk-mitigating hedge only in

two situations: (i) When acting as intermediary on behalf of a customer

that is not itself a banking entity to facilitate exposure by the

customer to the profits and losses of the covered fund; and (ii) with

respect to a compensation arrangement with an employee of the banking

entity that directly provides investment advisory or other services to

that fund.\2377\ The proposed rule imposed specific requirements on a

banking entity seeking to rely on this exemption.\2378\

---------------------------------------------------------------------------

\2376\ See 12 U.S.C. 1851(d)(1)(C).

\2377\ See proposed rule Sec. 75.13(b)(1)(i)(A) and (B).

\2378\ These requirements were substantially similar to the

requirements for the risk-mitigating hedging exemption for trading

activities contained in proposed Sec. 75.5. In addition, proposed

Sec. 75.13(b) also required that: (i) The hedge represent a

substantially similar offsetting exposure to the same covered fund

and in the same amount of ownership interest in that covered fund

arising out of the transaction to accommodate a specific customer

request or directly connected to the banking entity's compensation

arrangement with an employee; and (ii) the banking entity document,

at the time the transaction is executed, the hedging rationale for

all hedging transactions involving an ownership interest in a

covered fund.

---------------------------------------------------------------------------

The Agencies received a range of comments on the proposed risk-

mitigating hedging exemption for ownership interests in covered funds.

Some commenters objected to the limited applicability of the statutory

risk-mitigating hedging exemption in the covered funds context and

urged the Agencies to allow ownership interests in covered funds to be

used in any appropriate risk-mitigating hedging.\2379\ In contrast,

other commenters urged the Agencies to delete one or both of the risk-

mitigating hedging exemptions as the commenters argued they were

inconsistent with the statute or otherwise inappropriate.\2380\

Commenters also argued that a separate risk-mitigating hedging

exemption for covered funds is unnecessary because the statute provides

a single risk-mitigating hedging exemption.\2381\

---------------------------------------------------------------------------

\2379\ See BoA; Credit Suisse (Williams); Deutsche Bank (Fund-

Linked Products); ISDA (Feb. 2012); SIFMA et al. (Covered Funds)

(Feb. 2012).

\2380\ See AFR et al. (Feb. 2012); Occupy; Public Citizen; Sens.

Merkley & Levin (Feb. 2012).

\2381\ See BoA.

---------------------------------------------------------------------------

Some commenters argued that the proposed rule would impede banking

entities from offering covered-fund linked products to customers,

including hedging these products, and would, in particular, impair the

ability of banking entities to hedge the risks of fund-linked

derivatives with fund-linked swaps or shares of covered funds

referenced in fund-linked products.\2382\ These commenters argued this

limitation would increase risks at banking entities and was

inconsistent with the purpose of the risk-mitigating hedging exemption.

Commenters also proposed modifying the proposal to permit risk-

mitigating hedging activities that facilitate a customer's exposure to

profits and/or losses of the covered fund, to permit portfolio or

dynamic hedging strategies involving covered fund interests, and to

eliminate the proposed condition that a customer would not itself be a

banking entity.\2383\ Some commenters also urged the Agencies to

grandfather existing risk-mitigating hedging activities with respect to

any covered-fund linked products that comply with the hedging

[[Page 6009]]

requirements for proprietary trading under Sec. 75.5 of the proposed

rule.\2384\

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\2382\ See ISDA (Feb. 2012); BoA; Credit Suisse (Williams);

Deutsche Bank (Fund-Linked Products); ISDA (Feb. 2012); SIFMA et al.

(Covered Funds) (Feb. 2012).

\2383\ See, e.g., BoA; SIFMA et al. (Covered Funds) (Feb. 2012);

Deutsche Bank (Fund-Linked Products).

\2384\ See SIFMA et al. (Covered Funds) (Feb. 2012); BoA.

---------------------------------------------------------------------------

In contrast, other commenters objected to the exemption for hedging

covered fund-linked products sold to customers. These commenters

asserted that this activity would authorize investment in covered funds

in a manner that would not be subject to the three percent per-fund

limitation; \2385\ or would be inconsistent with the statutory

requirement that a banking entity actively seek additional investors

for a fund.\2386\

---------------------------------------------------------------------------

\2385\ See Sens. Merkley & Levin (Feb. 2012).

\2386\ See AFR et al. (Feb. 2012).

---------------------------------------------------------------------------

Some commenters urged the Agencies to expand the hedging exemption

to allow banking entities to invest in covered funds in order to hedge

obligations relating to deferred compensation plans for employees who

do not directly provide services to the covered fund for which the

hedge relates.\2387\ Another commenter argued that banking entities

should be permitted to hedge compensation investment accounts for

executive officers who are not involved in the management of the

investment accounts.\2388\ In contrast, other commenters objected to

the hedging exemption for compensation arrangements, arguing that it

may increase risk to banking entities,\2389\ is unnecessary,\2390\ or

may provide banking entities with an opportunity to evade the

limitations on the amount of ownership interests they may have as an

investment in a covered fund.\2391\

---------------------------------------------------------------------------

\2387\ See Arnold & Porter.

\2388\ See BOK.

\2389\ See Occupy.

\2390\ See AFR et al. (Feb. 2012); Public Citizen.

\2391\ See Occupy.

---------------------------------------------------------------------------

After review of the comments, the Agencies believe at this time

that permitting only limited risk-mitigating hedging activities

involving ownership interests in covered funds is consistent with the

safe and sound conduct of banking entities, and that increased use of

ownership interests in covered funds could result in exposure to higher

risks.\2392\

---------------------------------------------------------------------------

\2392\ See 12 U.S.C. 1851(d)(2).

---------------------------------------------------------------------------

In particular, the Agencies have determined that transactions by a

banking entity to act as principal in providing exposure to the profits

and losses of a covered fund for a customer, even if hedged by the

entity with ownership interests of the covered fund, is a high risk

strategy that could threaten the safety and soundness of the banking

entity. These transactions expose the banking entity to the risk that

the customer will fail to perform, thereby effectively exposing the

banking entity to the risks of the covered fund. Furthermore, a

customer's failure to perform may be concurrent with a decline in value

of the covered fund, which could expose the banking entity to

additional losses. Accordingly, the Agencies believe that these

transactions pose a significant potential to expose banking entities to

the same or similar economic risks that section 13 of the BHC Act

sought to eliminate, and have not adopted the proposed exemption for

using ownership interests in covered funds to hedge these types of

transactions in the final rule.

As argued by some commenters, modifying the proposal to eliminate

the exemption for permitting banking entities to acquire covered fund

interests in connection with customer facilitation may impact banking

entities ability to hedge the risks of fund-linked derivatives through

the use of fund-linked swaps or shares of covered funds referenced by

fund-linked products.\2393\ Some commenters on the proposal argued that

innovation of financial products may potentially be reduced if the

final rule does not permit this type of activity related to fund-linked

products.\2394\ The Agencies recognize that U.S. banking entities may

no longer be able to participate in offering certain customer

facilitation products relating to covered funds, but believe it is

consistent with the purposes of section 13 to restrict these

activities.

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\2393\ See ISDA (Feb. 2012); BoA; Credit Suisse (Williams);

Deutsche Bank (Fund-Linked Products); SIFMA et al. (Covered Funds)

(Feb. 2012).

\2394\ See SIFMA et al. (Covered Funds) (Feb. 2012); Credit

Suisse (Williams).

---------------------------------------------------------------------------

The final rule maintains the proposed exemption for hedging

employee compensation arrangements with several changes. To ensure that

exempt hedging activities are designed to reduce one or more specific

risks, as required by section 13(d)(1)(C) of the BHC Act, the proposed

rule required that permitted hedging activity be designed to reduce the

specific risks to the banking entity in connection with and related to

its obligations or liabilities. The final rule permits a banking entity

to acquire or retain an ownership interest in a covered fund provided

that the ownership interest is designed to demonstrably reduce or

otherwise significantly mitigate the specific, identifiable risks to

the banking entity in connection with a compensation arrangement with

an employee who directly provides investment advisory or other services

to the covered fund. Under the final rule, a banking entity may not use

as a hedge ownership interests of a covered fund for which the employee

does not provide services. The requirement under the final rule that

the hedging activity be designed to demonstrably reduce or otherwise

significantly mitigate the specific, identifiable risks to the banking

entity is consistent with the requirement in Sec. 75.5 of the final

rule, as discussed above in Part VI.A.4. The final rule permits a

banking entity to hedge its exposures to price and other risks based on

fund performance that arise from restricted profit interest and other

performance based compensation arrangements with its investment

managers.

Section 13(a)(2) of the final rule describes the criteria a banking

entity must meet in order to rely on the risk-mitigating hedging

exemption for covered funds. These requirements, which are based on the

requirements for the risk-mitigating hedging exemption for trading

activities under Sec. 75.5 of the final rule and which are discussed

in detail above in Part VI.A.4, have been modified from the proposal to

reflect the more limited scope of this section.\2395\ In particular,

the final rule permits a banking entity to engage in risk-mitigating

hedging activities involving ownership interests in a covered fund only

if the banking entity has established and implements, maintains and

enforces an internal compliance program that is reasonably designed to

ensure the covered banking entity's compliance with the requirements of

the hedging exemption, including reasonably designed written policies

and procedures and internal controls and ongoing monitoring and

authorization procedures, and has acquired or retained the ownership

interest in accordance with these written policies, procedures and

internal controls. Furthermore, the acquisition or retention of an

ownership interest must demonstrably reduce or otherwise significantly

mitigate, at the inception of the hedge, one or more specific,

identifiable risks arising in connection with the compensation

arrangement with an employee that directly provides investment advisory

or other services to the covered fund. The acquisition or retention

also may not, at the inception of the hedge, result in any significant

new or additional risk that is not itself hedged contemporaneously in

accordance with the hedging exemption, and the hedge must be subject to

continuing review, monitoring and management by the banking entity.

---------------------------------------------------------------------------

\2395\ See final rule Sec. 75.13(a)(2).

---------------------------------------------------------------------------

[[Page 6010]]

The final rule also permits a banking entity to engage in risk-

mitigating hedging activities in connection with a compensation

arrangement, subject to the conditions noted above, only if the

compensation arrangement relates solely to the covered fund in which

the banking entity or any affiliate thereof has acquired an ownership

interest and the losses on such ownership interest are offset by

corresponding decreases in the amounts payable in connection with the

related employee compensation arrangement.\2396\

---------------------------------------------------------------------------

\2396\ See final rule Sec. 75.13(a)(2)(iii).

---------------------------------------------------------------------------

b. Permitted Covered Fund Activities and Investments Outside of the

United States

Section 13(d)(1)(I) of the BHC Act \2397\ permits foreign banking

entities to acquire or retain an ownership interest in, or act as

sponsor to, covered funds, so long as those activities and investments

occur solely outside the United States and certain other conditions are

met (the ``foreign fund exemption'').\2398\ As described in the

proposal, the purpose of this statutory exemption appears to be to

limit the extraterritorial application of the statutory restrictions on

covered fund activities and investments, while preserving national

treatment and competitive equality among U.S. and foreign banking

entities within the United States.\2399\ The statute does not

explicitly define what is meant by ``solely outside of the United

States.''

---------------------------------------------------------------------------

\2397\ 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

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).

\2398\ This section's discussion of the concept ``solely outside

of the United States'' is provided solely for purposes of the final

rule's implementation of section 13(d)(1)(I) 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.

\2399\ See 156 Cong. Rec. S5897 (daily ed. July 15, 2010)

(statement of Sen. Merkley) (``Subparagraphs (H) and (I) recognize

rules of international regulatory comity by permitting foreign

banks, regulated and backed by foreign taxpayers, in the course of

operating outside of the United States to engage in activities

permitted under relevant foreign law. However, these subparagraphs

are not intended to permit a U.S. banking entity to avoid the

restrictions on proprietary trading simply by setting up an offshore

subsidiary or reincorporating offshore, and regulators should

enforce them accordingly. In addition, the subparagraphs seek to

maintain a level playing field by prohibiting a foreign bank from

improperly offering its hedge fund and private equity fund services

to U.S. persons when such offering could not be made in the United

States.'').

---------------------------------------------------------------------------

The proposed rule allowed foreign banking entities that met certain

qualifications to engage in covered fund activities, including owning,

organizing and offering, and sponsoring funds outside the United

States. The proposed rule defined both the type of foreign banking

entity that is eligible for the exemption and when an activity or

investment would occur ``solely outside of the United States.'' The

proposed rule allowed a qualifying foreign banking entity to acquire or

retain an ownership interest in, or act as sponsor to, a covered fund

under the exemption only if no subsidiary, affiliate or employee of the

banking entity that's incorporated or physically located in the United

States engaged in offering or selling the covered fund. The proposed

rule also implemented the statutory requirement that prohibited an

ownership interest in the covered fund from being offered for sale or

sold to a resident of the United States.

Commenters generally expressed support for an exemption to allow

foreign banking entities to conduct foreign covered fund activities and

make investments outside the United States.\2400\ A number of

commenters also expressed concerns that the proposed foreign fund

exemption was too narrow and would not be effective in permitting

foreign banking entities to engage in covered fund activities and

investments outside of the United States. For instance, many commenters

argued that several of the proposal's restrictions on the exemption

were not required by statute and were inconsistent with congressional

intent to limit the extraterritorial impact of section 13 of the BHC

Act.\2401\ These commenters argued that the foreign funds exemption

should focus on whether a prohibited activity, such as sponsoring or

investing in a covered fund, involves principal risk taken or held by

the foreign banking entity that poses risk to U.S. banking entities or

the financial stability of the United States.\2402\ Commenters also

argued that a broader exemption would better recognize the regulation

and supervision of the home country supervisor of the foreign banking

entity and of its covered fund activities.\2403\

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\2400\ See, e.g., IIB/EBF; SIFMA et al. (Covered Funds) (Feb.

2012); see also Occupy.

\2401\ See Ass'n. of German Banks; BVI; Allen & Overy (on behalf

of Canadian Banks); EFAMA; F&C; HSBC; IIB/EBF; ICSA; PEGCC;

Soci[eacute]t[eacute] G[eacute]n[eacute]rale; Union Asset; Ass'n. of

Banks in Malaysia; EBF; Credit Suisse (Williams); Cadwalader (on

behalf of Thai Banks).

\2402\ See IIB/EBF; EBF; Allen & Overy (on behalf of Canadian

Banks); Credit Suisse (Williams); Katten (on behalf of Int'l

Clients).

\2403\ See Credit Suisse (Williams); PEGCC; see also

Commissioner Barnier.

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Some commenters contended that the proposal represented an improper

extraterritorial application of U.S. law that could be found to violate

international treaty obligations of the United States, such as those

under the North American Free Trade Agreement, and might result in

retaliation by foreign countries in their treatment of U.S. banking

entities abroad.\2404\ Commenters also alleged that the proposal would

impose significant compliance costs on the foreign operations of

foreign banking entities conducting activity pursuant to this

exemption.\2405\ These commenters argued that foreign banking entities

relying on the foreign fund exemption should not be subject to the

compliance program requirements contained in Appendix C with respect to

their non-U.S. operations.\2406\

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\2404\ See e.g., Norinchukin; Cadwalader (on behalf of Thai

Banks); Barclays; EBF; Ass'n. of German Banks; Soci[eacute]t[eacute]

G[eacute]n[eacute]rale; Chamber (Feb. 2012).

\2405\ See BaFin/Deutsche Bundesbank; Norinchukin; IIF; Allen &

Overy (on behalf of Canadian Banks); ICFR; BoA. As discussed below

in Part VI.C.1, other parts of the final rule address commenters'

concerns regarding the compliance burden on foreign banking

entities.

\2406\ See AFG; Ass'n. of German Banks; BVI; Comm. on Capital

Markets Regulation; IIB/EBF; Japanese Bankers Ass'n.; Norinchukin;

Union Asset. As discussed in greater detail below in Part VI.C.1,

activities and investments of a foreign bank that are conducted

under the foreign funds exemption are generally not subject to the

specific requirements of Sec. 75.20 and Appendices A and B. The

U.S. operations of foreign banking entities are expected to have

policies and procedures in place to ensure that they conduct

activities under this part in full compliance with this part.

---------------------------------------------------------------------------

Several commenters argued that the restrictions of section 13(f),

which limits transactions between a banking entity and certain covered

funds, would not apply to activities and investments made in reliance

on the foreign fund exemption.\2407\ Some commenters argued that the

Agencies should grandfather all existing foreign covered funds and

argued that failure to provide relief for existing relationships could

cause substantial disruption to foreign covered funds and significantly

harm investors in existing funds without producing a clear offsetting

benefit.\2408\

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\2407\ See Australian Bankers Ass'n.; AFMA; Allen & Overy (on

behalf of Foreign Bank Group); British Bankers' Ass'n.; F&C; French

Banking Fed'n.; IIB/EBF; Japanese Bankers Ass'n; Katten (on behalf

of Int'l Clients); Union Asset. See also infra Part VI.B.5.

\2408\ See BVI; Credit Suisse (Williams); EFAMA; IIB/EBF; PEGCC;

Union Asset. See supra Part II for a discussion regarding the

conformance period.

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[[Page 6011]]

In response to comments received on the proposal, the final rule

contains a number of modifications to more effectively implement the

foreign fund exemption in light of the language and purpose of the

statute. Importantly, as explained in the section defining covered

funds, the Agencies also believe that the more circumscribed definition

of covered fund, including the exclusion for foreign public funds,

should alleviate many of the concerns raised and potential burdens

identified by commenters with respect to the funds activities of

foreign banking entities.\2409\

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\2409\ For instance, many commenters raised concerns regarding

the treatment of foreign public funds such as UCITS. As discussed in

greater detail above in Part VI.B.1, the definition of covered fund

under the final rule has been modified from the proposal and

tailored to include only the types of foreign funds that the

Agencies believe are intended to be the focus of the statute (e.g.,

certain foreign funds that are established by U.S. banking

entities). Foreign public funds are also excluded from the

definition of covered fund under the final rule. The modifications

in the final rule in part address commenters' request that foreign

funds be grandfathered. To the extent that an entity qualifies for

one or more of the exclusions from the definition of covered fund,

that entity would not be a covered fund under the final rule.

Moreover, any entity that would be a covered fund would still be

able to rely on the conformance period in order to come into

compliance with the requirements of section 13 and the final rule.

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1. Foreign Banking Entities Eligible for the Exemption

The statutory language of section 13(d)(1)(I) provides that, in

order to be eligible for the foreign funds 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. Consistent with this statutory language, the proposed

rule limited the scope of the exemption to banking entities that are

organized under foreign law and, as applicable, controlled only by

entities organized under foreign law.

The Agencies did not receive substantive comment on this aspect of

the proposal related to the foreign fund exemption, though some

commenters offered suggestions to clarify various parts of the wording

of the scope of the definition of banking entities that may qualify for

the exemption. The final rule makes only minor, technical changes to

more fully carry out the purposes of the statute.

Consistent with the statutory language and purpose of section

13(d)(1)(I) of the BHC Act, the final rule provides that the exemption

is available only if the banking entity is not organized under \2410\

or directly or indirectly controlled by a banking entity that is

organized under the laws of the United States or of one or more States.

As noted above, section 13(d)(1)(I) of the BHC Act specifically

provides that its exemption is available only to a banking entity that

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.\2411\ Because of this express statutory requirement, a foreign

subsidiary controlled, directly or indirectly, by a banking entity

organized under the laws of the United States or one of its States, and

a foreign branch office of a banking entity organized under the laws of

the United States or one of the States, may not take advantage of this

exemption.

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\2410\ The final rule clarifies the eligibility requirements for

banking entities seeking to rely on the foreign fund exemption.

Section 13(d)(1)(I) of the BHC Act and Sec. 75.13(c)(1)(i) of the

proposal require that a banking entity seeking to rely on the

foreign fund exemption 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. For clarification purposes, in addition to

the eligibility requirement in Section 13(d)(1)(I) of the BHC Act

and the proposal, the final rule also expressly requires that the

banking entity not itself be organized under the laws of the United

States.

\2411\ See 12 U.S.C. 1851(d)(1)(I).

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Like the proposal, the final rule incorporates the statutory

requirement that the banking entity conduct its sponsorship or

investment activities pursuant to sections 4(c)(9) or 4(c)(13) of the

BHC Act. The final rule retains the tests in the proposed rule for

determining when a banking entity would meet that requirement. The

final rule also provides qualifying criteria for both a banking entity

that is a qualifying foreign banking organization under the Board's

Regulation K and a banking entity that is not a foreign banking

organization for purposes of Regulation K.\2412\

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\2412\ Section 75.13(b)(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 to date applied the general

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)(I) of the BHC Act, are unable to rely on the foreign funds

exemption.

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Section 4(c)(9) of the BHC Act applies to 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 the exemption would not be substantially at

variance with the purposes of the BHC Act and would be in the public

interest.\2413\ The Board has implemented section 4(c)(9) as part of

subpart B of the Board's Regulation K,\2414\ which specifies a number

of conditions and requirements that a foreign banking organization must

meet in order to act pursuant to that authority.\2415\ The qualifying

conditions and requirements include, for example, that the foreign

banking organization 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.\2416\ Under the final rule a banking entity

that is a qualifying foreign banking organization for purposes of the

Board's Regulation K, other than a foreign bank as defined in section

1(b)(7) of the International Banking Act of 1978 that is organized

under the laws of any commonwealth, territory, or possession of the

United States, will qualify for the foreign fund exemption.\2417\

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\2413\ See 12 U.S.C. 1843(c)(9).

\2414\ See 12 CFR 211.20 et seq.

\2415\ Some commenters argued that the Board's Regulation K

contains a number of limitations that may not be appropriate to

include as part of the requirements of the foreign fund exemption.

For example, subpart B of the Board's Regulation K includes various

approval requirements and interstate office location restrictions.

See Allen & Overy (on behalf of Foreign Bank Group); HSBC Life. The

final rule does not retain the proposal's requirement that the

activity be conducted in compliance with all of subpart B of the

Board's Regulation K (12 CFR 211.20 through 211.30). However, the

foreign fund exemption in section 13(d)(1)(I) of the BHC Act and the

final rule operates as an exemption and is not a separate grant of

authority to engage in an otherwise impermissible activity. To the

extent a banking entity is a foreign banking organization, it

remains subject to the Board's Regulation K and must, as a separate

matter, comply with any and all applicable rules and requirements of

that regulation.

\2416\ See 12 CFR 211.23(a), (c), and (e). The proposed rule

only referenced the qualifying test under section 211.23(a) of the

Board's Regulation K; however, because there are two other methods

by which a foreign banking organization may meet the requirements to

be considered a qualified foreign banking organization, the final

rule incorporates a reference to those provisions as well.

\2417\ This modification to the definition of foreign banking

organization from the proposed definition is necessary because,

under the International Banking Act and the Board's Regulation K,

depository institutions that are located in, or organized under the

laws of a commonwealth, territory, or possession of the United

States, are foreign banking organizations. However, for purposes of

the Federal securities laws and certain banking statutes, such as

section 2(c)(1) of the BHC Act and section 3 of the FDI Act, these

same entities are defined to be and treated as domestic entities.

For instance, these entities act as domestic broker-dealers under

U.S. securities laws and their deposits are insured by the FDIC.

Because one of the purposes of section 13 is to protect insured

depository institutions and the U.S. financial system from the

perceived risks of proprietary trading and covered fund activities,

the Agencies believe that these entities should be considered to be

located within the United States for purposes of section 13. The

final rule includes within the definition of State any State, the

District of Columbia, the Commonwealth of Puerto Rico, Guam,

American Samoa, the United States Virgin Islands, and the

Commonwealth of the Northern Mariana Islands.

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Section 13 of the BHC Act also applies to foreign companies that

control a U.S. insured depository institution but that are not subject

to the

[[Page 6012]]

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 final rule also provides that

a foreign banking entity that is not a foreign banking organization

would be considered to be conducting activities ``pursuant to section

4(c)(9)'' for purposes of the foreign fund exemption \2418\ if the

entity, on a fully-consolidated basis,\2419\ meets at least two of

three requirements that evaluate the extent to which the foreign

banking entity's business is conducted outside the United States, as

measured by assets, revenues, and income.\2420\ 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),

(c), or (e) of the Board's Regulation K, except that the test does not

require the foreign entity to demonstrate that more than half of its

banking business is outside the United States.\2421\ 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 restrictions

on covered fund activities and investments, a result that the Agencies

do not believe was intended.

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\2418\ 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.

\2419\ For clarification purposes, the final rule has been

modified from the proposal to provide that the requirements for this

provision must be met on a fully-consolidated basis.

\2420\ See final rule Sec. 75.13(b)(2)(ii)(B). For purposes of

determining whether, on a fully consolidated basis, it meets the

requirements under Sec. 75.13(b)(2)(ii)(B), a foreign banking

entity that is not a foreign banking organization should base its

calculation on the consolidated global assets, revenues, and income

of the top-tier affiliate within the foreign banking entity's

structure.

\2421\ See 12 U.S.C. 1843(c)(9); 12 CFR 211.23(a), (c), and (e);

final rule Sec. 75.13(b)(2)(ii)(B).

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2. Activities or Investments Solely Outside of the United States

As noted above, the proposed rule adopted a transaction-based

approach to implementing the foreign fund exemption and focused on the

extent to which the foreign fund transactions occur within, or are

carried out by personnel, subsidiaries or affiliates within, the United

States. In particular, Sec. 75.13(c)(3) of the proposed rule provided

that a transaction or activity be considered to have occurred solely

outside of the United States only if: (i) 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; (ii) 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 (iii) no

ownership interest in such covered fund is offered for sale or sold to

a resident of the United States.

Commenters suggested that, like the foreign trading exemption, the

foreign fund exemption should focus on the location of activities that

a banking entity engages in as principal.\2422\ These commenters argued

that the location of sales activities of a fund should not determine

whether a banking entity has sponsored or acquired an ownership

interest in a covered fund solely outside of the United States.

Commenters also argued that foreign banking entities typically locate

marketing and sales personnel for foreign funds in the United States in

order to serve customers, including those that are not residents of the

United States, and that the proposal would needlessly force all covered

fund sales activities to shift outside of the United States. These

commenters alleged that the restrictions under the proposal would cause

foreign banking entities to relocate their personnel from the United

States to overseas, diminishing U.S. jobs with no concomitant

benefit.\2423\

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\2422\ See Credit Suisse (Williams); IIB/EBF; Katten (on behalf

of Int'l Clients).

\2423\ See Allen & Overy (on behalf of Foreign Bank Group);

Ass'n. of German Banks; Credit Suisse (Williams); IIB/EBF;

Soci[eacute]t[eacute] G[eacute]n[eacute]rale; Union Asset.

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Many commenters requested removal of the proposal's prohibition on

a U.S. subsidiary, affiliate, or employee of the foreign banking entity

offering or selling fund interests in order to qualify for the foreign

fund exemption.\2424\ Commenters argued that this limitation was not

included in the statute and that the limited involvement of persons

located in the U.S. in the distribution of ownership interests in a

foreign covered fund should not, by itself, disqualify the banking

entity from relying on the foreign fund exemption so long as the fund

is offered only outside the United States.\2425\ These commenters

argued that organizing and offering a fund is not a prohibited activity

so long as it is not accompanied by ownership or sponsorship of the

covered fund. One commenter urged that the final rule permit U.S.

personnel of a foreign banking entity to engage in non-selling

activities related to a covered fund, including acting as investment

advisor, establishing fund vehicles, conducting back-office functions

such as day-to-day management and deal sourcing tax structuring,

obtaining licenses, interfacing with regulators, and other related

activities that do not involve U.S. sales activity.\2426\

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\2424\ See Allen & Overy (on behalf of Foreign Bank Group);

Ass'n. of German Banks; Credit Suisse (Williams); IIB/EBF; Katten

(on behalf of Int'l Clients); TCW; Union Asset.

\2425\ See IIB/EBF; Soci[eacute]t[eacute]

G[eacute]n[eacute]rale; TCW; Union Asset; Credit Suisse (Williams);

see also Katten (on behalf of Int'l Clients) (recommending that,

similar to the SEC's Regulation S (17 CFR 230.901 through 230.905),

the final rule provide that involvement of persons located in the

United States in the distribution of a non-U.S. covered fund's

securities to potential purchasers outside of the United States not

affect the analysis of whether a non-U.S. banking entity's

investment or sponsorship occurs outside the United States).

\2426\ See Allen & Overy (on behalf of Foreign Bank Group).

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Instead of the proposal's transaction-based approach to

implementing the foreign fund exemption, many commenters suggested the

final rule adopt a risk-based approach.\2427\ These commenters argued

that a risk-based approach would prohibit or significantly limit the

amount of financial risk from such activities that could be transferred

to the United States by the foreign activity of foreign banking

entities in line with the purpose of the statue.\2428\ Commenters also

contended that foreign activities of most foreign banking entities are

already subject to activities limitations, capital requirements, and

other prudential requirements of their home-country

supervisor(s).\2429\

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\2427\ See BaFin/Deutsche Bundesbank; ICSA; IIB/EBF; EBF; Allen

& Overy (on behalf of Canadian Banks); Credit Suisse (Williams);

George Osborne.

\2428\ See IIB/EBF.

\2429\ See IIB/EBF.

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In response to commenters' concerns and in order to more

effectively implement both the statutory prohibition as well as the

foreign fund exemption, the final rule has been modified to better

reflect the purpose of the statute by ensuring that the principal risks

of covered fund investments and sponsorship by foreign banking entities

permitted under the foreign funds exemption occur and remain solely

outside of the United States. One of the principal purposes of section

13 is to limit the risks that covered fund investments and activities

pose to the safety and soundness of U.S. banking entities and the U.S.

financial

[[Page 6013]]

system. Another purpose of the foreign fund exemption was to limit the

extraterritorial application of section 13 as it applies to foreign

banking entities subject to section 13.

To accomplish these purposes in light of the structure and purpose

of the statute and in response to commenters, the final rule adopts a

risk-based approach rather than a transaction approach to the foreign

fund exemption. In order to ensure these risks remain solely outside of

the United States, the final rule also includes several conditions on

the availability of the foreign fund exemption. Specifically, the final

rule provides that an activity or investment occurs solely outside the

United States for purposes of the foreign fund exemption only if:

The banking entity acting as sponsor, or engaging as

principal in the acquisition or retention of an ownership interest in

the covered fund, is not itself, and it not controlled directly or

indirectly by, a banking entity that is located in the United States or

established under the laws of the United States or of any State;

The banking entity (including relevant personnel) that

makes the decision to acquire or retain the ownership interest or act

as sponsor to the covered fund is not located in the United States or

organized under the laws of the United States or of any State;

The investment or sponsorship, including any transaction

arising from risk-mitigating hedging related to an ownership interest,

is not accounted for as principal directly or indirectly on a

consolidated basis by any branch or affiliate that is located in the

United States or organized under the laws of the United States or of

any State; and

No financing for the banking entity's ownership or

sponsorship is provided, directly or indirectly, by any branch or

affiliate that is located in the United States or organized under the

laws of the United States or of any State.\2430\

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\2430\ See final rule Sec. 75.13(b)(4).

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These requirements are designed to ensure that any foreign banking

entity engaging in activity under the foreign fund exemption does so in

a manner that ensures the risk and sponsorship of the activity or

investment occurs and resides solely outside of the United States.

The final rule has been modified from the proposal to specifically

recognize that, for purposes of the foreign fund exemption, a U.S.

branch, agency, or subsidiary of a foreign bank, is located in the

United States; however, a foreign bank that operates or controls that

branch, agency, or subsidiary is not considered to be located in the

United States solely by virtue of operation of the U.S. branch, agency,

or subsidiary.\2431\ A subsidiary (wherever located) of a U.S. branch,

agency, or subsidiary of a foreign bank is also considered itself to be

located in the United States. This provision helps give effect to the

statutory language limiting the foreign fund exemption to activities of

foreign banking entities that occur ``solely outside of the United

States'' by clarifying that the U.S. operations of foreign banking

entities may not sponsor or acquire or retain an ownership interest in

a covered fund as principal based on this exemption.

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\2431\ See final rule Sec. 75.13(b)(5).

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Because so-called ``back office'' activities do not involve

sponsoring or acquiring or retaining an ownership interest in a covered

fund, the final rule does not impose restrictions on U.S. personnel of

a foreign banking entity engaging in these activities in connection

with one or more covered funds. This allows providing administrative

services or similar functions to the covered fund as an incident to the

activity conducted under the foreign fund exemption (such as clearing

and settlement, maintaining and preserving records of the fund,

furnishing statistical and research data, or providing clerical support

for the fund).

The foreign fund exemption in the final rule also permits the U.S.

personnel and operations of a foreign banking entity to act as

investment adviser to a covered fund in certain circumstances. For

instance, the U.S. personnel of a foreign banking entity may provide

investment advice and recommend investment selections to the manager or

general partner of a covered fund so long as that investment advisory

activity in the United States does not result in the U.S. personnel

participating in the control of the covered fund or offering or selling

an ownership interest to a resident of the United States. As explained

above, the final rule also explicitly provides that acquiring or

retaining an ownership interest does not include acquiring or retaining

an ownership interest in a covered fund by a banking entity acting

solely as agent, broker, or custodian, subject to certain conditions,

or acting on behalf of customers as a trustee, or in a similar

fiduciary capacity for a customer that is not a covered fund, so long

as the activity is conducted for the account of the customer and the

banking entity and its affiliates do not have or retain beneficial

ownership of the ownership interest.\2432\ The final rule would thus

allow a foreign bank to engage in any of these capacities in the U.S.

without the need to rely on the foreign fund exemption.

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\2432\ See final rule Sec. 75.10(a)(2).

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3. Offered for Sale or Sold to a Resident of the United States

The proposed rule provided that no ownership interest in the

covered fund be offered for sale or sold to a resident of the United

States, a requirement of the statute.\2433\ Numerous commenters focused

on the definition of ``resident of the United States'' in the proposed

rule and the manner in which the restriction on offers and sales to

such persons would interrelate with Regulation S under the Securities

Act of 1933. Commenters asserted that, since market participants have

long conducted offerings of foreign funds in reliance on Regulation S

\2434\ in order to comply with U.S. securities law obligations, these

same securities law principles should be applied to determine whether a

person is a resident of the United States for purposes of section 13

and the final rule to determine whether an offer or sale is made to

residents of the United States.\2435\

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\2433\ See proposed rule Sec. 75.13(c)(1)(iii).

\2434\ See 17 CFR 230.901-905.

\2435\ See IIB/EBF; EFAMA; ICI Global.

---------------------------------------------------------------------------

Certain commenters argued that because of the way the restriction

in the statute and proposed rule was written, it was unclear whether

the restriction on offering for sale to a resident of the United States

applied to the foreign banking entity or to any third party that

establishes a fund.\2436\ Commenters argued the prohibition against

offers or sales of ownership interests to residents of the United

States should apply only to offers and sales of covered funds organized

and offered by the foreign banking entity but not to covered funds

established by unaffiliated third parties.\2437\ These commenters

reasoned that a foreign banking entity should be permitted to make a

passive investment in a covered fund sponsored and controlled by an

unaffiliated third party that has U.S. investors as long as the foreign

banking entity does not itself offer or sell ownership interest in the

covered fund to residents of the United

[[Page 6014]]

States.\2438\ Commenters contended that this interpretation would be

consistent with section 13's purpose to prevent foreign banks from

using the foreign fund exemption to market and sell covered funds to

U.S. investors, while simultaneously limiting the extraterritorial

impact of section 13.\2439\ Commenters argued that the proposal's

foreign fund exemption would negatively impact U.S. asset managers

unaffiliated with any banking entity because they would either be

forced to exclude foreign banking entities from investing in their

funds or would need to ensure that no residents of the United States

hold ownership interests in funds offered to these entities.\2440\

Commenters also contended that foreign banking entities, including

sovereign wealth funds that own or control foreign banking

organizations, invest tens of billions of dollars in U.S. covered funds

and that if these types of investments were not permitted under the

foreign fund exemption an important source of foreign investment in the

U.S. could be eliminated.\2441\

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\2436\ See Cadwalader (on behalf of Thai Banks); Grosvenor;

SIFMA et al. (Covered Funds) (Feb. 2012).

\2437\ See Ass'n. of German Banks; BAROC; Cadwalader (on behalf

of Thai Banks); Comm. on Capital Markets Regulation; Credit Suisse

(Williams); IIB/EBF; Japanese Bankers Ass'n.; Katten (on behalf of

Int'l Clients); PEGCC.

\2438\ See Grosvenor; IIB/EBF; Japanese Bankers Ass'n.; Katten

(on behalf of Int'l Clients); Sens. Merkley & Levin (Feb.2012);

Norinchukin; SIFMA et al. (Covered Funds) (Feb. 2012).

\2439\ See BAROC; Credit Suisse (Williams); Grosvenor; IIB/EBF.

\2440\ See Comm. on Capital Markets Regulation; Credit Suisse

(Williams); PEGCC.

\2441\ See SIFMA et al. (Covered Funds) (Feb. 2012); see also

Grosvenor; PEGCC.

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Commenters argued that an investment by a foreign banking entity in

a third-party unaffiliated fund does not pose any risk to a U.S.

banking entity or to the U.S. financial system. Moreover, commenters

argued that a foreign banking entity that has invested in a fund

sponsored and advised by a third party has no control over whether--and

may have no knowledge--that the third party has determined to offer or

sell the fund to U.S. residents.\2442\

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\2442\ See AFG; BAROC; Cadwalader (on behalf of Thai Banks);

Japanese Bankers Ass'n.

---------------------------------------------------------------------------

As noted above, one of the purposes of section 13 is to limit the

risk to banking entities and the financial system of the United States.

Another purpose of the statute appears to be to permit foreign banking

entities to engage in foreign activities without being subject to the

restrictions of section 13 while also ensuring that these foreign

entities do not receive a competitive advantage over U.S. banking

entities with respect to offering and selling their covered fund

services in the United States.\2443\ As such, the final rule does not

prohibit a foreign banking entity from making an investment in or

sponsoring a foreign fund. However, a foreign banking entity would not

be permitted under the foreign fund exemption to invest in, or engage

in the sponsorship of, a U.S. or foreign covered fund that offers

ownership interests to residents in the United States unless it does so

pursuant to and subject to the limitations of the permitted activity

exemption for organizing and offering a covered fund, for example,

which has the same effect for U.S. banking entities. The final rule

ensures that the risk of the sponsoring and investing in non-U.S.

covered funds by foreign banking entities remains outside of the United

States and that the foreign fund exemption does not advantage foreign

banking entities relative to U.S. banking entities with respect to

providing their covered fund services in the United States by

prohibiting the offer or sale of ownership interests in related covered

funds to residents of the United States.

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\2443\ See 156 Cong. Rec. S5897 (daily ed. July 15, 2010)

(statement of Sen. Merkley).

---------------------------------------------------------------------------

Commenters also argued that foreign investors in a foreign covered

fund should not be treated as residents of the United States for

purposes of the final rule if, after purchasing their interest in the

covered fund, they relocate to the U.S.,\2444\ or travel to the U.S. on

a temporary basis.\2445\ Commenters also argued that non-U.S. investors

in a fund offered by a foreign banking entity should not be prohibited

from transferring their interests to residents of the United States in

the secondary market.\2446\ One commenter alleged that, notwithstanding

the reasonable efforts of foreign banking entities to prevent residents

of the United States from investing in their foreign covered funds,

investors may find ways to circumvent and invest in covered funds

without knowledge or assistance from the foreign banking entity.\2447\

---------------------------------------------------------------------------

\2444\ See IIB/EBF; Katten (on behalf of Int'l Clients); Union

Asset.

\2445\ See IFIC; see also Allen & Overy (on behalf of Canadian

Banks).

\2446\ See Ass'n. of German Banks; Credit Suisse (Williams);

IIB/EBF; Katten (on behalf of Int'l Clients).

\2447\ See Credit Suisse (Williams).

---------------------------------------------------------------------------

Certain commenters argued that there was a substantial risk that

foreign funds offered by foreign banking entities would not be able to

rely on the exemption due to the presence of a limited number of

investors who are residents of the United States.\2448\ A few

commenters suggested that the final rule should require that, for both

related and unrelated covered funds, a banking entity need only have a

reasonable belief that an ownership interest in a covered fund is not

offered or sold to residents of the United States in order to qualify

for the foreign fund exemption. Commenters argued that only active

targeting or marketing towards a resident of the United States by the

foreign banking entity should be prohibited by the final rule, and that

the incidental presence of a limited number of investors that are

residents of the United States in a foreign covered fund offered by a

foreign banking entity should not prohibit the foreign banking entity

from relying on the foreign fund exemption.\2449\ One commenter argued

that, for certain complex fund structures (e.g., a structure with a

master fund and multiple feeder funds that investors invest in or a

parallel fund structure both managed by the same fund manager),

eligibility for the foreign fund exemption should not be precluded for

a fund with no ownership interests offered for sale or sold to U.S.

residents even if a related covered fund is offered to residents of the

United States.\2450\

---------------------------------------------------------------------------

\2448\ See BVI; EFAMA; Union Asset.

\2449\ See AFG; Union Asset; see also BVI; Allen & Overy (on

behalf of Canadian Banks); Katten (on behalf of Int'l Clients).

\2450\ See Japanese Bankers Ass'n.

---------------------------------------------------------------------------

After considering comments received on the proposal, the final rule

retains the statutory requirement that no ownership interest in the

covered fund be offered for sale to a resident of the United

States.\2451\ The final rule provides that an ownership interest in a

covered fund is offered for sale or sold to a resident of the United

States for purposes of the foreign fund exemption only if it is sold or

has been sold pursuant to an offering that targets residents of the

United States.\2452\

---------------------------------------------------------------------------

\2451\ See final rule Sec. 75.13(b)(1)(iii).

\2452\ See final rule Sec. 75.13(b)(3).

---------------------------------------------------------------------------

Absent circumstances otherwise indicating a nexus with residents of

the United States, the sponsor of a foreign fund would not be viewed as

targeting U.S. residents for purposes of the foreign fund exemption if

it conducts an offering directed to residents of one or more countries

other than the United States; includes in the offering materials a

prominent disclaimer that the securities are not being offered in the

United States or to residents of the United States; and includes other

reasonable procedures to restrict access to offering and subscription

materials to persons that are not residents of the United States.\2453\

If ownership interests

[[Page 6015]]

that are issued in a foreign offering are listed on a foreign exchange,

secondary market transactions could be undertaken by the banking entity

outside the United States in accordance with Regulation S under the

foreign fund exemption.\2454\ Foreign banking entities should use

precautions not to send offering materials into the United States or

conduct discussions with persons located in the United States (other

than to or with a person known to be a dealer or other professional

fiduciary acting on behalf of a discretionary account or similar

account for a person who is not a resident of the United States).\2455\

In order to comply with the rule as adopted, sponsors of covered funds

established outside of the United States must examine the facts and

circumstances of their particular offerings and confirm that the

offering does not target residents of the United States.

---------------------------------------------------------------------------

\2453\ See Statement of the Commission Regarding Use of Internet

Web sites to Offer Securities, Solicit Securities Transactions or

Advertise Investment Services Offshore, Securities Act Release No.

7516 (Mar. 23, 1998). Reliance on these principles only applies with

respect to whether an ownership interest in a covered fund is

offered for sale or sold to a resident of the United States for

purposes of section 13 of the BHC Act. In addition, reliance would

not be appropriate if a foreign fund engages in a private placement

of ownership interests in the United States in reliance on Section

4(a)(2) of the Securities Act of 1933 or Regulation D (17 CFR

230.501-230.506).

\2454\ An offer or sale is made in an ``offshore transaction''

under Regulation S if, among other conditions, the transaction is

executed in, on or through the facilities of a ``designated offshore

securities market'' as described in Regulation S, which includes a

number of foreign stock exchanges and markets and any others the SEC

designates. See Securities Act rule 902(h).

\2455\ See Securities Act rule 902(k)(2).

---------------------------------------------------------------------------

With respect to the treatment of multi-tiered fund structures under

the foreign fund exemption, the Agencies expect that activities related

to certain complex fund structures should be integrated in order to

determine whether an ownership interest in a covered fund is offered

for sale to a resident of the United States. For example, a banking

entity may not be able to rely on the foreign fund exemption to sponsor

or invest in an initial covered fund (that is offered for sale only

overseas and not to residents of the United States) that is itself

organized or operated for the purpose of investing in another covered

fund (that is sold pursuant to an offering that targets U.S. residents)

and that is either organized and offered or is advised by that banking

entity.

4. Definition of ``Resident of the United States''

As discussed in greater detail above in Part VI.B.1, section

13(d)(1)(I) of the BHC Act provides that a foreign banking entity may

acquire or retain an ownership interest in or act as sponsor to a

covered fund, but only if that activity is conducted according to the

requirements of the statute, including that no ownership interest in

the covered fund is offered for sale or sold to a ``resident of the

United States.'' As noted above in Part VI.B.1.f describing the

definition of ``resident of the United States,'' the statute does not

define this term.

After carefully considering comments received, the Agencies have

defined the term ``resident of the United States'' in the final rule to

mean a ``U.S. person'' as defined in the SEC's Regulation S.\2456\ The

Agencies note, however, that it would not be permissible under the

foreign fund exemption for a foreign banking entity to facilitate or

participate in the formation of a non-U.S. investment vehicle for a

person or entity that is itself a U.S. person for the specific purpose

of investing in a foreign fund. The Agencies believe that this type of

activity would constitute an evasion of the requirements of section 13

of the BHC Act.

---------------------------------------------------------------------------

\2456\ See final rule Sec. 75.10(d)(8).

---------------------------------------------------------------------------

c. Permitted Covered Fund Interests and Activities by a Regulated

Insurance Company

As discussed above, section 13(d)(1)(F) of the BHC Act permits a

banking entity that 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, to purchase or sell a financial

instrument subject to certain conditions.\2457\ Section 13(d)(1)(D) of

the Act permits a banking entity to purchase or sell a financial

instrument on behalf of customers.\2458\ The proposal implemented these

exemptions with respect to the proprietary trading activities of

insurance companies by permitting a banking entity that is an insurance

company to purchase or sell a financial instrument for the general

account of the insurance company or for a separate account, in each

case subject to certain restrictions.\2459\ The proposal did not apply

these exemptions to covered fund activities or investments.

---------------------------------------------------------------------------

\2457\ See 12 U.S.C. 1851(d)(1)(F).

\2458\ See 12 U.S.C. 1851(d)(1)(D).

\2459\ See proposed rule Sec. Sec. 75.6(b)(2)(iii); 75.6(c).

---------------------------------------------------------------------------

A number of commenters argued that section 13 was designed to

accommodate the business of insurance by exempting both the proprietary

trading and covered fund activities of insurance companies.\2460\ These

commenters argued that providing an exemption for covered fund

activities and investments through both the general account and

separate accounts of an insurance company was integral to the business

of insurance and that, absent an exemption from the covered fund

provisions, insurance companies would lack an effective means to

diversify their holdings and obtain adequate rates of return in order

to maintain affordable premiums for customers.\2461\

---------------------------------------------------------------------------

\2460\ See, e.g., Sutherland (on behalf of Comm. of Annuity

Insurers); ACLI (Jan. 2012); Country Fin. et al.; Nationwide; NAMIC;

Fin. Services Roundtable (Feb. 3, 2012) (citing FSOC study at 71);

HSBC Life; Chamber (Feb. 2012); Country Fin. et al.; Mutual of

Omaha; see also Rep. McCarthy et al.; Sen. Nelson; Sen. Hagan; Sens.

Brown & Harkin.

\2461\ See, e.g., Fin. Services Roundtable (Feb. 3, 2012); TIAA-

CREF (Feb. 13, 2012); Sutherland (on behalf of Comm. of Annuity

Insurers); USAA (citing FSOC study at 71); HSBC Life; ACLI; NAMIC;

Nationwide.

---------------------------------------------------------------------------

Some commenters argued that section 13 of the BHC Act specifically

provides exemptions from both the covered fund prohibition of section

13(a)(1), and the prohibition on proprietary trading.\2462\ Commenters

contended that the exemptions in section 13(d)(1)(F) (referencing

activity in general accounts of insurance companies) and 13(d)(1)(D)

(referencing activities on behalf of customers) cross-reference the

instruments described in section 13(h)(4) and not activity described in

section 13(h)(4). On this basis, commenters argued the statute exempts

both proprietary trading in these instruments described in section

13(h)(4) and investments in those instruments (including when those

instruments are ownership interests in covered funds).\2463\

---------------------------------------------------------------------------

\2462\ See Sutherland (on behalf of Comm. of Annuity Insurers);

Nationwide; see also Rep. McCarthy et al.; Sens. Brown & Harkin.

\2463\ See, e.g., Fin. Services Roundtable (Feb. 3, 2012); USAA;

HSBC Life; Country Fin. et al.; Sutherland (on behalf of Comm. of

Annuity Insurers); Nationwide (discussing the exemption for the

general account of an insurance company); ACLI; Nationwide

(discussing the exemption for separate accounts).

---------------------------------------------------------------------------

Alternatively, commenters argued that the Agencies should use their

authority in section 13(d)(1)(J) of the BHC Act to provide an exemption

for the covered fund activities and investments of insurance

companies.\2464\ These commenters argued that exempting covered funds

activities and investments of insurance companies would promote and

protect the safety and soundness of the banking entity and financial

stability of the United States and provide certain benefits to the U.S.

financial system by allowing insurance companies to access important

asset classes (for better investment diversity and returns), provide

more diverse product offerings to customers, better manage their

investment risks through diversification and more closely matching the

maturity of their assets

[[Page 6016]]

and liabilities, contribute liquidity to capital markets, and support

economic growth through the provision of capital to entrepreneurs and

businesses.\2465\ Commenters also argued that an exemption for

insurance companies from the covered fund prohibitions was necessary to

permit insurance companies that are banking entities to effectively

compete with insurance companies not affiliated with an insured

depository institution.\2466\ Commenters alleged that insurance

companies are already subject to extensive regulation under state

insurance laws that specifically include provisions designed to

diversify risk among investment categories, limit exposure to

particular types of asset classes including covered fund investments,

and protect the safety and soundness of the insurance company.\2467\

---------------------------------------------------------------------------

\2464\ See, e.g., Sutherland (on behalf of Comm. of Annuity

Insurers).

\2465\ See Fin. Services Roundtable (Feb. 3, 2012); TIAA-CREF

(Feb. 13, 2012); USAA; HSBC Life; ACLI (Jan. 2012); NAMIC;

Nationwide.

\2466\ See, e.g., Nationwide.

\2467\ See, e.g., ACLI (Jan. 2012); Fin. Services Roundtable

(Feb. 3, 2012); USAA; Chamber (Feb. 2012); Country Fin. et al.;

Mutual of Omaha; NAMIC; Nationwide; Rep. McCarthy et al. See also

156 Cong. Reg. S. 5896 (daily ed. July 15, 2010) (statement of Sen.

Merkley) (arguing that activities of insurance companies ``are

heavily regulated by State insurance regulators, and in most cases

do not pose the same level of risk as other proprietary trading'').

---------------------------------------------------------------------------

After careful review of the comments in light of the statutory

provisions, the final rule has been modified to permit an insurance

company or its affiliate \2468\ to acquire or retain an ownership

interest in, or act as sponsor to, a covered fund for either the

general account of the insurance company or one or more separate

accounts established by the insurance company.\2469\

---------------------------------------------------------------------------

\2468\ Some commenters urged the Agencies to provide that an

affiliate or subsidiary of an insurance company could purchase

covered funds for the insurance company's general account or a

separate account. See e.g., Fin. Services Roundtable (Feb. 3, 2012);

TIAA-CREF (Feb. 13, 2012). The Agencies note that the final rule

provides (as does the statute) an exemption that permits an

insurance company or its affiliate to acquire and retain an

ownership interest in a covered fund solely for the insurance's

company general account (or one or more of its separate account);

such an affiliate or subsidiary also may be a wholly-owned

subsidiary, as defined in the final rule.

\2469\ The final rule defines the terms ``general account'' and

``separate account'' largely as proposed, and includes the new

defined term ``insurance company,'' defined as a company that is

organized as an insurance company, primarily and predominantly

engaged in writing insurance or reinsuring risks underwritten by

insurance companies, subject to supervision as such by a state

insurance regulator or a foreign insurance regulator, and not

operated for the purpose of evading the provisions of section 13 of

the BHC Act. Cf. section 2(a)(17) of the Investment Company Act

(defining the term insurance company).

---------------------------------------------------------------------------

These activities are only permitted under the final rule so long

as: (1) The insurance company or its affiliate acquires and retains the

ownership interest solely for the general account of the insurance

company or for one or more separate accounts established by the

insurance company; (2) the acquisition and retention of the ownership

interest is conducted in compliance with, and subject to, the insurance

company investment laws, regulations, and written guidance of the State

or jurisdiction in which the insurance company is domiciled; and (3)

the appropriate Federal banking agencies, after consultation with the

Financial Stability Oversight Council and the relevant insurance

commissioners of the States and relevant foreign jurisdictions, as

appropriate, have not jointly determined, after notice and comment,

that a particular law, regulation, or written guidance described in

Sec. 75.13(c)(2) of the final rule is insufficient to protect the

safety and soundness of the banking entity, or the financial stability

of the United States.\2470\

---------------------------------------------------------------------------

\2470\ See final rule Sec. 75.13(c).

---------------------------------------------------------------------------

The Agencies believe that exempting insurance activities and

investments from the covered fund restrictions is supported by the

language of sections 13(d)(1)(D) and (F) of the BHC Act,\2471\ and more

fully carries out Congressional intent and the statutory purpose of

appropriately accommodating the business of insurance within an

insurance company.\2472\ Section 13(d)(1)(F) of the statute

specifically exempts general accounts of insurance companies, and, as

explained above in Part VI.A.7, separate accounts are managed and

maintained on behalf of customers, an activity exempt under section

13(d)(1)(D) of the statute. By their terms, these are statutory

exemptions from the prohibitions in section 13(a), which includes both

the prohibition on proprietary trading and the prohibition on covered

fund investments and sponsorship. Moreover, the statutory language of

sections 13(d)(1)(D) and 13(d)(1)(F), both cross-reference the

instruments described in section 13(h)(4) and not activity described in

section 13(h)(4). These instruments are ``any security, any derivative,

any contract of sale of a commodity for future delivery, any option on

any such security, derivative or contract or any other security or

financial instrument that [the Agencies determine by rule.]'' This

reference covers an ownership interest in a covered fund. The Agencies

believe these exemptions as modified more fully carry out Congressional

intent and the statutory purpose of appropriately accommodating the

business of insurance within an insurance company.\2473\ Insurance

companies are already subject to a robust regulatory regime including

limitations on their investment activities.

---------------------------------------------------------------------------

\2471\ See 12 U.S.C. 1851(d)(1)(D), (F).

\2472\ See 12 U.S.C. 1851(b)(1)(F). See also 156 Cong. Reg. S.

5896 (daily ed. July 15, 2010) (statement of Sen. Merkley) (arguing

that ``section 13 of the BHC Act] was never meant to affect the

ordinary business of insurance'').

\2473\ See 12 U.S.C. 1851(b)(1)(F). See also 156 Cong. Reg. S.

5896 (daily ed. July 15, 2010) (statement of Sen. Merkley) (arguing

that ``section 13 of the BHC Act] was never meant to affect the

ordinary business of insurance'').

---------------------------------------------------------------------------

5. Section 75.14: Limitations on Relationships With a Covered Fund

Section 13(f) of the BHC Act generally prohibits a banking entity

that, directly or indirectly, serves as investment manager, investment

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

entering into a transaction with a covered fund that would be a covered

transaction as defined in section 23A of the Federal Reserve Act (``FR

Act'').\2474\ The statute also provides an exemption for prime

brokerage transactions between a banking entity and a covered fund in

which a covered fund managed, sponsored, or advised by that banking

entity has taken an ownership interest. Section 13(f) subjects any

transaction permitted under section 13(f) of the BHC Act (including a

permitted prime brokerage transaction) between the banking entity and

covered fund to section 23B of the FR Act.\2475\ In general, section

23B of the FR Act 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.

Section 75.16 of the proposed rule implemented these provisions.\2476\

---------------------------------------------------------------------------

\2474\ 12 U.S.C. 371c. The Agencies note that this does not

alter the applicability of section 23A of the FR Act and the Board's

Regulation W to covered transactions between insured depository

institutions and their affiliates.

\2475\ 12 U.S.C. 371c-1.

\2476\ See proposed rule Sec. 75.16.

---------------------------------------------------------------------------

a. Scope of Application

Section 13(f) of the BHC Act and the related provisions of the

proposal were among the most commented upon aspects of the covered

funds section. The majority of commenters argued that the broad

definition of ``covered fund'' under the proposal made the proposed

implementation of section 13(f) unworkable and disruptive to existing

market practices because it would

[[Page 6017]]

prohibit corporate funding transactions with ordinary corporate

entities that do not engage in hedge fund or private equity

activities.\2477\ Commenters also argued that activities that the

proposal appeared to permit as a permitted activity exemption (e.g.,

investments in public welfare funds) would be prohibited by the

restrictions in 13(f) \2478\ and that the Agencies should construe

section 13(d)(1)(J) of the BHC Act as allowing them to permit banking

entities to enter into covered transactions with a covered fund, if

those activities would promote and protect the safety and soundness of

banking entities and the financial stability of the United

States.\2479\ However, many of the comments discussed above and some of

the economic burdens noted by these commenters have been addressed by

revisions discussed above in Part VI.B.1 to the definition of covered

fund.\2480\ A number of these and related comments are also addressed

by portions of the final rule that provide that the prohibitions of

section 13 do not apply to interests acquired, for example, as agent,

broker, custodian, in satisfaction of a debt previously contracted,

through a pension fund, or as trustee or fiduciary (all within the

limits defined in the final rule).

---------------------------------------------------------------------------

\2477\ See, e.g., Allen & Overy (on behalf of Foreign Bank

Group); BoA; Barclays; Credit Suisse (Williams); Deutsche Bank

(Fund-Linked Products); GE (Feb. 2012); Goldman Sachs (Covered

Funds); ICI Global; ISDA (Feb. 2012); RMA; SIFMA et al. (Covered

Funds) (Feb. 2012).

\2478\ See SunTrust; AHIC; SBIA.

\2479\ See SIFMA et al. (Covered Funds) (Feb. 2012).

\2480\ See final rule Sec. 75.10(b). See supra Part VI.B.1.

---------------------------------------------------------------------------

Several commenters argued that applying the restrictions in section

13(f) to foreign activities of foreign banking entities would be

inconsistent with the presumption against extraterritorial application

of U.S. law and principles of international comity, including deference

to home-country regulation.\2481\ For example, one commenter expressed

concern that rules being developed around custody obligations in the

European Union may require a prime broker or custodian to indirectly

guarantee assets of a fund, which would directly conflict with the

prohibition on guarantees in section 13(f) of the BHC Act.\2482\ As

explained above, the final rule has been modified to more narrowly

focus the scope of the definition of covered fund as it applies to

foreign funds.\2483\ These changes substantially address the issues

raised by commenters regarding the applicability of section 13(f) of

the BHC Act to foreign funds.

---------------------------------------------------------------------------

\2481\ See IIB/EBF; Katten (on behalf of Int'l Clients); EBF;

EFAMA; French Banking Fed'n.; Japanese Bankers Ass'n.

\2482\ See AIMA.

\2483\ See final rule Sec. 75.10(b)(1)(ii) and (c)(1). See

supra Part VI.B.1.

---------------------------------------------------------------------------

Commenters also raised a number of other issues. For instance, some

commenters argued that applying section 13(f) to securitization

entities would in some instances run counter to the rule of

construction contained in section 13(g)(2) regarding the sale and

securitization of loans.\2484\ These commenters recommended that the

final rule, at a minimum, grandfather pre-existing relationships

between banking entities and existing securitization vehicles to reduce

the potential effects of the final rule on agreements and positions

entered into before the enactment of the statute.\2485\

---------------------------------------------------------------------------

\2484\ Section 75.11(b) of the final rule provides that for

purposes of securitizations, organizing and offering includes acting

as the securitizer. As discussed in greater detail above in Part

VI.B.2.b, a banking entity that continues to hold interests in a

securitization in reliance on this exemption must comply with

certain requirements, including the requirements of Sec. 75.14.

Accordingly, Sec. 75.14 of the final rule has also been modified

from the proposal to prohibit a banking entity that continues to

hold an ownership interest in accordance with Sec. 75.11(b), and

its affiliates, from entering into a covered transaction with a

covered fund, subject to certain exceptions.

\2485\ See AFME et al.: ASF (Feb. 2012); Ashurst; BoA; Barclays;

Cadwalader (Municipal Securities); Credit Suisse (Williams);

Commercial Real Estate Fin. Council; Deutsche Bank (Fund-Linked

Products); Fidelity; GE (Feb. 2012); Goldman Sachs (Covered Funds);

ICI (Feb. 2012); IIB/EBF; ISDA (Feb. 2012); JPMC; PNC et al.; PNC;

RBC; SIFMA et al. (Covered Funds) (Feb. 2012); SIFMA

(Securitization) (Feb. 2012); Chamber (Feb. 2012). These comments

are addressed above in Part II regarding availability of the

conformance period provisions of section 13 of the BHC Act.

---------------------------------------------------------------------------

One commenter argued that a banking entity that delegates its

responsibility for acting as sponsor, investment manager, or investment

adviser to an unaffiliated entity should no longer be subject to the

restrictions of section 13(f).\2486\ By its terms, section 13(f) of the

BHC Act applies to a banking entity that, directly or indirectly,

serves as investment manager, investment adviser, or sponsor to a

covered fund (or that relies on section 13(d)(1)(G) of the BHC Act in

connection with organizing and offering a covered fund). The Agencies

believe that a banking entity that delegates its responsibility to act

as sponsor, investment manager, or investment adviser to an

unaffiliated party would still be subject to the limitations of section

13(f) if the banking entity retains the ability to select, remove,

direct, or otherwise exert control over the sponsor, investment

manager, or investment adviser designee. In addition, the unaffiliated

party designated as sponsor, investment manager, or investment adviser

would be subject to the restrictions of section 13(f) if the third

party is a banking entity.

---------------------------------------------------------------------------

\2486\ See Katten (on behalf of Int'l Clients).

---------------------------------------------------------------------------

b. Transactions That Would Be a ``Covered Transaction''

Section 13(f) of the BHC Act prohibits covered transactions as

defined in section 23A of the FR Act between a banking entity that

serves as investment manager, investment advisor or sponsor to a

covered fund or that relies on the exemption in section 13(d)(1)(G) and

a covered fund.\2487\ A number of commenters contended that the

definition of ``covered transaction'' in section 13(f) of the BHC Act

should incorporate the exemptions available under section 23A and the

Board's Regulation W.\2488\ These commenters alleged that the statute's

general reference to section 23A suggests that the term ``covered

transaction'' should be construed in light of section 23A as a whole,

including the exemptions in subsection (d) of that Act and as

implemented in the Board's Regulation W.\2489\ These commenters also

argued that the Board's authority to interpret and issue rules pursuant

to section 23A of the FR Act and section 5(b) of the BHC Act, the

general rule-making authority contained in section 13(b) of the BHC

Act, and the exemptive authority in section 13(d)(1)(J) all

[[Page 6018]]

provide a basis for providing such exemptions.\2490\

---------------------------------------------------------------------------

\2487\ 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.

\2488\ See 12 U.S.C. 371c(d); 12 CFR 223.42; ABA (Keating);

Ass'n. of Institutional Investors (Feb. 2012); BoA; BNY Mellon et

al.; Credit Suisse (Williams); SIFMA et al. (Covered Funds) (Feb.

2012); see also Allen & Overy (on behalf of Foreign Bank Group).

\2489\ See ABA (Keating); Ass'n. of Institutional Investors

(Feb. 2012); BoA; BNY Mellon et al.; SIFMA et al. (Covered Funds)

(Feb. 2012).

\2490\ See BNY Mellon et al.; SIFMA et al. (Covered Funds) (Feb.

2012); see also Credit Suisse (Williams).

---------------------------------------------------------------------------

In particular, commenters argued that intraday extensions of

credit; \2491\ transactions fully secured by cash or U.S. government

securities; \2492\ purchases of liquid assets and marketable securities

from covered funds; \2493\ and riskless principal transactions with

covered funds all should be exempt from the restrictions in section

13(f) of the BHC Act.\2494\ These commenters argued that providing an

exemption for intraday extensions of credit in particular was necessary

to allow a banking entity to continue to provide affiliated covered

funds with standard custody, clearing, and settlement services that

include intra-day or overnight overdrafts necessary to facilitate

securities settlement, contractual settlement, pre-determined income,

or similar custody-related transactions. Some commenters argued that

transactions fully secured by cash or U.S. government securities do not

expose banking entities to inappropriate risks, are permitted in

unlimited amounts under section 23A, and should not be entirely

prohibited under the rule.\2495\ A few commenters argued that the

proposal would prohibit securities lending transactions and argued that

borrower default indemnifications by a banking entity in agency

securities lending arrangements should not be prohibited under section

13(f).\2496\ Some commenters argued that a banking entity should be

allowed to accept the shares of a sponsored covered fund as collateral

for a loan to any person or entity, in particular where the loan is not

for the purpose of purchasing interests in the covered fund.\2497\

---------------------------------------------------------------------------

\2491\ See ABA (Keating); AFG; Ass'n. of Institutional Investors

(Feb. 2012); BoA; BNY Mellon et al.; Credit Suisse (Williams);

EFAMA; French Treasury et al.; JPMC; IMA; RMA; SIFMA et al. (Covered

Funds) (Feb. 2012); State Street (Feb. 2012); SSgA (Feb. 2012);

Vanguard.

\2492\ See BoA; Credit Suisse (Williams); SIFMA et al. (Covered

Funds) (Feb. 2012).

\2493\ See Credit Suisse (Williams).

\2494\ See, e.g., Credit Suisse (Williams).

\2495\ See BoA; Credit Suisse (Williams); SIFMA et al. (Covered

Funds) (Feb. 2012).

\2496\ See State Street (Feb. 2012); RMA.

\2497\ See BoA; SIFMA et al. (Covered Funds) (Feb. 2012); see

also Katten (on behalf of Int'l Clients).

---------------------------------------------------------------------------

One commenter argued that no exceptions should be granted to the

definition of covered transaction, and financing of covered funds would

relate to greater fund risk.\2498\ In addition, that commenter

contended that the Agencies should prohibit a sale of securities by a

banking entity to a covered fund even though these transactions are not

within the definition of covered transaction for purposes of section

23A of the FR Act.\2499\

---------------------------------------------------------------------------

\2498\ See Occupy.

\2499\ See 12 U.S.C. 371c(b)(7); see also 12 U.S.C. 371c-

1(a)(2)(B) (including the sale of securities or other assets to an

affiliate as a transaction subject to section 23B).

---------------------------------------------------------------------------

The final rule continues to apply the same definition of covered

transaction as the proposal. Section 13(f) refers to a covered

transaction, as defined in section 23A of the FR Act. Section 13(f) of

the BHC Act does not incorporate or reference the exemptions contained

in section 23A of the FR Act or the Board's Regulation W. Indeed, the

exemptions for these transactions are not included in the definition of

covered transactions in section 23A; the exemptions are instead in a

different subsection of section 23A and provide an exemption from only

some (but not all) of the provisions of section 23A governing covered

transactions.\2500\ Therefore, the final rule does not incorporate the

exemptions in section 23A.

---------------------------------------------------------------------------

\2500\ See 12 U.S.C. 371c(d).

---------------------------------------------------------------------------

Similarly, the final rule incorporates the statutory restriction as

written, which provides that a banking entity that serves in certain

specified roles may not enter into a transaction with a covered fund

that would be a covered transaction as defined in section 23A of the FR

Act as if the banking entity were a member bank and the covered fund

were an affiliate thereof. There are certain occasions when the

restrictions of section 23A apply to transactions that involve a third

party other than an affiliate of a member bank. For example, section

23A would apply to an extension of credit by a member bank to a

customer where the extension of credit is secured by shares of an

affiliate. The Agencies believe that these transactions between a

banking entity and a third party that is not a covered fund are not

covered by the terms of section 13(f), which (as discussed above) make

specific reference to transactions by the banking entity with the

covered fund. A contrary reading would prohibit securities margin

lending, which Congress has specifically addressed (and permitted) in

other statutes. There is no indication in the legislative history that

Congress intended section 13(f) to prohibit margin lending that occurs

in accordance with other specific statutes. Thus, section 13(f) does

not prohibit a banking entity from extending credit to a customer

secured by shares of a covered fund (as well as, perhaps, other

securities) held in a margin account. However, the Agencies expect

banking entities not to structure transactions with third parties in an

attempt to evade the restrictions on transactions with covered funds,

and the Agencies will use their supervisory authority to monitor and

restrict transactions that appear to be evasions of section 13(f).

c. Certain Transactions and Relationships Permitted

While section 13(f)(1) of the BHC Act generally prohibits a banking

entity from entering 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 permit a banking entity

to engage in certain transactions or relationships with such funds.

1. Permitted Investments and Ownerships Interests

The proposed rule permitted a banking entity to acquire or retain

an ownership interest in a covered fund in accordance with the

requirements of section 13.\2501\ This was consistent with the text of

section 13(f), which by its terms is triggered by the presence of

certain ownership interests. This view also resolved an apparent

conflict between the text of section 13(f) and the reference in section

13(f) prohibiting covered transactions under section 23A of the FR Act,

which includes acquiring or retaining an interest in securities issued

by an affiliate.

---------------------------------------------------------------------------

\2501\ See proposed rule Sec. 75.16(a)(2)(i).

---------------------------------------------------------------------------

Several commenters supported this aspect of the proposal.\2502\

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. Therefore, the final rule

adopts this provision as proposed.\2503\

---------------------------------------------------------------------------

\2502\ See, e.g., SIFMA et al. (Covered Funds) (Feb. 2012).

\2503\ The final rule modifies the proposal to clarify that a

banking entity may acquire and retain an ownership interest in a

covered fund by express reference to the permitted activities

described in Sec. Sec. 75.11, 75.12 and 75.13.

---------------------------------------------------------------------------

2. Prime Brokerage Transactions

Section 13(f) provides an exception from the prohibition on covered

transactions with a covered fund for any prime brokerage transaction

with a covered fund in which a covered fund managed, sponsored, or

advised by a banking entity has taken an ownership interest (a

``second-tier fund''). However, the statute does not define

[[Page 6019]]

prime brokerage transaction. The proposed rule defined prime brokerage

transaction to include providing one or more products or services, such

as custody, clearance, securities borrowing or lending services, trade

execution, or financing, data, operational, and portfolio management

support.\2504\

---------------------------------------------------------------------------

\2504\ See proposed rule Sec. 75.10(b)(4).

---------------------------------------------------------------------------

A few commenters argued that the proposed definition of prime

brokerage transaction was overly broad and should not permit securities

lending or borrowing services. These commenters argued that securities

lending and borrowing (and certain other services) could increase

leverage by covered funds and the risk that a banking entity would

bailout these funds.\2505\

---------------------------------------------------------------------------

\2505\ See, e.g., Occupy; Public Citizen.

---------------------------------------------------------------------------

Other commenters argued that the proposed definition of prime

brokerage transaction was confusing because it included transactions

(such as data or portfolio management support) that were not ``covered

transactions'' under section 23A of the FR Act and thus not prohibited

as an initial matter by section 13(f). These commenters argued that

including otherwise permissible transactions within the definition of

prime brokerage transaction created uncertainty about the

permissibility of other transactions or services that are not expressly

covered transactions under section 23A of the FR Act and thus not

prohibited under section 13(f). One commenter proposed defining prime

brokerage transaction as any ``covered transaction'' entered into by a

banking entity with a covered fund ``for purposes of custody,

clearance, securities borrowing or lending services, trade execution

and settlement, financing and related hedging, intermediation, or a

similar purpose.'' \2506\

---------------------------------------------------------------------------

\2506\ See SIFMA et al. (Mar. 2012).

---------------------------------------------------------------------------

A few commenters supported expanding the definition of prime

brokerage transaction to include any service or transaction ``related

to'' a specific list of permissible transactions. For instance, one

commenter argued that acting as agent in providing contractual income

and settlement services and intraday and overnight overdraft protection

should expressly be included within the definition of prime brokerage

transaction.\2507\ This commenter also urged that borrower default

indemnification should be included as a prime brokerage transaction to

the extent it would be a covered transaction that is prohibited by

section 13(f).\2508\ Another commenter recommended that the definition

of prime brokerage transaction expressly include transactions in

commodities, futures and foreign exchange, as well as securities, and

transactions effected through OTC derivatives, including, without

limitation, contracts for differences, various swaps and security-based

swaps, foreign exchange swaps and forwards and ``FX prime

brokerage''.\2509\

---------------------------------------------------------------------------

\2507\ See RMA.

\2508\ See RMA.

\2509\ See Katten (on behalf of Int'l Clients).

---------------------------------------------------------------------------

Based on review of the comments, the definition of prime brokerage

transaction has been modified in several ways. For purposes of the

final rule, prime brokerage transaction is defined to mean any

transaction that would be a covered transaction, as defined in section

23A(b)(7) of the FR Act (12 U.S.C. 371c(b)(7)), that is provided in

connection with custody, clearance and settlement, securities borrowing

or lending services, trade execution, financing, or data, operational,

and administrative support. The definition of prime brokerage

transaction under the final rule generally recognizes the same

relationships that were considered when defining prime brokerage

transaction under the proposal,\2510\ without certain of the

modifications suggested by some commenters that are discussed above.

The Agencies carefully considered comments received on the definition

of prime brokerage transaction. As noted above, certain commenters

requested that various types of transactions be included in or omitted

from the definition. The Agencies believe it appropriate to include

within the definition of prime brokerage transaction those transactions

that the Agencies believe generally constitute the typical type of

prime brokerage transactions provided in the market. Including this

list of relationships provides clarity and certainty for transactions

that are commonly considered to be prime brokerage transactions.

---------------------------------------------------------------------------

\2510\ See final rule Sec. 75.10(d)(5).

---------------------------------------------------------------------------

The final rule incorporates within the definition of prime

brokerage transaction a reference to covered transactions under section

23A(b)(7) of the FR Act. This change aligns the final rules with

section 13(f) of the BHC Act and is designed to eliminate confusion and

provide certainty regarding both the breath of the prohibition on

covered transactions in section 13(f) and the scope of the exception

for prime brokerage transactions. Thus, a transaction or relationship

that is not a covered transaction under section 13(f) of the BHC Act is

not prohibited in the first instance (unless prohibited elsewhere in

section 13). Within the category of transactions prohibited by section

13(f), transactions within the definition of prime brokerage

transaction are permitted.

Some commenters argued that the Agencies should provide an

exemption for prime brokerage transactions with a broader array of

funds than the proposal permitted. For instance, some commenters argued

that the Agencies should permit a banking entity to enter into a prime

brokerage transaction with any covered fund or fund structure that the

banking entity organizes and offers or for which it directly serves as

investment manager, investment adviser, or sponsor, and should not

limit the exception for prime brokerage transactions to only a second-

tier covered fund.\2511\ Conversely, a few commenters argued that the

prime brokerage exemption should only permit a banking entity to

provide these services to a third-party fund in order to ensure that

the provision of prime brokerage services does not give rise to the

same risks that section 13 was designed more generally to limit.\2512\

---------------------------------------------------------------------------

\2511\ See RMA; Katten (on behalf of Int'l Clients); EFAMA; see

also Hong Kong Inv. Funds Ass'n.; IMA; Union Asset.

\2512\ See Sens. Merkley & Levin (Feb. 2012); Occupy.

---------------------------------------------------------------------------

The Agencies note that the statute by its terms does not restrict

prime brokerage transactions generally. As noted above, section

13(f)(3)(A) of the BHC Act provides that a banking entity may enter

into any prime brokerage transaction with a second-tier fund. The

statute by its terms permits a banking entity with a relationship to a

covered fund described in section 13(f) to engage in prime brokerage

transactions (that are covered transactions) only with second-tier

funds and does not extend to covered funds more generally. Neither the

statute nor the final rule limit covered transactions between a banking

entity and a covered fund for which the banking entity does not serve

as investment manager, investment adviser, or sponsor (as defined in

section 13 of the BHC Act) or have an interest in reliance on section

13(d)(1)(G) of the BHC Act. Under the statute, the exemption for prime

brokerage transactions is available only so long as certain enumerated

conditions are satisfied.\2513\ The conditions are that (i) the chief

executive officer (or equivalent officer) of the banking entity

certifies in writing annually that the banking entity does not,

directly or indirectly, guarantee, assume, or otherwise insure the

obligations or performance of the

[[Page 6020]]

covered fund or of any covered fund in which such covered fund invests,

and (ii) the Board has not determined that such transaction is

inconsistent with the safe and sound operation and condition of the

banking entity. The proposed rule incorporated each of these

provisions. The final rule provides that this certification be made to

the appropriate Federal supervisor for the banking entity.

---------------------------------------------------------------------------

\2513\ See 12 U.S.C. 1851(f)(3).

---------------------------------------------------------------------------

A few commenters argued that the proposal did not adequately

address how the CEO attestation requirement in section 13(f) would

apply to foreign banking organizations. They argued that a senior

officer with authority for the U.S. operations of the foreign bank

should be permitted to make the required attestation.\2514\

---------------------------------------------------------------------------

\2514\ See proposed rule Sec. 75.16(a)(2)(ii); IIB/EBF; Credit

Suisse (Williams).

---------------------------------------------------------------------------

The statute allows the attestation for purposes of the prime

brokerage exception in section 13(f) of the BHC Act to be from the

chief executive officer or ``equivalent officer.'' \2515\ In the case

of the U.S. operations of foreign banking entities, the senior officer

of the foreign banking entity's U.S. operations or the chief executive

officer of the U.S. banking entity may provide the required

attestation.

---------------------------------------------------------------------------

\2515\ See 12 U.S.C. 1851(f)(3)(A)(ii).

---------------------------------------------------------------------------

d. Restrictions on Transactions With Any Permitted Covered Fund

Sections 13(f)(2) and 13(f)(3)(B) of the BHC Act apply section 23B

of the FR Act \2516\ 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.\2517\

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

the banking entity as those prevailing at the time for comparable

transactions with or involving 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, non-affiliated companies.\2518\

---------------------------------------------------------------------------

\2516\ 12 U.S.C. 371c-1.

\2517\ See proposed rule Sec. 75.16(b).

\2518\ 12 U.S.C. 371c-1(a); 12 CFR 223.51.

---------------------------------------------------------------------------

Mirroring the statute, the proposal applied this requirement to

transactions between a banking entity that serves as investment

manager, investment adviser, or sponsor to a covered fund and that fund

and any other fund controlled by that fund. It also applied this

condition to a permissible prime brokerage transaction in which a

banking entity may engage under the proposal.

Commenters generally did not raise any issues regarding the

proposal's implementation of section 13(f)(2) and 13(f)(3)(B). The

final rule generally implements these requirements in the same manner

as the proposal.\2519\

---------------------------------------------------------------------------

\2519\ See final rule Sec. 75.14(b). As discussed above, Sec.

75.11(b) of the final rule provides that for purposes of

securitizations, organizing and offering includes acting as the

securitizer. A banking entity that continues to own interests in a

securitization in reliance on this exemption must comply, among

other things, with the requirements of Sec. 75.14. Accordingly,

Sec. 75.14(b) of the final rule has been modified to require that a

banking entity that continues to hold an ownership interest in

accordance with Sec. 75.11(b) is subject to section 23B of the

Federal Reserve Act, as if such banking entity were a member bank

and the covered fund were an affiliate.

---------------------------------------------------------------------------

6. Section 75.15: Other Limitations on Permitted Covered Fund

Activities

Like Sec. 75.8, Sec. 75.17 of the proposed rule implemented

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. 75.8

of the proposed rule, Sec. 75.17 provided that no transaction, class

of transactions, or activity was permissible under Sec. Sec. 75.11

through 75.14 and Sec. 75.16 of the proposed rule if the transaction,

class of transactions, or activity would: (i) Involve or result in a

material conflict of interest between the banking entity and its

clients, customers, or counterparties; (ii) result, directly or

indirectly, in a material exposure by the banking entity to a high-risk

asset or a high-risk trading strategy; or (iii) pose a threat to the

safety and soundness of the banking entity or the financial stability

of the United States.

Section 75.17 of the proposed rule defined ``material conflict of

interest,'' ``high-risk assets,'' and ``high-risk trading strategies''

for these purposes in a fashion identical to the definitions of the

same terms for purposes of Sec. 75.8 of the proposed rule related to

proprietary trading. In the final rule, other than the permitted

activities to which Sec. Sec. 75.7 and 75.15 apply, Sec. Sec. 75.7

and 75.15 are also identical. Comments received on the definitions in

these sections, as well as the treatment of these concepts under the

final rule, are described in detail in Part VI.A.9 above.

The Agencies also note that some concerns identified by commenters

regarding the rule's extraterritorial application are addressed by

modifications in the final rule to the definition of a covered fund

under Sec. 75.10. As noted above, commenters requested that the

Agencies clarify that the limitations in Sec. Sec. 75.8 or 75.17 of

the proposed rule apply only to a foreign banking entity's U.S.

activities and affiliates.\2520\ As discussed in greater detail above

in Part VI.B.1, the final rule has been modified to more narrowly focus

the scope of the definition of covered fund as it applies to foreign

funds. Pursuant to the definition of a covered fund in Sec.

75.10(b)(1), a foreign fund may be a covered fund with respect to the

U.S. banking entity that sponsors the fund, but not be a covered fund

with respect to a foreign bank that invests in the fund solely outside

the United States. Foreign public funds, as defined in Sec.

75.10(c)(1) of the final rule, are also excluded from the definition of

a covered fund. By excluding foreign public funds from the definition

of covered fund and by narrowing the scope of the definition of a

covered fund with respect to foreign funds, the Agencies have addressed

some commenters' concerns regarding the burdens imposed by proposed

rule Sec. 75.17.

---------------------------------------------------------------------------

\2520\ See EBF; Ass'n. of German Banks.

---------------------------------------------------------------------------

C. Subpart D and Appendices A and B--Compliance Program, Reporting, and

Violations

Subpart D of the proposed rule implemented section 13(e)(1) of the

BHC Act and required 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

activities and investments set forth in section 13 and the proposed

rule.\2521\

---------------------------------------------------------------------------

\2521\ For Commission registrants that are swap dealers and to

which this rule applies, it is noted that the compliance

requirements of subpart D are included in the Commission's

regulations that are to be addressed as part of the chief compliance

officer duties and requirements under CFTC regulation 3.3.

---------------------------------------------------------------------------

As explained in detail below, in response to comments on the

compliance program requirements and Appendix C (Minimum Standards for

Programmatic Compliance) and to conform to modifications to other

sections of the proposed rule, the Agencies are adopting a variety of

modifications to Subpart D of the proposed rule, which 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 proprietary

trading activities and

[[Page 6021]]

covered fund activities and investments set forth in section 13 of the

BHC Act and the final rule. As described above, this compliance program

requirement forms a key part of the 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 proprietary trading activities and covered fund

activities and investments.

The proposal adopted a tiered approach to implementing the

compliance program mandate, requiring a banking entity engaged in

proprietary trading activities or covered fund activities and

investments to establish a compliance program that contained specific

elements and, if the banking entity's activities were significant, meet

a number of more detailed minimum standards. If a banking entity did

not engage in proprietary trading activities and covered fund

activities and investments, it was required to ensure that its existing

compliance policies and procedures included measures that were designed

to prevent the banking entity from becoming engaged in such activities

and making such investments and to develop and provide for the required

program under Sec. 75.20(a) of the proposed rule prior to engaging in

such activities or making such investments, but was not otherwise

required to meet the requirements of subpart D of the proposed rule.

1. Section 75.20: Compliance Program Mandate

a. Program Requirement

A number of commenters argued that the compliance program

requirements of the proposal were overly specific, too prescriptive and

complex to be workable, and not justified by the costs and benefits of

having a compliance program.\2522\ For instance, one commenter

expressed concern that the complexity of the proposed compliance regime

would undermine compliance efforts because the requirements were

overlapping, imprecise, and did not provide sufficient clarity to

traders or banking entities as to what types or levels of activities

would be viewed as permissible trading.\2523\ Some commenters argued

that the compliance program would be challenging to enforce or

administer with any consistency across different banking entities and

jurisdictions.\2524\ A few commenters objected to any attempt to

identify every possible instance of prohibited proprietary trading in

otherwise permitted activity.\2525\ By contrast, some commenters

supported the proposed compliance program as effective and consistent

with the statute but also suggested a number of ways that the

proposal's compliance program could be improved.\2526\

---------------------------------------------------------------------------

\2522\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012);

Citigroup (Feb. 2012); Wells Fargo (Prop. Trading); see also

Barclays; BlackRock; Chamber (Dec. 2011); Comm. on Capital Markets

Regulation; Credit Suisse (Williams); FIA; Goldman (Covered Funds);

Investure; NYSE Euronext; RBC; STANY; Wedbush; see also Northern

Trust; Chamber (Feb. 2012).

\2523\ See Citigroup (Feb. 2012).

\2524\ See ABA (Abernathy); IIB/EBF; ICFR. While the Agencies

recognize these issues, the Agencies believe the final rule's

modifications to the proposal--for example, providing for simplified

programs for smaller, less active banking entities and increasing

the asset threshold that triggers enhanced compliance requirements--

helps balance enforceability and consistency concerns with

implementing a program that helps to ensure compliance consistent

with section 13(e)(1) of the BHC Act. See 12 U.S.C. 1851(e)(1).

\2525\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012); RBC;

STANY; see also Barclays.

\2526\ See AFR (Nov. 2012); Occupy; Sens. Merkley & Levin (Feb.

2012)

---------------------------------------------------------------------------

A few commenters argued that the proposed compliance program should

be replaced with a more principles-based framework that provides

banking entities the discretion and flexibility to customize compliance

programs tailored to the structure and activities of their

organizations.\2527\ A few commenters argued that building on

compliance regimes that already exist at banking entities, including

risk limits, risk management systems, board-level governance protocols,

and the level at which compliance is monitored, would reduce the costs

and complexity of the proposal while also enabling a robust compliance

mechanism for section 13.\2528\

---------------------------------------------------------------------------

\2527\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Wells Fargo

(Prop. Trading); see also M&T Bank; Credit Suisse (Seidel); State

Street (Feb. 2012); see also NYSE Euronext; Stephen Roach.

\2528\ See Citigroup (Feb. 2012); SIFMA et al. (Prop. Trading)

(Feb. 2012); see also ABA (Abernathy); Paul Volcker.

---------------------------------------------------------------------------

Another commenter suggested that the focus of the compliance

program be on the key goal of reducing risk at banking entities by

requiring each banking entity to establish a risk architecture that

prescribes a customer-focused business model for market making-related

activities including a comprehensive set of risk limits that focuses on

servicing customers and ensuring safety and soundness.\2529\ This

commenter suggested the proposal's compliance requirements be replaced

by a simpler compliance framework that could be harmonized with the

broader systemic capital and risk management framework under the Basel

accord. This commenter argued such a framework would increase

transparency as well as reduce overall complexity and costs of

regulation, and that information relevant to the compliance

infrastructure, including customer orientation policies and procedures,

target customer and product lists, trade histories, and risk limit

calibration methodology and analyses, should all be made available to

examiners.\2530\ Another commenter urged that the compliance program

could be generally improved by having a greater focus on the

compensation incentives within the compliance program of banking

entities.\2531\

---------------------------------------------------------------------------

\2529\ See Citigroup (Feb. 2012); see also SIFMA et al. (Prop.

Trading) (Feb. 2012).

\2530\ See Citigroup (Feb. 2012).

\2531\ See Occupy.

---------------------------------------------------------------------------

A number of other commenters requested certain types of banking

entities be specifically excluded from having to implement the

requirements of the compliance program. For example, some commenters

urged that the details required in proposed Appendix C apply only to

those banking entities and business lines within a banking group that

have ``significant'' covered funds or trading activities and not apply

to an affiliate of a banking entity that does not engage in the types

of activities section 13 is designed to address (e.g., an industrial

affiliate that manufactures machinery).\2532\ One commenter argued that

the final rule should not impose a compliance program requirement on a

banking entity that owns 50 percent or less of another banking entity

in order to ensure the compliance program did not discourage joint

ventures or other arrangements where a banking entity does not have

actual control over an affiliate.\2533\ As discussed in Part VI.B.4.c.

above,\2534\ other commenters argued that the reporting and

recordkeeping and compliance requirements of the rule should not apply

to permitted insurance company investment activities because insurance

companies are already subject to comprehensive regulation of the kinds

[[Page 6022]]

and amounts of investments they can make under State or foreign

insurance laws and regulations.\2535\ However, another commenter

suggested that insurance company affiliates of banking entities

expressly be made subject to data collection and reporting requirements

to prevent possible evasion of the restrictions of section 13 and the

final rule using their insurance affiliates.\2536\

---------------------------------------------------------------------------

\2532\ See, e.g., Credit Suisse (Williams); GE (Feb. 2012); see

also NAIB et al.; Chamber (Feb. 2012).

\2533\ See GE (Feb. 2012). Under the BHC Act, an entity would

generally be considered an affiliate of a banking entity, and

therefore a banking entity itself, if it controls, is controlled by,

or is under common control with an insured depository institution.

Pursuant to the BHC Act, a company controls another company if, for

instance, the company directly or indirectly or acting through one

or more other persons owns, controls, or has power to vote 25 per

cent or more of any class of voting securities of the company. See

12 U.S.C. 1841(a)(2). The compliance program requirement applies to

all banking entities in order to ensure their compliance with the

final rule.

\2534\ See Part VI.B.4.c.

\2535\ See, e.g., ACLI (Jan. 2012); Country Fin. et al.; NAMIC.

\2536\ See Sens. Merkley & Levin (Feb. 2012). As noted above,

the compliance program requirement applies to all banking entities,

including insurance companies that are considered banking entities,

in order to ensure their compliance with the final rule.

---------------------------------------------------------------------------

A few commenters argued that requiring securitization vehicles to

establish even the minimal requirements set forth in Sec. 75.20(d)

would impose unnecessary costs and burdens on these entities.\2537\ By

contrast, another commenter argued that, because of the perceived risks

of these entities, securitization vehicles related to a banking entity

should be required to comply fully with the proposed rule regardless of

how such compliance procedures are funded by the banking entity.\2538\

---------------------------------------------------------------------------

\2537\ See ASF (Feb. 2012); AFME et al.; SIFMA (Securitization)

(Feb. 2012); Commercial Real Estate Fin. Council.

\2538\ See Occupy.

---------------------------------------------------------------------------

Several commenters urged that foreign activities of foreign banking

entities, which are already subject to their own prudential regulation

under applicable home country regulation, be excluded from the

compliance program and argued that to do otherwise would be an

extraterritorial expansion of U.S. law.\2539\ These commenters

contended that the compliance program requirements for foreign banking

entities should, in any event, be narrowly circumscribed.\2540\ One

commenter proposed that the foreign activity of foreign banking

entities be excluded from compliance, reporting and other obligations

where the risk of the activity is outside of the United States because

those risks do not pose a threat to U.S. taxpayers.\2541\ Another

commenter argued that only U.S. affiliates of foreign banking entities

engaged in proprietary trading and covered fund activities as principal

in the United States should be required to institute the compliance and

reporting systems required in the proposal, and that all foreign

affiliates only be required to have policies and procedures designed to

prevent the banking entity from engaging in relevant trading and

covered fund activities in the United States.\2542\ This commenter also

expressed concern that the reporting and recordkeeping requirements

could be interpreted to apply to an entire trading unit, even trading

activities with no U.S. nexus, if any portion of a trading unit's

activities, even a single trade, would be required to rely on the

market-making, hedging, underwriting or U.S. government security

exemptions.\2543\

---------------------------------------------------------------------------

\2539\ See, e.g., Soci[eacute]t[eacute] G[eacute]n[eacute]rale;

IIB/EBF; Australian Bankers Ass'n. (Feb. 2012); Banco de

M[eacute]xico; Norinchukin; Cadwalader (on behalf of Thai Banks);

Cadwalader (on behalf of Singapore Banks); Allen & Overy (on behalf

of Canadian Banks); BAROC; Comm. on Capital Markets Regulation;

Credit Suisse (Williams); EFAMA; Hong Kong Inv. Funds Ass'n.; HSBC;

IIAC; IMA; Katten (on behalf of Int'l Clients); Ass'n. of Banks in

Malaysia; RBC; Sumitomo Trust; see also AFME et al.; British

Bankers' Ass'n.; EBF; Commissioner Barnier; French Banking Fed'n.;

UBS; Union Asset.

\2540\ See, e.g., AFME et al.; IIB/EBF; BaFin/Deutsche

Bundesbank; Credit Suisse (Williams); HSBC.

\2541\ See Australian Bankers Ass'n. (Feb. 2012); see also RBC.

\2542\ See IIB/EBF.

\2543\ See IIB/EBF.

---------------------------------------------------------------------------

Commenters also offered thoughts on the timeframe within which

banking entities must establish a compliance program. One commenter

urged that reporting begin immediately,\2544\ while another commenter

contended that the effective date provided banking entities with

sufficient time to implement the proposal's compliance program.\2545\

Other commenters, however, argued that banking entities should have

additional time to establish compliance programs.\2546\ Some commenters

argued banking entities should have one-year from the date of

publication of the final rule to implement their compliance

programs,\2547\ while others urged that banking entities have a two-

year period to build compliance systems.\2548\ One commenter suggested

the Board amend its conformance rule to provide U.S. banking entities

with an additional year for implementing the compliance requirements

with respect to their foreign operations.\2549\

---------------------------------------------------------------------------

\2544\ See Occupy.

\2545\ See Alfred Brock.

\2546\ See Wells Fargo (Prop. Trading); PNC et al.; Australian

Bankers Ass'n. (Feb. 2012); SIFMA et al. (Prop. Trading) (Feb.

2012); ABA (Keating); AFME et al.; BoA; Barclays; SIFMA et al.

(Covered Funds) (Feb. 2012); SIFMA et al. (Mar. 2012); Comm. on

Capital Markets Regulation; Credit Suisse (Williams); T. Rowe Price;

see also Citigroup (Feb. 2012); Soci[eacute]t[eacute]

G[eacute]n[eacute]rale; IIB/EBF; Am. Express; Arnold & Porter; BDA

(Mar. 2012).

\2547\ See Wells Fargo (Prop. Trading); PNC et al.; Australian

Bankers Ass'n. (Feb. 2012); BoA; Barclays; SIFMA et al. (Covered

Funds) (Feb. 2012); SIFMA et al. (Mar. 2012); Credit Suisse

(Seidel); see also BDA (Mar. 2012).

\2548\ See SIFMA et al. (Prop. Trading) (Feb. 2012); ABA

(Keating); AFME et al.; GE; Credit Suisse (Williams); Goldman (Prop.

Trading); Morgan Stanley; RBC; SVB.

\2549\ See Morgan Stanley.

---------------------------------------------------------------------------

After considering comments on the proposal, the final rule retains

the compliance program requirement with a variety of modifications. In

particular, the modifications are designed to make the compliance

program requirements clearer and more tailored to the size, complexity

and type of activity conducted by each banking entity.\2550\ The

Agencies also believe that the revisions build on the limits,

procedures and elements of risk management programs that many banking

entities have already developed to monitor and control the risk of

existing trading and investment activities.\2551\

---------------------------------------------------------------------------

\2550\ The Agencies believe these modifications, such as

increasing the threshold that triggers enhanced compliance standards

and allowing smaller banking entities to customize their compliance

programs, help address concerns that the proposed requirement was

too complex and unworkable. See, e.g., SIFMA et al. (Prop. Trading)

(Feb. 2012); Citigroup (Feb. 2012); Wells Fargo (Prop. Trading).

\2551\ Some commenters argued that the requirement should build

on banking entities' existing compliance regimes. See Citigroup

(Feb. 2012); SIFMA et al. (Prop. Trading) (Feb. 2012); see also ABA

(Abernathy); Paul Volcker.

---------------------------------------------------------------------------

The final rule builds on the proposed rule's tiered approach by

adjusting asset thresholds and by adding a new provision allowing a

banking entity with modest covered activities to customize its

compliance program. Specifically, the final rule allows banking

entities with total assets below $10 billion to fold compliance

measures into their existing compliance program in a manner that

addresses the types and amounts of activities the entity

conducts.\2552\ The proposal did not contain such a provision. Similar

to the proposal, the final rule requires that a banking entity that

conducts no activity subject to section 13 of the BHC Act is not

required to develop any compliance program until it begins conducting

activities subject to section 13.\2553\ The final rule further modifies

the proposal by requiring that a banking entity with total assets

greater than $10 billion but less than $50 billion is generally

required to establish a compliance program suited to its activities

which includes the six elements described in the final rule.\2554\

Additionally, the final

[[Page 6023]]

rule requires that the largest and most active banking entities, with

total assets above $50 billion, or that are subject to the quantitative

measurements requirement due to the size of their trading assets and

liabilities, adopt an enhanced compliance program that addresses the

six elements described in the rule plus a number of more detailed

requirements described in Appendix B.\2555\

---------------------------------------------------------------------------

\2552\ See final rule Sec. 75.20(f)(2).

\2553\ See final rule Sec. 75.20(f)(1). In response to a few

commenters, the final rule, unlike Sec. 75.20(d) of the proposed

rule, no longer requires a banking entity include measures that are

designed to prevent such entity from becoming engaged in covered

trading activities or covered fund investments and activities.

\2554\ Under the proposal, each banking entity was required to

have a compliance program that addressed the elements described in

the rule, unless the banking entity did not engage in prohibited

activities or investments, in which case it need only have existing

policies and procedures requiring the banking entity to develop a

compliance program before engaging in such activities. Further, a

banking entity that has trading assets and liabilities equal to or

greater than $1 billion, or equal to 10% or more of total assets,

would have been subject to additional standards under the proposed

rule. See proposed rule Sec. 75.20(a), (c), (d).

\2555\ Because the Agencies have determined not to retain

proposed Appendix B in the final rule, proposed Appendix C is now

Appendix B under the final rule.

---------------------------------------------------------------------------

In response to commenters' concerns regarding compliance program

burdens in connection with covered fund activities and investments, the

final rule is further modified with respect to thresholds for covered

fund activities and investments. As noted above, this and the other

modifications are designed to make the compliance program requirement

clearer and more tailored to the size, complexity and type of activity

conducted by each banking entity. The final rule, unlike the proposal,

does not require a banking entity to adopt the enhanced compliance

program if the banking entity, together with its affiliates and

subsidiaries, invests in the aggregate more than $1 billion in covered

funds or if they sponsor or advise covered funds, the average total

assets of which are equal to or greater than $1 billion. Banking

entities would look to the total asset thresholds discussed above,

instead of the amount of covered fund investments and activities, in

determining whether they would be subject to the enhanced compliance

program requirements. The Agencies have also modified the compliance

program reporting obligations of foreign banking entities with respect

to their covered trading and covered fund activities that are conducted

pursuant to the exemptions contained in Sec. Sec. 75.6(e) and

75.13(b).\2556\

---------------------------------------------------------------------------

\2556\ See, e.g., Soci[eacute]t[eacute] G[eacute]n[eacute]rale;

IIB/EBF; Australian Bankers Ass'n. (Feb. 2012); Banco de

M[eacute]xico; Norinchukin; Cadwalader (on behalf of Thai Banks);

Cadwalader (on behalf of Singapore Banks); Allen & Overy (on behalf

of Canadian Banks); BAROC; Comm. on Capital Markets Regulation;

Credit Suisse (Williams); EFAMA; Hong Kong Inv. Funds Ass'n.; HSBC;

IIAC; IMA; Katten (on behalf of Int'l Clients); Ass'n. of Banks in

Malaysia; RBC; Sumitomo Trust; see also AFME et al.; British

Bankers' Ass'n.; EBF; Commissioner Barnier; French Banking Fed'n.;

UBS; Union Asset.

---------------------------------------------------------------------------

The final rule also responds to commenters' concerns regarding the

timeframe within which a banking entity must establish and implement

the compliance program required for that entity under Sec. 75.20.

Under the final rule, each banking entity must establish the compliance

program required for that entity under Sec. 75.20 as soon as

practicable and in no case later than the end of the conformance

period.\2557\ The Agencies expect that during this period a banking

entity will develop and implement the compliance program requirements

of the final rule as part of its good-faith efforts to fully conform

its activities and investments to the requirements of section 13 and

the final rule. As explained below in the discussion of the enhanced

minimum standards for compliance programs under Appendix B, the final

rule also requires larger and more active banking entities to report

certain data regarding their trading activities. These requirements

have been phased-in to provide banking entities an opportunity to

develop the necessary systems to capture and report the relevant

data.\2558\ In addition, as explained below, the Agencies will

consider, after a period to gain experience with the data, revisiting

these data collections to determine their usefulness in monitoring the

risk and types of activities conducted by banking entities.

---------------------------------------------------------------------------

\2557\ As discussed in Part II., the Board is extending the

conformance period by one year. Extension of the conformance period

will, among other things, provide banking entities with additional

time to establish the required compliance program. The Agencies

believe the extension of the conformance period, as well as the

phased-in approach to implementing the enhanced compliance program

in Appendix B, address certain commenters' requests for additional

time to establish a compliance program. See Wells Fargo (Prop.

Trading); PNC et al.; Australian Bankers Ass'n. (Feb. 2012); SIFMA

et al. (Prop. Trading) (Feb. 2012); ABA (Keating); AFME et al.; BoA;

Barclays; SIFMA et al. (Covered Funds) (Feb. 2012); SIFMA et al.

(Mar. 2012); Comm. on Capital Markets Regulation; Credit Suisse

(Williams); T. Rowe Price; see also Citigroup (Feb. 2012);

Soci[eacute]t[eacute] G[eacute]n[eacute]rale; IIB/EBF; Am. Express;

Arnold & Porter; BDA (Mar. 2012); Morgan Stanley.

\2558\ Commenters provided a wide range of feedback regarding

the timeframe for establishing a compliance program, from requesting

that reporting begin immediately to requesting two years from the

date of publication of the final rule. See, e.g., Occupy; Alfred

Brock; Wells Fargo (Prop. Trading); PNC et al.; SIFMA et al. (Prop.

Trading) (Feb. 2012). The Agencies believe that the final rule's

approach appropriately balances the desire for effective regulation

with requests for additional time to establish a compliance program.

---------------------------------------------------------------------------

b. Compliance Program Elements

Section 75.20 of the final rule specifies six elements that each

compliance program required under that section must at a minimum

contain. With some minor modifications, these are the same six elements

that were included in the proposed rule. The changes reflect

modifications made in requirements and limits in the other provisions

of the rule and, in particular, acknowledge the importance of trading

and hedging limits, appropriate setting, monitoring and management

review of trading and hedging limits, strategies, and activities and

investments, incentive compensation and other matters.

The six elements specified in Sec. 75.20(b) are:

Written policies and procedures reasonably designed to

document, describe, monitor and limit trading activities and covered

fund activities and investments conducted by the banking entity to

ensure that all activities and investments that are subject to section

13 of the BHC Act and the rule comply with section 13 of the BHC Act

and the rule; \2559\

---------------------------------------------------------------------------

\2559\ This requirement is substantially the same as the

proposed written policies and procedures requirement. See proposed

rule Sec. 75.20(b)(1).

---------------------------------------------------------------------------

A system of internal controls reasonably designed to

monitor compliance with section 13 of the BHC Act and the rule and to

prevent the occurrence of activities or investments that are prohibited

by section 13 of the BHC Act and the rule; \2560\

---------------------------------------------------------------------------

\2560\ This requirement is substantially the same as the

proposed internal controls requirement. See proposed rule Sec.

75.20(b)(2).

---------------------------------------------------------------------------

A management framework that clearly delineates

responsibility and accountability for compliance with section 13 of the

BHC Act and the rule and includes appropriate management review of

trading limits, strategies, hedging activities, investments, incentive

compensation and other matters identified in the rule or by management

as requiring attention; \2561\

---------------------------------------------------------------------------

\2561\ The final rule modifies the proposed management framework

requirement by adding that the management framework element must

include appropriate management review of trading limits, strategies,

hedging activities, incentive compensation, and other matters. See

final rule Sec. 75.20(b)(3). See also proposed rule Sec.

75.20(b)(3). One commenter suggested that the compliance program

requirement have a greater focus on compensation incentives. See

Citigroup (Feb. 2012).

---------------------------------------------------------------------------

Independent testing and audit of the effectiveness of the

compliance program conducted periodically by qualified personnel of the

banking entity or by a qualified outside party; \2562\

---------------------------------------------------------------------------

\2562\ The final rule modifies the proposed independent testing

requirement by specifying that such testing must be done

``periodically.'' See final rule Sec. 75.20(b)(4). See also

proposed rule Sec. 75.20(b)(4). The meaning of ``independent

testing'' is discussed in more detail below in Part VI.C.2.e. The

reference to ``audit'' does not mean that the independent testing

must be performed by a designated auditor, whether internal or

external.

---------------------------------------------------------------------------

Training for trading personnel and managers, as well as

other appropriate personnel, to effectively implement and

[[Page 6024]]

enforce the compliance program; \2563\ and

---------------------------------------------------------------------------

\2563\ The final rule retains the proposed training requirement.

See final rule Sec. 75.20(b)(5). See also proposed rule Sec.

75.20(b)(5).

---------------------------------------------------------------------------

Making and keeping records sufficient to demonstrate

compliance with section 13 of the BHC Act and the 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.

Under the final rule, these six elements must be part of the

compliance program of each banking entity with total consolidated

assets greater than $10 billion that engages in activities covered by

section 13 of the BHC Act.

As discussed above, the Agencies have moved particular elements

with respect to the required compliance program for the exemptions

contained in Sec. 75.4(a), Sec. 75.4(b), and Sec. 75.5 into the

specific requirements of these exemptions. The Agencies believe this

structure more effectively conveys that satisfying the requirements of

these exemptions involves specific compliance measures or, with respect

to underwriting and market making, a customer-focused business model,

as requested by some commenters.\2564\

---------------------------------------------------------------------------

\2564\ One of these commenters suggested the Agencies adopt a

simpler compliance framework that could be harmonized with the Basel

accord. See Citigroup (Feb. 2012). The Agencies believe the final

framework described above helps address concerns about streamlining

the compliance program requirement while meeting the statutory

requirement to issue regulations ``in order to insure compliance''

with section 13. 12 U.S.C. 1851(e)(1).

---------------------------------------------------------------------------

In addition to the generally required compliance program elements

specified in Sec. 75.20(b), a banking entity relying on any of these

exemptions should employ the specific compliance tools specified within

the relevant section of this rule to facilitate compliance with the

applicable exemption and should appropriately tailor the required

compliance program elements to the individual trading activities and

strategies of each trading desk on an ongoing basis. By specifying

particular compliance program-related requirements in the exemptions,

the Agencies have sought to provide additional guidance and clarity as

to how a compliance program should be structured,\2565\ while at the

same time providing the banking entity with sufficient discretion to

consider the type, size, scope and complexity of its activities and

business structure in designing a compliance program to meet the

requirements set forth in Sec. 75.20(b).\2566\

---------------------------------------------------------------------------

\2565\ One commenter stated that the proposed rule did not

provide sufficient clarity as to what types or levels of activities

would be permissible. See Citigroup (Feb. 2012).

\2566\ Some commenters requested a more principles-based

framework that allows banking entities to customize compliance

programs to the structure and activities of their organizations. See

SIFMA et al. (Prop. Trading) (Feb. 2012); Wells Fargo (Prop.

Trading); see also M&T Bank; Credit Suisse (Seidel); State Street

(Feb. 2012); NYSE Euronext; Stephen Roach.

---------------------------------------------------------------------------

For a banking entity with more than $10 billion in total

consolidated assets, the compliance program requires additional

documentation with respect to funds. For example, the banking entity is

required to maintain records that include documentation of exclusions

or exemptions other than sections 3(c)(1) and 3(c)(7) of the Investment

Company Act of 1940 relied on by each fund sponsored by the banking

entity (including all subsidiaries and affiliate) in determining that

such fund is not a covered fund.\2567\ The banking entity is also

required to maintain, with respect to each fund sponsored by the

banking entity (including all subsidiaries and affiliates) for which

the banking entity relies on one or more of the exclusions provided by

Sec. Sec. 75.10(c)(1), 75.10(c)(5), 75.10(c)(8), 75.10(c)(9), or

75.10(c)(10) of subpart C, documentation supporting the banking

entity's determination that the fund is not a covered fund pursuant to

one or more of those exclusions.\2568\ If the banking entity operates a

seeding vehicle described in Sec. Sec. 75.10(c)(12)(i) or

75.10(c)(12)(iii) of subpart C that will become a registered investment

company or SEC-regulated business development company, the compliance

program must also include a written plan documenting the banking

entity's determination that the seeding vehicle will become a

registered investment company or SEC-regulated business development

company; the period of time during which the vehicle will operate as a

seeding vehicle; and the banking entity's plan to market the vehicle to

third-party investors and convert it into a registered investment

company or SEC-regulated business development company within the time

period specified in Sec. 75.12(a)(2)(i)(B) of subpart C.\2569\

Furthermore, for any banking entity that is, or is controlled directly

or indirectly by a banking entity that is, located in or organized

under the laws of the United States or of any State, if the aggregate

amount of ownership interest in foreign public funds as described in

Sec. 75.10(c)(1) of subpart C owned by such banking entity (including

ownership interests owned by any affiliate that is controlled directly

or indirectly by a banking entity that is located in or organized under

the laws of the United States or of any State) exceeds $50 million at

the end of two or more consecutive calendar quarters, beginning with

the next succeeding calendar quarter, such banking entity must include

in its compliance program documentation the value of the ownership

interests owned by the banking entity (and such affiliates) in each

foreign public fund and each jurisdiction in which any such foreign

public fund is organized. Such calculation must be done at the end of

each calendar quarter and must continue until the banking entity's

aggregate amount of ownership interests in foreign public funds is

below $50 million for two consecutive calendar quarters.\2570\

---------------------------------------------------------------------------

\2567\ See final rule Sec. 75.20(e)(1). As discussed under

Sec. 75.10 regarding entities excluded from the definition of

covered fund, the Agencies recognize that the final rule's

definition of covered fund does not include certain pooled

investment vehicles. The Agencies expect that the types of pooled

investment vehicles sponsored by the financial services industry

will continue to evolve, including in response to the final rule,

and the Agencies will be monitoring this evolution to determine

whether excluding these and other types of entities remains

appropriate. The Agencies will also monitor use of the exclusions

for attempts to evade the requirements of section 13 and intend to

use their authority where appropriate to prevent evasions of the

rule. The Agencies are adopting this additional documentation

requirement to facilitate such monitoring activities.

\2568\ See final rule Sec. 75.20(e)(2). The Agencies are

adopting this additional documentation requirement for the same

reasons discussed above with respect to Sec. 75.20(e)(1).

\2569\ See final rule Sec. 75.20(e)(3). The rationale for this

additional documentation requirement is provided under the

discussion regarding registered investment companies and business

development companies in Sec. 75.10.

\2570\ See final rule Sec. 75.20(e)(4). The rationale for this

additional documentation requirement is provided under the

discussion regarding foreign public funds in Sec. 75.10. For

purposes of this requirement, a U.S. branch, agency, or subsidiary

of a foreign banking entity is located in the United States;

however, the foreign bank that operates or controls that branch,

agency, or subsidiary is not considered to be located in the United

States solely by virtue of operating or controlling the U.S. branch,

agency, or subsidiary. See final rule Sec. 75.20(e)(5).

---------------------------------------------------------------------------

c. Simplified Programs for Less Active Banking Entities

The proposed rule provided that the six elements of the compliance

program required by Sec. 75.20 would apply to all banking entities

engaged in covered trading activities or covered fund activities and

investments and that the minimum detailed standards of Appendix C would

apply to only those banking entities above specified thresholds. The

application of detailed minimum standards was intended to reflect the

heightened compliance risks of significant covered trading and

[[Page 6025]]

significant covered fund activities and investments.

The proposed rule provided that a banking entity with no covered

activities or investments could satisfy the requirements of Sec. 75.20

if its existing compliance policies and procedures were amended to

include measures that were designed to prevent the banking entity from

becoming engaged in such activities or making such investments and

required the banking entity to develop and provide for the required

compliance program prior to engaging in covered activities or making

covered investments.

Several commenters expressed concern over the requirement in Sec.

75.20(d) of the proposed rule that a banking entity that did not engage

in any covered trading activities or covered fund activities or

investments must ensure that its existing compliance policies and

procedures include measures designed to prevent the banking entity from

becoming engaged in such activities and making such investments.\2571\

In particular, some commenters expressed concern that the proposal

would have a burdensome impact on community banks and force community

banks to hire specialists to amend their policies and procedures to

ensure compliance with section 13 and the final regulations. These

commenters argued that a banking entity should not be required to amend

its compliance policies and procedures and set up a monitoring program

if the banking entity does not engage in prohibited activities.\2572\

---------------------------------------------------------------------------

\2571\ See, e.g., ICBA; ABA (Keating); Conf. of State Bank

Supervisors; NAIB; Ryan Kamphuis; Wisconsin Bankers Ass'n.

\2572\ See, e.g., ICBA; ABA (Keating).

---------------------------------------------------------------------------

A few commenters argued that the Agencies should more carefully

consider the burden of the compliance program on smaller institutions

that engage in a modest level of permissible trading or covered fund

activity.\2573\ One commenter recommended that smaller banks be given

the benefit of the doubt regarding compliance.\2574\ For instance, one

commenter recommended that banking entities with consolidated assets of

$10 billion or less be permitted to engage in a limited amount of

interest rate swaps and certain other traditional banking activities

without being required to establish a compliance program.\2575\

---------------------------------------------------------------------------

\2573\ See Sens. Merkley & Levin (Feb. 2012); Conf. of State

Bank Supervisors; Ryan Kamphuis; SVB.

\2574\ See Sens. Merkley & Levin (Feb. 2012).

\2575\ See ICBA.

---------------------------------------------------------------------------

The Agencies have considered carefully the comments received and,

as noted above, have modified the rule in order to limit the

implementation, operational or other burdens or expenses associated

with the compliance requirements for a banking entity that engages in

no covered activities or investments. The final rule permits banking

entities that have no covered activities or investments (other than

covered transactions in obligations of or guaranteed by the United

States or an agency of the United States and municipal securities) to

satisfy the compliance program requirements by establishing the

required compliance program prior to becoming engaged in such

activities or making such investments. This eliminates the burden on

banking entities that do not engage in covered activities or

investments.

Similarly, Sec. 75.20(f)(2) of the final rule provides that a

banking entity with total consolidated assets of $10 billion or less as

measured on December 31 of the previous two years that does engage in

covered activities and investments may satisfy the requirements of

Sec. 75.20 by including in its existing compliance policies and

procedures references to the requirements of section 13 and subpart D

as appropriate given the activities, size, scope and complexity of the

banking entity.\2576\ This could include appropriate references to the

limits on trading activities permitted in reliance upon any of the

exemptions contained in Sec. 75.4(a), Sec. 75.4(b) or Sec. 75.5.

---------------------------------------------------------------------------

\2576\ Some commenters asked the Agencies to consider the burden

of the compliance program requirement on smaller institutions and

recommended that small banks be given the benefit of the doubt

regarding compliance. See Sens. Merkley & Levin (Feb. 2012); Conf.

of State Bank Supervisors; Ryan Kamphuis; SVB. The Agencies decline

to follow the approach suggested by another commenter to allow

banking entities with assets of $10 billion or less be permitted to

engage in certain limited activities without having to establish a

compliance program. See ICBA. The Agencies believe that requiring a

banking entity engaged in covered trading or covered fund activity

to establish a compliance program is a fundamental part of the

multi-faceted approach to implementing section 13 of the BHC Act,

which requires the Agencies to implement rules ``to insure

compliance with this section.'' 12 U.S.C. 1851(e)(1). Further, the

Agencies believe that the final rule's modification of the proposal

to allow banking entities with total assets under $10 billion to

customize their compliance programs helps ease the burden of this

requirement on smaller institutions.

---------------------------------------------------------------------------

d. Threshold for Application of Enhanced Minimum Standards

Under the proposed rule, banking entities with significant covered

trading activities or covered fund activities and investments were

required to establish an enhanced compliance program in accordance with

Appendix C, which contained detailed compliance program requirements.

The proposed rule required a banking entity to implement the enhanced

compliance program under Appendix C if the banking entity engaged in

covered activities and investments and either: (i) Has, on a

consolidated basis, 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, is equal to or

greater than $1 billion or equals 10 percent or more of its total

assets; or (ii) has, on a consolidated basis, aggregate investments in

covered funds the average value of which (on a worldwide consolidated

basis), as measured as of the last day of each of the four prior

calendar quarters, is equal to or greater than $1 billion, or sponsors

and advises one or more covered funds the 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 general, commenters argued that the activities and investments

subject to section 13 are conducted by only a small number of the

nation's largest financial firms and that the compliance program

requirements should be tailored to target these firms.\2577\ Some

commenters urged the Agencies to raise substantially the proposed $1

billion threshold for trading assets and liabilities in Sec.

75.20(c)(2) of the proposal to $10 billion or higher due to the high

costs of implementing the enhanced compliance program. A few commenters

argued that even if the threshold were raised to $10 billion, an

overwhelming percentage of trading assets and liabilities in the

banking industry (approximately 98 percent) would still remain subject

to heightened compliance requirements included in Appendix C.\2578\

Some of these commenters recommended the threshold for trading assets

for compliance should be increased to no less than $10 billion to

mitigate the costs and impact on regional banking organizations that do

not engage proprietary trading subject to the prohibition of section

13. These commenters argued that the compliance requirements of Sec.

75.20(a)-(b) are sufficient to ensure that regional banking

organizations have appropriate compliance programs.\2579\ One commenter

suggested the threshold for the enhanced compliance requirement be

increased to $50 billion in combined

[[Page 6026]]

trading assets and liabilities.\2580\ One commenter also argued that

banking entities required to establish enhanced compliance programs

should no longer be required to do so if they fall below the

threshold.\2581\

---------------------------------------------------------------------------

\2577\ See, e.g., Sens. Merkley & Levin (Feb. 2012); PNC et al.

\2578\ See ABA (Keating); M&T Bank; PNC et al.

\2579\ See PNC et al.; M&T Bank; see also ABA (Abernathy).

\2580\ See State Street (Feb. 2012).

\2581\ See ABA (Keating).

---------------------------------------------------------------------------

Commenters also offered a number of suggestions for modifying the

activity that would be considered in meeting the thresholds for

determining which compliance program requirements apply to a banking

entity. Several commenters argued that certain types of trading assets

or fund investments should not be included for purposes of determining

whether the relevant dollar threshold triggering the enhanced

compliance was met, particularly those that are not prohibited

activities or investments. For instance, some commenters urged that

trading in U.S. government obligations should not count toward the

calculation of whether a banking organization meets the trading

threshold triggering Appendix C.\2582\ These commenters also argued

that other positions or transactions that do not involve financial

instruments and that may constitute trading assets and liabilities,

such as loans, should be excluded from the thresholds because exempt

activities should not determine the type of compliance program a

banking entity must implement.\2583\ One commenter urged that foreign

exchange swaps and forwards be excluded from the definition of a

``derivative'' and not be subject to compliance requirements as a

result.\2584\ Conversely, one commenter urged that all assets and

liabilities defined as trading assets for purposes of the Market Risk

Capital Rule should be included in the $1 billion standard for becoming

subject to any reporting and recordkeeping requirements under the final

rule.\2585\

---------------------------------------------------------------------------

\2582\ See PNC et al.

\2583\ See PNC et al.

\2584\ See Northern Trust.

\2585\ See Occupy.

---------------------------------------------------------------------------

A few commenters argued that the $1 billion threshold for

establishing an enhanced compliance program should not include the

amount of investments in, or assets of, funds that are SBICs or similar

funds that contain, SBICs or other investments specified under section

13(d)(1)(E) of the BHC Act, such as investments in and funds that

qualify for low-income housing tax credits, or New Markets Tax Credits

or that qualify for Federal historic tax credits or similar state

programs.\2586\ These commenters argued that each of these types of

funds is expressly permitted by the statute and that including these

investments and funds in the dollar thresholds that trigger the

programmatic compliance requirements of Appendix C would provide a

disincentive to banking entities investing in or sponsoring these

funds, a result inconsistent with permitting these types of

investments. Similarly, one commenter urged that investments by a

banking entity in, and assets held by, loan securitizations not be

included in these thresholds because these activities and investments

are expressly excluded from coverage under the rule of construction

contained in section 13(g)(2) of the BHC Act regarding the

securitization of loans.\2587\ Another commenter urged that this

threshold not include investments in, or assets of, any securitization

vehicle that would be considered a covered fund because many smaller

and regional banking entities that were not intended to be subject to

Appendix C likely would exceed the $1 billion threshold if these assets

are included.\2588\ A few commenters also argued that, during the

conformance period, investments in, and relationships with, a covered

fund that a banking entity is required to terminate or otherwise divest

in order to comply with section 13 should not be included for purposes

of calculating the compliance thresholds.\2589\

---------------------------------------------------------------------------

\2586\ See ABA (Keating); PNC et al.

\2587\ See PNC et al.

\2588\ See ASF (Feb. 2012).

\2589\ See PNC et al.; SIFMA et al. (Covered Funds) (Feb. 2012).

---------------------------------------------------------------------------

After considering comments received on the proposal and in order to

implement a compliance program requirement that is consistent with the

purpose and language of the statute and rule while at the same time

appropriately calibrating the associated resource burden on banking

entities, the final rule applies the enhanced minimum standards

contained in Appendix B to only those banking entities with the most

significant covered trading activities or those that meet a specified

threshold of total consolidated assets. The final rule, unlike the

proposal, does not require a banking entity to adopt the enhanced

compliance program if the banking entity, together with its affiliates

and subsidiaries, invest in the aggregate more than $1 billion in

covered funds or if they sponsor or advise covered funds, the average

total assets of which are equal to or greater than $1 billion. Banking

entities would look to the total consolidated asset thresholds, instead

of the amount of covered fund investments and activities, in

determining whether they would be subject to the enhanced compliance

program requirements. The Agencies believe that commenters' concerns

about whether certain types of covered fund investments or activities

(e.g., amounts or relationships held during the conformance period) are

included for purposes of calculating the enhanced compliance thresholds

are addressed because under the final rule, the enhanced compliance

thresholds are based on total consolidated assets and not the amount of

covered fund investments and activities. Similar to the proposed rule,

which provided that a banking entity could be subject to the enhanced

compliance program if the Agency deemed it appropriate, the final

rule's enhanced compliance program also could apply if the Agency

notifies the banking entity in writing that it must satisfy the

requirements.\2590\

---------------------------------------------------------------------------

\2590\ See proposed rule Sec. 75.20(c)(2)(iii); final rule

Sec. 75.20(c)(3).

---------------------------------------------------------------------------

Section 75.20 provides that three categories of banking entities

will be subject to the enhanced minimum standards contained in Appendix

B. The first category is any banking entity that engages in proprietary

trading and is required to report metrics regarding its trading

activities to its primary Federal supervisory agency under the final

rule.\2591\ This category includes a banking entity that has, together

with its affiliates and subsidiaries, trading assets and liabilities

that equal or exceed $50 billion based on the average gross sum of

trading assets and liabilities (on a worldwide consolidated basis and

after excluding trading assets and liabilities involving obligations of

or guaranteed by the United States or any agency of the United States)

over the previous consecutive four quarters, as measured as of the last

day of each of the four prior calendar quarters. A foreign banking

entity with U.S. operations is required to adopt an enhanced compliance

program if its total trading assets and liabilities across all its U.S.

operations equal or exceed $50 billion (after excluding trading assets

and liabilities involving obligations of or guaranteed by the U.S. or

any agency of the U.S.). While these banking entities will be required

to begin to report and record quantitative measurements by June 30,

2014, they will not be required to implement an enhanced compliance

program by this date. Instead, as discussed above, a banking entity

must establish a compliance program as soon as practicable and in no

event later than the end of the conformance period. As explained more

fully in Part VI.C.3., this category expands over time to include

[[Page 6027]]

any banking entity with trading assets and liabilities that equal or

exceed $10 billion (as measured in the manner described above). For

banking entities below the $50 billion threshold that become subject to

the quantitative measurements requirement through the phased-in

approach, they will not become subject to the enhanced compliance

program until the date they are required to comply with the

quantitative measurements requirement. However, these banking entities

will be required to have a compliance program that meets the

requirements of Sec. 75.20(b) by the end of the conformance period.

Thus, banking entities with between $25 billion and $50 billion trading

assets and liabilities (as described in Sec. 75.20(d)) will be

required to implement an enhanced compliance program under Appendix B

by April 30, 2016. Similarly, banking entities with between $10 billion

and $25 billion trading assets and liabilities will be subject to the

requirements of Appendix B by December 31, 2016.

---------------------------------------------------------------------------

\2591\ Issues related to the threshold for reporting

quantitative measurements are discussed in detail in Part VI.C.3.,

below.

---------------------------------------------------------------------------

After considering comments, the Agencies have increased the trading

asset and liability thresholds triggering the enhanced compliance

program requirements. The Agencies believe that banking entities with a

significant amount of trading assets should have the most detailed

programs for ensuring compliance with the trading and other

requirements of section 13 of the BHC Act and the final rule.

Specifically, consistent with the thresholds for reporting and

recording quantitative measurements, the threshold will initially be

$50 billion trading assets and liabilities and, over time, will be

reduced to $10 billion.\2592\ As noted by commenters, these thresholds

will continue to capture a significant percentage of the total trading

assets and liabilities in the banking system, but will reduce the

burdens to smaller, less complex banking entities.\2593\ With respect

to this first category, the Agencies determined, in response to

comments,\2594\ that the threshold for proprietary trading should not

include trading assets and liabilities involving obligations of or

guaranteed by the United States or any agency of the United States.

This approach reduces the burdens associated with the enhanced minimum

compliance program on banking entities whose trading operations consist

primarily of trading U.S. government or agency obligations, which are

generally exempt from the proprietary trading prohibition under Sec.

75.6(a)(1)(i). While some commenters argued that additional assets or

liabilities, such as securitizations or investments in SBICs, should be

excluded from the calculation,\2595\ the Agencies believe that trading

in other assets involves more complex trading activity and warrants

being included in the threshold calculation for applying the enhanced

compliance program requirement.

---------------------------------------------------------------------------

\2592\ Some commenters requested raising this dollar threshold

to at least $10 billion. See PNC et al.; PNC; ABA (Keating). One

commenter suggested the threshold be increased to $50 billion. See

State Street (Feb. 2012).

\2593\ See PNC et al.; M&T Bank; see also ABA (Abernathy); ABA

(Keating). The Agencies recognize that, at the $10 billion

threshold, a significant percentage of the trading assets and

liabilities in the banking industry will remain subject to the

enhanced compliance program requirement. See PNC.

\2594\ See PNC et al.

\2595\ See, e.g., ABA (Keating) (suggesting the threshold should

not include the amount of investments in or assets of SBICs, or

those that qualify for low-income housing tax credits (LIHTC) New

Markets Tax Credits (NMTC), or Federal historic tax credits (HTC));

PNC et al. (loans); Northern Trust.

---------------------------------------------------------------------------

To balance the increased trading asset and liability threshold with

the goal of requiring appropriate specificity and rigor for large and

complex banking organizations' compliance programs, the Agencies have

determined to also require an enhanced compliance program for any

banking entity that has reported total consolidated assets, as of the

previous calendar year-end, of $50 billion or more. Banking entities

with total assets of $50 billion or more are among the most complex

banking entities and have been found by Congress to pose sufficient

risk to the financial stability of the United States to warrant being

generally subject to enhanced prudential standards under section 165 of

the Dodd-Frank Act. With respect to foreign banking entities, this

threshold is calculated by reference solely to the aggregate assets of

the foreign banking entity's U.S. operations, including its U.S.

branches and agencies. This approach is consistent with the statute's

focus on the risks posed by covered trading activities and investments

within the United States and also responds to commenters' concerns

regarding the level of burden placed on foreign banking entities with

respect to their foreign operations.\2596\

---------------------------------------------------------------------------

\2596\ Several commenters requested that foreign activities of

foreign banking entities be excluded from the compliance program

requirement. See, e.g., Soci[eacute]t[eacute]

G[eacute]n[eacute]rale; IIB/EBF; Australian Bankers Ass'n. (Feb.

2012); Banco de Mexico; Norinchukin. One commenter stated the only

U.S. affiliates of foreign banking entities should be required to

institute the proposed reporting and compliance requirements. See

IIB/EBF.

---------------------------------------------------------------------------

The third category includes any banking entity that is notified by

its primary Federal supervisory Agency in writing that it must satisfy

the requirements and other standards contained in Appendix B. By

retaining the flexibility to impose enhanced compliance requirements on

a given banking entity upon specific notice to the firm, the Agencies

have the ability to apply additional standards to any banking entity

with a mix, level, complexity or risk of activities that, in the

judgment of the relevant supervisory Agency, indicates that the firm

should appropriately have in place an enhanced compliance program.

Some commenters argued that the final rule should not require a

banking entity to establish the type of detailed compliance regime

dictated by Appendix C for both trading and covered fund activities and

investments simply because the banking entity engages in one but not

the other activity.\2597\

---------------------------------------------------------------------------

\2597\ See, e.g., SIFMA et al. (Prop. Trading) (Feb. 2012).

---------------------------------------------------------------------------

To comply with the applicable compliance program requirements under

Sec. 75.20 and Appendix B of the final rule, banking entities should

appropriately take into account the type, size, scope and complexity of

their activities and business structure in determining the terms, scope

and detail of the compliance program to be instituted.\2598\ For

example, if all of a banking entity's activities subject to the rule

involve covered fund activities or investments, it would be expected

that the banking entity would have an appropriate compliance program

governing those activities (including an enhanced compliance program if

applicable) and it would not be expected that the banking entity would

construct the same detailed compliance program under the proprietary

trading provision of the rule. Similarly, if a banking entity engages

only in activities that are subject to the proprietary trading

provisions of the rule and does not engage in any covered fund

activities or investments, it would not be expected that the banking

entity would implement the same detailed compliance program under the

covered funds section as would be required for its proprietary trading

activities. In each of these situations, the banking entity would be

expected to put in place sufficient controls to ensure that an

appropriate compliance program is established before the banking entity

commences a new covered activity. The

[[Page 6028]]

Agencies believe that this treatment is consistent with the statutory

language regarding internal controls and recordkeeping to ensure

compliance with section 13 and also reduces unnecessary costs and

burdens associated with requiring banking entities to implement

compliance requirements that are not appropriate to the size, scope and

risk of their relevant activities.

---------------------------------------------------------------------------

\2598\ This is generally consistent with the proposed rule's

compliance program requirement. See proposed rule Sec. 75.20(a)

(requiring that the banking entity's compliance program be

appropriate for the size, scope and complexity of activities and

business structure of the banking entity).

---------------------------------------------------------------------------

2. Appendix B: Enhanced Minimum Standards for Compliance Programs

The proposed rule contained an appendix (Appendix C) which

specified 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. The Agencies 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 for

the rule.

As explained above, the Agencies continue to believe that the

inclusion of specified minimum standards for the compliance program

within the regulation itself rather than as accompanying guidance

serves to reinforce the importance of the compliance program in the

implementation framework for section 13 of the BHC Act. As explained

above, the Agencies believe that large banking entities and banking

entities engaged in significant trading activities should establish,

maintain and enforce an enhanced compliance program. The requirements

for an enhanced compliance program have been consolidated in Appendix B

of the final rule.

Similar to the proposed rule, section I of Appendix B provides that

the enhanced compliance program must:

Be reasonably designed to identify, document, monitor and

report the covered trading and covered fund activities and investments

of the banking entity; identify, monitor and promptly address the risks

of these covered activities and investments and 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 rule;

Establish and enforce appropriate limits on the covered

activities and investments of the banking entity, including limits on

the size, scope, complexity, and risks of the individual activities or

investments consistent with the requirements of section 13 of the BHC

Act and the rule;

Subject the effectiveness of the compliance program to

periodic independent review and testing, and ensure that the entity's

internal audit, corporate compliance and internal control functions

involved in review and testing are effective and independent;

Make senior management, and others as appropriate,

accountable for the effective implementation of the compliance program,

and ensure that the board of directors and CEO (or equivalent) of the

banking entity review the effectiveness of the compliance program; and

Facilitate supervision and examination by the Agencies of

the banking entity's covered trading and covered fund activities and

investments.

The proposed rule included several definitions within the appendix.

In the final rule, all definitions have been moved to other sections of

the rule or into Appendix A (governing metrics). Any banking entity

subject to the enhanced minimum standards contained in Appendix B may

incorporate existing policies, procedures and internal controls into

the compliance program required by Appendix B to the extent that such

existing policies, procedures and internal controls assist in

satisfying the requirements of Appendix B.

Section II of Appendix B contains two parts: One that sets forth

the enhanced minimum compliance program standards applicable to covered

trading activities of a banking entity and one that sets forth the

corresponding enhanced minimum compliance program standards with

respect to covered fund activities and investments. As noted above, if

all of a banking entity's activities subject to the final rule involve

only covered trading activities (or only covered fund activities and

investments), it would be expected that the banking entity would have

an appropriate compliance program governing those activities (including

an enhanced compliance program if applicable) and it would not be

expected that the banking entity would construct the same detailed

compliance program under the covered funds (or proprietary trading)

provisions of the rule. As discussed below, the Agencies have

determined not to include the provisions regarding enterprise-wide

compliance programs.

a. Proprietary Trading Activities

Like the proposed compliance appendix, section II.a of Appendix B

requires a banking entity subject to the enhanced minimum standards

contained in Appendix B to establish, maintain and enforce a compliance

program that includes written policies and procedures that are

appropriate for the types, size, and complexity of, and risks

associated with, its permitted trading activities.\2599\ This portion

of Appendix B requires a banking entity to devote adequate resources

and use knowledgeable personnel in conducting, supervising and managing

its covered trading activities, and to promote consistency,

independence and rigor in implementing its risk controls and compliance

efforts. The compliance program must be updated with a frequency

sufficient to account for changes in the activities of the banking

entity, results of independent testing of the program, identification

of weaknesses in the program and changes in legal, regulatory or other

requirements.

---------------------------------------------------------------------------

\2599\ See Joint Proposal, 76 FR at 68963.

---------------------------------------------------------------------------

Similar to the proposed rule, section II.a of Appendix B requires a

banking entity subject to the Appendix to: (i) Have written policies

and procedures governing each trading desk that include a description

of certain information specific to each trading desk that will

delineate its processes, mission and strategy, risks, limits, types of

clients, customers and counterparties and its compensation

arrangements; (ii) include a comprehensive description of the risk

management program for the trading activity of the banking entity, as

well as a description of the governance, approval, reporting,

escalation, review and other processes that the banking entity will use

to reasonably ensure that trading activity is conducted in compliance

with section 13 of the BHC Act and subpart B; (iii) implement and

enforce limits and internal controls for each trading desk that are

reasonably designed to ensure that trading activity is conducted in

conformance with section 13 of the BHC Act and subpart B and with the

banking entity's policies and procedures, and establish and enforce

risk limits appropriate for the activity of each trading desk; and (iv)

for any hedging activities that are conducted in reliance on the

exemption contained in Sec. 75.5, establish, maintain and enforce

policies and procedures regarding the use of risk-mitigating hedging

instruments and strategies that describe the positions, techniques and

strategies that each trading desk may use, the manner in which the

banking entity will determine that the risks generated by each trading

desk have been properly and effectively hedged, the level of the

organization at which

[[Page 6029]]

hedging activity and management will occur, the management in which

such hedging strategies will be monitored and the personnel responsible

for such monitoring, the risk management processes used to control

unhedged or residual risks, and a description of the process for

developing, documenting, testing, approving and reviewing all hedging

positions, techniques and strategies permitted for each trading desk

and for the banking entity in reliance on Sec. 75.5.

To the extent that any of the standards contained in Appendix B may

be appropriately met by policies and procedures, internal controls and

other requirements that are common to more than one trading desk, a

banking entity may satisfy the requirements for the enhanced minimum

standards of the compliance program by implementing such common

requirements with respect to any such desks as to which they are

appropriately applicable.\2600\ To the extent the required elements of

the compliance program apply differently to different trading desks

that conduct trading in the same financial instruments, a banking

entity must document the differences and adopt policies and procedures

and implement internal controls specific to each of the different

trading desks. Overall, the policies and procedures should provide the

Agencies with a clear, comprehensive picture of a banking entity's

covered trading activities that can be effectively reviewed.

---------------------------------------------------------------------------

\2600\ This is consistent with proposed Appendix C, except that

the term ``trading unit'' from the proposal has been replaced with

the term ``trading desk.'' See Joint Proposal, 76 FR at 68965.

---------------------------------------------------------------------------

Appendix B also requires that the banking entity perform robust

analysis and quantitative measurement of its covered trading activities

that is reasonably designed to ensure that the trading activity of each

trading desk is consistent with the banking entity's compliance

program; monitor and assist in the identification of potential and

actual prohibited proprietary trading activity; and prevent the

occurrence of prohibited proprietary trading. In particular, the

banking entity must incorporate into its compliance program any

quantitative measure reported by the banking entity pursuant to

Appendix A where applicable, and include at a minimum: (i) Internal

controls and written policies and procedures reasonably designed to

ensure the accuracy and integrity of the quantitative measures

employed; (ii) ongoing timely monitoring and review of calculated

quantitative measurements; (iii) the establishment of thresholds and

trading measures for each trading desk and heightened review of any

trading activity that is inconsistent with those thresholds; and (iv)

review, investigation and escalation with respect to matters that

suggest a reasonable likelihood that a trading desk has violated any

part of section 13 of the BHC Act or the rule.\2601\

---------------------------------------------------------------------------

\2601\ See Joint Proposal, 76 FR at 68965.

---------------------------------------------------------------------------

Where a banking entity is subject to the reporting requirements of

Appendix A, any additional quantitative measurements developed and

implemented by the banking entity under the compliance program

requirement are not required to be routinely submitted to the relevant

Agency as provided in Appendix A, but are subject to the recordkeeping

requirements set forth in subpart D, including the requirement to

promptly produce such records to the relevant Agency upon request.

Where a banking entity is not subject to the requirements of Appendix

A, that banking entity would likewise not be required by this rule to

routinely submit these additional quantitative measurements to the

relevant Agency, but would be subject to the recordkeeping requirements

set forth in subpart D, including the requirement to promptly produce

such records to the relevant Agency upon request.

In addition to the other requirements that are specific to

proprietary trading, the banking entity's compliance program must

identify the activities of each trading desk that will be conducted in

reliance on the exemptions contained in Sec. Sec. 75.4 through 75.6,

including an explanation of (i) how and where in the organization such

activity occurs, and (ii) which exemption is being relied on and how

the activity meets the specific requirements of such exemption. For

trading activities that rely on an exemption contained in Sec. Sec.

75.4 through 75.6, the banking entity's compliance program should

include an explanation of how, and its policies, procedures and

internal controls that demonstrate that, such trading activities

satisfy such exemption and any other requirements of section 13 of the

BHC Act and the final rule that are applicable to such activities. A

foreign banking entity that engages in proprietary trading in reliance

on the exemption contained in Sec. 75.6(e) will be expected to provide

information regarding the compliance program implemented to ensure

compliance with the requirements of that section, including compliance

by the U.S. operations of the foreign banking firm, but will only be

expected to provide trading information regarding activity conducted

within the United States (absent an indication of activity conducted or

designed to evade the requirements of section 13 of the BHC Act of the

final rule).\2602\

---------------------------------------------------------------------------

\2602\ See AFME et al.; IIB/EBF; BaFin/Deutsche Bundesbank;

Credit Suisse (Seidel); HSBC.

---------------------------------------------------------------------------

In addition, the compliance program must describe the process for

ensuring that liquidity management activities are conducted in

conformance with the limits and policies contained in Sec. 75.3(d)(3).

This includes processes for ensuring that liquidity management

activities are not conducted for the purpose of prohibited proprietary

trading.

The banking entity's compliance program must be reasonably designed

and established to effectively monitor and identify for further

analysis any proprietary trading activity that may indicate potential

violations of section 13 of the BHC Act and subpart B and to prevent

violations of section 13 of the BHC Act and subpart B. The standards

set forth in subpart D direct the banking entity to include

requirements in its compliance program for documenting remediation

efforts, assessing the extent to which modification of the compliance

program is warranted and providing prompt notification to appropriate

management and the board of directors of material weakness or

significant deficiencies in the implementation of the compliance

program.

b. Covered Fund Activities or Investments

Section II.b of Appendix B requires a banking entity subject to the

enhanced minimum standards contained in Appendix B to establish,

maintain and enforce a compliance program that includes written

policies and procedures that are appropriate for the types, size,

complexity and risks of the covered fund and related activities

conducted and investments made, by the banking entity.

The enhanced compliance program requirements for covered funds and

investments focus on: (i) Ensuring that the compliance program provides

a process for identifying all covered funds that the banking entity

sponsors, organizes or offers, and covered funds in which the banking

entity invests; (ii) ensuring that the compliance program provides a

method for identifying all funds and pools that the banking entity

sponsors or has an interest in and the type of exemption from the

Investment Company Act or Commodity Exchange Act (whether or not the

fund relies on section 3(c)(1) or 3(c)(7) of the

[[Page 6030]]

Investment Company Act or section 4.7 of the regulations under the

Commodity Exchange Act), and the amount of ownership interest the

banking entity has in those funds or pools; (iii) identifying,

documenting, and mapping where any covered fund activities are

permitted to be conducted within the banking entity; and (iv) including

an explanation of compliance; (v) describing sponsorship activities

related to covered funds; and (vi) establishing, maintaining and

enforcing internal controls that are reasonably designed to ensure that

its covered fund activities or investments comply with the requirements

of section 13 of the BHC Act and subpart C, and (vii) monitoring of the

banking entity's investments in and transactions with any covered

funds.

In addition, the banking entity's compliance program must document

the banking entity's plan for seeking unaffiliated investors to ensure

that any investment by the banking entity in a covered fund conforms to

the limits contained in the final rule or that the covered fund is

registered in compliance with the securities laws within the

conformance period provided in the final rule. Similarly, the

compliance program must ensure that the banking entity complies with

any limits on transactions or relationships with the covered fund

contained in the final rule, including in situations in which the

banking entity is designated as a sponsor, investment manager,

investment adviser or commodity trading adviser by another banking

entity.

The banking entity's compliance program must be reasonably designed

and established to effectively monitor and identify for further

analysis any covered fund activity that may indicate potential

violations of section 13 of the BHC Act and subpart C. The standards

set forth in subpart D require the banking entity to include

requirements in its compliance program for documenting remediation

efforts, assessing the extent to which modification of the compliance

program is warranted and providing prompt notification to appropriate

management and the board of directors of material weakness or

significant deficiencies in the design or implementation of the

compliance program.

c. Enterprise-Wide Programs

Appendix C in the proposed rule contained a provision that

permitted a banking entity to establish a compliance program on an

enterprise-wide basis. Some commenters argued that a less specific and

more flexible compliance regime would be essential to make the

enterprise-wide compliance structures contemplated in Appendix C

effective because requiring individualized policies and procedures for

each business line would diminish the benefits of enterprise-wide

compliance and prevent consistency of these policies and procedures

within the banking entity.\2603\ One of these commenters recommended

the Agencies provide greater options for developing a compliance

program and not limit a banking entity to a choice between a single

enterprise-wide program or a separate program for each subsidiary

engaged in activities covered by the proposed rule.\2604\

---------------------------------------------------------------------------

\2603\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Wells Fargo

(Prop. Trading).

\2604\ See Wells Fargo (Prop. Trading).

---------------------------------------------------------------------------

In contrast, one commenter argued that any enterprise-wide

compliance program would only be effective if combined with additional

programs at the trading unit or subsidiary level to train all employees

at a banking entity.\2605\ This commenter argued that each trading unit

is different and suggested that it would be more efficient to mandate

enterprise-wide default internal controls, but provide each individual

trading unit the flexibility to tailor these requirements to its own

specific business.\2606\ This commenter also urged that Appendix C's

elements III (internal controls), IV (responsibility and

accountability) and VII (recordkeeping) should not be imposed solely at

the enterprise-wide level.\2607\

---------------------------------------------------------------------------

\2605\ See Occupy.

\2606\ See Occupy.

\2607\ See Occupy.

---------------------------------------------------------------------------

After considering carefully the comments on the proposal, the

Agencies have removed the reference to an enterprise-wide compliance

program from the final rule; however, the Agencies acknowledge that a

banking entity may establish a compliance program on an enterprise-wide

basis, as long as the program satisfies the requirements of Sec. 75.20

and, where applicable, Appendix B. A banking entity may employ common

policies and procedures that are established at the enterprise-wide

level or at a business-unit level to the extent that such policies and

procedures are appropriately applicable to more than one trading desk

or activity, as long as the required elements of Appendix B and all of

the other applicable compliance-related provisions of the rule are

incorporated in the compliance program and effectively administered

across trading desks and banking entities within the consolidated

enterprise or designated business. If a banking entity establishes an

enterprise-wide program, like a non-enterprise wide program, that

program will be subject to supervisory review and examination by any

Agency vested with rule writing authority under section 13 of the BHC

Act with respect to the compliance program and the activities or

investments of each banking entity for which the Agency has such

authority.\2608\ The banking organization would be expected to provide

each appropriate Agency with 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 rule writing

authority.

---------------------------------------------------------------------------

\2608\ See 12 U.S.C. 1851(b)(2)(B)(i).

---------------------------------------------------------------------------

For similar reasons, the Agencies have determined not to adopt some

commenters' requests that a single agency be responsible for

determining compliance with section 13.\2609\ At this time the Agencies

do not believe such an approach would be consistent with the statute,

which requires each Agency to adopt a rule for the types of banking

entities under its jurisdiction,\2610\ or effective given the different

authorities and expertise of each Agency. The Agencies expect to

continue to coordinate their supervisory efforts related to section 13

of the BHC Act and to share information as appropriate in order to

effectively implement the requirements of that section and the final

rule.\2611\

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\2609\ See Barclays; Goldman (Prop. Trading); BoA; SIFMA Funds

et al. (Prop. Trading) (Feb. 2012); Comm. on Capital Markets

Regulation.

\2610\ See 12 U.S.C. 1851(b)(2)(B).

\2611\ Accordingly, the SEC's and the CFTC's final rules, unlike

the applicable proposals, do not incorporate by reference the rules

and interpretations of the Federal banking agencies with respect to

covered fund activities or investments. See SEC proposed rule Sec.

255.10(a)(2), Joint Proposal, 76 FR at 68942-68943, and CFTC

Proposal, 77 FR at 8421-8423.

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d. Responsibility and Accountability

Section III of Appendix B includes the enhanced minimum standards

for responsibility and accountability. Section III contains many of the

provisions contained in the proposed rule relating to responsibility

and accountability, with certain modifications.\2612\ Section III

requires a banking entity to establish, maintain and enforce both a

governance and management framework to manage its business and

employees with a view to preventing violations of section 13 of the BHC

Act and the rule. The standards in Section III focus on four key

constituencies--the board of directors,

[[Page 6031]]

the CEO, senior management, and business line managers. Certain of the

standards contained in the proposed rule relating to business

management are separately covered by specific requirements contained in

sections II.a and II.b of Appendix B. Section III makes it clear that

the board of directors, or similar corporate body, and the CEO and

senior management 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 the firm's

trading activities and its fund activities and investments. Senior

management must be made responsible for communicating and reinforcing

the culture of compliance established by it and the board of directors,

for the actual implementation and enforcement of the approved

compliance program, and for taking corrective action where appropriate.

---------------------------------------------------------------------------

\2612\ See Joint Proposal, 76 FR at 68966.

---------------------------------------------------------------------------

In response to a question in the preamble to the proposed rule

regarding whether the chief executive officer or similar officer of a

banking entity should be required to provide a certification regarding

the compliance program requirements, a few commenters urged that the

final rule should not require that the board of directors or CEO of a

banking entity review or certify the effectiveness of the compliance

program.\2613\ These commenters argued that existing processes

developed by large, complex banking entities for board of director

reporting and governance processes ensure that compliance programs work

appropriately, and argued that these protocols would establish

appropriate management and board of directors' oversight of the section

13 compliance program.\2614\ By contrast, several commenters advocated

requiring CEO attestation regarding compliance with section 13.\2615\

One commenter suggested that the rule require an annual assessment by

management of the effectiveness of internal controls and policies and

require a public accounting firm to attest to the accuracy of those

annual assessments.\2616\

---------------------------------------------------------------------------

\2613\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Wells Fargo

(Prop. Trading).

\2614\ See SIFMA et al. (Prop. Trading); see also Wells Fargo

(Prop. Trading).

\2615\ See Occupy; AFR et al. (Feb. 2012); Sens. Merkley & Levin

(Feb. 2012); Public Citizen; Ralph Saul (Oct. 2011); John Reed; see

also BEC et al. (Oct. 2011); Matthew Richardson.

\2616\ See Merkley & Levin (Feb. 2012).

---------------------------------------------------------------------------

After considering comments received on the proposal, the Agencies

have determined to include a requirement in the final rule that a

banking entity's CEO annually attest in writing to the appropriate

Agency for the banking entity that the banking entity has in place

processes to establish, maintain, enforce, review, test and modify the

compliance program established pursuant to Appendix B and Sec. 75.20

of the rule in a manner reasonably designed to achieve compliance with

section 13 of the BHC Act and this rule. Although some commenters

stated that existing protocols of certain banking entities would

establish appropriate oversight of the rule's compliance program,\2617\

the Agencies believe this requirement will better help to ensure that a

strong governance framework is implemented with respect to compliance

with section 13 of the BHC Act, and that it more directly underscores

the importance of CEO engagement in the governance and management

framework supporting compliance with the rule. In the case of the U.S.

operations of a foreign banking entity, including a U.S. branch or

agency of a foreign banking entity, the attestation may be provided for

the entire U.S. operations of the foreign banking entity by the senior

management officer of the U.S. operations of the foreign banking entity

who is located in the United States.

---------------------------------------------------------------------------

\2617\ See SIFMA et al. (Prop. Trading) (Feb. 2012); see also

Wells Fargo (Prop. Trading).

---------------------------------------------------------------------------

e. Independent Testing

Section IV of the Appendix B includes the enhanced minimum

standards for independent testing, which are substantially similar to

the proposed independent testing standards.\2618\ A banking entity

subject to Appendix B must ensure that independent testing regarding

the effectiveness of the banking entity's compliance program is

conducted by a qualified independent party, such as the banking

entity's internal audit department, compliance personnel or risk

managers independent of the trading desk or other organizational unit

being tested, outside auditors, consultants, or other qualified

independent parties. If a banking entity uses internal personnel to

conduct the independent testing, the Agencies would expect that the

banking entity ensure that the personnel responsible for the testing

are separate from the unit and functions being tested (e.g., the

personnel do not report to a person who is directly responsible for the

unit or involved in the functions being tested) and have knowledge of

the requirements of section 13 and its implementing rules. Although an

external audit is not required to meet the independent testing

requirement, the Agencies would expect that, when external auditors are

engaged to review compliance by a banking entity with laws and

regulations, the banking entity would give appropriate consideration to

the need to review the compliance program required under this rule.

---------------------------------------------------------------------------

\2618\ See Joint Proposal, 76 FR at 68967.

---------------------------------------------------------------------------

While one commenter suggested the final rule prescribe the precise

manner in which a banking entity must conduct its compliance

testing,\2619\ the Agencies believe such a requirement is unnecessary

because the standards in the final rule will ensure that independent

testing of the effectiveness of a banking entity's compliance program

is objective and robust. The independent testing must examine both the

banking entity's compliance program and its actual compliance with the

rule. This testing must include not only testing of the overall

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

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.

---------------------------------------------------------------------------

\2619\ One commenter suggested that any compliance testing under

the final rule be monitored by the Agencies and initially tested by

internal audit personnel of the banking entity who are subject to a

specific licensing and registration process for section 13 of the

BHC Act and supplemented by an annual independent external review.

See Occupy; see also proposed rule Sec. 75.20(b)(4). The Agencies

believe it would be unnecessarily burdensome to require particular

licensing and registration processes for internal auditors that are

specific to section 13 of the BHC Act.

---------------------------------------------------------------------------

f. Training

Like the proposed compliance appendix, Section V of Appendix B

includes the enhanced minimum standards for training.\2620\ It requires

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 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

[[Page 6032]]

support the banking entity's compliance with section 13 of the BHC Act

and the rule. 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.

---------------------------------------------------------------------------

\2620\ See Joint Proposal, 76 FR at 68967.

---------------------------------------------------------------------------

g. Recordkeeping

Section VI of Appendix B contains the enhanced minimum standards

for recordkeeping which are consistent with the proposed recordkeeping

standards.\2621\ 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 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 must include trading records of

the trading units, including trades and positions of each such unit.

Records created and retained under the enhanced compliance program must

also include documentation of any exemption in the final rule relied on

by the banking entity to invest in or sponsor a covered fund.

---------------------------------------------------------------------------

\2621\ See Joint Proposal, 76 FR at 68967.

---------------------------------------------------------------------------

While one commenter requested that the period for retaining records

be extended from 5 years to 6 years, the final rule does not make this

change.\2622\ The Agencies believe that 5 years is an appropriate

minimum period for requiring retention of records to demonstrate

compliance with the final rule. The final rule allows the Agencies to

require a banking entity to retain records for a longer period if

appropriate.

---------------------------------------------------------------------------

\2622\ One commenter specifically urged that records for any

type of compliance program be required to be kept on all hedges,

rather than only those placed at a different level or trading unit

as under the proposal, and that the retention period for all

compliance records be changed from 5 years to 6 years in line with

the statute of limitations on civil suits for fraud, contracts and

collection of debt in accounts in New York State. See Occupy.

---------------------------------------------------------------------------

3. Section 75.20(d) and Appendix A: Reporting and Recordkeeping

Requirements Applicable to Trading Activities

Section 75.7 of the proposed rule, which the Agencies proposed to

implement in part section 13(e)(1) of the BHC Act,\2623\ required

certain banking entities to comply with the reporting and recordkeeping

requirements specified in Appendix A of the proposed rule. In addition,

Sec. 75.7 required banking entities to comply with the recordkeeping

requirements in Sec. 75.20 of the proposed rule, related to the

banking entity's compliance program,\2624\ 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.\2625\

---------------------------------------------------------------------------

\2623\ 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

75.20 and Appendix C of the proposed rule also implemented section

13(e)(1) of the BHC Act.

\2624\ See Part III.D. of this SUPPLEMENTARY INFORMATION.

\2625\ See proposed rule Sec. 75.7.

---------------------------------------------------------------------------

Proposed Appendix A required 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 varied depending on the scope, type,

and size of trading activities. In addition, proposed Appendix B

contained 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.\2626\ Under the proposal, a

banking entity was required to comply with proposed Appendix A's

reporting and recordkeeping requirements only if it had, together with

its affiliates and subsidiaries, trading assets and liabilities the

average gross sum of which (on a worldwide consolidated basis) was, as

measured as of the last day of each of the four prior calendar

quarters, equal to or greater than $1 billion.\2627\ The Agencies did

not propose to extend the reporting and recordkeeping requirements to

banking entities with smaller amounts of trading activity, as it

appeared 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.

---------------------------------------------------------------------------

\2626\ See supra Part VI.A.3.c.8 (explaining why Appendix B was

removed from the final rule).

\2627\ See proposed rule Sec. 75.7(a).

---------------------------------------------------------------------------

a. Approach to Reporting and Recordkeeping Requirements Under the

Proposal

The proposal explained that the reporting and recordkeeping

requirements of Sec. 75.7 and Appendix A of the proposed rule were an

important part of the proposed rule's multi-faceted approach to

implementing the prohibition on proprietary trading. These requirements

were 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 required certain banking

entities to calculate and report detailed quantitative measurements of

their trading activity, by trading unit. These measurements were meant

to 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 required to be

reported under the proposed rule were 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 measured the size and type of revenues

generated, and the types of risks taken, by a trading unit. Each of

these measurements appeared to be useful in assessing whether a trading

unit was (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

measured how much revenue was 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

appeared to be useful in assessing whether a trading unit is

[[Page 6033]]

engaged in permitted market making-related activity.

However, as noted in the proposal, 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

proposed 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 proposed to take a heuristic

approach to implementation in this area that recognized 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 noted 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.\2628\

---------------------------------------------------------------------------

\2628\ Joint Proposal, 76 FR at 68883.

---------------------------------------------------------------------------

Consistent with this heuristic approach, the proposed rule included

a large number of potential quantitative measurements on which public

comment was sought, many of which overlap to some degree in terms of

their informational value. The proposal explained that not all of these

quantitative measurements may ultimately be adopted in the final rule,

depending on their relative strengths, weaknesses, costs, and benefits.

The Agencies noted 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 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 sought comment on whether the quantitative measurements

described in the proposal were appropriate to use to help assess

compliance with section 13 of the BHC Act.

In addition to the proposed quantitative measurements, the proposal

explained that 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. 75.20 of the proposed rule and

Appendix C. The Agencies noted that the proposed quantitative

measurements in Appendix A were intended to assist banking entities and

Agencies in monitoring compliance with the proprietary trading

restrictions and would not necessarily provide all the data necessary

for the banking entity to establish an effective compliance program.

The Agencies also recognized 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 needed

to 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 proposed to utilize the

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.\2629\ This heuristic,

gradual approach to implementing reporting requirements for

quantitative measurements was 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.

---------------------------------------------------------------------------

\2629\ See 12 U.S.C. 1851(c)(2); Joint Proposal, 76 FR at 68883.

---------------------------------------------------------------------------

In addition, the Agencies requested comment on the use of 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. The Agencies did not propose 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 intended to carefully consider public

comments provided on this issue and to separately determine whether it

would be appropriate to propose, subsequent to finalizing the current

proposal, such numerical thresholds.

Part III of proposed Appendix A defined the scope of the reporting

requirements. The proposed rule adopted a tiered approach that required

banking entities with the most extensive trading activities to report

the largest number of quantitative measurements, while banking entities

with smaller trading activities had fewer or no reporting requirements.

This tiered approach was 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.

Under the proposal, any banking entity that had, 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 would be required the banking entity to furnish

quantitative measurements for all trading units of the banking entity

engaged in trading activity subject to Sec. Sec. 75.4, 75.5, or

75.6(a) of the proposed

[[Page 6034]]

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 depended on the activity in which the

trading unit was engaged. First, for the trading units of such a

banking entity that are engaged in market making-related activity

pursuant to Sec. 75.4(b) of the proposed rule, proposed Appendix A

required that a banking entity furnish seventeen quantitative

measurements.\2630\ Second, all trading units of such a banking entity

engaged in trading activity subject to Sec. Sec. 75.4(a), 75.5, or

75.6(a) of the proposed rule were required to report five quantitative

measurements designed to measure the general risk and profitability of

the trading unit.\2631\ The Agencies expected that each of these

general types of measurements would 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 applicable only

to trading units engaged in market making-related activities were

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.

---------------------------------------------------------------------------

\2630\ See proposed rule Appendix A.III.A. These seventeen

quantitative measurements are discussed further below.

\2631\ 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.

---------------------------------------------------------------------------

Under the proposal, any banking entity that had, 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 would be required to

provide quantitative measurements to be furnished for trading units

that engaged in market making-related activity subject to Sec. 75.4(b)

of the proposed rule. Trading units of such banking entities that

engaged in market making-related activities needed to report eight

quantitative measurements 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.\2632\ The proposal

applied 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. The Agencies noted in the proposal that a less

burdensome reporting regime, coupled with other elements of the

proposal (e.g., the compliance program requirement), was 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.

---------------------------------------------------------------------------

\2632\ 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.

---------------------------------------------------------------------------

Section III.B of proposed Appendix A specified the frequency of

required calculation and reporting of quantitative measurements. Under

the proposed rule, each required quantitative measurement needed to be

calculated for each trading day. Required quantitative measurements

were required to 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 required 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

included records for each trade and position.

b. General Comments on the Proposed Metrics

A number of commenters were supportive of metrics. A few commenters

argued that the metrics could reveal prohibited proprietary trading

activity and be an appropriate and valuable tool in analyzing

positions.\2633\ One commenter argued that metrics are the single most

valuable tool available to the Agencies for distinguishing between

prohibited and permitted activities and recommended the compliance

program be structured around metrics.\2634\ Another commenter stated

that the identification of metrics is one of the strengths of the

proposed rule and offered great promise for successful implementation

of the rule.\2635\ One commenter expressed support for the metrics and

argued that there would be substantial evasion of the rule without

reporting of these measurements.\2636\ Some commenters proposed a

presumption of compliance so long as trading activity is conducted in a

manner consistent with tailored quantitative metrics and related

specific thresholds as coordinated and agreed with the relevant

Agency.\2637\ A few of commenters suggested that metrics not be used as

a bright-line trigger and recommended flexibility in the application of

metrics for assessing market-making activities.\2638\ Two commenters

supported metrics as part of a bright lines approach.\2639\

---------------------------------------------------------------------------

\2633\ See, e.g., Paul Volcker; SIFMA et al. (Prop. Trading)

(Feb. 2012); Invesco; Comm. on Capital Markets Regulation.

\2634\ See Goldman (Prop. Trading).

\2635\ See Sens. Merkley & Levin (Feb. 2012).

\2636\ See Occupy.

\2637\ See Barclays; see also BoA; Invesco; ISDA (Feb. 2012);

JPMC; Morgan Stanley; SIFMA et al. (Prop. Trading) (Feb. 2012).

\2638\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Wells Fargo

(Prop. Trading); NYSE Euronext; Oliver Wyman (Feb. 2012); UBS;

Western Asset Mgmt.; Goldman (Prop. Trading); Northern Trust.

\2639\ See John Reed; Public Citizen.

---------------------------------------------------------------------------

A number of commenters felt that some metrics might be more

relevant than others, depending upon the particular asset class,

activity, particular market, and unique characteristics of each banking

entity.\2640\ These commenters advocated an approach where banking

entities and examiners would determine over time the usefulness and

relevance of particular metrics.\2641\ One commenter expressed support

for the 5 metrics required for trading in U.S. government

obligations.\2642\ A number of commenters recommended that metrics be

tailored to different asset classes and markets, to avoid the drawbacks

of a one-size-fits-all approach.\2643\ One commenter argued that

application of metrics to market-making activities at different firms

may produce very different results, all of which might reflect

legitimate market-making.\2644\ Commenters also indicated that not all

metrics are meaningful and calculable

[[Page 6035]]

for all trading units and some would be unnecessarily burdensome.\2645\

---------------------------------------------------------------------------

\2640\ See Morgan Stanley; SIFMA et al. (Prop. Trading) (Feb.

2012); Stephen Roach.

\2641\ See Wells Fargo (Prop. Trading); Morgan Stanley; SIFMA et

al. (Prop. Trading) (Feb. 2012); Stephen Roach.

\2642\ See UBS.

\2643\ See Goldman (Prop. Trading); Northern Trust; see also

UBS.

\2644\ See Comm. on Capital Markets Regulation.

\2645\ See Morgan Stanley; see also ISDA (Feb. 2012).

---------------------------------------------------------------------------

Other commenters did not support the use of metrics. These

commenters argued that metrics reporting was one aspect of the

complexity of the proposal that increased the cost and difficulty of

distinguishing market-making from prohibited proprietary trading.\2646\

One commenter argued that banking entities may avoid legitimate market

making activities that would produce ``worse'' metrics results.\2647\

---------------------------------------------------------------------------

\2646\ See ABA (Keating); Barclays; Citigroup (Feb. 2012); ISDA

(Feb. 2012); UBS; Oliver Wyman (Feb. 2012); Prof. Duffie;

Wellington.

\2647\ See Oliver Wyman (Feb. 2012).

---------------------------------------------------------------------------

Several commenters expressed concern that the costs exceeded the

benefits of the required quantitative metrics in the proposal. In

particular, commenters argued that the 17 metrics in the proposal

calculated at each trading unit was excessive, would generate an

unmanageable amount of data, would yield numerous false positives, and

would require the construction and programming of highly sophisticated

systems that are not currently employed.\2648\ A few commenters

suggested that a more limited set of metrics would reduce compliance

complexity.\2649\ Some commenters noted that many of these metrics have

not been historically reported by banking entities and some of the

metrics would require substantial resources and investment

infrastructure to produce some of the metrics without a clear

functional purpose.\2650\ According to other commenters, however,

banking entities currently use all or nearly all of the proposed

metrics.\2651\ One commenter urged that it would be good to make

metrics consistent with the banking entities' internal reporting and

control systems.\2652\ Some commenters argued it was critical for the

Agencies to get the metrics right,\2653\ while others indicated it was

unclear how the Agencies could analyze such information to draw useful

conclusions.\2654\

---------------------------------------------------------------------------

\2648\ See BoA (expressing concern about the need for new

systems to distinguish bid-ask spreads from price appreciation);

UBS; Wellington.

\2649\ See BoA; Barclays; Citigroup (Feb. 2012).

\2650\ See Credit Suisse (Seidel); Morgan Stanley; UBS; Wells

Fargo (Prop. Trading); Soci[eacute]t[eacute] G[eacute]n[eacute]rale

(arguing that many calculation questions need to be resolved before

banking entities can create necessary systems to measure metrics).

\2651\ See Occupy; AFR et al. (Feb. 2012); Western Asset Mgmt.;

Public Citizen. For example, one commenter cited a study finding

that 14 out of 17 of the proposed metrics are either in wide use

today or are possible to implement fairly easily using data already

collected for internal risk management and profit and loss purposes.

See AFR et al. (Feb. 2012) (citing John Lester and Dylan Walsh,

``The Volcker Rule Ban On Prop Trading: A Step Closer to Reality,

Point of View,'' Oliver Wyman Company (Oct. 2011)).

\2652\ See Paul Volcker.

\2653\ See, e.g., UBS.

\2654\ See BoA; UBS; Wellington.

---------------------------------------------------------------------------

Some commenters expressed concern that metrics were vulnerable to

manipulation and arbitrage.\2655\ These commenters generally felt that

the quantitative measurements were only appropriate for certain liquid

and transparent trading activities but not meaningful for illiquid

markets, including opaque securities and derivatives.\2656\ These

commenters also argued that the vast majority of proprietary trading

would not be differentiable through analysis of the data.\2657\ Other

commenters expressed concern that the use of metrics not replace

regulatory review of actual specific trading positions held by banking

entities.\2658\ One commenter argued that in relying on metrics to be

elaborated upon and discussed in the examination process, the proposed

rule did not meet the fundamental fair notice goal of regulation.\2659\

---------------------------------------------------------------------------

\2655\ See AFR (Nov. 2012); see also Occupy; Public Citizen.

\2656\ See Occupy; AFR (Nov. 2012); Wells Fargo (Prop. Trading).

\2657\ See Occupy.

\2658\ See Sens. Merkley & Levin (Feb. 2012).

\2659\ See ISDA (Feb. 2012) (citing Mason v. Florida Bar, 208

F.3d 952, 958-59 (11th Cir. 2000)).

---------------------------------------------------------------------------

A few commenters also recommended creation of a central data

repository or data sharing protocol that would promote consistency and

accountability in oversight and regulation and suggested the Office of

Financial Research (``OFR'') be given access to this data so that it

can provide centralized analysis and monitoring to identify any trends

that give rise to systemic risk.\2660\ These commenters generally

supported compliance benefits that would result from increased public

disclosure of banking entities' trading and funds activities, including

all of their trading positions, their valuation models, and their

compliance metrics.\2661\

---------------------------------------------------------------------------

\2660\ See Sens. Merkley & Levin (Feb. 2012); see also Occupy;

Public Citizen.

\2661\ See Sens. Merkley & Levin (Feb. 2012); see also Public

Citizen; John Reed.

---------------------------------------------------------------------------

Some commenters expressed support for the reporting thresholds

contained in Appendix A.\2662\ One commenter suggested that all banking

entities that engage in any trading (regardless of threshold) report

certain metrics.\2663\ Other commenters supported metrics reporting,

but recommended the threshold for trading assets and liabilities be

increased from $1 billion to $10 billion to mitigate any cost and

burden impact on smaller banking entities.\2664\ These commenters

pointed out that even if the minimum dollar threshold were raised to

$10 billion, an overwhelming percentage of trading assets and

liabilities in the banking industry (approximately 98 percent) would

still remain subject to heightened compliance requirements including

Appendix A.\2665\ One commenter suggested the threshold be raised to

$50 billion in combined trading assets and liabilities.\2666\

---------------------------------------------------------------------------

\2662\ See ICBA; Occupy.

\2663\ See Occupy (suggesting all banking entities that engage

in trading be required to provide VaR Exceedance, Risk Factor

Sensitivities and Risk and Position Limits).

\2664\ See PNC et al.; M&T Bank; see also ABA (Abernathy).

\2665\ See ABA (Keating); M&T Bank; PNC et al.

\2666\ See State Street (Feb. 2012).

---------------------------------------------------------------------------

Commenters also offered a number of suggestions for modifying the

activity that would be considered in meeting the thresholds for

determining which reporting requirements apply to a banking entity.

Several commenters argued that certain types of trading assets or fund

investments should not be included for purposes of determining whether

the relevant dollar threshold for compliance was met, particularly

those that are not prohibited activities or investments. For instance,

some commenters urged that trading in U.S. government obligations

should not count toward the calculation of whether a banking

organization meets the trading threshold triggering metrics

reporting.\2667\ These commenters also argued that other positions or

transactions that do not involve financial instruments and that may

constitute trading assets and liabilities, such as loans, should be

excluded from the thresholds because exempt activities should not

determine the type of compliance program a banking entity must

implement.\2668\ One commenter urged that foreign exchange swaps and

forwards be excluded from the definition of a ``derivative'' and not be

subject to compliance requirements as a result.\2669\ Conversely, one

commenter urged that all assets and liabilities defined as trading

assets for purposes of the Market Risk Capital Rule should be included

in the $1 billion standard for becoming subject to any reporting and

record-keeping requirements under the final rule.\2670\

---------------------------------------------------------------------------

\2667\ See PNC et al.

\2668\ See PNC et al.

\2669\ See Northern Trust.

\2670\ See Occupy at 60.

---------------------------------------------------------------------------

A number of commenters argued that monthly reporting was too

frequent because of the complexity of the process that surrounds

generation of regulatory

[[Page 6036]]

reports and suggested that the frequency of reporting should be

quarterly.\2671\ One commenter supported the reporting frequency as

extremely effective and said it should not be reduced in any way.\2672\

---------------------------------------------------------------------------

\2671\ See JPMC; see also Stephen Roach.

\2672\ See Occupy.

---------------------------------------------------------------------------

A number of comments were received on the implementation timeframe

for metrics reporting. Several commenters urged allowing banking

entities the use of the full conformance period for creating the

systems and processes to capture and report the quantitative

metrics.\2673\ Some commenters suggested that metrics should not be

required to be reported until one year after adoption of final

regulations.\2674\ A different commenter suggested that the Agencies

provide a one-year period during which they determine which metrics

will be employed for different asset classes and an additional one-year

period during which such metrics could be reviewed so metrics would be

a required component of a banking entity's compliance program no sooner

than 2 years after issuance of the final rule.\2675\ Another commenter

suggested that banking entities and regulators use the first year of

the conformance period to consult with one another and determine the

usefulness and relevance of individual metrics for different

activities, asset classes, and markets and the second year of the

conformance period to test the metrics systems to validate the accuracy

and relevance of metrics that are agreed upon the first year.\2676\ One

commenter suggested a subset of metrics be rolled out gradually across

trading units before implementing the full suite of metrics that are

ultimately adopted or metrics could be rolled out one trading unit at a

time.\2677\ Another commenter said the Agencies should identify key

metrics that are clearly workable across all ranges of trading activity

and most likely to provide useful data and require those metrics be

implemented first and require other metrics to be phased in over time

in consultation with the banking entity's primary Federal

regulator.\2678\ One commenter supported the heuristic approach of the

proposal and suggested the Agencies should draw on resources and

comment from the public and the industry in continuing the process of

developing and building out metrics.\2679\

---------------------------------------------------------------------------

\2673\ See BoA; Barclays; Citigroup (Feb. 2012); Goldman (Prop.

Trading); JPMC; Morgan Stanley; SIFMA et al. (Prop. Trading) (Feb.

2012); UBS; Stephen Roach.

\2674\ See Credit Suisse (Seidel); JPMC; Wells Fargo (Prop.

Trading).

\2675\ See BoA.

\2676\ See Morgan Stanley; see also SIFMA et al. (Prop. Trading)

(Feb. 2012).

\2677\ See Goldman (Prop. Trading).

\2678\ See Wells Fargo (Prop. Trading).

\2679\ See AFR et al. (Feb. 2012).

---------------------------------------------------------------------------

Another commenter requested that the final rule specify how trading

assets and liabilities should be reported for savings and loan holding

companies.\2680\ This commenter requested clarification that positions

held for hedging or liquidity management purposes should not count as

trading assets or liabilities for the $5 billion threshold in Appendix

A. Another commenter expressed concern that derivatives valuation may

value derivatives substantially lower than their notional exposure and

thereby make high reporting thresholds not meaningful or reflective of

inherent risk.\2681\

---------------------------------------------------------------------------

\2680\ See GE (Feb. 2012).

\2681\ See Occupy.

---------------------------------------------------------------------------

Many commenters expressed concern that the smallest trading unit

level was too low a level for collecting metrics data and suggested the

final rule provide a higher reporting level.\2682\ These commenters

stated that calculating at too low of a level would be more likely to

generate false positives\2683\ and would be burdensome, particularly

for firms with large trading operations.\2684\ In addition, some

commenters indicated that it would be problematic if the definition of

``trading unit'' is applied at a legal entity level and cannot be

applied across multiple legal entities within the same affiliate

group.\2685\ By contrast, two commenters supported the collection of

metrics at the trading desk level and appropriate levels above the

trading desk.\2686\ One of these commenters expressed concern that the

rule allowed for an inappropriately large trading desk unit that could

combine significantly unrelated trading desks, which would impede

detection of proprietary trading and supported measurements at multiple

levels of organization to combat evasion concerns.

---------------------------------------------------------------------------

\2682\ See, e.g., BoA; Goldman (Prop. Trading); JPMC; SIFMA et

al. (Prop. Trading) (Feb. 2012); Morgan Stanley; RBC.

\2683\ See JPMC; Goldman (Prop. Trading); SIFMA et al. (Prop.

Trading) (Feb. 2012); BoA. See also Sen. Gillibrand.

\2684\ See Goldman (Prop. Trading); SIFMA et al. (Prop. Trading)

(Feb. 2012); BoA.

\2685\ See Goldman (Prop. Trading); SIFMA et al. (Prop. Trading)

(Feb. 2012).

\2686\ See Sens. Merkley & Levin (Feb. 2012); Occupy.

---------------------------------------------------------------------------

In response to questions in the proposal about whether the Agencies

should establish numerical thresholds for some or all of the proposed

quantitative measurements, a number of commenters expressed opposition

to establishing numerical thresholds for purposes of the rule,\2687\

while others stated that thresholds should be established over

time.\2688\ In opposition of thresholds, one commenter expressed

concern that numerical thresholds could be easily abused and evaded and

may need to be constantly revised and updated as financial markets

evolve.\2689\ In addition, another commenter stated that numerical

thresholds should not be imposed because metric levels will differ by

asset class and type of activity.\2690\ A few commenters suggested that

numerical thresholds, based on the specific asset class or market,

would be useful to provide clarity or consistency about the types of

activity that are permitted under the rule.\2691\ Two commenters

expressed support for banking entities establishing numerical

thresholds, in consultation with the relevant regulator, for different

trading units based on differences between markets and asset

classes.\2692\

---------------------------------------------------------------------------

\2687\ See SIFMA et al. (Prop. Trading) (Feb. 2012); Occupy;

Alfred Brock.

\2688\ See Wellington; Barclays; Goldman (Prop. Trading);

CalPERS; John Reed.

\2689\ See Occupy.

\2690\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\2691\ See Wellington; CalPERS; John Reed.

\2692\ See Goldman (Prop. Trading); Barclays.

---------------------------------------------------------------------------

c. Approach of the Final Rule

As explained below, the Agencies have reduced the number of metrics

that banking entities must report under Appendix A from the 17 metrics

in the proposal to 7 metrics in the final rule. The final rule also

increases the level of activity that is required to trigger mandatory

reporting of metrics data and phases in the reporting requirement over

time.

Under the final rule, a banking entity engaged in significant

trading activity as defined by Sec. 75.20 must furnish the following

quantitative measurements for each of its trading desks engaged in

covered trading activity calculated in accordance with Appendix A:

Risk and Position Limits and Usage;

Risk Factor Sensitivities;

Value-at-Risk and Stress VaR;

Comprehensive Profit and Loss Attribution;

Inventory Turnover;

Inventory Aging; and

Customer Facing Trade Ratio.

In response to comments, the final rule raises the threshold for

metrics reporting from the proposal to capture only firms that engage

in significant trading activity, identified at specified aggregate

trading asset and liability thresholds, and delays the dates for

reporting metrics through a phased-in

[[Page 6037]]

approach based on the size of trading assets and liabilities.\2693\

Banking entities that meet the relevant thresholds must collect and

report metrics for all trading desks engaged in covered trading

activity beginning on the dates established in Sec. 75.20 of the final

rule. Specifically, the Agencies have delayed the reporting of metrics

until June 30, 2014 for the largest banking entities that, together

with their affiliates and subsidiaries, have trading assets and

liabilities the average gross sum of which equal or exceed $50 billion

on a worldwide consolidated basis over the previous four calendar

quarters (excluding trading assets and liabilities involving

obligations of or guaranteed by the United States or any agency of the

United States). Banking entities with less than $50 billion and greater

than or equal to $25 billion in trading assets and liabilities and

banking entities with less than $25 billion and greater than or equal

to $10 billion in trading assets and liabilities would also be required

to report these metrics beginning on April 30, 2016, and December 31,

2016, respectively. The Agencies believe that these delayed dates for

reporting metrics should allow firms adequate time to develop systems

to calculate and report the quantitative metrics. The Agencies will

review the data collected and revise this collection requirement as

appropriate based on a review of the data collected prior to September

30, 2015.

---------------------------------------------------------------------------

\2693\ As noted above, a number of commenters suggested setting

a higher threshold than the proposed $1 billion and $5 billion

trading asset and liability thresholds because even thresholds of

$10 billion to $50 billion would capture a significant percentage of

the total trading assets and liabilities in the banking system. See

ABA (Keating); M&T Bank; PNC et al.; State Street (Feb. 2012). The

Agencies believe that the phase-in approach to the metrics

requirement established in the final rule should generally address

commenters' concerns about the implementation timeframe by providing

time for analysis, development of systems (if needed), and

implementation of the quantitative measurements requirement. See,

e.g., BoA; Barclays; Citigroup (Feb. 2012); Goldman (Prop. Trading);

JPMC; Morgan Stanley; SIFMA et al. (Prop. Trading) (Feb. 2012); UBS;

Stephen Roach; Credit Suisse (Seidel); Wells Fargo (Prop. Trading).

The Agencies are establishing a phase-in approach, rather than

requiring all banking entities above the $10 billion threshold to

report metrics within the same timeframe, to strike a balance

between the benefits of receiving data to help monitor compliance

with the rule against the need for time to assess the effectiveness

and usefulness of the quantitative measurements in practice and for

some firms to develop additional systems for purposes of this

requirement.

---------------------------------------------------------------------------

Under the final rule, a banking entity required to report metrics

must calculate any applicable quantitative measurement for each trading

day. Each banking entity required to report must report each applicable

quantitative measurement to its primary supervisory Agency on the

reporting schedule established in Sec. 75.20 unless otherwise

requested by the primary supervisory Agency for the entity. The largest

banking entities with $50 billion or greater in trading assets and

liabilities must report the metrics on a monthly basis. Other banking

entities required to report metrics must do so on a quarterly

basis.\2694\ All quantitative measurements for any calendar month must

be reported no later than 10 days after the end of the calendar month

required by Sec. 75.20, unless another time is requested by the

primary supervisory Agency for the entity except for a preliminary

period when reporting will be required no later than 30 days after the

end of the calendar month. Banking entities subject to quarterly

reporting will be required to report quantitative measurements within

30 days of the end of the quarter, unless another time is requested by

the primary supervisory Agency for the entity in writing.\2695\

---------------------------------------------------------------------------

\2694\ Consistent with certain commenters' requests, the final

rule generally requires less frequent reporting than was proposed.

However, the Agencies continue to believe that monthly reporting is

appropriate for the largest banking entities above the $50 billion

threshold. More frequent reporting for these firms is appropriate to

allow for more effective supervision of their large-scale trading

operations. See JPMC; Stephen Roach.

\2695\ See final rule Sec. 75.20(d)(3). The final rule includes

a shorter period of time for reporting quantitative measurements

after the end of the relevant period than was proposed for the

largest banking entities. Like the monthly reporting requirement for

these firms, this is intended to allow for more effective

supervision of their large-scale trading operations.

---------------------------------------------------------------------------

The Agencies believe that together the reduced number of metrics,

the higher thresholds for reporting metrics, delayed reporting dates,

and modified reporting frequency reduce the costs and burden from the

proposal while allowing collection of data to permit better monitoring

of compliance with section 13 of the BHC Act. The Agencies also believe

that the delayed dates for reporting quantitative metrics will provide

banking entities with the time to develop systems to calculate and

report these metrics. The Agencies are not applying these 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 banking entities with lower levels of

trading activities, which represent entities that are typically small,

less complex, and easier to supervise, would not justify the burden

associated with complying with the reporting and recordkeeping

requirements of Appendix A.

The final rule defines ``trading desk'' to replace the concept of

``trading unit'' in the proposal.\2696\ Under the final rule, trading

desk means the smallest discrete unit of organization of a banking

entity that buys or sells financial instruments for the trading account

of the banking entity or an affiliate thereof. The Agencies believe

that applying quantitative measurements to 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.

---------------------------------------------------------------------------

\2696\ See final rule Sec. 75.3(e)(13); see also supra Parts

VI.A.2.c.1.c.ii. and VI.A.3.c.1.c.i.

---------------------------------------------------------------------------

While the Agencies recognize that applying quantitative

measurements at the trading desk level may result in some ``noise'' in

the data and false positives, the Agencies believe it is necessary to

apply the quantitative measurements at the trading desk level to

enhance consistency with other provisions of the final rule. For

example, because the requirements of the market-making exemption apply

at the trading desk level of organization, the Agencies believe

quantitative measurements used to monitor a banking entity's market

making-related activities should also calculated, reported, and

recorded at the trading desk level. In response to commenters' concerns

that trading desk level measurements are more likely to generate false

positives, the Agencies emphasize that quantitative measurements will

not be used as a dispositive tool for determining compliance and,

rather, will be used to monitor patterns and identify activity that may

warrant further review.

Like the proposal, the final rule does not include specific

numerical thresholds. Commenters did not suggest specific thresholds

for particular metrics or provide data and analysis that would support

particular thresholds.\2697\ Given the range of financial instruments

and trading activity covered by the final rule, as well as potential

differences among banking entities' organizational structures, trading

strategies, and level of presence in a particular market, the Agencies

are concerned that numerical thresholds for specific metrics would not

account for these differences and could inappropriately constrain

[[Page 6038]]

legitimate activity.\2698\ Further, mandated thresholds for the metrics

would not recognize the impact changing market conditions may have on a

given trading desk's quantitative measurements. Consistent with two

commenters' suggested approach, banking entities will be required to

establish their own numerical thresholds for quantitative measurements

under the enhanced compliance program requirement in Appendix B.\2699\

---------------------------------------------------------------------------

\2697\ See Wellington; CalPERS; John Reed.

\2698\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

\2699\ See Goldman (Prop. Trading); Barclays. See also final

rule Appendix B.

---------------------------------------------------------------------------

d. Proposed Quantitative Measurements and Comments on Specific Metrics

Section IV of proposed Appendix A described, in detail, the

individual quantitative measurements that must be furnished. These

measurements were 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 proposed these quantitative measurements because,

taken together, these measurements appeared 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 were proposed to identify different aspects

and characteristics of trading activity for the purpose of helping to

identify prohibited proprietary trading, and the Agencies stated in the

proposal that they expected that the quantitative measurements would be

most useful for this purpose when implemented and reviewed

collectively, rather than in isolation. The Agencies stated in the

proposal that they believed that, in the aggregate, many banking

entities already collect and review many of these measurements as part

of their risk management activities, and stated that they expected that

many of the quantitative measurements proposed would be readily

computed and monitored at the multiple levels of organization included

in proposed Appendix A's definition of ``trading unit,'' to which they

would apply.

Under the proposal, the first set of quantitative measurements

related to risk management, and included VaR, Stress VaR, VaR

Exceedance, Risk Factor Sensitivities, and Risk and Position Limits.

Commenters generally supported the use of risk-management metrics as

the most important measure of compliance, indicating that these metrics

could potentially provide useful supervisory information.\2700\

---------------------------------------------------------------------------

\2700\ See, e.g., AFR et al. (Feb. 2012); Barclays; Citigroup

(Feb. 2012); Prof. Duffie; Goldman (Prop. Trading); Invesco; JPMC;

Occupy; Public Citizen; see also BNY Mellon et al. (suggesting the

use of VaR measures for foreign exchange trading activity).

---------------------------------------------------------------------------

In general, commenters supported the use of the VaR metric.\2701\

One of these commenters argued that VaR was not particularly indicative

of proprietary trading, but could be helpful to reveal a trading unit's

overall size and risk profile.\2702\ Another commenter indicated that

significant, abrupt or inconsistent changes to VaR may need to be

absorbed by market makers who absorb large demand and supply shocks

into their inventories.\2703\ This commenter contended that the six

largest bank holding companies had proprietary trading losses that

frequently exceeded their VaR estimates and the design and supervision

of such risk measures should be revisited.

---------------------------------------------------------------------------

\2701\ See, e.g., Citigroup (Feb. 2012); Prof. Duffie; Goldman

(Prop. Trading); Invesco; Public Citizen.

\2702\ See Goldman (Prop. Trading).

\2703\ See Prof. Duffie.

---------------------------------------------------------------------------

One commenter argued that the definition of VaR was not made clear

in the proposal and was missing some important information regarding

methodology as VaR methodologies tend to vary among banking

entities.\2704\ This commenter recommended the development of a

standard methodology by the OFR including a central repository for

historical calculation data for each asset for the purpose of ensuring

standard calculation across the industry. This commenter also expressed

concern that VaR calculations are heavily reliant on the quality of

input data and stated that many markets are unable to provide

sufficient information such that VaR calculations are meaningful,

including markets for illiquid products for which accurate historical

price and market information is sparse and could severely under

represent true potential losses under VaR calculations.\2705\

---------------------------------------------------------------------------

\2704\ See Occupy.

\2705\ See Occupy.

---------------------------------------------------------------------------

A few commenters expressed concern about the applicability of VaR

when applied to ALM activities.\2706\ These commenters argued that risk

management metrics such as VaR would not help to distinguish ALM and

valid risk mitigating hedging activities from prohibited proprietary

trading. For instance, one of these commenters stated that the proposed

reliance on VaR and Stress VaR to demonstrate bona fide hedging is

misleading for ALM activities due to the typical accounting asymmetry

in ALM where, for example, managed liabilities such as deposits are not

marked to market but the corresponding hedge may be.

---------------------------------------------------------------------------

\2706\ See JPMC; State Street (Feb. 2012); see also BoA; CH/

ABASA. For instance, one of these commenters stated that the

proposed reliance on VaR and Stress VaR to demonstrate bona fide

hedging is misleading for ALM activities due to the typical

accounting asymmetry in ALM where, for example, managed liabilities

such as deposits are not mark-to-market but the corresponding hedge

may be. See State Street (Feb. 2012).

---------------------------------------------------------------------------

One commenter argued that the use of stress VaR would be important

to guard against excessive risk taking.\2707\ A few commenters

suggested that additional guidance be provided for Stress VaR including

linking it to the broader stress testing regime and based on extreme

conditions that are not based on historic precedent.\2708\ These

commenters also argued that a one-day holding period assumption is

inadequate, especially for less liquid asset classes, and recommended

that stress be measured over a longer period. One commenter argued that

Stress VaR should be removed from the list of required metrics as it is

not in regular use for day-to-day risk management and provides little

relevant information about the intent or proportionality

[[Page 6039]]

between risk assumed and client demands.\2709\

---------------------------------------------------------------------------

\2707\ See Public Citizen.

\2708\ See AFR et al. (Feb. 2012); Public Citizen.

\2709\ See JPMC.

---------------------------------------------------------------------------

A number of commenters requested that VaR Exceedance be removed

from the list of metrics. These commenters argued that the primary

function of VaR Exceedance is to analyze the quality of a VaR model and

that VaR backtesting is already reported to regulators as part of the

supervisory process. These commenters argued that VaR Exceedance does

not reveal trading intent or actual risk taken.\2710\ One commenter

argued that VaR Exceedance may be useful to the Agencies as an

indicator of the quality of the VaR measure relative to the profit and

loss of the trading unit but that a more rigorous back-testing process

would serve as a better analytical tool than VaR Exceedance to evaluate

the quality of the VaR model result and should be included as an

additional metric.\2711\ One commenter suggested that risk-based

metrics should measure risk as a function of capital.\2712\ Another

commenter warned that risk metrics could be significantly higher during

times of market stress and volatility than during normal times.\2713\

---------------------------------------------------------------------------

\2710\ See ABA (Keating); Barclays; Goldman (Prop. Trading);

SIFMA et al. (Prop. Trading) (Feb. 2012); Wells Fargo (Prop.

Trading); UBS.

\2711\ See Occupy.

\2712\ See Citigroup (Feb. 2012).

\2713\ See SIFMA et al. (Prop. Trading) (Feb. 2012).

---------------------------------------------------------------------------

A few commenters expressed support for risk factor sensitivities as

useful, supervisory information.\2714\ One of these commenters

suggested that risk factor sensitivities could orient regulators to a

trading unit's overall size and risk profile,\2715\ while another

commenter stated that risk factor sensitivities would be the most

useful tool for identifying the accumulation of market risk in

different areas of a banking entity.\2716\ One commenter suggested that

several risk factor sensitivity snapshots be taken throughout the day

with an average value reported at the end of day.\2717\ This commenter

also recommended that trading strategies that rely heavily on models to

calculate risk exposures (e.g., correlation trading portfolios), should

trigger additional disclosures in risk factor sensitivity

reporting.\2718\

---------------------------------------------------------------------------

\2714\ See Citigroup (Feb. 2012); Prof. Duffie; Occupy.

\2715\ See Goldman (Prop. Trading).

\2716\ See Occupy.

\2717\ See Occupy.

\2718\ See Occupy.

---------------------------------------------------------------------------

Commenters also supported risk and position limits as providing

useful, supervisory information. Several commenters indicated that

these limits could be helpful to orient regulators to a trading unit's

overall size and risk profile.\2719\ Another commenter expressed the

view risk and position limits are the most comprehensive measures of

risk taking and incorporate VaR, Stress VaR, and Risk Factor

Sensitivities.\2720\ A different commenter argued it was unclear how

position limits are in fact a quantitative metric and not a description

of a banking entity's internal risk policies.\2721\

---------------------------------------------------------------------------

\2719\ See, e.g., Barclays; Citigroup (Feb. 2012); Prof. Duffie;

Goldman (Prop. Trading).

\2720\ See Barclays.

\2721\ See Occupy.

---------------------------------------------------------------------------

After carefully considering the comments received, the final rule

retains the risk-management metrics other than VaR Exceedance. The

collection of information regarding Risk and Position Limits, VaR,

Stress VaR, and Risk Factor Sensitivities is consistent with the aim of

providing a means of characterizing the overall risk profile of the

trading activities of each trading desk and evaluating the extent to

which the quantitative profile of a trading desk's activities is

consistent with permissible activities. Moreover, a number of

commenters indicated that the risk management measures would be

effective at achieving these goals.\2722\ The risk management measure

that was not retained in the final rule, VaR Exceedance, was

considered, in light of the comments, as not offering significant

additional information on the overall risk profile and activities of

the trading desk relative to the burden associated with computing,

auditing and reporting it on an ongoing basis.\2723\

---------------------------------------------------------------------------

\2722\ See, e.g., AFR et al. (Feb. 2012); Barclays; Citigroup

(Feb. 2012); Prof. Duffie; Goldman (Prop. Trading); Invesco; JPMC;

Occupy; Public Citizen; see also Northern Trust; State Street (Feb.

2012).

\2723\ See ABA (Keating); Barclays; Goldman (Prop. Trading);

SIFMA et al. (Prop. Trading) (Feb. 2012); Wells Fargo (Prop.

Trading); UBS.

---------------------------------------------------------------------------

The risk-management measurements included in the final rule are

widely used by banking entities to measure and manage trading risks and

activities.\2724\ VaR, Stress VaR, and Risk Factor Sensitivities

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. The provided description and calculation guidance for

each of these measures is consistent with both current market practice

and regulatory capital requirements for banks. The final rule does not

provide a prescriptive definition of each of these measurements as

these measures must be flexible enough to be tailored to the specific

trading activities of each trading desk. Supervisory guidance and

comparisons of these measures across similarly situated trading desks

at a given entity as well as across entities will be used to ensure

that the provided measurements conform to the description and

calculation guidance provided in Appendix A. Risk and Position Limits

and Usage provide an explicit assessment of management's expectation of

how much risk is required to perform permitted market-making,

underwriting and hedging activities. The final rule requires that the

usage of each risk and position limit be reported so that the risk

taking by each trading desk can be monitored and assessed on an ongoing

basis.\2725\

---------------------------------------------------------------------------

\2724\ See Joint Proposal, 76 FR at 68887.

\2725\ The Agencies believe this clarification responds to one

commenter's question regarding how risk and position limits will be

used and assessed for purposes of the rule. See Occupy.

---------------------------------------------------------------------------

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.\2726\ 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 desks and

management's stated expectations for such measures may indicate

impermissible proprietary trading, and may warrant further review. In

addition, indicators of unanticipated or unusual levels of risk taken,

such as breaches of internal Risk and Position Limits, may suggest

behavior that is inconsistent with appropriate levels of risk and may

warrant further scrutiny. The limits required under Sec.

75.4(b)(2)(iii) and Sec. 75.5(b)(1)(i) must meet the applicable

requirements under Sec. 75.4(b)(2)(iii) and Sec. 75.5(b)(1)(i) and

also must include appropriate metrics for the trading desk limits

including, at a minimum, the ``Risk Factor Sensitivities'' and ``Value-

at-Risk and Stress Value-at-Risk'' metrics except to the extent any of

the ``Risk Factor Sensitivities'' or ``Value-at-Risk and Stress Value-

at-Risk'' metrics are demonstrably ineffective for measuring and

monitoring the risks of a

[[Page 6040]]

trading desk based on the types of positions traded by, and risk

exposures of, that desk.

---------------------------------------------------------------------------

\2726\ See Joint Proposal, 76 FR at 68887.

---------------------------------------------------------------------------

Under the proposal, the second set of quantitative measurements

related to the source of revenues, and included Comprehensive Profit

and Loss, Portfolio Profit and Loss, Fee Income, Spread Profit and

Loss, and Comprehensive Profit and Loss Attribution. A few commenters

expressed support for Comprehensive Profit and Loss as a reasonable

contextual metric and contended that the metric could inform the

analysis of whether market-making revenues are from customer

transactions.\2727\

---------------------------------------------------------------------------

\2727\ See Goldman (Prop. Trading); Japanese Bankers Ass'n;

Occupy; see also Barclays.

---------------------------------------------------------------------------

As described above, a number of commenters expressed concern about

a focus on revenues as part of evaluating market-making.\2728\ For

instance, one commenter argued that the rule should not require, even

in guidance, that market making-related permitted activities be

``designed to generate revenues from fees, commissions, bid-asks

spreads or other income,'' arguing that this prejudges appropriate

results for revenue metrics and implies that a bona fide market maker

is not permitted to benefit from revenues from market movements.\2729\

One commenter expressed concern that the source-of-revenue metrics are

subject to manipulation as these metrics depend on correctly

classifying revenue into market bid-ask spreads as opposed to other

sources of revenue.\2730\ One commenter stated that this metric should

serve as a secondary indication of risk levels because it could be

subject to manipulation.\2731\ Another commenter recommended use of the

sub-metric in Comprehensive P&L Attribution.\2732\ A different

commenter recommended the adoption of clearer metrics to distinguish

customer revenues from revenues from price movements.\2733\ One

commenter indicated that after-the-fact application of quantitative

measurements such as Comprehensive Profit and Loss may cause firms to

reconsider their commitment to market making and recommended that, to

the extent this metric is used, it should be applied flexibly in light

of market conditions prevailing during the relevant time period, and as

one of many factors relevant to an overall assessment of bona fide

market making.\2734\

---------------------------------------------------------------------------

\2728\ See supra Part VI.A.3.c.7.b.

\2729\ See SIFMA (May 2012).

\2730\ See AFR (Nov. 2012).

\2731\ See Occupy.

\2732\ See Barclays.

\2733\ See Public Citizen.

\2734\ See NYSE Euronext.

---------------------------------------------------------------------------

A few commenters supported Portfolio Profit and Loss as a

reasonable contextual metric to inform whether revenues from market-

making transactions are from customer transactions.\2735\ However, one

of these commenters argued that this metric would not necessarily be

indicative of prohibited proprietary trading and profits may reflect

bona fide market making-related, underwriting, and hedging

activities.\2736\ Another commenter argued that this metric should

serve as a secondary indication of risk levels and may be subject to

manipulation.\2737\

---------------------------------------------------------------------------

\2735\ See Goldman (Prop. Trading); Japanese Bankers Ass'n;

Occupy.

\2736\ See Goldman (Prop. Trading).

\2737\ See Occupy.

---------------------------------------------------------------------------

Some commenters felt that Fee Income and Expense was a useful

metric.\2738\ One of these commenters argued this metric has the

potential to help distinguish permitted activities from prohibited

proprietary trading.\2739\ Another commenter felt this metric would be

useful in liquid markets that trade with the convention of fees and

commissions but less useful, but still indicative, in other markets

that use inter-dealer brokers to conduct client-related

activities.\2740\ One commenter argued that it would be impracticable

to produce Fee Income and Expense data for foreign exchange trading,

which is predominantly based on bid/offer spread.\2741\

---------------------------------------------------------------------------

\2738\ See Goldman (Prop. Trading); Japanese Bankers Ass'n;

Occupy.

\2739\ See Goldman (Prop. Trading). This commenter urged that

fee income and expense should be considered together with Spread P&L

arguing that these two both measures of customer revenues and, in

practice, may function as substitutes for each other.

\2740\ See Occupy.

\2741\ See Northern Trust.

---------------------------------------------------------------------------

A few commenters thought that Spread P&L could be useful.\2742\ One

of these commenters argued that Spread P&L has the potential to help

distinguish permitted activities from prohibited proprietary

trading.\2743\ This commenter suggested that the final rule remove the

proposal's revenue requirement as part of market-making and instead

rely on revenue metrics such as Spread P&L.\2744\ This commenter

argued, however, that it will not always be clear how to best calculate

Spread P&L and it would be critical for the Agencies to be flexible and

work with banking entities to determine the appropriate proxies for

spreads on an asset-class-by-asset class and trading desk-by-trading-

desk basis. One commenter contended that the proposed implementation in

the proposal was more difficult than necessary and suggested End of Day

Spread Proxy is sufficient. Another commenter suggested expanding the

flexibility offered in choosing a bid-offer source to calculate Spread

P&L.\2745\

---------------------------------------------------------------------------

\2742\ See, e.g., Goldman (Prop. Trading); JPMC; UBS.

\2743\ See Goldman (Prop. Trading).

\2744\ See Goldman (Prop. Trading); see also Paul Volcker

(supporting a metric considering the extent to which earnings are

generated by pricing spreads rather than changes in price).

\2745\ See JPMC; UBS; see also SIFMA et al. (Prop. Trading)

(Feb. 2012).

---------------------------------------------------------------------------

However, the majority of commenters recommended removal of Spread

P&L as a metric.\2746\ These commenters argued that a meaningful

measure for Spread P&L cannot be calculated in the absence of a

continuous bid-ask spread, making this metric misleading especially for

illiquid positions and shallow markets.

---------------------------------------------------------------------------

\2746\ See ABA et al.; BoA; Barclays; Credit Suisse (Seidel);

Japanese Bankers Ass'n; Northern Trust; SIFMA et al. (Prop. Trading)

(Feb. 2012); Wells Fargo (Prop. Trading); see also AFR et al. (Feb.

2012); Occupy.

---------------------------------------------------------------------------

A few commenters generally expressed support for the inclusion of

Comprehensive Profit and Loss Attribution.\2747\ One of these

commenters stated that this metric was the most comprehensive metric

for measuring sources of revenue and included other metrics as sub-

metrics, such as Comprehensive Profit and Loss, Portfolio Profit and

Loss, and Fee Income and Expense. Another commenter contended the

mention of ``customer spreads'' and ``bid-ask spreads'' was unclear and

that both of these terms should be removed from the calculation

guidance. Other commenters argued that the benefits of this metric do

not justify the costs of generating a report of Comprehensive P&L

Attribution on a daily basis.\2748\ One commenter urged the Agencies to

ensure that each institution be permitted to calculate this metric in a

way that reflects the institution's unique characteristics.\2749\

---------------------------------------------------------------------------

\2747\ See Barclays; Occupy.

\2748\ See BOK; Goldman (Prop. Trading); SIFMA et al. (Prop

Trading) (Feb. 2012); Wells Fargo (Prop. Trading).

\2749\ See SIFMA et al. (Prop Trading) (Feb. 2012).

---------------------------------------------------------------------------

After carefully considering the comments received, the final rule

maintains only a modified version of Comprehensive P&L Attribution

metric and does not retain the proposed Comprehensive Profit and Loss,

Portfolio Profit and Loss, Fee Income, or Spread Profit and Loss

metrics. The final rule also requires volatility of comprehensive

profit and loss to be reported. As pointed out by a number of

[[Page 6041]]

commenters, Comprehensive Profit and Loss Attribution provides a

holistic attribution of each trading desk's profit and loss and

contains much of the information content that is provided by many of

the other metrics, such as Fee Income and Expense.\2750\ Accordingly,

the use of Comprehensive Profit and Loss Attribution in the final rule

greatly simplifies the metric reporting requirement and reduces burden

while retaining much of the information and analysis that was provided

in the full set of five metrics that were contained in the proposal. In

addition, in response to commenters' concerns about the burdens of

separately identifying specific revenue sources (e.g., revenues from

bid-ask spreads, revenues from price appreciation), the Agencies have

modified the focus of the proposed source of revenue metrics to focus

on when revenues are generated, rather than the specific sources of

revenue.\2751\ This approach should also help address one commenter's

concern about the need for new, sophisticated systems to differentiate

bid-ask spreads from price appreciation.\2752\ The utility of this

modified approach is discussed in more detail in the discussion of the

market-making exemption.\2753\ Finally, the Comprehensive Profit and

Loss Attribution metric will ensure that all components of a trading

desk's profit and loss are measured in a consistent and comprehensive

fashion so that each individual component can be reliably compared

against other components of a trading desk's profit and loss without

being considered in isolation or taken out of context.

---------------------------------------------------------------------------

\2750\ See Barclays.

\2751\ See JPMC; UBS; SIFMA et al. (Prop Trading) (Feb. 2012);

ABA (Keating); BoA; Barclays; Credit Suisse (Seidel).

\2752\ See BoA.

\2753\ See supra Part VI.A.3.c.7.c.

---------------------------------------------------------------------------

This measurement is 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 managing, 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.

Under the proposal, the third set of measurements related 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 Portfolio Profit and Loss, and

Skewness of Portfolio Profit and Loss and Kurtosis of Portfolio Profit

and Loss.

A few commenters indicated support for these metrics as

appropriate, contextual metrics.\2754\ These commenters indicated that

these metrics may serve to highlight areas requiring further

investigation, since high P&L volatility may indicate a deviation from

traditional client related activities and that a well-structured

trading operation should be able to obtain relatively high ratios of

revenue-to-risk (as measured by various metrics), low volatility, and

relatively high turnover.\2755\ One commenter recommended that New

Trades P&L be substituted for Portfolio P&L for purposes of computing

Volatility of P&L because New Trades P&L captures customer revenues

more completely and is therefore more useful for distinguishing market

making from proprietary trading.\2756\ Another commenter indicated that

Skewness of Portfolio Profit and Loss and Kurtosis of Portfolio Profit

and Loss incorporates (and therefore obviates the need for a separate

calculation of) the metric Volatility of Portfolio Profit and

Loss.\2757\

---------------------------------------------------------------------------

\2754\ See, e.g., Goldman (Prop. Trading); Volcker; John S.

Reed; see also AFR et al. (Feb. 2012); Sen. Merkley; Occupy; Public

Citizen.

\2755\ See Occupy; Public Citizen; Sen. Merkley.

\2756\ See Goldman (Prop. Trading) (also suggesting that New

Trades P&L be substituted for Portfolio P&L in Comprehensive Profit

and Loss to Volatility Ratio and Portfolio Profit and Loss to

Volatility Ratio and Unprofitable Trading Days based on

Comprehensive Profit and Loss and Unprofitable Trading Days based on

Portfolio Profit and Loss).

\2757\ See Barclays.

---------------------------------------------------------------------------

One commenter urged that after-the-fact application of

Comprehensive Profit and Loss to Volatility Ratio may cause firms to

reconsider their commitment to market making and argued that this

metric should be applied flexibly in light of market conditions

prevailing during the relevant time period and as one of many factors

relevant to an assessment of overall bona fide market making.\2758\ One

commenter supported monitoring Portfolio Profit and Loss to Volatility

Ratio and argued that the Agencies should establish a clear pattern of

profit and loss results of individual trading units through iterative

application of the metrics.\2759\

---------------------------------------------------------------------------

\2758\ See NYSE Euronext.

\2759\ See AFR et al. (Feb. 2012).

---------------------------------------------------------------------------

One commenter expressed support for Unprofitable Trading Days based

on Comprehensive Profit and Loss and Unprofitable Trading Days based on

Portfolio Profit and Loss indicating that these metrics may serve to

highlight areas requiring further investigation, since a significant

number of unprofitable trading days may indicate a deviation from

traditional client-related activities.\2760\ Another commenter

suggested that these metrics be removed as they would result in market

makers being less likely to take client-facing positions due to

reluctance to incur unprofitable trading days that could indicate the

presence of impermissible activity despite the utility of such trades

in providing liquidity to customers.\2761\

---------------------------------------------------------------------------

\2760\ See Occupy.

\2761\ See Barclays.

---------------------------------------------------------------------------

One commenter requested including Skewness of Portfolio Profit and

Loss and Kurtosis of Portfolio Profit and Loss in the metrics set as

the most comprehensive metric in the revenue-relative-to-risk category

making other metrics unnecessary in this area.\2762\ Another commenter

argued that this metric would produce inconsistent results within and

across trading units and would generally not support any meaningful

conclusions regarding the permissibility or risk of trading

activities.\2763\

---------------------------------------------------------------------------

\2762\ See Barclays.

\2763\ See Goldman (Prop. Trading).

---------------------------------------------------------------------------

After carefully considering the comments received, the final rule

does not include any of the proposed revenue-relative-to-risk

measurements. Each of these measures provides information that may

generally be useful for characterizing the overall risk profile of the

trading activities of each trading unit and evaluating the extent to

which the quantitative profile of a trading unit's activities is

consistent with permissible trading activities. The broad information

content of these measures, however, can largely be reproduced from

transformations of information that will be provided in the

Comprehensive Profit and Loss Attribution and, as noted above,

volatility of comprehensive profit and loss must be reported. Analogs

to the other metrics such as Skewness of Portfolio Profit and Loss and

Kurtosis of Portfolio Profit and Loss can be computed similarly from

information that will be provided in the Comprehensive Profit and Loss

Attribution. Accordingly, the information contained in these metrics

[[Page 6042]]

is retained in the final rule while the burden associated with

computing, auditing and reporting these additional metrics on an

ongoing basis has been eliminated.

Under the proposal, the fourth set of quantitative measurements

related to customer-facing activity measurements. These metrics include

Inventory Risk Turnover, Inventory Aging, and Customer-facing Trade

Ratio.

A few commenters supported the proposal's Inventory Risk Turnover

metric though some of these commenters suggested modifications to the

metric.\2764\ One commenter argued that this metric could indicate

whether a given trading unit holds risk and inventory consistently with

the asset class in which such trading unit deals, the types of trading

activity in which the trading unit engages, and the scale and scope of

the client activity that such trading unit serves.\2765\ Another

commenter argued that the final rule should explicitly state that a

trading unit's inventory management practices will be evaluated using

this metric.\2766\ Some commenters expressed the view that this metric

might be useful in the case of liquid positions but not in the case of

illiquid or difficult-to-hedge products, which naturally have lower

risk turnover. Others noted support for this metric tailored on an

asset-by-asset basis.\2767\

---------------------------------------------------------------------------

\2764\ See Goldman (Prop. Trading); Barclays; John Reed; JPMC;

SIFMA et al. (Prop. Trading) (Feb. 2012); Wells Fargo (Prop.

Trading).

\2765\ See Barclays.

\2766\ See Goldman (Prop. Trading).

\2767\ See, e.g., Barclays; Goldman (Prop. Trading); JPMC; John

Reed.

---------------------------------------------------------------------------

A few commenters requested that the final rule clarify that this

metric will not be required to be calculated for every possible Risk

Factor Sensitivity measurement for the applicable portfolio and that a

banking entity and its regulator should determine one or two core risk

factors per asset classes with respect to which this metric that will

be calculated to strike a reasonable balance between costs of

calculations and benefits of this metric.\2768\ Other commenters argued

the Inventory Risk Turnover Metric was difficult to measure,

burdensome, and would create uncertainty for derivatives

counterparties.\2769\

---------------------------------------------------------------------------

\2768\ See Goldman (Prop. Trading); JPMC; SIFMA et al. (Prop.

Trading) (Feb. 2012); see also Morgan Stanley.

\2769\ See Japanese Bankers Ass'n; SIFMA (Asset Mgmt.) (Feb.

2012); Morgan Stanley.

---------------------------------------------------------------------------

A few commenters supported the Inventory Aging metric. One

commenter argued it should be included in the metrics set to indicate

whether a given trading desk holds risk and inventory consistently

within the asset class in which such trading desk deals, the type of

trading activity in which the trading unit engages, and the scale and

scope of the client activity that such trading desk serves.\2770\ This

commenter suggested tailoring the metric based on the market for a

particular asset class and market conditions because aging levels may

be higher in less liquid markets. A number of commenters argued that

application of the Inventory Aging metric is only appropriate for cash

products and should not be used for trading units engaged in

transactions in financial instruments such as derivatives.\2771\

Another commenter argued that the Inventory Aging metric is generally

not useful for derivatives, and for non-derivatives it provides

essentially similar information to Inventory Risk Turnover.\2772\ One

commenter requested additional guidance on how to calculate this

metric.\2773\

---------------------------------------------------------------------------

\2770\ See Barclays; see also Invesco.

\2771\ See Barclays; Goldman (Prop. Trading); Japanese Bankers

Ass'n; Morgan Stanley; SIFMA (Prop. Trading) (Feb. 2012).

\2772\ See Goldman (Prop. Trading).

\2773\ See Soci[eacute]t[eacute] G[eacute]n[eacute]rale.

---------------------------------------------------------------------------

A few commenters indicated that the Customer-Facing Trade Ratio

could be helpful in distinguishing prohibited proprietary trading from

market making and would be more effective than the proposal's negative

presumption against interdealer trading to evaluate the amount of

interdealer trading that is consistent with market making-related or

hedging activity in a particular business.\2774\ Some commenters

suggested that the metric could be improved and argued that the number

of transactions executed over a calculation period does not provide an

adequate measure for the level of customer-facing trading because it

does not reflect the size of transactions or the amount of risk. These

commenters suggested replacing the metric with a more risk-sensitive

metric or defining the ratio so that it measures notional principal

risk associated with customer transactions and is appropriately

tailored to the relevant asset class or market.\2775\

---------------------------------------------------------------------------

\2774\ See Goldman (Prop. Trading); see also Invesco.

\2775\ See Barclays; Goldman (Prop. Trading) ; JPMC; SIFMA

(Prop. Trading) (Feb. 2012); UBS.

---------------------------------------------------------------------------

A number of commenters raised concerns about the definition of

customer for purposes of this metric. One commenter argued that a

failure to define ``customer'' to differentiate between customers and

non-customers would render this metric meaningless.\2776\ Another

commenter contended that the metric would be appropriate as long as

banking entities have the flexibility to determine who is a

customer.\2777\ One commenter argued that using a definition of

``customer'' that is different between the market making-related

activity and the reported metric could make legitimate market making-

related activity with customers appear to be prohibited proprietary

trading.\2778\ This commenter argued that other dealers and other

registered market participants should be recognized as customers of the

banking entity. A few commenters contended that this metric would be

burdensome if it required a banking entity to tag individual trades as

customer or non-customer.\2779\ A few commenters argued that

interdealer trading should be allowed as part of market making and

argued this metric would not provide a useful measure of customer-

facing activity.\2780\ Some commenters also expressed concern about the

implications of such a metric for hedging activity, which may involve

relatively less customer-facing activity.\2781\

---------------------------------------------------------------------------

\2776\ See Occupy.

\2777\ See Wells Fargo (Prop. Trading).

\2778\ See SIFMA (Prop. Trading) (Feb. 2012).

\2779\ See SIFMA (Prop. Trading) (Feb. 2012); see also Goldman

(Prop Trading).

\2780\ See Barclays; Japanese Bankers Ass'n; Oliver Wyman (Dec.

2011); SIFMA (Prop. Trading) (Feb. 2012).

\2781\ See Barclays; Wells Fargo (Prop. Trading).

---------------------------------------------------------------------------

After carefully considering the comments received, the final rule

retains all three of the customer-facing activity measurements from the

proposal, though each measure has been modified. A number of commenters

raised issues regarding the complexities associated with computing the

Inventory Risk Turnover metric. In particular, as noted above, some

commenters argued that computing the metric for every reported risk

factor sensitivity would be burdensome and would not be

informative.\2782\ The inventory metric required in the final rule,

Inventory Turnover, is applied at the transaction level and not at the

risk factor sensitivity level. Accordingly, for a given trading desk

and calculation period, e.g., 30 days, there is only one value of the

Inventory Turnover metric rather than one value for each risk factor

sensitivity that is managed and reported by the trading desk. In this

sense, the turnover metric required in the final rule is similar to

more traditional and common measures of inventory turnover. Moreover,

the required turnover metric is simpler and less costly to track and

record while still

[[Page 6043]]

providing banking entities and Agencies with meaningful information

regarding the extent to which the size and volume of trading activities

are directed at servicing the demands of customers. In addition, the

description of Inventory Turnover in the final rule provides explicit

guidance on how to apply the metric to derivative positions.\2783\

---------------------------------------------------------------------------

\2782\ See Goldman (Prop. Trading); JPMC; SIFMA (Prop. Trading)

(Feb. 2012).

\2783\ The Agencies believe that this should address commenters'

uncertainty with respect to how the Inventory Risk Turnover metric

would work for derivatives. See Japanese Bankers Ass'n; SIFMA (Asset

Mgmt.) (Feb. 2012); Morgan Stanley.

---------------------------------------------------------------------------

Inventory Aging provides banking entities and Agencies with

meaningful information regarding the extent to which the size and

volume of trading activities are directed at servicing the demands of

customers. In the case of Inventory Aging, the proposal required that

the aging schedule be organized according to a specific set of age

ranges (i.e., 0-30 days, 30-60 days, 60-90 days, 90-180 days, 180-360

days, and more than 360 days). This requirement has not been adopted in

the final rule in order to provide greater flexibility and to recognize

that specific age ranges that may be relevant for one asset class may

be less relevant for another asset class. Also, to address commenters'

uncertainty about how this metric would apply to derivatives, the final

rule's description of the Inventory Aging metric provides guidance on

how to apply the metric to derivative positions.\2784\

---------------------------------------------------------------------------

\2784\ See Barclays; Goldman (Prop. Trading); Japanese Bankers

Ass'n; Morgan Stanley; SIFMA (Prop. Trading) (Feb. 2012).

---------------------------------------------------------------------------

The Customer Facing Trade Ratio provides directionally useful

information regarding the extent to which trading transactions are

conducted with customers. In the case of the Customer Facing Trade

Ratio, the proposal required that customer trades be measured on a

trade count basis. The final rule requires that the Customer Facing

Trade Ratio be computed in two ways. As in the proposal, the metric

must be computed by measuring trades on a trade count basis.

Additionally, as suggested by some commenters, the final rule requires

that the metric be computed by measuring trades on a notional value

basis. The value based approach is required to reflect the fact noted

by some commenters, that a trade count based measure may not accurately

represent the amount of customer facing activity if customer trade

sizes systematically differ from the sizes of non-customer trades. In

addition, the term ``customer'' for purposes of the Customer-Facing

Trade Ratio is defined in the same manner as the terms client,

customer, and counterparty used for purposes of the market-making

exemption. This will ensure that the information provided by this

metric is useful for purposes of monitoring compliance with the market-

making exemption.\2785\

---------------------------------------------------------------------------

\2785\ See SIFMA (Prop. Trading) (Feb. 2012).

---------------------------------------------------------------------------

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 was 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 expected that the proposed Pay-to-

Receive Spread Ratio measurement would 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 desks and management's stated expectations for such

measures could indicate impermissible proprietary trading.

One commenter expressed concern that after-the-fact application of

the Pay-to-Receive Spread Ratio could cause firms to reconsider their

commitment to market making. This commenter suggested that if this

measure is used, it be applied flexibly, in light of market conditions

prevailing during the relevant time period, and as one of many factors

relevant to an overall assessment of bona fide market making.\2786\

Another commenter suggested expanding the flexibility offered in

choosing a bid-offer source to the entire process of calculating Pay-

to-Receive Spread Ratio.\2787\ A number of commenters argued for

removing this metric because its calculation incorporates the Spread

P&L metric.\2788\ Some of these commenters argued that the metric

requires a trade-by-trade analysis which would be expensive to compute

and would not provide any additional information that is not available

from other metrics. One commenter alleged that this metric was not

calculable by any methodology.\2789\

---------------------------------------------------------------------------

\2786\ See NYSE Euronext.

\2787\ See UBS.

\2788\ See CH/ABASA; Goldman (Prop. Trading); Japanese Bankers

Ass'n; Occupy; SIFMA (Prop. Trading) (Feb. 2012); Wells Fargo (Prop.

Trading).

\2789\ See Morgan Stanley.

---------------------------------------------------------------------------

The Pay-to-Receive Spread Ratio has not been retained in the final

rule. As noted by some commenters, the broad information content of

this metric will largely be captured in the Comprehensive Profit and

Loss Attribution measurement. In addition, the Comprehensive Profit and

Loss Attribution will place such factors that are related to the

proposed Pay-to-Receive Spread Ratio in context with other factors that

determine total profitability. Accordingly, factors relating to the

payment of fees, commissions and spreads will not be considered in

isolation but will be viewed in a context that is appropriate to the

entirety of the trading desk's activities. Finally, using the

information contained in the Comprehensive Profit and Loss Attribution

to holistically assess the range of factors that determine overall

profitability, rather than requiring a large number of separate and

distinct measurements, will reduce the resulting compliance burden

while ensuring an integrated and holistic approach to assessing the

activities of each trading desk.

Commenters also suggested a number of additional metrics be added

to the final rule that were not contained in the proposal. One

commenter, who advocated for an alternative framework for market making

supported by structural and transactional metrics, suggested that

structural metrics could include the ratio of salespeople to traders

and the level of resources devoted to client research and trading

content.\2790\ Two commenters supported the use of a counterparty risk

exposure measure, not only to the risk of counterparty default but also

to potential gains and losses to major counterparties for each of a

list of systemically important scenarios.\2791\ One of these commenters

suggested that entity-wide inflation risk assessments be produced on a

daily basis.\2792\ This commenter also argued that an important metric

that is missing is a Liquidity Gap Risk metric that estimates

[[Page 6044]]

the price change that occurs following a sudden disruption in liquidity

for a product, arguing that there needs to be an industry-wide effort

to more accurately measure and account for the significant effect that

liquidity and changes in its prevailing level have on the valuation of

each asset.

---------------------------------------------------------------------------

\2790\ See Morgan Stanley.

\2791\ See Prof. Duffie; Occupy.

\2792\ See Occupy.

---------------------------------------------------------------------------

One commenter argued that the metrics regime was well-designed for

market-making but lacking in other areas like hedging. This commenter

recommended the addition of additional metrics more applicable to other

non-market making activities like a net profit metric for

hedging.\2793\ Two commenters argued that quantitative measurement for

underwriting was not included in the proposal and stated that in a bona

fide underwriting, unsold balances should be relatively small so a

marker for potential non-bona fide underwriting should be recognized if

VaR (unhedged and uncovered) of the unsold balance that is allocated to

a banking entity is large relative to the expected revenue measured by

the pro rata underwriting spread.\2794\

---------------------------------------------------------------------------

\2793\ See AFR et al. (Feb. 2012).

\2794\ See AFR et al. (Feb. 2012); see also Public Citizen.

---------------------------------------------------------------------------

After carefully considering the comments received, these and other

proposed metrics have not been included as part of the final rule. One

major concern raised by a range of commenters was the degree of

complexity and burden that would be required by the metrics reporting

regime. In light of these comments, the final rule includes a number of

quantitative measurements that are expected to provide a means of

characterizing the overall risk profile of the trading activities of

each trading desk and evaluating the extent to which the quantitative

profile of a trading desk's activities is consistent with permissible

trading activities in a cost effective and efficient manner while being

appropriate for a range of different trading activities. Moreover,

while many commenters suggested a number of different alternative

metrics, many of these alternatives are consistent with the broad

themes, risk management, sources of revenues, customer facing activity,

that inform the quantitative measurements that are retained in the

final rule. Finally, banking entities will be expected to develop their

own metrics, as appropriate, to further inform and improve their own

monitoring and understanding of their trading activities. Many of the

alternative metrics that were suggested by commenters, especially those

that relate to a specific market or type of instrument, may be used by

banking entities as they develop their own quantitative measurements.

For each individual quantitative measurement in the final rule,

Appendix A describes the measurement, provides general guidance

regarding how the measurement should be calculated 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 Appendix A and at the trading desk

level mandated by the final rule may require banking entities to

implement new processes to calculate and furnish the required

data.\2795\

---------------------------------------------------------------------------

\2795\ See Credit Suisse (Seidel); Morgan Stanley; UBS; Wells

Fargo (Prop. Trading); Soci[eacute]t[eacute] G[eacute]n[eacute]rale;

Occupy; Paul Volcker; AFR et al. (Feb. 2012); Western Asset Mgmt.;

Public Citizen.

---------------------------------------------------------------------------

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 tailored 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 desks across firms.

The Agencies expect to evaluate the data collected during the

compliance period both for its usefulness as a barometer of

impermissible trading activity and excessive risk-taking and for its

costs. This evaluation will consider, among other things, whether all

of the quantitative measurements are useful for all asset classes and

markets, as well as for all the trading activities subject to the

metrics requirement, or if further tailoring is warranted.\2796\ The

Agencies propose to revisit the metrics and determine, based on a

review of the data collected by September 30, 2015, whether to modify,

retain or replace the metrics. To allow firms to develop systems to

calculate and report these metrics, the Agencies have delayed all

reporting of the metrics until July 2014, phased in the reporting

requirements over a multi-year period, and reduced the category of

banking entities that must report the metrics to a smaller number of

firms that engage in significant trading activity. These steps,

combined with the reduction in the number of metrics required to be

reported, are designed to reduce the cost and burden associated with

compiling and reporting the metrics while retaining the usefulness of

this data collection in helping to ensure that trading activities are

conducted in compliance with section 13 of the BHC Act and the final

rule and in a manner that monitors, assesses and controls the risks

associated with these activities.

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\2796\ The Agencies believe this review, along with the fact

that quantitative measurements will not be used as a dispositive

tool for determining compliance and the removal of many of the

proposed metrics, should help address commenters' concerns that some

of the proposed quantitative measurements will not be as relevant

for certain asset classes, markets, and activities. See Morgan

Stanley; SIFMA et al. (Prop. Trading); Stephen Roach.

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4. Section 75.21: Termination of Activities or Investments; Authorities

for Violations

Section 75.21 implements section 13(e)(2) of the BHC Act, which

authorizes an Agency to order a banking entity subject to its

jurisdiction to terminate activities or investments that violate or

function as an evasion of section 13 of the Act.\2797\ Section 13(e)(2)

further provides that this paragraph shall not be construed to limit

the inherent authority of any Federal agency or State regulatory

authority to further restrict any investments or activities under

otherwise applicable provisions of law.\2798\

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\2797\ See 12 U.S.C. 1851(e)(2).

\2798\ Id.

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The proposed rule implemented section 13(e)(2) in two parts. First,

Sec. 75.21(a) of the proposal required 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

[[Page 6045]]

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.\2799\ Second, Sec. 75.21(b) of the proposal provided that

if, after due notice and an opportunity for hearing, the respective

Agency finds reasonable cause to believe that any banking entity has

engaged in an activity or made an investment described in paragraph

(a), the Agency may, by order, direct the entity to restrict, limit, or

terminate the activity and, as relevant, dispose of the

investment.\2800\

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\2799\ See proposed rule Sec. 75.21(a). The proposal noted that

the Agencies included Sec. 75.21(a), in addition to the provisions

of Sec. 75.21(b) of the proposed rule, to clarify that the

requirement to terminate an activity or, as relevant, dispose of an

investment would be triggered when a banking entity discovers the

violation or evasion, regardless of whether an Agency order has been

issued.

\2800\ See proposed rule Sec. 75.21(b).

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Several commenters urged the Agencies to strengthen the authorities

provided for under Sec. 75.21,\2801\ with some commenters expressing

concern that the proposed rule does not establish sufficient

enforcement mechanisms and penalties for violations of the rule's

requirements.\2802\ Some commenters suggested the Agencies add language

in Sec. 75.21 authorizing the imposition of automatic and significant

financial penalties--as significant as the potential gains from illegal

proprietary trading--on traders, supervisors, executives, and firms for

violating section 13 of the BHC Act and the final rule.\2803\ These

commenters suggested the Agencies incorporate reference to the Board's

authority under section 8 of the BHC Act into the rule,\2804\ and

others encouraged the Agencies to rely on their inherent authority to

impose automatic penalties and fines.\2805\ A few commenters stated

that traders, management, and banking entities should be held

responsible for violations under certain circumstances.\2806\ Finally,

another commenter recommended that officers and directors of a banking

entity be removed from office, be prohibited from being affiliated with

a banking entity, and be subject to salary clawbacks for violations of

section 13 of the BHC Act and the final rule.\2807\

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\2801\ See Sen. Merkley; Better Markets (Feb. 2012); Occupy; AFR

et al. (Feb. 2012); Public Citizen.

\2802\ See, e.g., BEC et al. (Jan. 2012); John Reed; Better

Markets (Feb. 2012); AFR et al. (Feb. 2012); Occupy; Sen. Merkley;

Public Citizen.

\2803\ See, e.g., Form Letter Type A; Form Letter Type B; Sarah

McKee; David R. Wilkes; Ben Leet; Karen Michaelis; Barry Rein; Allan

Richardson; Ronald Gedrim; Susan Pashkoff; Joan Budd; Frances

Vreman; Lisa Kazmier; Michael Wenger; Dyanne DiRosario; Alexander

Clayton; James Ofsink; Richard Leining (arguing that violators

should face penalties such as seizure and discharge of the board and

executives); Lee Smith; see also Occupy; Public Citizen.

\2804\ See Better Markets (Feb. 2012) (contending that penalties

should include specific administrative penalties, including monetary

penalties, bars, cease and desist orders, strengthened penalties for

recurring violations, and sanctioning of employees involved in the

violation and public reporting of such sanctions); AFR et al.

(arguing that section 8 of the BHC Act provides civil penalties for

violations by a company or individual and criminal penalties for

willful violations of the BHC Act). See also Occupy (requesting the

Agencies provide penalties that are specific to this rule in

addition to the general framework for criminal and civil penalties

in section 8 of the BHC Act).

\2805\ See Better Markets (Feb. 2012); Occupy; AFR et al. (Feb.

2012).

\2806\ See John Reed; Better Markets (Feb. 2012). See also BEC

et al. (Jan. 2012) (arguing that CEOs and CFOs should be held fully

responsible for any violations of the rule by any employees above

the clerical level); Occupy (recommending that traders relying on an

exemption in the proposed rule be held personally liable for any

losses on trading positions).

\2807\ See Occupy.

---------------------------------------------------------------------------

The Agencies note that the authorities provided for in Sec. 75.21

are not exclusive. The Agencies have a number of enforcement tools at

their disposal to carry out their obligations to ensure compliance with

section 13 of the BHC Act and the final rule, and need not reference

them expressly in Sec. 75.21 in order to exercise them. Specifically,

the Agencies may rely on their inherent authorities under otherwise

applicable provisions of banking, securities, and commodities laws to

bring enforcement actions against banking entities, their officers and

directors, and other institution-affiliated parties for violations of

law.\2808\ For example, a banking entity that violates section 13 of

the BHC Act and the final rule may be subject to criminal and civil

penalties under section 8 of the BHC Act. Banking entities may also be

subject to formal enforcement actions under section 8 of the Federal

Deposit Insurance Act (FDIA), such as cease and desist orders or civil

money penalty actions,\2809\ or safety and soundness orders under

section 39 of the FDIA which may be enforceable through assessment of

civil money penalties and through the Federal court system. In

addition, officers, directors, and other institution-affiliated parties

\2810\ may be subject to civil money penalties, prohibition or removal

actions, and personal cease and desist orders under section 8 of the

FDIA. Submission of late, false, or misleading reports, including false

statements on compliance with section 13 of the BHC Act or the final

rule, may also result in actions under applicable securities,

commodities, banking, and criminal laws, including imposition of civil

money and criminal penalties.\2811\ Therefore, the final rule is

consistent with the proposal and does not mention other enforcement

actions available to address violations of section 13 of the BHC Act

and this final rule.

---------------------------------------------------------------------------

\2808\ See 12 U.S.C. 1851(g)(3).

\2809\ See, e.g., 12 U.S.C. 1818(i) (authorizing imposition of

civil money penalties up to the maximum daily amount of $1,000,000

for, among other things, knowing violations of law or regulation).

\2810\ See 12 U.S.C. 1813(u) (defining ``institution-affiliated

party'').

\2811\ See, e.g., 12 U.S.C. 164 (authorizing imposition of civil

money penalties for, among other things, submitting false or

misleading reports or information to the OCC); 18 U.S.C. 1005

(authorizing imposition of fines of not more than $1,000,000 or

imprisonment not more than 30 years, or both, for, among other

things, making a false entry in the books, reports or statements of

a bank with intent to injure, defraud or deceive).

---------------------------------------------------------------------------

Section 13 of the BHC Act and the final rule do not limit the reach

or applicability of the antifraud and other provisions of the Federal

laws to banking entities, including, for example, section 17(a) of the

Securities Act of 1933 or section 10(b) and 15(c) of the Exchange Act

and the rules promulgated thereunder.

One commenter also suggested that the Agencies use their authority

under section 13(d)(3) of the BHC Act to impose additional capital

requirements and quantitative limitations on banking entities for

repeat violations of the prohibition on proprietary trading.\2812\ The

Agencies believe they can rely on other inherent enforcement

authorities to address repeat violations. The Agencies note that

several other commenters also requested the Agencies to exercise their

authority under section 13(d)(3).\2813\ The Agencies do not believe

that it is appropriate to exercise their authority under this section

at this time, primarily because the capital treatment of banking

entities' trading activities is currently being addressed through the

Agencies' risk-based capital rulemakings.\2814\ Additionally, the

Agencies believe Congress intended section 13(d)(3) to serve the

prudential purposes of bolstering the safety and soundness of

individual banking entities and the wider U.S. financial system. To the

extent commenters

[[Page 6046]]

suggested section 13(d)(3) be employed for a punitive purpose, the

Agencies do not believe the provision was designed to serve such a

purpose nor do the Agencies believe that would be an appropriate use of

the provision. Thus, the Agencies believe section 13(d)(3) is more

appropriately employed for the prudential purposes of bolstering the

safety and soundness of individual banking entities and the wider

financial stability of the U.S. financial system.

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\2812\ See Better Markets (Feb. 2012).

\2813\ See Sen. Merkley; Public Citizen; Better Markets (Feb.

2012); Profs. Admati & Pfleiderer.

\2814\ See Regulatory Capital Rules: Regulatory Capital,

Implementation of Basel III, Capital Adequacy, Transition

Provisions, Prompt Corrective Action, Standardized Approach for

Risk-weighted Assets, Market Discipline and Disclosure Requirements,

Advanced Approaches Risk-Based Capital Rule, and Market Risk Capital

Rule; Final Rule, 78 FR 62017 (Friday, October 11, 2013).

---------------------------------------------------------------------------

Commenters also urged the Agencies to clearly delineate in the

final rule the jurisdictional authority of each of the Agencies to

enforce compliance with section 13 of the BHC Act and the implementing

final rule. A number of commenters recommended approaches to

coordinating examinations and enforcement among the Agencies, as well

as to providing interpretive guidance.\2815\ For example, some

commenters observed that more than one Agency would have jurisdiction

over a given banking entity, and recommended that supervision and

enforcement of the final rule for all entities within a banking

enterprise remain completely with one Agency.\2816\ Further, some

commenters recommended that a single Agency be appointed to provide

interpretations, supervision, and enforcement of section 13 and the

rules thereunder for all banking entities.\2817\ Similarly, one

commenter suggested that the Board be given initial authority to

supervise the implementation of the rule because it is the primary

enforcer of the BHC Act and the single regulator that can currently

look across a banking group's entire global businesses, regardless of

legal entity. This commenter stated that the Board could then determine

whether an activity should be delegated to one of the other Agencies

for further examination or enforcement.\2818\ In addition, with respect

to interpretive authority, some commenters indicated that the Board

should be given sole interpretive authority of the statute and the

rules thereunder.\2819\ Other commenters urged the Agencies to

supervise and enforce the rule on a coordinated basis so as to minimize

duplicative enforcement efforts, reduce costs, and promote

certainty.\2820\

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\2815\ See SIFMA et al. (Prop. Trading) (Feb. 2012); JPMC;

Barclays; Goldman (Prop. Trading); BoA; ABA (Keating); Comm. on

Capital Market Regulation; BEC et al.; ISDA (Apr. 2012).

\2816\ See Barclays (arguing that ideally the umbrella Federal

regulator of the enterprise should take this role); Goldman (Prop.

Trading).

\2817\ See BoA; BEC et al.

\2818\ See Comm. on Capital Market Regulation.

\2819\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA

(recommending that the Board be responsible for resolving

potentially conflicting supervisory recommendations or matters

requiring attention arising from examinations as well); ISDA (Apr.

2012). See also ABA (Keating) (arguing that the Agencies should

defer to the Board's sole authority to interpret provisions of

Volcker that intersect with other statutory provisions subject to

the Board's jurisdictional authority, such as Super 23A); JPMC

(contending that the Agencies should adopt and seek comment on a

protocol for supervision and enforcement that will ensure a given

banking entity will face one set of rules and different banking

entities will face the same set of rules). The Agencies decline to

adopt the commenter's suggested approach of deferring to the Board's

sole interpretive authority with respect to the provisions of the

final rule. The Agencies believe at this time that such an approach

would be neither appropriate nor effective given the different

authorities and expertise of each Agency. See Part VI.C (discussing

the Agencies' decision not to adopt some commenters' requests that a

single agency be responsible for determining compliance with section

13).

\2820\ See SIFMA et al. (Prop. Trading) (Feb. 2012); BoA

(stating that the Agencies should issue one set of exam findings

under these circumstances); ISDA (Apr. 2012).

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Section 13(e)(2) mandates that each Agency enforce compliance of

section 13 with respect to a banking entity ``under the respective

[A]gency's jurisdiction.'' \2821\ This section provides the Agencies

with the authority to order a banking entity to terminate activities or

investments that violate or function as an evasion of section 13 of the

BHC Act.\2822\ Decisions about whether to issue such orders could be

made after examinations or otherwise. Nothing in the final rule limits

an Agency's inherent authority to conduct examinations or otherwise

inspect banking entities to ensure compliance with the final rule.

Section 75.1 of each Agency's proposed rule described the specific

types of banking entities to which that Agency's rule applies. The

Agencies acknowledge commenters' concerns about overlapping

jurisdictional authority. The Agencies recognize that, on occasion, a

banking entity may be subject to jurisdiction by more than one Agency.

As is customary, the Agencies plan to coordinate their examination and

enforcement proceedings under section 13, to the extent possible and

practicable, so as to limit duplicative actions and undue costs and

burdens for banking entities.\2823\

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\2821\ See 12 U.S.C. 1851(c)(2).

\2822\ See 12 U.S.C. 1851(e)(2) (requiring ``due notice and

opportunity for hearing'').

\2823\ See 12 U.S.C. 1844 (establishing jurisdictional

boundaries for regulation of bank holding companies); see also 12

U.S.C. 1828a (antievasion statute empowering OCC, FDIC, and the

Board to impose restrictions on relationships or transactions

between banks and their subsidiaries and affiliates).

---------------------------------------------------------------------------

The Agencies are adopting Sec. 75.21 substantially as proposed.

Accordingly, Sec. 75.21(a) of the final rule provides that any banking

entity that engages in an activity or makes an investment in violation

of section 13 of the BHC Act or the final rule or acts in a manner that

functions as an evasion of the requirements of section 13 of the BHC

Act or the final rule, including through an abuse of any activity or

investment permitted or expressly excluded by the terms of the final

rule, or otherwise violates the restrictions and requirements of

section 13 of the BHC Act or the final rule, shall, upon discovery,

promptly terminate the activity and, as relevant, dispose of the

investment. This provision allows the Agencies to enforce the rule's

prohibitions against proprietary trading and sponsoring or owning

interests in covered funds regardless of how banking entities classify

their actions, while also providing banking entities the freedom to

legitimately engage in those banking activities which are outside the

scope of the statute.

VII. Administrative Law Matters

A. Paperwork Reduction Act Analysis

The Paperwork Reduction Act (``PRA'') provides that a Federal

agency may not conduct or sponsor, and a person is not required to

respond to, a collection of information unless it displays a currently

valid control number issued by the Office of Management and Budget

(``OMB'').\2824\ This final rulemaking contains several collections of

information for which the three Federal banking agencies--the Board,

the OCC, and FDIC--sought control numbers at the time they proposed the

same substantive requirements that the Commission later proposed.\2825\

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\2824\ 44 U.S.C. 3501 et seq.

\2825\ See 76 FR 68846, 68936, Nov. 7, 2011 (joint release of

the Board, OCC, FDIC, and the SEC), and 77 FR 8332, 8420, Feb. 14,

2012.

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To avoid double accounting of information collections for which

control numbers were sought, the Commission did not propose and is not

finalizing an information collection request for this rulemaking.

Rather, as indicated in its proposed rulemaking, the Board provided

that it would submit its information collection to OMB once its final

rule is published, and that the submission would include burden for

Federal Reserve-supervised institutions, as well as burden for OCC-,

FDIC-, SEC-, and CFTC-supervised institutions under a holding

company.\2826\ The Board, OCC, and FDIC, as well as the SEC, are

expected to adopt equivalent final rulemakings on or about the same

date as the CFTC adopts its final rule. The Board, OCC, and FDIC

included in

[[Page 6047]]

the Supplementary Information of their final rulemakings an overview of

their PRA analyses including burden cost estimates, with further

analyses to be provided in the supporting statements required to be

submitted to OMB according to their regulations implementing the PRA.

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\2826\ 76 FR at 68936.

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In particular, section 619 of the Dodd-Frank Act provides that the

banking agencies, the SEC, and the Commission engage in ``coordinated

rulemaking,'' which includes all entities for which the Commission ``is

the primary financial regulatory agency, as defined in section 2'' of

the Dodd-Frank Act. Section 2 defines ``primary financial regulatory

agency'' as a Federal banking agency with respect to certain depository

institutions except as provided in other subsections of section 2. In

subsection (12)(C), the Commission is designated as the primary

financial regulatory agency for, among other things, ``any . . . swap

dealer . . . registered with the [Commission] . . ..'' Section 4s(c)(1)

of the CEA, as adopted in section 731 of the Dodd-Frank Act, provides

that ``any person that is required to be registered as a swap dealer

shall register with the Commission regardless of whether the person is

also a depository institution.''

Accordingly, banking entities, including domestic depository

institutions and branches and agencies of foreign banks subject to

supervision by OCC or the Board, have registered with the Commission.

It is presently not known how many additionally may register. To ensure

that the Commission has access to fulfill its statutory obligations and

not unduly burden its registrants with duplicative information

collection requirements, and pursuant to its proposed rulemaking, the

Commission will request, pursuant to 44 U.S.C. 3509, that the director

of the OMB designate the banking agencies as the respective collection

agencies for PRA purposes for all banking entities for which the

Commission is the primary financial regulatory agency with respect to

this rulemaking.

B. Regulatory Flexibility Act Analysis

In general, section 4 of the Regulatory Flexibility Act (5 U.S.C.

604) (RFA) requires an agency to prepare a final regulatory flexibility

analysis (FRFA) for a final rule unless the agency certifies that the

rule will not, if promulgated, have a significant economic impact on a

substantial number of small entities (defined as of July 22, 2013, to

include banking entities with total assets of $500 million or less

(``small banking entities'').\2827\ Pursuant to section 605(b) of the

RFA, a FRFA is not required if an agency certifies that the final rule

will not have a significant economic impact on a substantial number of

small entities. The Agencies have considered the potential economic

impact of the final rule on small banking entities in accordance with

the RFA. The Agencies believe that the final rule will not have a

significant economic impact on a substantial number of small banking

entities for the reasons described below.

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\2827\ See 13 CFR 121.201; see also 13 CFR 121.103(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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The Agencies previously considered the impact of the proposed rule

for purposes of the RFA and concluded that the proposed rule would not

appear to have a significant economic impact on a substantial number of

small banking entities. In support of this conclusion, the proposed

rule, among other things, noted that the thresholds for the metrics

reporting requirements under Sec. 75.7 and Appendix A and for the

enhanced and core compliance program requirements under Sec. 75.20 and

Appendix C of the proposed rule would not capture small banking

entities.\2828\

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\2828\ See Joint Proposal, 76 FR at 68938-68939.

---------------------------------------------------------------------------

The Agencies received several comments on the impact of the

proposed rule on small entities. Commenters argued that the Agencies

incorrectly concluded that the proposed rule would not have a

significant economic impact on a substantial number of small

entities.\2829\ Commenters asserted that the proposed rule would have a

significant economic impact on numerous small non-banking entities by

restricting their access to a variety of products and services,

including covered fund-linked products for investment and hedging

purposes and underwriting and market-making related services.\2830\

---------------------------------------------------------------------------

\2829\ See BoA; SIFMA et al. (Covered Funds) (Feb. 2012);

Chamber (Feb. 2012); ABA (Keating).

\2830\ See SIFMA et al. (Covered Funds) (Feb. 2012); Chamber

(Feb. 2012).

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The Agencies have carefully considered these comments in developing

a final rule. To minimize burden on small banking entities, section

75.20(f)(1) of the final rule provides that a banking entity that does

not engage in covered trading activities (other than trading in U.S.

government or agency obligations, obligations of specified government

sponsored entities, and state and municipal obligations) or covered

fund activities and investments need only establish a compliance

program prior to becoming engaged in such activities or making such

investments. In addition, to minimize the burden on small banking

entities, a banking entity with total consolidated assets of $10

billion or less that engages in covered trading activities and/or

covered fund activities may satisfy the requirements of the final rule

by including in its existing compliance policies and procedures

appropriate references to the requirements of section 13 and the final

rule and adjustments as appropriate given the activities, size, scope

and complexity of the banking entity. Only those banking entities with

total assets of greater than $10 billion will need to adopt more

detailed or enhanced compliance requirements under the final rule. (For

purposes of the enhanced compliance program in Appendix B of the final

rule, the threshold for banking entities is total consolidated assets

of $50 billion or more.) Accordingly, the compliance requirements under

the final rule do not have a significant economic impact on a

substantial number of small banking entities.

Likewise, the final rule raises the threshold for metrics reporting

from the proposed rule to capture only firms that engage in significant

trading activities. Specifically, the metrics reporting requirements

under Sec. 75.20 and Appendix A of the final rule apply only to

banking entities with average trading assets and liabilities on a

consolidated, worldwide basis for the preceding year equal to or

greater than $10 billion. Accordingly, the metrics reporting

requirements under the final rule do not impact small banking entities.

Moreover, the Agencies have revised the definition of covered fund

in the final rule to address many of the concerns raised by commenters

regarding the unintended consequences of the proposed definition.\2831\

The definition of covered fund under the final rule contains a number

of exclusions for entities that may rely on exclusions from the

Investment Company Act of 1940 contained in section 3(c)(1) or 3(c)(7)

of that Act but that are not engaged in investment activities of the

type contemplated by section 13 of the BHC Act. These include, for

example, exclusions for wholly owned subsidiaries, joint ventures,

acquisition vehicles, insurance company separate accounts, registered

investments companies, and public welfare investment funds. The

Agencies believe that these changes will

[[Page 6048]]

further minimize the burden for small banking entities such as those

that may use wholly owned subsidiaries for organizational convenience

or make public welfare investments to achieve their financial and

Community Reinvestment Act goals.

---------------------------------------------------------------------------

\2831\ See Part VI.B.1. of this SUPPLEMENTARY INFORMATION.

---------------------------------------------------------------------------

Finally, in response to commenters' assertion that the proposed

rule would have had a significant economic impact on numerous small

non-banking entities by restricting their access to a variety of

products and services,\2832\ the Agencies note that the RFA does not

require the Agencies to consider the impact of the final rule,

including its indirect economic effects, on small entities that are not

subject to the requirements of the final rule.\2833\

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\2832\ See SIFMA et al. (Covered Funds) (Feb. 2012); Chamber

(Feb. 2012).

\2833\ See e.g., In Mid-Tex Electric Cooperative v. FERC, 773

F.2d 327 (D.C. Cir. 1985); United Distribution Cos. v. FERC, 88 F.3d

1105, 1170 (D.C. Cir. 1996); Cement Kiln Recycling Coalition v. EPA,

255 F.3d 855 (D.C. Cir. 2001). Commenters relied on Aeronautical

Repair Station Association v. Federal Aviation Administration, 494

F.3d 161 (DC Cir 2007) to argue that the Agencies must consider the

indirect economic effects of the final rule on small non-banking

entities. This case is inapposite, however, because there the

agency's own rulemaking release expressly stated that the rule

imposed responsibilities directly on certain small business

contractors. The court reaffirmed its prior holdings that the RFA

limits its application to small entities ``which will be subject to

the proposed regulation--that is, those small entities to which the

proposed rule will apply.'' Id. at 176 (emphasis and internal

quotations omitted).

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For the reasons stated above, the OCC, FDIC, SEC, and CFTC certify,

for the banking entities subject to each such Agency's jurisdiction,

that the final rule will not result in a significant economic impact on

a substantial number of small entities. In light of the foregoing, the

Board does not believe, for the banking entities subject to the Board's

jurisdiction, that the final rule would have a significant economic

impact on a substantial number of small entities.

List of Subjects in 17 CFR Part 75

Banks, Banking, Compensation, Credit, Derivatives, Federal branches

and agencies, Federal savings associations, Government securities,

Hedge funds, Insurance, Investments, National banks, Penalties,

Proprietary trading, Reporting and recordkeeping requirements, Risk,

Risk retention, Securities, Swap dealers, Trusts and trustees, Volcker

rule.

For the reasons discussed in the preamble, the Commodity Futures

Trading Commission adds part 75 to 17 CFR Chapter I to read as follows:

PART 75--PROPRIETARY TRADING AND CERTAIN INTERESTS IN AND

RELATIONSHIPS WITH COVERED FUNDS

Subpart A--Authority and Definitions

Sec.

75.1 Authority, purpose, scope, and relationship to other

authorities.

75.2 Definitions.

Subpart B--Proprietary Trading

75.3 Prohibition on proprietary trading.

75.4 Permitted underwriting and market making-related activities.

75.5 Permitted risk-mitigating hedging activities.

75.6 Other permitted proprietary trading activities.

75.7 Limitations on permitted proprietary trading activities.

75.8-75.9 [Reserved]

Subpart C--Covered Fund Activities and Investments

75.10 Prohibition on acquiring or retaining an ownership interest in

and having certain relationships with a covered fund.

75.11 Permitted organizing and offering, underwriting, and market

making with respect to a covered fund.

75.12 Permitted investment in a covered fund.

75.13 Other permitted covered fund activities and investments.

75.14 Limitations on relationships with a covered fund.

75.15 Other limitations on permitted covered fund activities.

75.16-75.19 [Reserved]

Subpart D--Compliance Program Requirement; Violations

75.20 Program for compliance; reporting.

75.21 Termination of activities or investments; penalties for

violations.

Appendix A to Part 75--Reporting and Recordkeeping Requirements for

Covered Trading Activities

Appendix B to Part 75--Enhanced Minimum Standards for Compliance

Programs

Authority: 12 U.S.C. 1851.

Subpart A--Authority and Definitions

Sec. 75.1 Authority, purpose, scope, and relationship to other

authorities.

(a) Authority. This part is issued by the Commission 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 by, and

investments in or relationships with covered funds by, certain banking

entities. 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 further

explaining the statute's requirements.

(c) Scope. This part implements section 13 of the Bank Holding

Company Act with respect to banking entities for which the CFTC is the

primary financial regulatory agency, as defined in section 2(12) of the

Dodd-Frank Act.

(d) Relationship to other authorities. Except as otherwise provided

under section 13 of the BHC Act, and notwithstanding any other

provision of law, the prohibitions and restrictions under section 13 of

the BHC Act shall apply to the activities of an applicable banking

entity, even if such activities are authorized for the applicable

banking entity under other applicable provisions of law.

Sec. 75.2 Definitions.

Unless otherwise specified, for purposes of this part:

(a) Affiliate has the same meaning as in section 2(k) of the Bank

Holding Company Act of 1956 (12 U.S.C. 1841(k)).

(b) Bank holding company has the same meaning as in section 2 of

the Bank Holding Company Act of 1956 (12 U.S.C. 1841).

(c) Banking entity. (1) Except as provided in paragraph (c)(2) of

this section, banking entity means:

(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 entity described in

paragraphs (c)(1)(i), (ii), or (iii) of this section.

(2) Banking entity does not include:

(i) A covered fund that is not itself a banking entity under

paragraphs (c)(1)(i), (ii), or (iii) of this section;

(ii) A portfolio company held under the authority contained in

section 4(k)(4)(H) or (I) of the BHC Act (12 U.S.C. 1843(k)(4)(H),

(I)), or any portfolio concern, as defined under 13 CFR 107.50, that is

controlled by a small business investment company, as defined in

section 103(3) of the Small Business Investment Act of 1958 (15 U.S.C.

662), so long as the portfolio company or portfolio concern is not

itself a banking entity under paragraphs (c)(1)(i), (ii), or (iii) of

this section; or

(iii) The FDIC acting in its corporate capacity or as conservator

or receiver under the Federal Deposit Insurance Act or Title II of the

Dodd-Frank Wall Street Reform and Consumer Protection Act.

(d) Board means the Board of Governors of the Federal Reserve

System.

[[Page 6049]]

(e) CFTC or Commission means the Commodity Futures Trading

Commission.

(f) Dealer has the same meaning as in section 3(a)(5) of the

Exchange Act (15 U.S.C. 78c(a)(5)).

(g) Depository institution has the same meaning as in section 3(c)

of the Federal Deposit Insurance Act (12 U.S.C. 1813(c)).

(h) Derivative. (1) Except as provided in paragraph (h)(2) of this

section, derivative means:

(i) 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));

(ii) Any purchase or sale of a commodity, that is not an excluded

commodity, for deferred shipment or delivery that is intended to be

physically settled;

(iii) 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));

(iv) 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));

(v) Any agreement, contract, or transaction 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

(vi) Any transaction authorized under section 19 of the Commodity

Exchange Act (7 U.S.C. 23(a) or (b));

(2) A derivative does not include:

(i) 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)); or

(ii) 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)).

(i) Employee includes a member of the immediate family of the

employee.

(j) Exchange Act means the Securities Exchange Act of 1934 (15

U.S.C. 78a et seq.).

(k) Excluded commodity has the same meaning as in section 1a(19) of

the Commodity Exchange Act (7 U.S.C. 1a(19)).

(l) FDIC means the Federal Deposit Insurance Corporation.

(m) Federal banking agencies means the Board, the Office of the

Comptroller of the Currency, and the FDIC.

(n) Foreign banking organization has the same meaning as in section

211.21(o) of the Board's Regulation K (12 CFR 211.21(o)), but does not

include a foreign bank, as defined in section 1(b)(7) of the

International Banking Act of 1978 (12 U.S.C. 3101(7)), that is

organized under the laws of the Commonwealth of Puerto Rico, Guam,

American Samoa, the United States Virgin Islands, or the Commonwealth

of the Northern Mariana Islands.

(o) Foreign insurance regulator means the insurance commissioner,

or a similar official or agency, of any country other than the United

States that is engaged in the supervision of insurance companies under

foreign insurance law.

(p) General account means all of the assets of an insurance company

except those allocated to one or more separate accounts.

(q) Insurance company means a company that is organized as an

insurance company, primarily and predominantly engaged in writing

insurance or reinsuring risks underwritten by insurance companies,

subject to supervision as such by a state insurance regulator or a

foreign insurance regulator, and not operated for the purpose of

evading the provisions of section 13 of the BHC Act (12 U.S.C. 1851).

(r) 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 an insured depository institution that is

described in section 2(c)(2)(D) of the BHC Act (12 U.S.C.

1841(c)(2)(D)).

(s) Loan means any loan, lease, extension of credit, or secured or

unsecured receivable that is not a security or derivative.

(t) Primary financial regulatory agency has the same meaning as in

section 2(12) of the Dodd-Frank Wall Street Reform and Consumer

Protection Act (12 U.S.C. 5301(12)).

(u) Purchase includes any contract to buy, purchase, or otherwise

acquire. For security futures products, purchase includes any contract,

agreement, or transaction for future delivery. With respect to a

commodity future, purchase includes any contract, agreement, or

transaction for future delivery. With respect to a derivative, purchase

includes 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.

(v) Qualifying foreign banking organization means a foreign banking

organization that qualifies as such under Sec. 211.23(a), (c) or (e)

of the Board's Regulation K (12 CFR 211.23(a), (c), or (e)).

(w) SEC means the Securities and Exchange Commission.

(x) 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.

(y) Security has the meaning specified in section 3(a)(10) of the

Exchange Act (15 U.S.C. 78c(a)(10)).

(z) Security-based swap dealer has the same meaning as in section

3(a)(71) of the Exchange Act (15 U.S.C. 78c(a)(71)).

(aa) Security future has the meaning specified in section 3(a)(55)

of the Exchange Act (15 U.S.C. 78c(a)(55)).

(bb) Separate account means an account established and maintained

by an insurance company in connection with one or more insurance

contracts to hold assets that are legally segregated from the insurance

company's other assets, 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.

(cc) State means any State, the District of Columbia, the

Commonwealth of Puerto Rico, Guam, American Samoa, the United States

Virgin Islands, and the Commonwealth of the Northern Mariana Islands.

(dd) Subsidiary has the same meaning as in section 2(d) of the Bank

Holding Company Act of 1956 (12 U.S.C. 1841(d)).

(ee) State insurance regulator means the insurance commissioner, or

a similar official or agency, of a State that is engaged in the

supervision of insurance companies under State insurance law.

[[Page 6050]]

(ff) Swap dealer has the same meaning as in section 1(a)(49) of the

Commodity Exchange Act (7 U.S.C. 1a(49)).

Subpart B--Proprietary Trading

Sec. 75.3 Prohibition on proprietary trading.

(a) Prohibition. Except as otherwise provided in this subpart, a

banking entity may not engage in proprietary trading. Proprietary

trading means engaging as principal for the trading account of the

banking entity in any purchase or sale of one or more financial

instruments.

(b) Definition of trading account. (1) Trading account means any

account that is used by a banking entity to:

(i) Purchase or sell one or more financial instruments principally

for the purpose of:

(A) Short-term resale;

(B) Benefitting from actual or expected short-term price movements;

(C) Realizing short-term arbitrage profits; or

(D) Hedging one or more positions resulting from the purchases or

sales of financial instruments described in paragraphs (b)(1)(i)(A),

(B), or (C) of this section;

(ii) Purchase or sell one or more financial instruments that are

both market risk capital rule covered positions and trading positions

(or hedges of other market risk capital rule covered positions), if the

banking entity, or any affiliate of the banking entity, is an insured

depository institution, bank holding company, or savings and loan

holding company, and calculates risk-based capital ratios under the

market risk capital rule; or

(iii) Purchase or sell one or more financial instruments for any

purpose, if the banking entity:

(A) Is licensed or registered, or is required to be licensed or

registered, to engage in the business of a dealer, swap dealer, or

security-based swap dealer, to the extent the instrument is purchased

or sold in connection with the activities that require the banking

entity to be licensed or registered as such; or

(B) Is engaged in the business of a dealer, swap dealer, or

security-based swap dealer outside of the United States, to the extent

the instrument is purchased or sold in connection with the activities

of such business.

(2) Rebuttable presumption for certain purchases and sales. The

purchase (or sale) of a financial instrument by a banking entity shall

be presumed to be for the trading account of the banking entity under

paragraph (b)(1)(i) of this section if the banking entity holds the

financial instrument for fewer than sixty days or substantially

transfers the risk of the financial instrument within sixty days of the

purchase (or sale), unless the banking entity can demonstrate, based on

all relevant facts and circumstances, that the banking entity did not

purchase (or sell) the financial instrument principally for any of the

purposes described in paragraph (b)(1)(i) of this section.

(c) Financial instrument--(1) Financial instrument means:

(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

option on a contract of sale of a commodity for future delivery.

(2) A financial instrument does not include:

(i) A loan;

(ii) A commodity that is not:

(A) An excluded commodity (other than foreign exchange or

currency);

(B) A derivative;

(C) A contract of sale of a commodity for future delivery; or

(D) An option on a contract of sale of a commodity for future

delivery; or

(iii) Foreign exchange or currency.

(d) Proprietary trading does not include:--(1) Any purchase or sale

of one or more financial instruments by a banking entity that arises

under a repurchase or reverse repurchase agreement pursuant to which

the 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;

(2) Any purchase or sale of one or more financial instruments by a

banking entity that arises 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 by the parties;

(3) Any purchase or sale of a security by a banking entity for the

purpose of liquidity management in accordance with a documented

liquidity management plan of the banking entity that:

(i) Specifically contemplates and authorizes the particular

securities to be used for liquidity management purposes, the amount,

types, and risks of these securities that are consistent with liquidity

management, and the liquidity circumstances in which the particular

securities may or must be used;

(ii) Requires that any purchase or sale of securities 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 taken for such short-term purposes;

(iii) Requires that any securities purchased or sold for liquidity

management purposes be highly liquid and limited to securities the

market, credit, and other risks of which the banking entity does not

reasonably expect to give rise to appreciable profits or losses as a

result of short-term price movements;

(iv) Limits any securities purchased or sold for liquidity

management purposes, together with any other instruments purchased or

sold for such purposes, to an amount that is consistent with the

banking entity's near-term funding needs, including deviations from

normal operations of the banking entity or any affiliate thereof, as

estimated and documented pursuant to methods specified in the plan;

(v) Includes written policies and procedures, internal controls,

analysis, and independent testing to ensure that the purchase and sale

of securities that are not permitted under Sec. 75.6(a) or (b) are for

the purpose of liquidity management and in accordance with the

liquidity management plan described in paragraph (d)(3) of this

section; and

(vi) Is consistent with the Commission's supervisory requirements,

guidance, and expectations regarding liquidity management;

(4) Any purchase or sale of one or more financial instruments by a

banking entity that is a derivatives clearing organization or a

clearing agency in connection with clearing financial instruments;

(5) Any excluded clearing activities by a banking entity that is a

member of a clearing agency, a member of a derivatives clearing

organization, or a member of a designated financial market utility;

(6) Any purchase or sale of one or more financial instruments by a

banking entity, so long as:

(i) The purchase (or sale) satisfies an existing delivery

obligation of the banking entity or its customers, including to prevent

or close out a failure to deliver, in connection with delivery,

clearing, or settlement activity; or

(ii) The purchase (or sale) satisfies an obligation of the banking

entity in connection with a judicial,

[[Page 6051]]

administrative, self-regulatory organization, or arbitration

proceeding;

(7) Any purchase or sale of one or more financial instruments by a

banking entity that is acting solely as agent, broker, or custodian;

(8) Any purchase or sale of one or more financial instruments by a

banking entity through a deferred compensation, stock-bonus, profit-

sharing, or pension plan of the banking entity that is established and

administered in accordance with the law of the United States or a

foreign sovereign, if the purchase or sale is made directly or

indirectly by the banking entity as trustee for the benefit of persons

who are or were employees of the banking entity; or

(9) Any purchase or sale of one or more financial instruments by a

banking entity in the ordinary course of collecting a debt previously

contracted in good faith, provided that the banking entity divests the

financial instrument as soon as practicable, and in no event may the

banking entity retain such instrument for longer than such period

permitted by the Commission.

(e) Definition of other terms related to proprietary trading. For

purposes of this subpart:

(1) Anonymous means that each party to a purchase or sale is

unaware of the identity of the other party(ies) to the purchase or

sale.

(2) Clearing agency has the same meaning as in section 3(a)(23) of

the Exchange Act (15 U.S.C. 78c(a)(23)).

(3) 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;

(4) 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))).

(5) Derivatives clearing organization means:

(i) A derivatives clearing organization registered under section 5b

of the Commodity Exchange Act (7 U.S.C. 7a-1);

(ii) A derivatives clearing organization that, pursuant to CFTC

regulation, is exempt from the registration requirements under section

5b of the Commodity Exchange Act (7 U.S.C. 7a-1); or

(iii) A foreign derivatives clearing organization that, pursuant to

CFTC regulation, is permitted to clear for a foreign board of trade

that is registered with the CFTC.

(6) Exchange, unless the context otherwise requires, means any

designated contract market, swap execution facility, or foreign board

of trade registered with the CFTC, or, for purposes of securities or

security-based swaps, an exchange, as defined under section 3(a)(1) of

the Exchange Act (15 U.S.C. 78c(a)(1)), or security-based swap

execution facility, as defined under section 3(a)(77) of the Exchange

Act (15 U.S.C. 78c(a)(77)).

(7) Excluded clearing activities means:

(i) With respect to customer transactions cleared on a derivatives

clearing organization, a clearing agency, or a designated financial

market utility, any purchase or sale necessary to correct trading

errors made by or on behalf of a customer provided that such purchase

or sale is conducted in accordance with, for transactions cleared on a

derivatives clearing organization, the Commodity Exchange Act, CFTC

regulations, and the rules or procedures of the derivatives clearing

organization, or, for transactions cleared on a clearing agency, the

rules or procedures of the clearing agency, or, for transactions

cleared on a designated financial market utility that is neither a

derivatives clearing organization nor a clearing agency, the rules or

procedures of the designated financial market utility;

(ii) Any purchase or sale in connection with and related to the

management of a default or threatened imminent default of a customer

provided that such purchase or sale is conducted in accordance with,

for transactions cleared on a derivatives clearing organization, the

Commodity Exchange Act, CFTC regulations, and the rules or procedures

of the derivatives clearing organization, or, for transactions cleared

on a clearing agency, the rules or procedures of the clearing agency,

or, for transactions cleared on a designated financial market utility

that is neither a derivatives clearing organization nor a clearing

agency, the rules or procedures of the designated financial market

utility;

(iii) Any purchase or sale in connection with and related to the

management of a default or threatened imminent default of a member of a

clearing agency, a member of a derivatives clearing organization, or a

member of a designated financial market utility;

(iv) Any purchase or sale in connection with and related to the

management of the default or threatened default of a clearing agency, a

derivatives clearing organization, or a designated financial market

utility; and

(v) Any purchase or sale that is required by the rules or

procedures of a clearing agency, a derivatives clearing organization,

or a designated financial market utility to mitigate the risk to the

clearing agency, derivatives clearing organization, or designated

financial market utility that would result from the clearing by a

member of security-based swaps that reference the member or an

affiliate of the member.

(8) Designated financial market utility has the same meaning as in

section 803(4) of the Dodd-Frank Act (12 U.S.C. 5462(4)).

(9) Issuer has the same meaning as in section 2(a)(4) of the

Securities Act of 1933 (15 U.S.C. 77b(a)(4)).

(10) Market risk capital rule covered position and trading position

means a financial instrument that is both a covered position and a

trading position, as those terms are respectively defined:

(i) In the case of a banking entity that is a bank holding company,

savings and loan holding company, or insured depository institution,

under 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 or savings and loan holding company, other than a

banking entity to which a market risk capital rule is applicable, under

the market risk capital rule that is applicable to the affiliated bank

holding company or savings and loan holding company.

(11) Market risk capital rule means the market risk capital rule

that is contained in subpart F of 12 CFR part 3, 12 CFR parts 208 and

225, or 12 CFR part 324, as applicable.

(12) Municipal security means a security that is a direct

obligation of or issued by, or an obligation guaranteed as to principal

or interest by, a State or any political subdivision thereof, or any

agency or instrumentality of a State or any political subdivision

thereof, or any municipal corporate instrumentality of one or more

States or political subdivisions thereof.

(13) Trading desk means the smallest discrete unit of organization

of a banking entity that purchases or sells financial instruments for

the trading account of the banking entity or an affiliate thereof.

Sec. 75.4 Permitted underwriting and market making-related

activities.

(a) Underwriting activities--(1) Permitted underwriting activities.

The prohibition contained in Sec. 75.3(a) does not apply to a banking

entity's underwriting activities conducted in accordance with paragraph

(a) of this section.

[[Page 6052]]

(2) Requirements. The underwriting activities of a banking entity

are permitted under paragraph (a)(1) of this section only if:

(i) The banking entity is acting as an underwriter for a

distribution of securities and the trading desk's underwriting position

is related to such distribution;

(ii) The amount and type of the securities in the trading desk's

underwriting position are designed not to exceed the reasonably

expected near term demands of clients, customers, or counterparties,

and reasonable efforts are made to sell or otherwise reduce the

underwriting position within a reasonable period, taking into account

the liquidity, maturity, and depth of the market for the relevant type

of security;

(iii) The banking entity has established and implements, maintains,

and enforces an internal compliance program required by subpart D of

this part that is reasonably designed to ensure the banking entity's

compliance with the requirements of paragraph (a) of this section,

including reasonably designed written policies and procedures, internal

controls, analysis and independent testing identifying and addressing:

(A) The products, instruments or exposures each trading desk may

purchase, sell, or manage as part of its underwriting activities;

(B) Limits for each trading desk, based on the nature and amount of

the trading desk's underwriting activities, including the reasonably

expected near term demands of clients, customers, or counterparties, on

the:

(1) Amount, types, and risk of its underwriting position;

(2) Level of exposures to relevant risk factors arising from its

underwriting position; and

(3) Period of time a security may be held;

(C) Internal controls and ongoing monitoring and analysis of each

trading desk's compliance with its limits; and

(D) Authorization procedures, including escalation procedures that

require review and approval of any trade that would exceed a trading

desk's limit(s), demonstrable analysis of the basis for any temporary

or permanent increase to a trading desk's limit(s), and independent

review of such demonstrable analysis and approval;

(iv) The compensation arrangements of persons performing the

activities described in paragraph (a) of this section are designed not

to reward or incentivize prohibited proprietary trading; and

(v) The banking entity is licensed or registered to engage in the

activity described in paragraph (a) of this section in accordance with

applicable law.

(3) Definition of distribution. For purposes of paragraph (a) of

this section, a distribution of securities means:

(i) An offering of securities, whether or not subject to

registration under the Securities Act of 1933, that is distinguished

from ordinary trading transactions by the presence of special selling

efforts and selling methods; or

(ii) An offering of securities made pursuant to an effective

registration statement under the Securities Act of 1933.

(4) Definition of underwriter. For purposes of paragraph (a) of

this section, underwriter means:

(i) A person who has agreed with an issuer or selling security

holder to:

(A) Purchase securities from the issuer or selling security holder

for distribution;

(B) Engage in a distribution of securities for or on behalf of the

issuer or selling security holder; or

(C) Manage a distribution of securities for or on behalf of the

issuer or selling security holder; or

(ii) A person who has agreed to participate or is participating in

a distribution of such securities for or on behalf of the issuer or

selling security holder.

(5) Definition of selling security holder. For purposes of

paragraph (a) of this section, selling security holder means any

person, other than an issuer, on whose behalf a distribution is made.

(6) Definition of underwriting position. For purposes of paragraph

(a) of this section, underwriting position means the long or short

positions in one or more securities held by a banking entity or its

affiliate, and managed by a particular trading desk, in connection with

a particular distribution of securities for which such banking entity

or affiliate is acting as an underwriter.

(7) Definition of client, customer, and counterparty. For purposes

of paragraph (a) of this section, the terms client, customer, and

counterparty, on a collective or individual basis, refer to market

participants that may transact with the banking entity in connection

with a particular distribution for which the banking entity is acting

as underwriter.

(b) Market making-related activities--(1) Permitted market making-

related activities. The prohibition contained in Sec. 75.3(a) does not

apply to a banking entity's market making-related activities conducted

in accordance with paragraph (b) of this section.

(2) Requirements. The market making-related activities of a banking

entity are permitted under paragraph (b)(1) of this section only if:

(i) The trading desk that establishes and manages the financial

exposure routinely stands ready to purchase and sell one or more types

of financial instruments related to its financial exposure and is

willing and available to quote, purchase and sell, or otherwise enter

into long and short positions in those types of financial instruments

for its own account, in commercially reasonable amounts and throughout

market cycles on a basis appropriate for the liquidity, maturity, and

depth of the market for the relevant types of financial instruments;

(ii) The amount, types, and risks of the financial instruments in

the trading desk's market-maker inventory are designed not to exceed,

on an ongoing basis, the reasonably expected near term demands of

clients, customers, or counterparties, based on:

(A) The liquidity, maturity, and depth of the market for the

relevant types of financial instrument(s); and

(B) Demonstrable analysis of historical customer demand, current

inventory of financial instruments, and market and other factors

regarding the amount, types, and risks, of or associated with financial

instruments in which the trading desk makes a market, including through

block trades;

(iii) The banking entity has established and implements, maintains,

and enforces an internal compliance program required by subpart D of

this part that is reasonably designed to ensure the banking entity's

compliance with the requirements of paragraph (b) of this section,

including reasonably designed written policies and procedures, internal

controls, analysis and independent testing identifying and addressing:

(A) The financial instruments each trading desk stands ready to

purchase and sell in accordance with paragraph (b)(2)(i) of this

section;

(B) The actions the trading desk will take to demonstrably reduce

or otherwise significantly mitigate promptly the risks of its financial

exposure consistent with the limits required under paragraph

(b)(2)(iii)(C) of this section; the products, instruments, and

exposures each trading desk may use for risk management purposes; the

techniques and strategies each trading desk may use to manage the risks

of its market making-related activities and inventory; and the process,

strategies, and personnel responsible for ensuring that the actions

taken by the trading desk to mitigate these risks are and continue to

be effective;

[[Page 6053]]

(C) Limits for each trading desk, based on the nature and amount of

the trading desk's market making-related activities, that address the

factors prescribed by paragraph (b)(2)(ii) of this section, on:

(1) The amount, types, and risks of its market-maker inventory;

(2) The amount, types, and risks of the products, instruments, and

exposures the trading desk may use for risk management purposes;

(3) The level of exposures to relevant risk factors arising from

its financial exposure; and

(4) The period of time a financial instrument may be held;

(D) Internal controls and ongoing monitoring and analysis of each

trading desk's compliance with its limits; and

(E) Authorization procedures, including escalation procedures that

require review and approval of any trade that would exceed a trading

desk's limit(s), demonstrable analysis that the basis for any temporary

or permanent increase to a trading desk's limit(s) is consistent with

the requirements of paragraph (b) of this section, and independent

review of such demonstrable analysis and approval;

(iv) To the extent that any limit identified pursuant to paragraph

(b)(2)(iii)(C) of this section is exceeded, the trading desk takes

action to bring the trading desk into compliance with the limits as

promptly as possible after the limit is exceeded;

(v) The compensation arrangements of persons performing the

activities described in paragraph (b) of this section are designed not

to reward or incentivize prohibited proprietary trading; and

(vi) The banking entity is licensed or registered to engage in

activity described in paragraph (b) of this section in accordance with

applicable law.

(3) Definition of client, customer, and counterparty. For purposes

of paragraph (b) of this section, the terms client, customer, and

counterparty, on a collective or individual basis refer to market

participants that make use of the banking entity's market making-

related services by obtaining such services, responding to quotations,

or entering into a continuing relationship with respect to such

services, provided that:

(i) A trading desk or other organizational unit of another banking

entity is not a client, customer, or counterparty of the trading desk

if that other entity has trading assets and liabilities of $50 billion

or more as measured in accordance with Sec. 75.20(d)(1), unless:

(A) The trading desk documents how and why a particular trading

desk or other organizational unit of the entity should be treated as a

client, customer, or counterparty of the trading desk for purposes of

paragraph (b)(2) of this section; or

(B) The purchase or sale by the trading desk is conducted

anonymously on an exchange or similar trading facility that permits

trading on behalf of a broad range of market participants.

(ii) [Reserved]

(4) Definition of financial exposure. For purposes of paragraph (b)

of this section, financial exposure means the aggregate risks of one or

more financial instruments and any associated loans, commodities, or

foreign exchange or currency, held by a banking entity or its affiliate

and managed by a particular trading desk as part of the trading desk's

market making-related activities.

(5) Definition of market-maker inventory. For the purposes of

paragraph (b) of this section, market-maker inventory means all of the

positions in the financial instruments for which the trading desk

stands ready to make a market in accordance with paragraph (b)(2)(i) of

this section that are managed by the trading desk, including the

trading desk's open positions or exposures arising from open

transactions.

Sec. 75.5 Permitted risk-mitigating hedging activities.

(a) Permitted risk-mitigating hedging activities. The prohibition

contained in Sec. 75.3(a) does not apply to the risk-mitigating

hedging activities of a banking entity in connection with and related

to individual or aggregated positions, contracts, or other holdings of

the banking entity and designed to reduce the specific risks to the

banking entity in connection with and related to such positions,

contracts, or other holdings.

(b) Requirements. The risk-mitigating hedging activities of a

banking entity are permitted under paragraph (a) of this section only

if:

(1) The banking entity has established and implements, maintains

and enforces an internal compliance program required by subpart D of

this part that is reasonably designed to ensure the banking entity's

compliance with the requirements of this section, including:

(i) Reasonably designed written policies and procedures regarding

the positions, techniques and strategies that may be used for hedging,

including documentation indicating what positions, contracts or other

holdings a particular trading desk may use in its risk-mitigating

hedging activities, as well as position and aging limits with respect

to such positions, contracts or other holdings;

(ii) Internal controls and ongoing monitoring, management, and

authorization procedures, including relevant escalation procedures; and

(iii) The conduct of analysis, including correlation analysis, and

independent testing designed to ensure that the positions, techniques

and strategies that may be used for hedging may reasonably be expected

to demonstrably reduce or otherwise significantly mitigate the

specific, identifiable risk(s) being hedged, and such correlation

analysis demonstrates that the hedging activity demonstrably reduces or

otherwise significantly mitigates the specific, identifiable risk(s)

being hedged;

(2) The risk-mitigating hedging activity:

(i) Is conducted in accordance with the written policies,

procedures, and internal controls required under this section;

(ii) At the inception of the hedging activity, including, without

limitation, any adjustments to the hedging activity, is designed to

reduce or otherwise significantly mitigate and demonstrably reduces or

otherwise significantly mitigates one or more specific, identifiable

risks, including market risk, counterparty or other credit risk,

currency or foreign exchange risk, interest rate risk, commodity price

risk, basis risk, or similar risks, arising in connection with and

related to identified positions, contracts, or other holdings of the

banking entity, based upon the facts and circumstances of the

identified underlying and hedging positions, contracts or other

holdings and the risks and liquidity thereof;

(iii) Does not give rise, at the inception of the hedge, to any

significant new or additional risk that is not itself hedged

contemporaneously in accordance with this section;

(iv) Is subject to continuing review, monitoring and management by

the banking entity that:

(A) Is consistent with the written hedging policies and procedures

required under paragraph (b)(1) of this section;

(B) Is designed to reduce or otherwise significantly mitigate and

demonstrably reduces or otherwise significantly mitigates the specific,

identifiable risks that develop over time from the risk-mitigating

hedging activities undertaken under this section and the underlying

positions, contracts, and other holdings of the banking entity, based

upon the facts and circumstances of the underlying and hedging

positions, contracts and other holdings of the

[[Page 6054]]

banking entity and the risks and liquidity thereof; and

(C) Requires ongoing recalibration of the hedging activity by the

banking entity to ensure that the hedging activity satisfies the

requirements set out in paragraph (b)(2) of this section and is not

prohibited proprietary trading; and

(3) The compensation arrangements of persons performing risk-

mitigating hedging activities are designed not to reward or incentivize

prohibited proprietary trading.

(c) Documentation requirement. (1) A banking entity must comply

with the requirements of paragraphs (c)(2) and (c)(3) of this section

with respect to any purchase or sale of financial instruments made in

reliance on this section for risk-mitigating hedging purposes that is:

(i) Not established by the specific trading desk establishing or

responsible for the underlying positions, contracts, or other holdings

the risks of which the hedging activity is designed to reduce;

(ii) Established by the specific trading desk establishing or

responsible for the underlying positions, contracts, or other holdings

the risks of which the purchases or sales are designed to reduce, but

that is effected through a financial instrument, exposure, technique,

or strategy that is not specifically identified in the trading desk's

written policies and procedures established under paragraph (b)(1) of

this section or under Sec. 75.4(b)(2)(iii)(B) as a product,

instrument, exposure, technique, or strategy such trading desk may use

for hedging; or

(iii) Established to hedge aggregated positions across two or more

trading desks.

(2) In connection with any purchase or sale identified in paragraph

(c)(1) of this section, a banking entity must, at a minimum, and

contemporaneously with the purchase or sale, document:

(i) The specific, identifiable risk(s) of the identified positions,

contracts, or other holdings of the banking entity that the purchase or

sale is designed to reduce;

(ii) The specific risk-mitigating strategy that the purchase or

sale is designed to fulfill; and

(iii) The trading desk or other business unit that is establishing

and responsible for the hedge.

(3) A banking entity must create and retain records sufficient to

demonstrate compliance with the requirements of paragraph (c) of this

section for a period that is no less than five years in a form that

allows the banking entity to promptly produce such records to the

Commission on request, or such longer period as required under other

law or this part.

Sec. 75.6 Other permitted proprietary trading activities.

(a) Permitted trading in domestic government obligations. The

prohibition contained in Sec. 75.3(a) does not apply to the purchase

or sale by a banking entity of a financial instrument that is:

(1) An obligation of, or issued or guaranteed by, the United

States;

(2) An obligation, participation, or other instrument of, or issued

or guaranteed by, an agency of the United States, 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.);

(3) An obligation of any State or any political subdivision

thereof, including any municipal security; or

(4) An obligation of the FDIC, or any entity formed by or on behalf

of the FDIC for purpose of facilitating the disposal of assets acquired

or held by the FDIC in its corporate capacity or as conservator or

receiver under the Federal Deposit Insurance Act or Title II of the

Dodd-Frank Wall Street Reform and Consumer Protection Act.

(b) Permitted trading in foreign government obligations--(1)

Affiliates of foreign banking entities in the United States. The

prohibition contained in Sec. 75.3(a) does not apply to the purchase

or sale of a financial instrument that is an obligation of, or issued

or guaranteed by, a foreign sovereign (including any multinational

central bank of which the foreign sovereign is a member), or any agency

or political subdivision of such foreign sovereign, by a banking

entity, so long as:

(i) The banking entity is organized under or is directly or

indirectly controlled by a banking entity that is organized under the

laws of a foreign sovereign and is not directly or indirectly

controlled by a top-tier banking entity that is organized under the

laws of the United States;

(ii) The financial instrument is an obligation of, or issued or

guaranteed by, the foreign sovereign under the laws of which the

foreign banking entity referred to in paragraph (b)(1)(i) of this

section is organized (including any multinational central bank of which

the foreign sovereign is a member), or any agency or political

subdivision of that foreign sovereign; and

(iii) The purchase or sale as principal is not made by an insured

depository institution.

(2) Foreign affiliates of a U.S. banking entity. The prohibition

contained in Sec. 75.3(a) does not apply to the purchase or sale of a

financial instrument that is an obligation of, or issued or guaranteed

by, a foreign sovereign (including any multinational central bank of

which the foreign sovereign is a member), or any agency or political

subdivision of that foreign sovereign, by a foreign entity that is

owned or controlled by a banking entity organized or established under

the laws of the United States or any State, so long as:

(i) The foreign entity is a foreign bank, as defined in Sec.

211.2(j) of the Board's Regulation K (12 CFR 211.2(j)), or is regulated

by the foreign sovereign as a securities dealer;

(ii) The financial instrument is an obligation of, or issued or

guaranteed by, the foreign sovereign under the laws of which the

foreign entity is organized (including any multinational central bank

of which the foreign sovereign is a member), or any agency or political

subdivision of that foreign sovereign; and

(iii) The financial instrument is owned by the foreign entity and

is not financed by an affiliate that is located in the United States or

organized under the laws of the United States or of any State.

(c) Permitted trading on behalf of customers--(1) Fiduciary

transactions. The prohibition contained in Sec. 75.3(a) does not apply

to the purchase or sale of financial instruments by a banking entity

acting as trustee or in a similar fiduciary capacity, so long as:

(i) The transaction is conducted for the account of, or on behalf

of, a customer; and

(ii) The banking entity does not have or retain beneficial

ownership of the financial instruments.

(2) Riskless principal transactions. The prohibition contained in

Sec. 75.3(a) does not apply to the purchase or sale of financial

instruments by a banking entity acting as riskless principal in a

transaction in which the banking entity, after receiving an order to

purchase (or sell) a financial instrument from a customer, purchases

(or sells) the financial instrument for its own account to offset a

contemporaneous sale to (or purchase from) the customer.

(d) Permitted trading by a regulated insurance company. The

prohibition contained in Sec. 75.3(a) does not apply to the purchase

or sale of financial instruments by a banking entity that is an

insurance company or an affiliate of an insurance company if:

[[Page 6055]]

(1) The insurance company or its affiliate purchases or sells the

financial instruments solely for:

(i) The general account of the insurance company; or

(ii) A separate account established by the insurance company;

(2) 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

(3) The appropriate Federal banking agencies, after consultation

with the Financial Stability Oversight Council and the relevant

insurance commissioners of the States and foreign jurisdictions, as

appropriate, have not jointly determined, after notice and comment,

that a particular law, regulation, or written guidance described in

paragraph (d)(2) of this section is insufficient to protect the safety

and soundness of the covered banking entity, or the financial stability

of the United States.

(e) Permitted trading activities of foreign banking entities. (1)

The prohibition contained in Sec. 75.3(a) does not apply to the

purchase or sale of financial instruments by a banking entity if:

(i) The banking entity is not organized or directly or indirectly

controlled by a banking entity that is organized under the laws of the

United States or of any State;

(ii) The purchase or sale by the banking entity is made pursuant to

paragraph (9) or (13) of section 4(c) of the BHC Act; and

(iii) The purchase or sale meets the requirements of paragraph

(e)(3) of this section.

(2) A purchase or sale of financial instruments by a banking entity

is made pursuant to paragraph (9) or (13) of section 4(c) of the BHC

Act for purposes of paragraph (e)(1)(ii) of this section only if:

(i) The purchase or sale is conducted in accordance with the

requirements of paragraph (e) of this section; and

(ii)(A) With respect to a banking entity that is a foreign banking

organization, the banking entity meets the qualifying foreign banking

organization requirements of Sec. 211.23(a), (c) or (e) of the Board's

Regulation K (12 CFR 211.23(a), (c) or (e)), as applicable; or

(B) With respect to a banking entity that is not a foreign banking

organization, the banking entity is not organized under the laws of the

United States or of any State and the banking entity, on a fully-

consolidated basis, meets at least two of the following requirements:

(1) Total assets of the banking entity held outside of the United

States exceed total assets of the banking entity held in the United

States;

(2) Total revenues derived from the business of the banking entity

outside of the United States exceed total revenues derived from the

business of the banking entity in the United States; or

(3) Total net income derived from the business of the banking

entity outside of the United States exceeds total net income derived

from the business of the banking entity in the United States.

(3) A purchase or sale by a banking entity is permitted for

purposes of paragraph (e) of this section only if:

(i) The banking entity engaging as principal in the purchase or

sale (including any personnel of the banking entity or its affiliate

that arrange, negotiate or execute such purchase or sale) is not

located in the United States or organized under the laws of the United

States or of any State;

(ii) The banking entity (including relevant personnel) that makes

the decision to purchase or sell as principal is not located in the

United States or organized under the laws of the United States or of

any State;

(iii) The purchase or sale, including any transaction arising from

risk-mitigating hedging related to the instruments purchased or sold,

is not accounted for as principal directly or on a consolidated basis

by any branch or affiliate that is located in the United States or

organized under the laws of the United States or of any State;

(iv) No financing for the banking entity's purchases or sales is

provided, directly or indirectly, by any branch or affiliate that is

located in the United States or organized under the laws of the United

States or of any State; and

(v) The purchase or sale is not conducted with or through any U.S.

entity, other than:

(A) A purchase or sale with the foreign operations of a U.S. entity

if no personnel of such U.S. entity that are located in the United

States are involved in the arrangement, negotiation, or execution of

such purchase or sale;

(B) A purchase or sale with an unaffiliated market intermediary

acting as principal, provided the purchase or sale is promptly cleared

and settled through a clearing agency or derivatives clearing

organization acting as a central counterparty; or

(C) A purchase or sale through an unaffiliated market intermediary

acting as agent, provided the purchase or sale is conducted anonymously

on an exchange or similar trading facility and is promptly cleared and

settled through a clearing agency or derivatives clearing organization

acting as a central counterparty,

(4) For purposes of paragraph (e) of this section, a U.S. entity is

any entity that is, or is controlled by, or is acting on behalf of, or

at the direction of, any other entity that is, located in the United

States or organized under the laws of the United States or of any

State.

(5) For purposes of paragraph (e) of this section, a U.S. branch,

agency, or subsidiary of a foreign banking entity is considered to be

located in the United States; however, the foreign bank that operates

or controls that branch, agency, or subsidiary is not considered to be

located in the United States solely by virtue of operating or

controlling the U.S. branch, agency, or subsidiary.

(6) For purposes of paragraph (e) of this section, unaffiliated

market intermediary means an unaffiliated entity, acting as an

intermediary, that is:

(i) A broker or dealer registered with the SEC under section 15 of

the Exchange Act or exempt from registration or excluded from

regulation as such;

(ii) A swap dealer registered with the CFTC under section 4s of the

Commodity Exchange Act or exempt from registration or excluded from

regulation as such;

(iii) A security-based swap dealer registered with the SEC under

section 15F of the Exchange Act or exempt from registration or excluded

from regulation as such; or

(iv) A futures commission merchant registered with the CFTC under

section 4f of the Commodity Exchange Act or exempt from registration or

excluded from regulation as such.

Sec. 75.7 Limitations on permitted proprietary trading activities.

(a) No transaction, class of transactions, or activity may be

deemed permissible under Sec. Sec. 75.4 through 75.6 if the

transaction, class of transactions, or activity would:

(1) Involve or result in a material conflict of interest between

the banking entity and its clients, customers, or counterparties;

(2) Result, directly or indirectly, in a material exposure by the

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 banking entity

or to the financial stability of the United States.

(b) Definition of material conflict of interest. (1) For purposes

of this section, a material conflict of interest between a

[[Page 6056]]

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, and the banking entity has not taken at

least one of the actions in paragraph (b)(2) of this section.

(2) Prior to effecting the specific transaction or class or type of

transactions, or engaging in the specific activity, the banking entity:

(i) Timely and effective disclosure. (A) Has made 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

(B) Such disclosure is made 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

(ii) Information barriers. 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 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

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 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 banking entity, significantly increase the

likelihood that the banking entity would incur a substantial financial

loss or would pose a threat to the financial stability of the United

States.

(2) High-risk trading strategy means a trading strategy that would,

if engaged in by a banking entity, significantly increase the

likelihood that the banking entity would incur a substantial financial

loss or would pose a threat to the financial stability of the United

States.

Sec. Sec. 75.8-75.9 [Reserved]

Subpart C--Covered Fund Activities and Investments

Sec. 75.10 Prohibition on acquiring or retaining an ownership

interest in and having certain relationships with a covered fund.

(a) Prohibition. (1) Except as otherwise provided in this subpart,

a banking entity may not, as principal, directly or indirectly, acquire

or retain any ownership interest in or sponsor a covered fund.

(2) Paragraph (a)(1) of this section does not include acquiring or

retaining an ownership interest in a covered fund by a banking entity:

(i) Acting solely as agent, broker, or custodian, so long as;

(A) The activity is conducted for the account of, or on behalf of,

a customer; and

(B) The banking entity and its affiliates do not have or retain

beneficial ownership of such ownership interest;

(ii) Through a deferred compensation, stock-bonus, profit-sharing,

or pension plan of the banking entity (or an affiliate thereof) that is

established and administered in accordance with the law of the United

States or a foreign sovereign, if the ownership interest is held or

controlled directly or indirectly by the banking entity as trustee for

the benefit of persons who are or were employees of the banking entity

(or an affiliate thereof);

(iii) In the ordinary course of collecting a debt previously

contracted in good faith, provided that the banking entity divests the

ownership interest as soon as practicable, and in no event may the

banking entity retain such ownership interest for longer than such

period permitted by the Commission; or

(iv) On behalf of customers as trustee or in a similar fiduciary

capacity for a customer that is not a covered fund, so long as:

(A) The activity is conducted for the account of, or on behalf of,

the customer; and

(B) The banking entity and its affiliates do not have or retain

beneficial ownership of such ownership interest.

(b) Definition of covered fund. (1) Except as provided in paragraph

(c) of this section, 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) Any commodity pool under section 1a(10) of the Commodity

Exchange Act (7 U.S.C. 1a(10)) for which:

(A) The commodity pool operator has claimed an exemption under

Sec. 4.7 of this chapter; or

(B) (1) A commodity pool operator is registered with the CFTC as a

commodity pool operator in connection with the operation of the

commodity pool;

(2) Substantially all participation units of the commodity pool are

owned by qualified eligible persons under Sec. 4.7(a)(2) and (3) of

this chapter; and

(3) Participation units of the commodity pool have not been

publicly offered to persons who are not qualified eligible persons

under Sec. 4.7(a)(2) and (3) of this chapter; or

(iii) For any banking entity that is, or is controlled directly or

indirectly by a banking entity that is, located in or organized under

the laws of the United States or of any State, an entity that:

(A) Is organized or established outside the United States and the

ownership interests of which are offered and sold solely outside the

United States;

(B) Is, or holds itself out as being, an entity or arrangement that

raises money from investors primarily for the purpose of investing in

securities for resale or other disposition or otherwise trading in

securities; and

(C) (1) Has as its sponsor that banking entity (or an affiliate

thereof); or

(2) Has issued an ownership interest that is owned directly or

indirectly by that banking entity (or an affiliate thereof).

(2) An issuer shall not be deemed to be a covered fund under

paragraph (b)(1)(iii) of this section if, were the issuer subject to

U.S. securities laws, the issuer could rely on an exclusion or

exemption from the definition of ``investment company'' under the

Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.) other than the

exclusions contained in section 3(c)(1) and 3(c)(7) of that Act.

(3) For purposes of paragraph (b)(1)(iii) of this section, a U.S.

branch, agency, or subsidiary of a foreign banking entity is located in

the United States; however, the foreign bank that operates or controls

that branch, agency, or subsidiary is not considered to be located in

the United States solely by virtue of operating or controlling the U.S.

branch, agency, or subsidiary.

(c) Notwithstanding paragraph (b) of this section, unless the

appropriate Federal banking agencies, the SEC, and

[[Page 6057]]

the CFTC jointly determine otherwise, a covered fund does not include:

(1) Foreign public funds. (i) Subject to paragraphs (c)(1)(ii) and

(iii) of this section, an issuer that:

(A) Is organized or established outside of the United States;

(B) Is authorized to offer and sell ownership interests to retail

investors in the issuer's home jurisdiction; and

(C) Sells ownership interests predominantly through one or more

public offerings outside of the United States.

(ii) With respect to a banking entity that is, or is controlled

directly or indirectly by a banking entity that is, located in or

organized under the laws of the United States or of any State and any

issuer for which such banking entity acts as sponsor, the sponsoring

banking entity may not rely on the exemption in paragraph (c)(1)(i) of

this section for such issuer unless ownership interests in the issuer

are sold predominantly to persons other than:

(A) Such sponsoring banking entity;

(B) Such issuer;

(C) Affiliates of such sponsoring banking entity or such issuer;

and

(D) Directors and employees of such entities.

(iii) For purposes of paragraph (c)(1)(i)(C) of this section, the

term public offering means a distribution (as defined in Sec.

75.4(a)(3)) of securities in any jurisdiction outside the United States

to investors, including retail investors, provided that:

(A) The distribution complies with all applicable requirements in

the jurisdiction in which such distribution is being made;

(B) The distribution does not restrict availability to investors

having a minimum level of net worth or net investment assets; and

(C) The issuer has filed or submitted, with the appropriate

regulatory authority in such jurisdiction, offering disclosure

documents that are publicly available.

(2) Wholly-owned subsidiaries. An entity, all of the outstanding

ownership interests of which are owned directly or indirectly by the

banking entity (or an affiliate thereof), except that:

(i) Up to five percent of the entity's outstanding ownership

interests, less any amounts outstanding under paragraph (c)(2)(ii) of

this section, may be held by employees or directors of the banking

entity or such affiliate (including former employees or directors if

their ownership interest was acquired while employed by or in the

service of the banking entity); and

(ii) Up to 0.5 percent of the entity's outstanding ownership

interests may be held by a third party if the ownership interest is

acquired or retained by the third party for the purpose of establishing

corporate separateness or addressing bankruptcy, insolvency, or similar

concerns.

(3) Joint ventures. A joint venture between a banking entity or any

of its affiliates and one or more unaffiliated persons, provided that

the joint venture:

(i) Is comprised of no more than 10 unaffiliated co-venturers;

(ii) Is in the business of engaging in activities that are

permissible for the banking entity or affiliate, other than investing

in securities for resale or other disposition; and

(iii) Is not, and does not hold itself out as being, an entity or

arrangement that raises money from investors primarily for the purpose

of investing in securities for resale or other disposition or otherwise

trading in securities.

(4) Acquisition vehicles. An issuer:

(i) Formed solely for the purpose of engaging in a bona fide merger

or acquisition transaction; and

(ii) That exists only for such period as necessary to effectuate

the transaction.

(5) Foreign pension or retirement funds. A plan, fund, or program

providing pension, retirement, or similar benefits that is:

(i) Organized and administered outside the United States;

(ii) A broad-based plan for employees or citizens that is subject

to regulation as a pension, retirement, or similar plan under the laws

of the jurisdiction in which the plan, fund, or program is organized

and administered; and

(iii) Established for the benefit of citizens or residents of one

or more foreign sovereigns or any political subdivision thereof.

(6) Insurance company separate accounts. A separate account,

provided that no banking entity other than the insurance company

participates in the account's profits and losses.

(7) Bank owned life insurance. A separate account that is used

solely for the purpose of allowing one or more banking entities to

purchase a life insurance policy for which the banking entity or

entities is beneficiary, provided that no banking entity that purchases

the policy:

(i) Controls the investment decisions regarding the underlying

assets or holdings of the separate account; or

(ii) Participates in the profits and losses of the separate account

other than in compliance with applicable supervisory guidance regarding

bank owned life insurance.

(8) Loan securitizations--(i) Scope. An issuing entity for asset-

backed securities that satisfies all the conditions of paragraph (c)(8)

of this section and the assets or holdings of which are comprised

solely of:

(A) Loans as defined in Sec. 75.2(s);

(B) Rights or other assets designed to assure the servicing or

timely distribution of proceeds to holders of such securities and

rights or other assets that are related or incidental to purchasing or

otherwise acquiring and holding the loans, provided that each asset

meets the requirements of paragraph (c)(8)(iii) of this section;

(C) Interest rate or foreign exchange derivatives that meet the

requirements of paragraph (c)(8)(iv) of this section; and

(D) Special units of beneficial interest and collateral

certificates that meet the requirements of paragraph (c)(8)(v) of this

section.

(ii) Impermissible assets. For purposes of paragraph (c)(8) of this

section, the assets or holdings of the issuing entity shall not include

any of the following:

(A) A security, including an asset-backed security, or an interest

in an equity or debt security other than as permitted in paragraph

(c)(8)(iii) of this section;

(B) A derivative, other than a derivative that meets the

requirements of paragraph (c)(8)(iv) of this section; or

(C) A commodity forward contract.

(iii) Permitted securities. Notwithstanding paragraph (c)(8)(ii)(A)

of this section, the issuing entity may hold securities if those

securities are:

(A) Cash equivalents for purposes of the rights and assets in

paragraph (c)(8)(i)(B) of this section; or

(B) Securities received in lieu of debts previously contracted with

respect to the loans supporting the asset-backed securities.

(iv) Derivatives. The holdings of derivatives by the issuing entity

shall be limited to interest rate or foreign exchange derivatives that

satisfy all of the following conditions:

(A) The written terms of the derivative directly relate to the

loans, the asset-backed securities, or the contractual rights of other

assets described in paragraph (c)(8)(i)(B) of this section; and

(B) The derivatives reduce the interest rate and/or foreign

exchange risks related to the loans, the asset-backed securities, or

the contractual rights or other assets described in paragraph

(c)(8)(i)(B) of this section.

(v) Special units of beneficial interest and collateral

certificates. The assets or holdings of the issuing entity may include

collateral certificates and special units of beneficial interest issued

by a special purpose vehicle, provided that:

[[Page 6058]]

(A) The special purpose vehicle that issues the special unit of

beneficial interest or collateral certificate meets the requirements in

paragraph (c)(8) of this section;

(B) The special unit of beneficial interest or collateral

certificate is used for the sole purpose of transferring to the issuing

entity for the loan securitization the economic risks and benefits of

the assets that are permissible for loan securitizations under

paragraph (c)(8) of this section and does not directly or indirectly

transfer any interest in any other economic or financial exposure;

(C) The special unit of beneficial interest or collateral

certificate is created solely to satisfy legal requirements or

otherwise facilitate the structuring of the loan securitization; and

(D) The special purpose vehicle that issues the special unit of

beneficial interest or collateral certificate and the issuing entity

are established under the direction of the same entity that initiated

the loan securitization.

(9) Qualifying asset-backed commercial paper conduits. (i) An

issuing entity for asset-backed commercial paper that satisfies all of

the following requirements:

(A) The asset-backed commercial paper conduit holds only:

(1) Loans and other assets permissible for a loan securitization

under paragraph (c)(8)(i) of this section; and

(2) Asset-backed securities supported solely by assets that are

permissible for loan securitizations under paragraph (c)(8)(i) of this

section and acquired by the asset-backed commercial paper conduit as

part of an initial issuance either directly from the issuing entity of

the asset-backed securities or directly from an underwriter in the

distribution of the asset-backed securities;

(B) The asset-backed commercial paper conduit issues only asset-

backed securities, comprised of a residual interest and securities with

a legal maturity of 397 days or less; and

(C) A regulated liquidity provider has entered into a legally

binding commitment to provide full and unconditional liquidity coverage

with respect to all of the outstanding asset-backed securities issued

by the asset-backed commercial paper conduit (other than any residual

interest) in the event that funds are required to redeem maturing

asset-backed securities.

(ii) For purposes of this paragraph (c)(9) of this section, a

regulated liquidity provider means:

(A) A depository institution, as defined in section 3(c) of the

Federal Deposit Insurance Act (12 U.S.C. 1813(c));

(B) A bank holding company, as defined in section 2(a) of the Bank

Holding Company Act of 1956 (12 U.S.C. 1841(a)), or a subsidiary

thereof;

(C) A savings and loan holding company, as defined in section 10a

of the Home Owners' Loan Act (12 U.S.C. 1467a), provided all or

substantially all of the holding company's activities are permissible

for a financial holding company under section 4(k) of the Bank Holding

Company Act of 1956 (12 U.S.C. 1843(k)), or a subsidiary thereof;

(D) A foreign bank whose home country supervisor, as defined in

Sec. 211.21(q) of the Board's Regulation K (12 CFR 211.21(q)), has

adopted capital standards consistent with the Capital Accord for the

Basel Committee on Banking Supervision, as amended, and that is subject

to such standards, or a subsidiary thereof; or

(E) The United States or a foreign sovereign.

(10) Qualifying covered bonds--(i) Scope. An entity owning or

holding a dynamic or fixed pool of loans or other assets as provided in

paragraph (c)(8) of this section for the benefit of the holders of

covered bonds, provided that the assets in the pool are comprised

solely of assets that meet the conditions in paragraph (c)(8)(i) of

this section.

(ii) Covered bond. For purposes of paragraph (c)(10) of this

section, a covered bond means:

(A) A debt obligation issued by an entity that meets the definition

of foreign banking organization, the payment obligations of which are

fully and unconditionally guaranteed by an entity that meets the

conditions set forth in paragraph (c)(10)(i) of this section; or

(B) A debt obligation of an entity that meets the conditions set

forth in paragraph (c)(10)(i) of this section, provided that the

payment obligations are fully and unconditionally guaranteed by an

entity that meets the definition of foreign banking organization and

the entity is a wholly-owned subsidiary, as defined in paragraph (c)(2)

of this section, of such foreign banking organization.

(11) SBICs and public welfare investment funds. An issuer:

(i) That is a small business investment company, as defined in

section 103(3) of the Small Business Investment Act of 1958 (15 U.S.C.

662), or that has received from the Small Business Administration

notice to proceed to qualify for a license as a small business

investment company, which notice or license has not been revoked; or

(ii) The business of which is to make investments that are:

(A) 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

(B) Qualified rehabilitation expenditures with respect to a

qualified rehabilitated 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.

(12) Registered investment companies and excluded entities. An

issuer:

(i) That is registered as an investment company under section 8 of

the Investment Company Act of 1940 (15 U.S.C. 80a-8), or that is formed

and operated pursuant to a written plan to become a registered

investment company as described in Sec. 75.20(e)(3) and that complies

with the requirements of section 18 of the Investment Company Act of

1940 (15 U.S.C. 80a-18);

(ii) That may rely on an exclusion or exemption from the definition

of ``investment company'' under the Investment Company Act of 1940 (15

U.S.C. 80a-1 et seq.) other than the exclusions contained in section

3(c)(1) and 3(c)(7) of that Act; or

(iii) That has elected to be regulated as a business development

company pursuant to section 54(a) of that Act (15 U.S.C. 80a-53) and

has not withdrawn its election, or that is formed and operated pursuant

to a written plan to become a business development company as described

in Sec. 75.20(e)(3) and that complies with the requirements of section

61 of the Investment Company Act of 1940 (15 U.S.C. 80a-60).

(13) Issuers in conjunction with the FDIC's receivership or

conservatorship operations. An issuer that is an entity formed by or on

behalf of the FDIC for the purpose of facilitating the disposal of

assets acquired in the FDIC's capacity as conservator or receiver under

the Federal Deposit Insurance Act or Title II of the Dodd-Frank Wall

Street Reform and Consumer Protection Act.

(14) Other excluded issuers. (i) Any issuer that the appropriate

Federal banking agencies, the SEC, and the CFTC jointly determine the

exclusion of which is consistent with the purposes of section 13 of the

BHC Act.

(ii) A determination made under paragraph (c)(14)(i) of this

section will be promptly made public.

(d) Definition of other terms related to covered funds. For

purposes of this subpart:

[[Page 6059]]

(1) Applicable accounting standards means U.S. generally accepted

accounting principles, or such other accounting standards applicable to

a banking entity that the Commission determines are appropriate and

that the banking entity uses in the ordinary course of its business in

preparing its consolidated financial statements.

(2) Asset-backed security has the meaning specified in section

3(a)(79) of the Exchange Act (15 U.S.C. 78c(a)(79)).

(3) 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)).

(4) Issuer has the same meaning as in section 2(a)(22) of the

Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(22)).

(5) Issuing entity means with respect to asset-backed securities

the special purpose vehicle that owns or holds the pool assets

underlying asset-backed securities and in whose name the asset-backed

securities supported or serviced by the pool assets are issued.

(6) Ownership interest--(i) Ownership interest means any equity,

partnership, or other similar interest. An ``other similar interest''

means an interest that:

(A) Has the right to participate in the selection or removal of a

general partner, managing member, member of the board of directors or

trustees, investment manager, investment adviser, or commodity trading

advisor of the covered fund (excluding the rights of a creditor to

exercise remedies upon the occurrence of an event of default or an

acceleration event);

(B) Has the right under the terms of the interest to receive a

share of the income, gains or profits of the covered fund;

(C) Has the right to receive the underlying assets of the covered

fund after all other interests have been redeemed and/or paid in full

(excluding the rights of a creditor to exercise remedies upon the

occurrence of an event of default or an acceleration event);

(D) Has the right to receive all or a portion of excess spread (the

positive difference, if any, between the aggregate interest payments

received from the underlying assets of the covered fund and the

aggregate interest paid to the holders of other outstanding interests);

(E) Provides under the terms of the interest that the amounts

payable by the covered fund with respect to the interest could be

reduced based on losses arising from the underlying assets of the

covered fund, such as allocation of losses, write-downs or charge-offs

of the outstanding principal balance, or reductions in the amount of

interest due and payable on the interest;

(F) Receives income on a pass-through basis from the covered fund,

or has a rate of return that is determined by reference to the

performance of the underlying assets of the covered fund; or

(G) Any synthetic right to have, receive, or be allocated any of

the rights in paragraphs (d)(6)(i)(A) through (d)(6)(i)(F) of this

section.

(ii) Ownership interest does not include restricted profit

interest, which is an interest held by an entity (or an employee or

former employee thereof) in a covered fund for which the entity (or

employee thereof) serves as investment manager, investment adviser,

commodity trading advisor, or other service provider so long as:

(A) The sole purpose and effect of the interest is to allow the

entity (or employee or former employee thereof) to share in the profits

of the covered fund as performance compensation for the investment

management, investment advisory, commodity trading advisory, or other

services provided to the covered fund by the entity (or employee or

former employee thereof), provided that the entity (or employee or

former employee thereof) may be obligated under the terms of such

interest to return profits previously received;

(B) All such profit, once allocated, is distributed to the entity

(or employee or former employee thereof) promptly after being earned

or, if not so distributed, is retained by the covered fund for the sole

purpose of establishing a reserve amount to satisfy contractual

obligations with respect to subsequent losses of the covered fund and

such undistributed profit of the entity (or employee or former employee

thereof) does not share in the subsequent investment gains of the

covered fund;

(C) Any amounts invested in the covered fund, including any amounts

paid by the entity (or employee or former employee thereof) in

connection with obtaining the restricted profit interest, are within

the limits of Sec. 75.12; and

(D) The interest is not transferable by the entity (or employee or

former employee thereof) except to an affiliate thereof (or an employee

of the banking entity or affiliate), to immediate family members, or

through the intestacy, of the employee or former employee, or in

connection with a sale of the business that gave rise to the restricted

profit interest by the entity (or employee or former employee thereof)

to an unaffiliated party that provides investment management,

investment advisory, commodity trading advisory, or other services to

the fund.

(7) Prime brokerage transaction means any transaction that would be

a covered transaction, as defined in section 23A(b)(7) of the Federal

Reserve Act (12 U.S.C. 371c(b)(7)), that is provided in connection with

custody, clearance and settlement, securities borrowing or lending

services, trade execution, financing, or data, operational, and

administrative support.

(8) Resident of the United States means a person that is a ``U.S.

person'' as defined in rule 902(k) of the SEC's Regulation S (17 CFR

230.902(k)).

(9) Sponsor means, with respect to a covered fund:

(i) To serve as a general partner, managing member, or trustee of a

covered fund, or to serve as a commodity pool operator with respect to

a covered fund as defined in (b)(1)(ii) of this section;

(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.

(10) Trustee. (i) For purposes of paragraph (d)(9) of this section

and Sec. 75.11, a trustee does not include:

(A) A trustee that does not exercise investment discretion with

respect to a covered fund, including a trustee that is subject to the

direction of an unaffiliated named fiduciary who is not a trustee

pursuant to section 403(a)(1) of the Employee's Retirement Income

Security Act (29 U.S.C. 1103(a)(1)); or

(B) A trustee that is subject to fiduciary standards imposed under

foreign law that are substantially equivalent to those described in

paragraph (d)(10)(i)(A) of this section;

(ii) Any entity that directs a person described in paragraph

(d)(10)(i) of this section, or that possesses authority and discretion

to manage and control the investment decisions of a covered fund for

which such person serves as trustee, shall be considered to be a

trustee of such covered fund.

Sec. 75.11 Permitted organizing and offering, underwriting, and

market making with respect to a covered fund.

(a) Organizing and offering a covered fund in general.

Notwithstanding Sec. 75.10(a), a banking entity is not prohibited from

acquiring or retaining an ownership interest in, or acting as sponsor

to, a covered fund in connection with, directly or indirectly,

organizing and offering a covered fund, including serving as a general

partner, managing member, trustee, or

[[Page 6060]]

commodity pool operator of the covered fund and in any manner 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:

(1) The banking entity (or an affiliate thereof) provides bona fide

trust, fiduciary, investment advisory, or commodity trading advisory

services;

(2) 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 banking entity (or an affiliate

thereof), pursuant to a written plan or similar documentation outlining

how the banking entity or such affiliate intends to provide advisory or

similar services to its customers through organizing and offering such

fund;

(3) The banking entity and its affiliates do not acquire or retain

an ownership interest in the covered fund except as permitted under

Sec. 75.12;

(4) The banking entity and its affiliates comply with the

requirements of Sec. 75.14;

(5) The banking entity and its affiliates do 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;

(6) The covered fund, for corporate, marketing, promotional, or

other purposes:

(i) Does not share the same name or a variation of the same name

with the banking entity (or an affiliate thereof); and

(ii) Does not use the word ``bank'' in its name;

(7) No director or employee of the banking entity (or an affiliate

thereof) takes or retains an ownership interest in the covered fund,

except for any director or employee of the banking entity or such

affiliate who is directly engaged in providing investment advisory,

commodity trading advisory, or other services to the covered fund at

the time the director or employee takes the ownership interest; and

(8) The banking entity:

(i) 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):

(A) That ``any losses in [such covered fund] will be borne solely

by investors in [the covered fund] and not by [the banking entity] or

its affiliates; therefore, [the banking entity's] 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 any

affiliate in its capacity as investor in the [covered fund] or as

beneficiary of a restricted profit interest held by [the banking

entity] or any affiliate'';

(B) That such investor should read the fund offering documents

before investing in the covered fund;

(C) 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

(D) The role of the banking entity and its affiliates and employees

in sponsoring or providing any services to the covered fund; and

(ii) 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.

(b) Organizing and offering an issuing entity of asset-backed

securities. (1) Notwithstanding Sec. 75.10(a), a banking entity is not

prohibited from acquiring or retaining an ownership interest in, or

acting as sponsor to, a covered fund that is an issuing entity of

asset-backed securities in connection with, directly or indirectly,

organizing and offering that issuing entity, so long as the banking

entity and its affiliates comply with all of the requirements of

paragraphs (a)(3) through (a)(8) of this section.

(2) For purposes of paragraph (b) of this section, organizing and

offering a covered fund that is an issuing entity of asset-backed

securities means acting as the securitizer, as that term is used in

section 15G(a)(3) of the Exchange Act (15 U.S.C. 78o-11(a)(3)) of the

issuing entity, or acquiring or retaining an ownership interest in the

issuing entity as required by section 15G of that Act (15 U.S.C. 78o-

11) and the implementing regulations issued thereunder.

(c) Underwriting and market making in ownership interests of a

covered fund. The prohibition contained in Sec. 75.10(a) does not

apply to a banking entity's underwriting activities or market making-

related activities involving a covered fund so long as:

(1) Those activities are conducted in accordance with the

requirements of Sec. 75.4(a) or (b), respectively;

(2) With respect to any banking entity (or any affiliate thereof)

that acts as a sponsor, investment adviser or commodity trading advisor

to a particular covered fund or otherwise acquires and retains an

ownership interest in such covered fund in reliance on paragraph (a) of

this section; acquires and retains an ownership interest in such

covered fund and is either a securitizer, as that term is used in

section 15G(a)(3) of the Exchange Act (15 U.S.C. 78o-11(a)(3)), or is

acquiring and retaining an ownership interest in such covered fund in

compliance with section 15G of that Act (15 U.S.C. 78o-11) and the

implementing regulations issued thereunder each as permitted by

paragraph (b) of this section; or, directly or indirectly, guarantees,

assumes, or otherwise insures the obligations or performance of the

covered fund or of any covered fund in which such fund invests, then in

each such case any ownership interests acquired or retained by the

banking entity and its affiliates in connection with underwriting and

market making related activities for that particular covered fund are

included in the calculation of ownership interests permitted to be held

by the banking entity and its affiliates under the limitations of Sec.

75.12(a)(2)(ii) and (d); and

(3) With respect to any banking entity, the aggregate value of all

ownership interests of the banking entity and its affiliates in all

covered funds acquired and retained under Sec. 75.11, including all

covered funds in which the banking entity holds an ownership interest

in connection with underwriting and market making related activities

permitted under paragraph (c) of this section, are included in the

calculation of all ownership interests under Sec. 75.12(a)(2)(iii) and

(d).

Sec. 75.12 Permitted investment in a covered fund.

(a) Authority and limitations on permitted investments in covered

funds. (1) Notwithstanding the prohibition contained in Sec. 75.10(a),

a banking entity may acquire and retain an ownership interest in a

covered fund that the banking entity or an affiliate thereof organizes

and offers pursuant to Sec. 75.11, for the purposes of:

(i) Establishment. Establishing the fund and providing the fund

with sufficient initial equity for investment to permit the fund to

attract unaffiliated investors, subject to the limits contained in

paragraphs (a)(2)(i) and (a)(2)(iii) of this section; or

(ii) De minimis investment. Making and retaining an investment in

the covered fund subject to the limits contained in paragraphs

(a)(2)(ii) and (a)(2)(iii) of this section.

[[Page 6061]]

(2) Investment limits--(i) Seeding period. With respect to an

investment in any covered fund made or held pursuant to paragraph

(a)(1)(i) of this section, the banking entity and its affiliates:

(A) Must actively seek unaffiliated investors to reduce, through

redemption, sale, dilution, or other methods, the aggregate amount of

all ownership interests of the banking entity in the covered fund to

the amount permitted in paragraph (a)(2)(i)(B) of this section; and

(B) Must, no 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), conform its ownership

interest in the covered fund to the limits in paragraph (a)(2)(ii) of

this section;

(ii) Per-fund limits. (A) Except as provided in paragraph

(a)(2)(ii)(B) of this section, an investment by a banking entity and

its affiliates in any covered fund made or held pursuant to paragraph

(a)(1)(ii) of this section may not exceed 3 percent of the total number

or value of the outstanding ownership interests of the fund.

(B) An investment by a banking entity and its affiliates in a

covered fund that is an issuing entity of asset-backed securities may

not exceed 3 percent of the total fair market value of the ownership

interests of the fund measured in accordance with paragraph (b)(3) of

this section, unless a greater percentage is retained by the banking

entity and its affiliates in compliance with the requirements of

section 15G of the Exchange Act (15 U.S.C. 78o-11) and the implementing

regulations issued thereunder, in which case the investment by the

banking entity and its affiliates in the covered fund may not exceed

the amount, number, or value of ownership interests of the fund

required under section 15G of the Exchange Act and the implementing

regulations issued thereunder.

(iii) Aggregate limit. The aggregate value of all ownership

interests of the banking entity and its affiliates in all covered funds

acquired or retained under this section may not exceed 3 percent of the

tier 1 capital of the banking entity, as provided under paragraph (c)

of this section, and shall be calculated as of the last day of each

calendar quarter.

(iv) Date of establishment. For purposes of this section, the date

of establishment of a covered fund shall be:

(A) In general. The date on which the investment adviser or similar

entity to the covered fund begins making investments pursuant to the

written investment strategy for the fund;

(B) Issuing entities of asset-backed securities. In the case of an

issuing entity of asset-backed securities, the date on which the assets

are initially transferred into the issuing entity of asset-backed

securities.

(b) Rules of construction--(1) Attribution of ownership interests

to a covered banking entity. (i) For purposes of paragraph (a)(2) of

this section, the amount and value of a banking entity's permitted

investment in any single covered fund shall include any ownership

interest held under Sec. 75.12 directly by the banking entity,

including any affiliate of the banking entity.

(ii) Treatment of registered investment companies, SEC-regulated

business development companies and foreign public funds. For purposes

of paragraph (b)(1)(i) of this section, a registered investment

company, SEC-regulated business development companies or foreign public

fund as described in Sec. 75.10(c)(1) will not be considered to be an

affiliate of the banking entity so long as the banking entity:

(A) Does not own, control, or hold with the power to vote 25

percent or more of the voting shares of the company or fund; and

(B) Provides investment advisory, commodity trading advisory,

administrative, and other services to the company or fund in compliance

with the limitations under applicable regulation, order, or other

authority.

(iii) Covered funds. For purposes of paragraph (b)(1)(i) of this

section, a covered fund will not be considered to be an affiliate of a

banking entity so long as the covered fund is held in compliance with

the requirements of this subpart.

(iv) Treatment of employee and director investments financed by the

banking entity. For purposes of paragraph (b)(1)(i) of this section, an

investment by a director or employee of a banking entity who acquires

an ownership interest in his or her personal capacity in a covered fund

sponsored by the banking entity will be attributed to the banking

entity if the banking entity, directly or indirectly, extends financing

for the purpose of enabling the director or employee to acquire the

ownership interest in the fund and the financing is used to acquire

such ownership interest in the covered fund.

(2) Calculation of permitted ownership interests in a single

covered fund. Except as provided in paragraphs (b)(3) or (4) of this

section, for purposes of determining whether an investment in a single

covered fund complies with the restrictions on ownership interests

under paragraphs (a)(2)(i)(B) and (ii)(A) of this section:

(i) The aggregate number of the outstanding ownership interests

held by the banking entity shall be the total number of ownership

interests held under this section by the banking entity in a covered

fund divided by the total number of ownership interests held by all

entities in that covered fund, as of the last day of each calendar

quarter (both measured without regard to committed funds not yet called

for investment);

(ii) The aggregate value of the outstanding ownership interests

held by the banking entity shall be the aggregate fair market value of

all investments in and capital contributions made to the covered fund

by the banking entity, divided by the value of all investments in and

capital contributions made to that covered fund by all entities, as of

the last day of each calendar quarter (all measured without regard to

committed funds not yet called for investment). If fair market value

cannot be determined, then the value shall be the historical cost basis

of all investments in and contributions made by the banking entity to

the covered fund;

(iii) For purposes of the calculation under paragraph (b)(2)(ii) of

this section, once a valuation methodology is chosen, the banking

entity must calculate the value of its investment and the investments

of all others in the covered fund in the same manner and according to

the same standards.

(3) Issuing entities of asset-backed securities. In the case of an

ownership interest in an issuing entity of asset-backed securities, for

purposes of determining whether an investment in a single covered fund

complies with the restrictions on ownership interests under paragraphs

(a)(2)(i)(B) and (a)(2)(ii)(B) of this section:

(i) For securitizations subject to the requirements of section 15G

of the Exchange Act (15 U.S.C. 78o-11), the calculations shall be made

as of the date and according to the valuation methodology applicable

pursuant to the requirements of section 15G of the Exchange Act (15

U.S.C. 78o-11) and the implementing regulations issued thereunder; or

(ii) For securitization transactions completed prior to the

compliance date of such implementing regulations (or as to which such

implementing regulations do not apply), the calculations shall be made

as of the date of establishment as defined in paragraph (a)(2)(iv)(B)

of this section or such earlier date on which the transferred assets

have been valued for purposes of transfer to the covered

[[Page 6062]]

fund, and thereafter only upon the date on which additional securities

of the issuing entity of asset-backed securities are priced for

purposes of the sales of ownership interests to unaffiliated investors.

(iii) For securitization transactions completed prior to the

compliance date of such implementing regulations (or as to which such

implementing regulations do not apply), the aggregate value of the

outstanding ownership interests in the covered fund shall be the fair

market value of the assets transferred to the issuing entity of the

securitization and any other assets otherwise held by the issuing

entity at such time, determined in a manner that is consistent with its

determination of the fair market value of those assets for financial

statement purposes.

(iv) For purposes of the calculation under paragraph (b)(3)(iii) of

this section, the valuation methodology used to calculate the fair

market value of the ownership interests must be the same for both the

ownership interests held by a banking entity and the ownership

interests held by all others in the covered fund in the same manner and

according to the same standards.

(4) Multi-tier fund investments--(i) Master-feeder fund

investments. If the principal investment strategy of a covered fund

(the ``feeder fund'') is to invest substantially all of its assets in

another single covered fund (the ``master fund''), then for purposes of

the investment limitations in paragraphs (a)(2)(i)(B) and (a)(2)(ii) of

this section, the banking entity's permitted investment in such funds

shall be measured only by reference to the value of the master fund.

The banking entity's permitted investment in the master fund shall

include any investment by the banking entity in the master fund, as

well as the banking entity's pro-rata share of any ownership interest

of the master fund that is held through the feeder fund; and

(ii) Fund-of-funds investments. If a banking entity organizes and

offers a covered fund pursuant to Sec. 75.11 for the purpose of

investing in other covered funds (a ``fund of funds'') and that fund of

funds itself invests in another covered fund that the banking entity is

permitted to own, then the banking entity's permitted investment in

that other fund shall include any investment by the banking entity in

that other fund, as well as the banking entity's pro-rata share of any

ownership interest of the fund that is held through the fund of funds.

The investment of the banking entity may not represent more than 3

percent of the amount or value of any single covered fund.

(c) Aggregate permitted investments in all covered funds. (1) For

purposes of paragraph (a)(2)(iii) of this section, the aggregate value

of all ownership interests held by a banking entity shall be the sum of

all amounts paid or contributed by the banking entity in connection

with acquiring or retaining an ownership interest in covered funds

(together with any amounts paid by the entity (or employee thereof) in

connection with obtaining a restricted profit interest under Sec.

75.10(d)(6)(ii)), on a historical cost basis.

(2) Calculation of tier 1 capital. For purposes of paragraph

(a)(2)(iii) of this section:

(i) Entities that are required to hold and report tier 1 capital.

If a banking entity is required to calculate and report tier 1 capital,

the banking entity's tier 1 capital shall be equal to the amount of

tier 1 capital of the banking entity as of the last day of the most

recent calendar quarter, as reported to its primary financial

regulatory agency; and

(ii) If a banking entity is not required to calculate and report

tier 1 capital, the banking entity's tier 1 capital shall be determined

to be equal to:

(A) In the case of a banking entity that is controlled, directly or

indirectly, by a depository institution that calculates and reports

tier 1 capital, be equal to the amount of tier 1 capital reported by

such controlling depository institution in the manner described in

paragraph (c)(2)(i) of this section;

(B) In the case of a 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 banking entity is a

subsidiary of a bank holding company or company that is treated as a

bank holding company, be equal to the amount of tier 1 capital reported

by the top-tier affiliate of such covered banking entity that

calculates and reports tier 1 capital in the manner described in

paragraph (c)(2)(i) of this section; and

(2) Other holding companies and any subsidiary or affiliate

thereof. If the banking entity is not a subsidiary of a bank holding

company or a company that is treated as a bank holding company, be

equal to 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.

(iii) Treatment of foreign banking entities--(A) Foreign banking

entities. Except as provided in paragraph (c)(2)(iii)(B) of this

section, with respect to a banking entity that is not itself, and is

not controlled directly or indirectly by, a banking entity that is

located or organized under the laws of the United States or of any

State, the tier 1 capital of the banking entity shall be the

consolidated tier 1 capital of the entity as calculated under

applicable home country standards.

(B) U.S. affiliates of foreign banking entities. With respect to a

banking entity that is located or organized under the laws of the

United States or of any State and is controlled by a foreign banking

entity identified under paragraph (c)(2)(iii)(A) of this section, the

banking entity's tier 1 capital shall be as calculated under paragraphs

(c)(2)(i) or (ii) of this section.

(d) Capital treatment for a permitted investment in a covered fund.

For purposes of calculating compliance with the applicable regulatory

capital requirements, a banking entity shall deduct from the banking

entity's tier 1 capital (as determined under paragraph (c)(2) of this

section) the greater of:

(1) The sum of all amounts paid or contributed by the banking

entity in connection with acquiring or retaining an ownership interest

(together with any amounts paid by the entity (or employee thereof) in

connection with obtaining a restricted profit interest under Sec.

75.10(d)(6)(ii)), on a historical cost basis, plus any earnings

received; and

(2) The fair market value of the banking entity's ownership

interests in the covered fund as determined under paragraph (b)(2)(ii)

or (3) of this section (together with any amounts paid by the entity

(or employee thereof) in connection with obtaining a restricted profit

interest under Sec. 75.10(d)(6)(ii)), if the banking entity accounts

for the profits (or losses) of the fund investment in its financial

statements.

(e) Extension of time to divest an ownership interest. (1) Upon

application by a banking entity, the Board may extend the period under

paragraph (a)(2)(i) 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 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) of this section.

[[Page 6063]]

(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 result, directly or indirectly, in

a material exposure by the banking entity to high-risk assets or high-

risk trading strategies;

(ii) The contractual terms governing the banking entity's interest

in the covered fund;

(iii) 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 paragraph (a)(2)(i) of this section;

(iv) 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 banking entity and the

financial stability of the United States;

(v) The cost to the banking entity of divesting or disposing of the

investment within the applicable period;

(vi) Whether the investment or the divestiture or conformance of

the investment would involve or result in a material conflict of

interest between the banking entity and unaffiliated parties, including

clients, customers or counterparties to which it owes a duty;

(vii) The 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;

(viii) Market conditions; and

(ix) Any other factor that the Board believes appropriate.

(3) Authority to impose restrictions on activities or investment

during any extension period. 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 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 and this part.

(4) Consultation. In the case of a 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 acting on an application

by the banking entity for an extension under paragraph (e)(1) of this

section.

Sec. 75.13 Other permitted covered fund activities and investments.

(a) Permitted risk-mitigating hedging activities. (1) The

prohibition contained in Sec. 75.10(a) does not apply with respect to

an ownership interest in a covered fund acquired or retained by a

banking entity that is designed to demonstrably reduce or otherwise

significantly mitigate the specific, identifiable risks to the banking

entity in connection with a compensation arrangement with an employee

of the banking entity or an affiliate thereof that directly provides

investment advisory, commodity trading advisory or other services to

the covered fund.

(2) Requirements. The risk-mitigating hedging activities of a

banking entity are permitted under paragraph (a) of this section only

if:

(i) The banking entity has established and implements, maintains

and enforces an internal compliance program required by subpart D of

this part that is reasonably designed to ensure the banking entity's

compliance with the requirements of this section, including:

(A) Reasonably designed written policies and procedures; and

(B) Internal controls and ongoing monitoring, management, and

authorization procedures, including relevant escalation procedures; and

(ii) The acquisition or retention of the ownership interest:

(A) Is made in accordance with the written policies, procedures and

internal controls required under this section;

(B) At the inception of the hedge, is designed to reduce or

otherwise significantly mitigate and demonstrably reduces or otherwise

significantly mitigates one or more specific, identifiable risks

arising in connection with the compensation arrangement with the

employee that directly provides investment advisory, commodity trading

advisory, or other services to the covered fund;

(C) Does not give rise, at the inception of the hedge, to any

significant new or additional risk that is not itself hedged

contemporaneously in accordance with this section; and

(D) Is subject to continuing review, monitoring and management by

the banking entity.

(iii) The compensation arrangement relates solely to the covered

fund in which the banking entity or any affiliate has acquired an

ownership interest pursuant to this paragraph and such compensation

arrangement provides that any losses incurred by the banking entity on

such ownership interest will be offset by corresponding decreases in

amounts payable under such compensation arrangement.

(b) Certain permitted covered fund activities and investments

outside of the United States. (1) The prohibition contained in Sec.

75.10(a) does not apply to the acquisition or retention of any

ownership interest in, or the sponsorship of, a covered fund by a

banking entity only if:

(i) The banking entity is not organized or 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 or investment by the banking entity is pursuant

to paragraph (9) or (13) of section 4(c) of the BHC Act;

(iii) No ownership interest in the covered fund is offered for sale

or sold to a resident of the United States; and

(iv) The activity or investment occurs solely outside of the United

States.

(2) An activity or investment by the banking entity is pursuant to

paragraph (9) or (13) of section 4(c) of the BHC Act for purposes of

paragraph (b)(1)(ii) of this section only if:

(i) The activity or investment is conducted in accordance with the

requirements of this section; and

(ii)(A) With respect to a banking entity that is a foreign banking

organization, the banking entity meets the qualifying foreign banking

organization requirements of Sec. 211.23(a), (c) or (e) of the Board's

Regulation K (12 CFR 211.23(a), (c) or (e)), as applicable; or

(B) With respect to a banking entity that is not a foreign banking

organization, the banking entity is not organized under the laws of the

United States or of one or more States and the banking entity, on a

fully-consolidated basis, meets at least two of the following

requirements:

(1) Total assets of the banking entity held outside of the United

States exceed total assets of the banking entity held in the United

States;

(2) Total revenues derived from the business of the banking entity

outside of the United States exceed total revenues derived from the

business of the banking entity in the United States; or

(3) Total net income derived from the business of the banking

entity outside of the United States exceeds total net income derived

from the business of the banking entity in the United States.

(3) An ownership interest in a covered fund is not offered for sale

or sold to a resident of the United States for purposes of paragraph

(b)(1)(iii) of this section only if it is sold or has been sold

pursuant to an offering that does not target residents of the United

States.

[[Page 6064]]

(4) An activity or investment occurs solely outside of the United

States for purposes of paragraph (b)(1)(iv) of this section only if:

(i) The banking entity acting as sponsor, or engaging as principal

in the acquisition or retention of an ownership interest in the covered

fund, is not itself, and is not controlled directly or indirectly by, a

banking entity that is located in the United States or organized under

the laws of the United States or of any State;

(ii) The banking entity (including relevant personnel) that makes

the decision to acquire or retain the ownership interest or act as

sponsor to the covered fund is not located in the United States or

organized under the laws of the United States or of any State;

(iii) The investment or sponsorship, including any transaction

arising from risk-mitigating hedging related to an ownership interest,

is not accounted for as principal directly or indirectly on a

consolidated basis by any branch or affiliate that is located in the

United States or organized under the laws of the United States or of

any State; and

(iv) No financing for the banking entity's ownership or sponsorship

is provided, directly or indirectly, by any branch or affiliate that is

located in the United States or organized under the laws of the United

States or of any State.

(5) For purposes of this section, a U.S. branch, agency, or

subsidiary of a foreign bank, or any subsidiary thereof, is located in

the United States; however, a foreign bank of which that branch,

agency, or subsidiary is a part is not considered to be located in the

United States solely by virtue of operation of the U.S. branch, agency,

or subsidiary.

(c) Permitted covered fund interests and activities by a regulated

insurance company. The prohibition contained in Sec. 75.10(a) does not

apply to the acquisition or retention by an insurance company, or an

affiliate thereof, of any ownership interest in, or the sponsorship of,

a covered fund only if:

(1) The insurance company or its affiliate acquires and retains the

ownership interest solely for the general account of the insurance

company or for one or more separate accounts established by the

insurance company;

(2) The acquisition and retention of the ownership interest 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

(3) The appropriate Federal banking agencies, after consultation

with the Financial Stability Oversight Council and the relevant

insurance commissioners of the States and foreign jurisdictions, as

appropriate, have not jointly determined, after notice and comment,

that a particular law, regulation, or written guidance described in

paragraph (c)(2) of this section is insufficient to protect the safety

and soundness of the banking entity, or the financial stability of the

United States.

Sec. 75.14 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 banking entity that serves,

directly or indirectly, as the investment manager, investment adviser,

commodity trading advisor, or sponsor to a covered fund, that organizes

and offers a covered fund pursuant to Sec. 75.11, or that continues to

hold an ownership interest in accordance with Sec. 75.11(b), 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(b)(7)), as if such 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 banking

entity may:

(i) Acquire and retain any ownership interest in a covered fund in

accordance with the requirements of Sec. Sec. 75.11, 75.12, or 75.13;

and

(ii) Enter into any prime brokerage transaction with any covered

fund in which a covered fund managed, sponsored, or advised by such

banking entity (or an affiliate thereof) has taken an ownership

interest, if:

(A) The banking entity is in compliance with each of the

limitations set forth in Sec. 75.11 with respect to a covered fund

organized and offered by such banking entity (or an affiliate thereof);

(B) The chief executive officer (or equivalent officer) of the

banking entity certifies in writing annually to the Commission (with a

duty to update the certification if the information in the

certification materially changes) 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; and

(C) The Board has not determined that such transaction is

inconsistent with the safe and sound operation and condition of the

banking entity.

(b) Restrictions on transactions with covered funds. A 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.

75.11, or that continues to hold an ownership interest in accordance

with Sec. 75.11(b), shall be subject to section 23B of the Federal

Reserve Act (12 U.S.C. 371c-1), as if such 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 banking entity.

Sec. 75.15 Other limitations on permitted covered fund activities.

(a) No transaction, class of transactions, or activity may be

deemed permissible under Sec. Sec. 75.11 through 75.13 if the

transaction, class of transactions, or activity would:

(1) Involve or result in a material conflict of interest between

the banking entity and its clients, customers, or counterparties;

(2) Result, directly or indirectly, in a material exposure by the

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 banking entity

or to the financial stability of the United States.

(b) Definition of material conflict of interest. (1) For purposes

of this section, 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, and the banking entity has not taken at least one of the

actions in paragraph (b)(2) of this section.

(2) Prior to effecting the specific transaction or class or type of

transactions, or engaging in the specific activity, the banking entity:

(i) Timely and effective disclosure. (A) Has made 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

[[Page 6065]]

reasonable client, customer, or counterparty to meaningfully understand

the conflict of interest; and

(B) Such disclosure is made 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

(ii) Information barriers. 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 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

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 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 banking entity, significantly increase the

likelihood that the banking entity would incur a substantial financial

loss or would pose a threat to the financial stability of the United

States.

(2) High-risk trading strategy means a trading strategy that would,

if engaged in by a banking entity, significantly increase the

likelihood that the banking entity would incur a substantial financial

loss or would pose a threat to the financial stability of the United

States.

Sec. Sec. 75.16-75.19 [Reserved]

Subpart D--Compliance Program Requirement; Violations

Sec. 75.20 Program for compliance; reporting.

(a) Program requirement. Each banking entity shall develop and

provide for the continued administration of a compliance 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. The terms, scope and detail of the compliance program shall

be appropriate for the types, size, scope and complexity of activities

and business structure of the banking entity.

(b) Contents of compliance program. Except as provided in paragraph

(f) of this section, the compliance program required by paragraph (a)

of this section, at a minimum, shall include:

(1) Written policies and procedures reasonably designed to

document, describe, monitor and limit trading activities subject to

subpart B of this part (including those permitted under Sec. Sec. 75.3

to 75.6), including setting, monitoring and managing required limits

set out in Sec. Sec. 75.4 and 75.5, and activities and investments

with respect to a covered fund subject to subpart C of this part

(including those permitted under Sec. Sec. 75.11 through 75.14)

conducted by the banking entity to ensure that all activities and

investments conducted by the banking entity that are subject to section

13 of the BHC Act and this part comply with section 13 of the BHC Act

and this part;

(2) A system of internal controls reasonably designed to monitor

compliance with section 13 of the BHC Act and this part 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 and includes appropriate management review of trading limits,

strategies, hedging activities, investments, incentive compensation and

other matters identified in this part or by management as requiring

attention;

(4) Independent testing and audit of the effectiveness of the

compliance program conducted periodically by qualified personnel of the

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) Records sufficient to demonstrate compliance with section 13 of

the BHC Act and this part, which a banking entity must promptly provide

to the Commission upon request and retain for a period of no less than

5 years or such longer period as required by the Commission.

(c) Additional standards. In addition to the requirements in

paragraph (b) of this section, the compliance program of a banking

entity must satisfy the requirements and other standards contained in

Appendix B of this part, if:

(1) The banking entity engages in proprietary trading permitted

under subpart B of this part and is required to comply with the

reporting requirements of paragraph (d) of this section;

(2) The banking entity has reported total consolidated assets as of

the previous calendar year end of $50 billion or more or, in the case

of a foreign banking entity, has total U.S. assets as of the previous

calendar year end of $50 billion or more (including all subsidiaries,

affiliates, branches and agencies of the foreign banking entity

operating, located or organized in the United States); or

(3) The Commission notifies the banking entity in writing that it

must satisfy the requirements and other standards contained in Appendix

B of this part.

(d) Reporting requirements under Appendix A of this Part. (1) A

banking entity engaged in proprietary trading activity permitted under

subpart B of this part shall comply with the reporting requirements

described in Appendix A of this part, if:

(i) The banking entity (other than a foreign banking entity as

provided in paragraph (d)(1)(ii) of this section) has, together with

its affiliates and subsidiaries, trading assets and liabilities

(excluding trading assets and liabilities involving obligations of or

guaranteed by the United States or any agency of the United States) the

average gross sum of which (on a worldwide consolidated basis) over the

previous consecutive four quarters, as measured as of the last day of

each of the four prior calendar quarters, equals or exceeds the

threshold established in paragraph (d)(2) of this section;

(ii) In the case of a foreign banking entity, the average gross sum

of the trading assets and liabilities of the combined U.S. operations

of the foreign banking entity (including all subsidiaries, affiliates,

branches and agencies of the foreign banking entity operating, located

or organized in the United States and excluding trading assets and

liabilities involving obligations of or guaranteed by the United States

or any agency of the United States) over the previous consecutive four

quarters, as measured as of the last day of each of the four prior

calendar quarters, equals or exceeds the threshold established in

paragraph (d)(2) of this section; or

(iii) The Commission notifies the banking entity in writing that it

must satisfy the reporting requirements contained in Appendix A of this

part.

(2) The threshold for reporting under paragraph (d)(1) of this

section shall be $50 billion beginning on June 30, 2014;

[[Page 6066]]

$25 billion beginning on April 30, 2016; and $10 billion beginning on

December 31, 2016.

(3) Frequency of reporting. Unless the Commission notifies the

banking entity in writing that it must report on a different basis, a

banking entity with $50 billion or more in trading assets and

liabilities (as calculated in accordance with paragraph (d)(1) of this

section) shall report the information required by Appendix A of this

part for each calendar month within 30 days of the end of the relevant

calendar month; beginning with information for the month of January

2015, such information shall be reported within 10 days of the end of

each calendar month. Any other banking entity subject to Appendix A of

this part shall report the information required by Appendix A of this

part for each calendar quarter within 30 days of the end of that

calendar quarter unless the Commission notifies the banking entity in

writing that it must report on a different basis.

(e) Additional documentation for covered funds. Any banking entity

that has more than $10 billion in total consolidated assets as reported

on December 31 of the previous two calendar years shall maintain

records that include:

(1) Documentation of the exclusions or exemptions other than

sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940

relied on by each fund sponsored by the banking entity (including all

subsidiaries and affiliates) in determining that such fund is not a

covered fund;

(2) For each fund sponsored by the banking entity (including all

subsidiaries and affiliates) for which the banking entity relies on one

or more of the exclusions from the definition of covered fund provided

by Sec. 75.10(c)(1), (5), (8), (9), or (10), documentation supporting

the banking entity's determination that the fund is not a covered fund

pursuant to one or more of those exclusions;

(3) For each seeding vehicle described in Sec. 75.10(c)(12)(i) or

(iii) that will become a registered investment company or SEC-regulated

business development company, a written plan documenting the banking

entity's determination that the seeding vehicle will become a

registered investment company or SEC-regulated business development

company; the period of time during which the vehicle will operate as a

seeding vehicle; and the banking entity's plan to market the vehicle to

third-party investors and convert it into a registered investment

company or SEC-regulated business development company within the time

period specified in Sec. 75.12(a)(2)(i)(B);

(4) For any banking entity that is, or is controlled directly or

indirectly by a banking entity that is, located in or organized under

the laws of the United States or of any State, if the aggregate amount

of ownership interests in foreign public funds that are described in

Sec. 75.10(c)(1) owned by such banking entity (including ownership

interests owned by any affiliate that is controlled directly or

indirectly by a banking entity that is located in or organized under

the laws of the United States or of any State) exceeds $50 million at

the end of two or more consecutive calendar quarters, beginning with

the next succeeding calendar quarter, documentation of the value of the

ownership interests owned by the banking entity (and such affiliates)

in each foreign public fund and each jurisdiction in which any such

foreign public fund is organized, calculated as of the end of each

calendar quarter, which documentation must continue until the banking

entity's aggregate amount of ownership interests in foreign public

funds is below $50 million for two consecutive calendar quarters; and

(5) For purposes of paragraph (e)(4) of this section, a U.S.

branch, agency, or subsidiary of a foreign banking entity is located in

the United States; however, the foreign bank that operates or controls

that branch, agency, or subsidiary is not considered to be located in

the United States solely by virtue of operating or controlling the U.S.

branch, agency, or subsidiary.

(f) Simplified programs for less active banking entities--(1)

Banking entities with no covered activities. A banking entity that does

not engage in activities or investments pursuant to subpart B or

subpart C of this part (other than trading activities permitted

pursuant to Sec. 75.6(a)) may satisfy the requirements of this section

by establishing the required compliance program prior to becoming

engaged in such activities or making such investments (other than

trading activities permitted pursuant to Sec. 75.6(a)).

(2) Banking entities with modest activities. A banking entity with

total consolidated assets of $10 billion or less as reported on

December 31 of the previous two calendar years that engages in

activities or investments pursuant to subpart B or subpart C of this

part (other than trading activities permitted under Sec. 75.6(a)) may

satisfy the requirements of this section by including in its existing

compliance policies and procedures appropriate references to the

requirements of section 13 of the BHC Act and this part and adjustments

as appropriate given the activities, size, scope and complexity of the

banking entity.

Sec. 75.21 Termination of activities or investments; penalties for

violations.

(a) Any banking entity that engages in an activity or makes an

investment in violation of section 13 of the BHC Act or this part, or

acts 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 of this

part, or otherwise violates the restrictions and requirements of

section 13 of the BHC Act or this part, shall, upon discovery, promptly

terminate the activity and, as relevant, dispose of the investment.

(b) Whenever the Commission finds reasonable cause to believe any

banking entity has engaged in an activity or made an investment in

violation of section 13 of the BHC Act or this part, or engaged in any

activity or made any investment that functions as an evasion of the

requirements of section 13 of the BHC Act or this part, the Commission

may take any action permitted by law to enforce compliance with section

13 of the BHC Act and this part, including directing the banking entity

to restrict, limit, or terminate any or all activities under this part

and dispose of any investment.

Appendix A to Part 75--Reporting and Recordkeeping Requirements for

Covered Trading Activities

I. Purpose

a. This appendix sets forth reporting and recordkeeping

requirements that certain 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. 75.20(d), this appendix generally applies to a

banking entity that, together with its affiliates and subsidiaries,

has significant trading assets and liabilities. These entities are

required to (i) furnish periodic reports to the Commission regarding

a variety of quantitative measurements of their covered trading

activities, which vary depending on the scope and size of covered

trading activities, and (ii) create and maintain records documenting

the preparation and content of these reports. The requirements of

this appendix must be incorporated into the banking entity's

internal compliance program under Sec. 75.20 and Appendix B of this

part.

b. The purpose of this appendix is to assist banking entities

and the Commission in:

(i) Better understanding and evaluating the scope, type, and

profile of the banking entity's covered trading activities;

(ii) Monitoring the banking entity's covered trading activities;

(iii) Identifying covered trading activities that warrant

further review or examination

[[Page 6067]]

by the banking entity to verify compliance with the proprietary

trading restrictions;

(iv) Evaluating whether the covered trading activities of

trading desks engaged in market making-related activities subject to

Sec. 75.4(b) are consistent with the requirements governing

permitted market making-related activities;

(v) Evaluating whether the covered trading activities of trading

desks that are engaged in permitted trading activity subject to

Sec. 75.4, 75.5, or 75.6(a) and (b) (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 covered trading

activities of the banking entity, and the individual trading desks

of the banking entity, to help establish the appropriate frequency

and scope of examination by the Commission of such activities; and

(vii) Assessing and addressing the risks associated with the

banking entity's covered trading activities.

c. 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.

d. In order to allow banking entities and the Agencies to

evaluate the effectiveness of these metrics, banking entities must

collect and report these metrics for all trading desks beginning on

the dates established in Sec. 75.20. The Agencies will review the

data collected and revise this collection requirement as appropriate

based on a review of the data collected prior to September 30, 2015.

e. In addition to the quantitative measurements required in this

appendix, a 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. 75.20 and Appendix B of 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 desk, 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 that the activities are

within risk tolerances established by the banking entity, and to

monitor and examine for compliance with the proprietary trading

restrictions in this part.

f. On an ongoing basis, banking entities must 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. 75.4 through 75.6(a) and (b), or that

result in a material exposure to high-risk assets or high-risk

trading strategies, must be escalated within the banking entity for

review, further analysis, explanation to the Commission, and

remediation, where appropriate. The quantitative measurements

discussed in this appendix should be helpful to 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. 75.2 and 75.3. In addition, for purposes of this

appendix, the following definitions apply:

Calculation period means the period of time for which a

particular quantitative measurement must be calculated.

Comprehensive profit and loss means the net profit or loss of a

trading desk's material sources of trading revenue over a specific

period of time, including, for example, any increase or decrease in

the market value of a trading desk's holdings, dividend income, and

interest income and expense.

Covered trading activity means trading conducted by a trading

desk under Sec. 75.4, 75.5, or 75.6(a) or (b). A banking entity may

include trading under Sec. 75.3(d) or 75.6(c), (d) or (e).

Measurement frequency means the frequency with which a

particular quantitative metric must be calculated and recorded.

Trading desk means the smallest discrete unit of organization of

a banking entity that purchases or sells financial instruments for

the trading account of the banking entity or an affiliate thereof.

III. Reporting and Recordkeeping of Quantitative Measurements

a. Scope of Required Reporting

General scope. Each banking entity made subject to this part by

Sec. 75.20 must furnish the following quantitative measurements for

each trading desk of the banking entity, calculated in accordance

with this appendix:

Risk and Position Limits and Usage;

Risk Factor Sensitivities;

Value-at-Risk and Stress VaR;

Comprehensive Profit and Loss Attribution;

Inventory Turnover;

Inventory Aging; and

Customer Facing Trade Ratio

b. Frequency of Required Calculation and Reporting

A banking entity must calculate any applicable quantitative

measurement for each trading day. A banking entity must report each

applicable quantitative measurement to the Commission on the

reporting schedule established in Sec. 75.20 unless otherwise

requested by the Commission. All quantitative measurements for any

calendar month must be reported within the time period required by

Sec. 75.20.

c. Recordkeeping

A banking entity must, for any quantitative measurement

furnished to the Commission pursuant to this appendix and Sec.

75.20(d), create and maintain records documenting the preparation

and content of these reports, as well as such information as is

necessary to permit the Commission to verify the accuracy of such

reports, for a period of 5 years from the end of the calendar year

for which the measurement was taken.

IV. Quantitative Measurements

a. Risk-Management Measurements

1. Risk and Position Limits and Usage

i. Description: For purposes of this appendix, Risk and Position

Limits are the constraints that define the amount of risk that a

trading desk is permitted to take at a point in time, as defined by

the banking entity for a specific trading desk. Usage represents the

portion of the trading desk's limits that are accounted for by the

current activity of the desk. Risk and position limits and their

usage are key risk management tools used to control and monitor risk

taking and include, but are not limited, to the limits set out in

Sec. Sec. 75.4 and 75.5. A number of the metrics that are described

below, including ``Risk Factor Sensitivities'' and ``Value-at-Risk

and Stress Value-at-Risk,'' relate to a trading desk's risk and

position limits and are useful in evaluating and setting these

limits in the broader context of the trading desk's overall

activities, particularly for the market making activities under

Sec. 75.4(b) and hedging activity under Sec. 75.5. Accordingly,

the limits required under Sec. Sec. 75.4(b)(2)(iii) and

75.5(b)(1)(i) must meet the applicable requirements under Sec. Sec.

75.4(b)(2)(iii) and 75.5(b)(1)(i) and also must include appropriate

metrics for the trading desk limits including, at a minimum, the

``Risk Factor Sensitivities'' and ``Value-at-Risk and Stress Value-

at-Risk'' metrics except to the extent any of the ``Risk Factor

Sensitivities'' or ``Value-at-Risk and Stress Value-at-Risk''

metrics are demonstrably ineffective for measuring and monitoring

the risks of a trading desk based on the types of positions traded

by, and risk exposures of, that desk.

ii. General Calculation Guidance: Risk and Position Limits must

be reported in the format used by the banking entity for the

purposes of risk management of each trading desk. 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 must be reported.

iii. Calculation Period: One trading day.

iv. Measurement Frequency: Daily.

2. Risk Factor Sensitivities

i. Description: For purposes of this appendix, Risk Factor

Sensitivities are changes in a trading desk's Comprehensive Profit

and Loss that are expected to occur in the event of a change in one

or more

[[Page 6068]]

underlying variables that are significant sources of the trading

desk's profitability and risk.

ii. General Calculation Guidance: A banking entity must report

the Risk Factor Sensitivities that are monitored and managed as part

of the trading desk's overall risk management policy. The underlying

data and methods used to compute a trading desk's Risk Factor

Sensitivities will depend on the specific function of the trading

desk and the internal risk management models employed. The number

and type of Risk Factor Sensitivities that are monitored and managed

by a trading desk, and furnished to the Commission, will depend on

the explicit risks assumed by the trading desk. In general, however,

reported Risk Factor Sensitivities must be sufficiently granular to

account for a preponderance of the expected price variation in the

trading desk's holdings.

A. Trading desks must 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: risk factors with

respect to the related commodities set out in Sec. 20.2 of this

chapter, 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: risk factors with respect to credit

spreads that are sufficiently granular to account for specific

credit sectors and market segments, the maturity profile of the

positions, and risk factors with respect to interest rates of all

relevant maturities;

Credit-related derivative positions: risk factor

sensitivities, for example credit spreads, shifts (parallel and non-

parallel) in credit spreads--volatility, and/or correlation

sensitivities (expressed in a manner that demonstrates any

significant non-linearities), and the maturity profile of the

positions;

Equity derivative positions: risk factor sensitivities

such as equity positions, volatility, and/or correlation

sensitivities (expressed in a manner that demonstrates any

significant non-linearities), and the maturity profile of the

positions;

Equity positions: risk factors for equity prices and

risk factors that differentiate between important equity market

sectors and segments, such as a small capitalization equities and

international equities;

Foreign exchange derivative positions: risk factors

with respect to major currency pairs and maturities, exposure to

interest rates at relevant maturities, 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: risk factors 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), and shifts (parallel and non-parallel)

in the interest rate curve, as well as the maturity profile of the

positions.

B. The methods used by a banking entity to calculate

sensitivities to a common factor shared by multiple trading desks,

such as an equity price factor, must be applied consistently across

its trading desks so that the sensitivities can be compared from one

trading desk to another.

iii. Calculation Period: One trading day.

iv. Measurement Frequency: Daily.

3. Value-at-Risk and Stress Value-at-Risk

i. 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 set of aggregated

positions 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 set of aggregated positions

over a specified period of time, based on market conditions during a

period of significant financial stress.

ii. General Calculation Guidance: Banking entities must compute

and report VaR and Stress VaR by employing generally accepted

standards and methods of calculation. VaR should reflect a loss in a

trading desk 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 must be computed and reported in

a manner that is consistent with such regulatory capital

requirements. In cases where a trading desk does not have a

standalone VaR or Stress VaR calculation but is part of a larger

aggregation of positions for which a VaR or Stress VaR calculation

is performed, a VaR or Stress VaR calculation that includes only the

trading desk's holdings must be performed consistent with the VaR or

Stress VaR model and methodology used for the larger aggregation of

positions.

iii. Calculation Period: One trading day.

iv. Measurement Frequency: Daily.

b. Source-of-Revenue Measurements

1. Comprehensive Profit and Loss Attribution

i. Description: For purposes of this appendix, Comprehensive

Profit and Loss Attribution is an analysis that attributes the daily

fluctuation in the value of a trading desk's positions to various

sources. First, the daily profit and loss of the aggregated

positions is divided into three categories: (i) Profit and loss

attributable to a trading desk's existing positions that were also

positions held by the trading desk as of the end of the prior day

(``existing positions''); (ii) profit and loss attributable to new

positions resulting from the current day's trading activity (``new

positions''); and (iii) residual profit and loss that cannot be

specifically attributed to existing positions or new positions. The

sum of (i), (ii), and (iii) must equal the trading desk's

comprehensive profit and loss at each point in time. In addition,

profit and loss measurements must calculate volatility of

comprehensive profit and loss (i.e., the standard deviation of the

trading desk's one-day profit and loss, in dollar terms) for the

reporting period for at least a 30-, 60- and 90-day lag period, from

the end of the reporting period, and any other period that the

banking entity deems necessary to meet the requirements of the rule.

A. The comprehensive profit and loss associated with existing

positions must reflect changes in the value of these positions on

the applicable day. The comprehensive profit and loss from existing

positions must be further attributed, as applicable, to changes in

(i) the specific Risk Factors and other factors that are monitored

and managed as part of the trading desk's overall risk management

policies and procedures; and (ii) any other applicable elements,

such as cash flows, carry, changes in reserves, and the correction,

cancellation, or exercise of a trade.

B. The comprehensive profit and loss attributed to new positions

must reflect commissions and fee income or expense and market gains

or losses associated with transactions executed on the applicable

day. New positions include purchases and sales of financial

instruments and other assets/liabilities and negotiated amendments

to existing positions. The comprehensive profit and loss from new

positions may be reported in the aggregate and does not need to be

further attributed to specific sources.

C. The portion of comprehensive profit and loss that cannot be

specifically attributed to known sources must be allocated to a

residual category identified as an unexplained portion of the

comprehensive profit and loss. Significant unexplained profit and

loss must be escalated for further investigation and analysis.

ii. General Calculation Guidance: The specific categories used

by a trading desk in the attribution analysis and amount of detail

for the analysis should be tailored to the type and amount of

trading activities undertaken by the trading desk. The new position

attribution must be computed by calculating the difference between

the prices at which instruments were bought and/or sold and the

prices at which those instruments are marked to market at the close

of business on that day multiplied by the notional or principal

amount of each purchase or sale. Any fees, commissions, or other

payments received (paid) that are associated with transactions

executed on that day must be added (subtracted) from such

difference. These factors must be measured consistently over time to

facilitate historical comparisons.

iii. Calculation Period: One trading day.

iv. Measurement Frequency: Daily.

c. Customer-Facing Activity Measurements

1. Inventory Turnover

i. Description: For purposes of this appendix, Inventory

Turnover is a ratio that measures the turnover of a trading desk's

inventory. The numerator of the ratio is the absolute value of all

transactions over the reporting period. The denominator of the ratio

is the value of the trading desk's inventory at the beginning of the

reporting period.

ii. General Calculation Guidance: For purposes of this appendix,

for derivatives, other than options and interest rate derivatives,

value means gross notional value, for options, value means delta

adjusted notional value, and for interest rate derivatives, value

means 10-year bond equivalent value.

iii. Calculation Period: 30 days, 60 days, and 90 days.

[[Page 6069]]

iv. Measurement Frequency: Daily.

2. Inventory Aging

i. Description: For purposes of this appendix, Inventory Aging

generally describes a schedule of the trading desk's aggregate

assets and liabilities and the amount of time that those assets and

liabilities have been held. Inventory Aging should measure the age

profile of the trading desk's assets and liabilities.

ii. General Calculation Guidance: In general, Inventory Aging

must be computed using a trading desk's trading activity data and

must identify the value of a trading desk's aggregate assets and

liabilities. Inventory Aging must include two schedules, an asset-

aging schedule and a liability-aging schedule. Each schedule must

record the value of assets or liabilities held over all holding

periods. For derivatives, other than options, and interest rate

derivatives, value means gross notional value, for options, value

means delta adjusted notional value and, for interest rate

derivatives, value means 10-year bond equivalent value.

iii. Calculation Period: One trading day.

iv. Measurement Frequency: Daily.

3. Customer-Facing Trade Ratio--Trade Count Based and Value Based

i. Description: For purposes of this appendix, the Customer-

Facing Trade Ratio is a ratio comparing (i) the transactions

involving a counterparty that is a customer of the trading desk to

(ii) the transactions involving a counterparty that is not a

customer of the trading desk. A trade count based ratio must be

computed that records the number of transactions involving a

counterparty that is a customer of the trading desk and the number

of transactions involving a counterparty that is not a customer of

the trading desk. A value based ratio must be computed that records

the value of transactions involving a counterparty that is a

customer of the trading desk and the value of transactions involving

a counterparty that is not a customer of the trading desk.

ii. General Calculation Guidance: For purposes of calculating

the Customer-Facing Trade Ratio, a counterparty is considered to be

a customer of the trading desk if the counterparty is a market

participant that makes use of the banking entity's market making-

related services by obtaining such services, responding to

quotations, or entering into a continuing relationship with respect

to such services. However, a trading desk or other organizational

unit of another banking entity would not be a client, customer, or

counterparty of the trading desk if the other entity has trading

assets and liabilities of $50 billion or more as measured in

accordance with Sec. 75.20(d)(1) unless the trading desk documents

how and why a particular trading desk or other organizational unit

of the entity should be treated as a client, customer, or

counterparty of the trading desk. Transactions conducted anonymously

on an exchange or similar trading facility that permits trading on

behalf of a broad range of market participants would be considered

transactions with customers of the trading desk. For derivatives,

other than options, and interest rate derivatives, value means gross

notional value, for options, value means delta adjusted notional

value, and for interest rate derivatives, value means 10-year bond

equivalent value.

iii. Calculation Period: 30 days, 60 days, and 90 days.

iv. Measurement Frequency: Daily.

Appendix B to Part 75--Enhanced Minimum Standards for Compliance

Programs

I. Overview

Section 75.20(c) requires certain banking entities to establish,

maintain, and enforce an enhanced compliance program that includes

the requirements and standards in this Appendix as well as the

minimum written policies and procedures, internal controls,

management framework, independent testing, training, and

recordkeeping provisions outlined in Sec. 75.20. This Appendix sets

forth additional minimum standards with respect to the

establishment, oversight, maintenance, and enforcement by these

banking entities of an enhanced internal compliance program for

ensuring and monitoring 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.

a. This compliance program must:

1. Be reasonably designed to identify, document, monitor, and

report the permitted trading and covered fund activities and

investments of the banking entity; identify, monitor and promptly

address the risks of these covered activities and investments and

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;

2. Establish and enforce appropriate limits on the covered

activities and investments of the banking entity, including limits

on the size, scope, complexity, and risks of the individual

activities or investments consistent with the requirements of

section 13 of the BHC Act and this part;

3. Subject the effectiveness of the compliance program to

periodic independent review and testing, and ensure that the

entity's internal audit, corporate compliance and internal control

functions involved in review and testing are effective and

independent;

4. Make senior management, and others as appropriate,

accountable for the effective implementation of the compliance

program, and ensure that the board of directors and chief executive

officer (or equivalent) of the banking entity review the

effectiveness of the compliance program; and

5. Facilitate supervision and examination by the Agencies of the

banking entity's permitted trading and covered fund activities and

investments.

II. Enhanced Compliance Program

a. Proprietary Trading Activities

A banking entity must establish, maintain and enforce a

compliance program that includes written policies and procedures

that are appropriate for the types, size, and complexity of, and

risks associated with, its permitted trading activities. The

compliance program may be tailored to the types of trading

activities conducted by the banking entity, and must include a

detailed description of controls established by the banking entity

to reasonably ensure that its trading activities are conducted in

accordance with the requirements and limitations applicable to those

trading activities under section 13 of the BHC Act and this part,

and provide for appropriate revision of the compliance program

before expansion of the trading activities of the banking entity. A

banking entity must devote adequate resources and use knowledgeable

personnel in conducting, supervising and managing its trading

activities, and promote consistency, independence and rigor in

implementing its risk controls and compliance efforts. The

compliance program must be updated with a frequency sufficient to

account for changes in the activities of the banking entity, results

of independent testing of the program, identification of weaknesses

in the program, and changes in legal, regulatory or other

requirements.

1. Trading Desks: The banking entity must have written policies

and procedures governing each trading desk that include a

description of:

i. The process for identifying, authorizing and documenting

financial instruments each trading desk may purchase or sell, with

separate documentation for market making-related activities

conducted in reliance on Sec. 75.4(b) and for hedging activity

conducted in reliance on Sec. 75.5;

ii. A mapping for each trading desk to the division, business

line, or other organizational structure that is responsible for

managing and overseeing the trading desk's activities;

iii. The mission (i.e., the type of trading activity, such as

market-making, trading in sovereign debt, etc.) and strategy (i.e.,

methods for conducting authorized trading activities) of each

trading desk;

iv. The activities that the trading desk is authorized to

conduct, including (i) authorized instruments and products, and (ii)

authorized hedging strategies, techniques and instruments;

v. The types and amount of risks allocated by the banking entity

to each trading desk to implement the mission and strategy of the

trading desk, including an enumeration of material risks resulting

from the activities in which the trading desk is authorized to

engage (including but not limited to price risks, such as basis,

volatility and correlation risks, as well as counterparty credit

risk). Risk assessments must take into account both the risks

inherent in the trading activity and the strength and effectiveness

of controls designed to mitigate those risks;

vi. How the risks allocated to each trading desk will be

measured;

vii. Why the allocated risks levels are appropriate to the

activities authorized for the trading desk;

viii. The limits on the holding period of, and the risk

associated with, financial instruments under the responsibility of

the trading desk;

ix. The process for setting new or revised limits, as well as

escalation procedures for

[[Page 6070]]

granting exceptions to any limits or to any policies or procedures

governing the desk, the analysis that will be required to support

revising limits or granting exceptions, and the process for

independently reviewing and documenting those exceptions and the

underlying analysis;

x. The process for identifying, documenting and approving new

products, trading strategies, and hedging strategies;

xi. The types of clients, customers, and counterparties with

whom the trading desk may trade; and

xii. The compensation arrangements, including incentive

arrangements, for employees associated with the trading desk, which

may not be designed to reward or incentivize prohibited proprietary

trading or excessive or imprudent risk-taking.

2. Description of risks and risk management processes: The

compliance program for the banking entity must include a

comprehensive description of the risk management program for the

trading activity of the banking entity. The compliance program must

also include a description of the governance, approval, reporting,

escalation, review and other processes the banking entity will use

to reasonably ensure that trading activity is conducted in

compliance with section 13 of the BHC Act and this part. Trading

activity in similar financial instruments should be subject to

similar governance, limits, testing, controls, and review, unless

the banking entity specifically determines to establish different

limits or processes and documents those differences. Descriptions

must include, at a minimum, the following elements:

i. A description of the supervisory and risk management

structure governing all trading activity, including a description of

processes for initial and senior-level review of new products and

new strategies;

ii. A description of the process for developing, documenting,

testing, approving and reviewing all models used for valuing,

identifying and monitoring the risks of trading activity and related

positions, including the process for periodic independent testing of

the reliability and accuracy of those models;

iii. A description of the process for developing, documenting,

testing, approving and reviewing the limits established for each

trading desk;

iv. A description of the process by which a security may be

purchased or sold pursuant to the liquidity management plan,

including the process for authorizing and monitoring such activity

to ensure compliance with the banking entity's liquidity management

plan and the restrictions on liquidity management activities in this

part;

v. A description of the management review process, including

escalation procedures, for approving any temporary exceptions or

permanent adjustments to limits on the activities, positions,

strategies, or risks associated with each trading desk; and

vi. The role of the audit, compliance, risk management and other

relevant units for conducting independent testing of trading and

hedging activities, techniques and strategies.

3. Authorized risks, instruments, and products. The banking

entity must implement and enforce limits and internal controls for

each trading desk that are reasonably designed to ensure that

trading activity is conducted in conformance with section 13 of the

BHC Act and this part and with the banking entity's written policies

and procedures. The banking entity must establish and enforce risk

limits appropriate for the activity of each trading desk. These

limits should be based on probabilistic and non-probabilistic

measures of potential loss (e.g., Value-at-Risk and notional

exposure, respectively), and measured under normal and stress market

conditions. At a minimum, these internal controls must monitor,

establish and enforce limits on:

i. The financial instruments (including, at a minimum, by type

and exposure) that the trading desk may trade;

ii. The types and levels of risks that may be taken by each

trading desk; and

iii. The types of hedging instruments used, hedging strategies

employed, and the amount of risk effectively hedged.

4. Hedging policies and procedures. The banking entity must

establish, maintain, and enforce written policies and procedures

regarding the use of risk-mitigating hedging instruments and

strategies that, at a minimum, describe:

i. The positions, techniques and strategies that each trading

desk may use to hedge the risk of its positions;

ii. The manner in which the banking entity will identify the

risks arising in connection with and related to the individual or

aggregated positions, contracts or other holdings of the banking

entity that are to be hedged and determine that those risks have

been properly and effectively hedged;

iii. The level of the organization at which hedging activity and

management will occur;

iv. The manner in which hedging strategies will be monitored and

the personnel responsible for such monitoring;

v. The risk management processes used to control unhedged or

residual risks; and

vi. The process for developing, documenting, testing, approving

and reviewing all hedging positions, techniques and strategies

permitted for each trading desk and for the banking entity in

reliance on Sec. 75.5.

5. Analysis and quantitative measurements. The banking entity

must perform robust analysis and quantitative measurement of its

trading activities that is reasonably designed to ensure that the

trading activity of each trading desk is consistent with the banking

entity's compliance program; monitor and assist in the

identification of potential and actual prohibited proprietary

trading activity; and prevent the occurrence of prohibited

proprietary trading. Analysis and models used to determine, measure

and limit risk must be rigorously tested and be reviewed by

management responsible for trading activity to ensure that trading

activities, limits, strategies, and hedging activities do not

understate the risk and exposure to the banking entity or allow

prohibited proprietary trading. This review should include periodic

and independent back-testing and revision of activities, limits,

strategies and hedging as appropriate to contain risk and ensure

compliance. In addition to the quantitative measurements reported by

any banking entity subject to Appendix A of this part, each banking

entity must develop and implement, to the extent appropriate to

facilitate compliance with this part, additional quantitative

measurements specifically tailored to the particular risks,

practices, and strategies of its trading desks. The banking entity's

analysis and quantitative measurements must incorporate the

quantitative measurements reported by the banking entity pursuant to

Appendix A of this part (if applicable) and include, at a minimum,

the following:

i. Internal controls and written policies and procedures

reasonably designed to ensure the accuracy and integrity of

quantitative measurements;

ii. Ongoing, timely monitoring and review of calculated

quantitative measurements;

iii. The establishment of numerical thresholds and appropriate

trading measures for each trading desk and heightened review of

trading activity not consistent with those thresholds to ensure

compliance with section 13 of the BHC Act and this part, including

analysis of the measurement results or other information,

appropriate escalation procedures, and documentation related to the

review; and

iv. Immediate review and compliance investigation of the trading

desk's activities, escalation to senior management with oversight

responsibilities for the applicable trading desk, timely

notification to the Commission, 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 quantitative

measurements or other information, considered together with the

facts and circumstances, or findings of internal audit, independent

testing or other review suggest a reasonable likelihood that the

trading desk has violated any part of section 13 of the BHC Act or

this part.

6. Other Compliance Matters. In addition to the requirements

specified above, the banking entity's compliance program must:

i. Identify activities of each trading desk that will be

conducted in reliance on exemptions contained in Sec. Sec. 75.4

through 75.6, including an explanation of:

A. How and where in the organization the activity occurs; and

B. Which exemption is being relied on and how the activity meets

the specific requirements for reliance on the applicable exemption;

ii. Include an explanation of the process for documenting,

approving and reviewing actions taken pursuant to the liquidity

management plan, where in the organization this activity occurs, the

securities permissible for liquidity management, the process for

ensuring that liquidity management activities are not conducted for

the purpose of prohibited proprietary trading, and the process for

ensuring that securities purchased as part of the liquidity

management plan are highly liquid and conform to the requirements of

this part;

iii. Describe how the banking entity monitors for and prohibits

potential or actual

[[Page 6071]]

material exposure to high-risk assets or high-risk trading

strategies presented by each trading desk that relies on the

exemptions contained in Sec. Sec. 75.3(d)(3) and 75.4 through 75.6,

which must take into account potential or actual exposure to:

A. Assets whose values cannot be externally priced or, where

valuation is reliant on pricing models, whose model inputs cannot be

externally validated;

B. Assets whose changes in value cannot be adequately mitigated

by effective hedging;

C. New products with rapid growth, including those that do not

have a market history;

D. Assets or strategies that include significant embedded

leverage;

E. Assets or strategies that have demonstrated significant

historical volatility;

F. Assets or strategies for which the application of capital and

liquidity standards would not adequately account for the risk; and

G. Assets or strategies that result in large and significant

concentrations to sectors, risk factors, or counterparties;

iv. Establish responsibility for compliance with the reporting

and recordkeeping requirements of subpart B of this part and Sec.

75.20; and

v. Establish policies for monitoring and prohibiting potential

or actual material conflicts of interest between the banking entity

and its clients, customers, or counterparties.

7. Remediation of violations. The banking entity's compliance

program must be reasonably designed and established to effectively

monitor and identify for further analysis any 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. The compliance program must describe procedures

for identifying and remedying violations of section 13 of the BHC

Act and this part, and must include, at a minimum, a requirement 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. The compliance program must include specific

written policies and procedures that are reasonably designed to

assess the extent to which any activity indicates that modification

to the banking entity's compliance program is warranted and to

ensure that appropriate modifications are implemented. The written

policies and procedures must provide for prompt notification to

appropriate management, including senior management and the board of

directors, of any material weakness or significant deficiencies in

the design or implementation of the compliance program of the

banking entity.

b. Covered Fund Activities or Investments

A banking entity must establish, maintain and enforce a

compliance program that includes written policies and procedures

that are appropriate for the types, size, complexity and risks of

the covered fund and related activities conducted and investments

made, by the banking entity.

1. Identification of covered funds. The banking entity's

compliance program must provide a process, which must include

appropriate management review and independent testing, for

identifying and documenting covered funds that each unit within the

banking entity's organization sponsors or organizes and offers, and

covered funds in which each such unit invests. In addition to the

documentation requirements for covered funds, as specified under

Sec. 75.20(e), the documentation must include information that

identifies all pools that the banking entity sponsors or has an

interest in and the type of exemption from the Commodity Exchange

Act (whether or not the pool relies on Sec. 4.7 of the regulations

under the Commodity Exchange Act (Sec. 4.7 of this chapter)), and

the amount of ownership interest the banking entity has in those

pools.

2. Identification of covered fund activities and investments.

The banking entity's compliance program must identify, document and

map each unit within the organization that is permitted to acquire

or hold an interest in any covered fund or sponsor any covered fund

and map each unit to the division, business line, or other

organizational structure that will be responsible for managing and

overseeing that unit's activities and investments.

3. Explanation of compliance. The banking entity's compliance

program must explain how:

i. The banking entity monitors for and prohibits potential or

actual material conflicts of interest between the banking entity and

its clients, customers, or counterparties related to its covered

fund activities and investments;

ii. The banking entity monitors for and prohibits potential or

actual transactions or activities that may threaten the safety and

soundness of the banking entity related to its covered fund

activities and investments; and

iii. The banking entity monitors for and prohibits potential or

actual material exposure to high-risk assets or high-risk trading

strategies presented by its covered fund activities and investments,

taking into account potential or actual exposure to:

A. Assets whose values cannot be externally priced or, where

valuation is reliant on pricing models, whose model inputs cannot be

externally validated;

B. Assets whose changes in values cannot be adequately mitigated

by effective hedging;

C. New products with rapid growth, including those that do not

have a market history;

D. Assets or strategies that include significant embedded

leverage;

E. Assets or strategies that have demonstrated significant

historical volatility;

F. Assets or strategies for which the application of capital and

liquidity standards would not adequately account for the risk; and

G. Assets or strategies that expose the banking entity to large

and significant concentrations with respect to sectors, risk

factors, or counterparties;

4. Description and documentation of covered fund activities and

investments. For each organizational unit engaged in covered fund

activities and investments, the banking entity's compliance program

must document:

i. The covered fund activities and investments that the unit is

authorized to conduct;

ii. The banking entity's plan for actively seeking unaffiliated

investors to ensure that any investment by the banking entity

conforms to the limits contained in Sec. 75.12 or registered in

compliance with the securities laws and thereby exempt from those

limits within the time periods allotted in Sec. 75.12; and

iii. How it complies with the requirements of subpart C of this

part.

5. Internal Controls. A banking entity must establish, maintain,

and enforce internal controls that are reasonably designed to ensure

that its covered fund activities or investments comply with the

requirements of section 13 of the BHC Act and this part and are

appropriate given the limits on risk established by the banking

entity. These written internal controls must be reasonably designed

and established to effectively monitor and identify for further

analysis any covered fund activity or investment that may indicate

potential violations of section 13 of the BHC Act or this part. The

internal controls must, at a minimum require:

i. Monitoring and limiting the banking entity's individual and

aggregate investments in covered funds;

ii. Monitoring the amount and timing of seed capital investments

for compliance with the limitations under subpart C of this part

(including but not limited to the redemption, sale or disposition

requirements of Sec. 75.12), and the effectiveness of efforts to

seek unaffiliated investors to ensure compliance with those limits;

iii. Calculating the individual and aggregate levels of

ownership interests in one or more covered fund required by Sec.

75.12;

iv. Attributing the appropriate instruments to the individual

and aggregate ownership interest calculations above;

v. Making disclosures to prospective and actual investors in any

covered fund organized and offered or sponsored by the banking

entity, as provided under Sec. 75.11(a)(8);

vi. Monitoring for and preventing any relationship or

transaction between the banking entity and a covered fund that is

prohibited under Sec. 75.14, including where the banking entity has

been designated as the sponsor, investment manager, investment

adviser, or commodity trading advisor to a covered fund by another

banking entity; and

vii. Appropriate management review and supervision across legal

entities of the banking entity to ensure that services and products

provided by all affiliated entities comply with the limitation on

services and products contained in Sec. 75.14.

6. Remediation of violations. The banking entity's compliance

program must be reasonably designed and established to effectively

monitor and identify for further analysis any covered fund activity

or investment that may indicate potential violations of section 13

of the BHC Act or this part and to prevent actual violations of

section 13 of the BHC Act and this part. The banking entity's

compliance program must describe procedures for identifying and

remedying violations of section 13 of the

[[Page 6072]]

BHC Act and this part, and must include, at a minimum, a requirement

to promptly document, address and remedy any violation of section 13

of the BHC Act or this part, including Sec. 75.21, and document all

proposed and actual remediation efforts. The compliance program must

include specific written policies and procedures that are reasonably

designed to assess the extent to which any activity or investment

indicates that modification to the banking entity's compliance

program is warranted and to ensure that appropriate modifications

are implemented. The written policies and procedures must provide

for prompt notification to appropriate management, including senior

management and the board of directors, of any material weakness or

significant deficiencies in the design or implementation of the

compliance program of the banking entity.

III. Responsibility and Accountability for the Compliance Program

a. A banking entity must establish, maintain, and enforce a

governance and 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 banking entity must have an appropriate

management framework reasonably designed to ensure that: Appropriate

personnel are 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

compliance program is reviewed periodically by senior management.

The board of directors (or equivalent governance body) and senior

management should have the appropriate authority and access to

personnel and information within the organizations as well as

appropriate resources to conduct their oversight activities

effectively.

1. Corporate governance. The banking entity must adopt a written

compliance program approved by the board of directors, an

appropriate committee of the board, or equivalent governance body,

and senior management.

2. Management procedures. The banking entity must establish,

maintain, and enforce a governance framework that is reasonably

designed to achieve compliance with section 13 of the BHC Act and

this part, which, at a minimum, provides for:

i. The designation of appropriate senior management or committee

of senior management with authority to carry out the management

responsibilities of the banking entity for each trading desk and for

each organizational unit engaged in covered fund activities;

ii. Written procedures addressing the management of the

activities of the banking entity that are reasonably designed to

achieve compliance with section 13 of the BHC Act and this part,

including:

A. 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 banking entity's

activities governed by section 13 of the BHC Act and this part; and

B. Procedures for determining compensation arrangements for

traders engaged in underwriting or market making-related activities

under Sec. 75.4 or risk-mitigating hedging activities under Sec.

75.5 so that such compensation arrangements are designed not to

reward or incentivize prohibited proprietary trading and

appropriately balance risk and financial results in a manner that

does not encourage employees to expose the banking entity to

excessive or imprudent risk.

3. Business line managers. Managers with responsibility for one

or more trading desks of the banking entity are accountable for the

effective implementation and enforcement of the compliance program

with respect to the applicable trading desk(s).

4. Board of directors, or similar corporate body, and senior

management. The board of directors, or similar corporate body, and

senior management are responsible for setting and communicating an

appropriate culture of compliance with section 13 of the BHC Act and

this part and ensuring that appropriate policies regarding the

management of trading activities and covered fund activities or

investments are adopted to comply with section 13 of the BHC Act and

this part. The board of directors or similar corporate body (such as

a designated committee of the board or an equivalent governance

body) must ensure that senior management is fully capable,

qualified, and properly motivated to manage compliance with this

part in light of the organization's business activities and the

expectations of the board of directors. The board of directors or

similar corporate body must also ensure that senior management has

established appropriate incentives and adequate resources 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 banking

entity.

5. Senior management. Senior management is responsible for

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. Senior management and control personnel

charged with overseeing compliance with section 13 of the BHC Act

and this part should review the compliance program for the banking

entity periodically and 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 banking entity's trading activities

and covered fund activities or investments, which shall be at least

annually.

6. CEO attestation. Based on a review by the CEO of the banking

entity, the CEO of the banking entity must, annually, attest in

writing to the Commission that the banking entity has in place

processes to establish, maintain, enforce, review, test and modify

the compliance program established under this appendix and Sec.

75.20 in a manner reasonably designed to achieve compliance with

section 13 of the BHC Act and this part. In the case of a U.S.

branch or agency of a foreign banking entity, the attestation may be

provided for the entire U.S. operations of the foreign banking

entity by the senior management officer of the United States

operations of the foreign banking entity who is located in the

United States.

IV. Independent Testing

a. Independent testing must occur with a frequency appropriate

to the size, scope, and risk profile of the banking entity's trading

and covered fund activities or investments, which shall be at least

annually. This independent testing must include an evaluation of:

1. The overall adequacy and effectiveness of the banking

entity's compliance program, including an analysis of the extent to

which the program contains all the required elements of this

appendix;

2. The effectiveness of the 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

3. The effectiveness of the banking entity's management

procedures.

b. A banking entity must ensure that independent testing

regarding the effectiveness of the banking entity's compliance

program is conducted by a qualified independent party, such as the

banking entity's internal audit department, compliance personnel or

risk managers independent of the organizational unit being tested,

outside auditors, consultants, or other qualified independent

parties. A banking entity must promptly take appropriate action to

remedy any significant deficiencies or material weaknesses in its

compliance program and to terminate any violations of section 13 of

the BHC Act or this part.

V. Training

Banking entities must provide adequate training to personnel and

managers of the banking entity engaged in activities or investments

governed by section 13 of the BHC Act or this part, as well as other

appropriate supervisory, risk, independent testing, and audit

personnel, 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 banking entity's

trading activities and covered fund activities or investments.

VI. Recordkeeping

Banking entities must create and retain records sufficient to

demonstrate compliance and support the operations and effectiveness

of the compliance program. A banking entity must retain these

records for a period that is no less than 5 years or such longer

period as required by the Commission in a form that allows it to

promptly produce such records to the Commission on request.

Issued in Washington, DC, on December 30, 2013, by the

Commission.

Melissa D. Jurgens,

Secretary of the Commission.

Note: The following appendices will not appear in the Code of

Federal Regulations.

[[Page 6073]]

Appendices to Prohibitions and Restrictions on Proprietary Trading and

Certain Interests in, and Relationships With, Hedge Funds and Private

Equity Funds--Commission Voting Summary and Statements of Commissioners

Appendix 1--Commission Voting Summary

On this matter, Chairman Gensler and Commissioners Chilton and

Wetjen voted in the affirmative. Commissioner O'Malia voted in the

negative.

Appendix 2--Statement of Chairman Gary Gensler

I support the final ``Volcker Rule'' before the Commission

today. It achieves the important balance, as directed by Congress,

of prohibiting banking entities from proprietary trading while at

the same time allowing banking entities to engage in permitted

activities, including market making and risk mitigating hedging.

Further, as directed by the Dodd-Frank Wall Street Reform and

Consumer Protection Act (Dodd-Frank Act), the final rule strikes an

appropriate balance regarding banking entities investment in hedge

funds and private equity funds. As Congress directed--other than for

de minimis investments--banking entities are prohibited from

sponsoring, owning, and having certain relationships with hedge

funds or private equity funds. The final rule focuses the

prohibition on entities formed for investing or trading in

securities or derivatives and that are typically offered to

institutional investors and high-net-worth individuals. The final

definition was tailored to exclude entities that are offered more

broadly to retail investors or have a more general corporate

purpose, such as loan securitizations.

The Commodity Futures Trading Commission (CFTC) consulted and

coordinated with the Federal Reserve, the Federal Deposit Insurance

Corporation, the Comptroller of the Currency and the Securities and

Exchange Commission in developing this rule. Based on this

collaboration, the CFTC's final rule mirrors the language being

adopted by the other financial regulators.

The CFTC authority to implement the Volcker Rule is for the

banking entities for which we are the primary financial regulatory

agency. As of today, the CFTC estimates that our authority primarily

applies to approximately 110 registered swap dealers and futures

commission merchants (FCMs) that would each individually be banking

entities under the Volcker Rule. Grouped by corporate affiliation

these represent about 45 different business enterprises.

As a foundation, the final Volcker Rule requires banking

entities to have a robust compliance program, including defined

limits on market making, underwriting and hedging activities as well

as continuous monitoring and management of such activities. It also

requires reporting to regulators on specific metrics and trading

details. This transparency will enhance the CFTC's ability to

oversee swap dealers and FCMs.

Banking entities' customers and counterparties will continue to

be provided liquidity through the banking entities' permitted market

making. The banking entities are permitted to do so as long as each

trading desk's market-maker inventory is designed not to exceed, on

an ongoing basis, the reasonably expected near-term demands of

clients, customers or counterparties. The banking entities will be

required to maintain an ongoing compliance program and follow the

rule's limits on market-maker inventory and financial exposure. For

instance, banking entities would not be able to stockpile or

accumulate positions over time that do not meet expected near-term

customer demand.

The final Volcker Rule also permits hedging to reduce

identified, specific risks from the banking entity's individual or

aggregated positions. Permitted hedging activity will be required to

(1) be designed to and (2) demonstrably reduce or otherwise

significantly mitigate one or more specific, identifiable risks. The

final rule's preamble further states that this activity is not

intended to be hedging of generalized risks based on non-position

specific modeling or other considerations. Hedging of the general

assets and liabilities of the banking entity or a guess as to the

direction of the economy will no longer be permitted.

Hedging strategies and positions are subject to analysis,

including required correlation analysis, as well as an ongoing

recalibration requirement to ensure it is not prohibited proprietary

trading.

The Commission also has the legal authority to enforce the

Volcker Rule. If the Commission believes there is a violation, Dodd-

Frank Section 619 and the final rule state that it can, after

providing an opportunity to respond, order the registrant to stop

that activity. The Commission also can use existing authority to

discipline registrants, including FCMs, swap dealers, and others.

The CEA and Commission rules provide that we may restrict, suspend

or revoke a registration for good cause. Depending on the facts and

circumstances, violation of Dodd-Frank Section 619 may rise to that

level.

The talented CFTC staff working along with my fellow

Commissioners--Mike Dunn, Jill Sommers, Bart Chilton, Scott O'Malia

and Mark Wetjen--really have delivered for the American public.

With this action, the staff of this small but remarkably

effective agency will have completed 68 rulemakings, orders and

guidances. Though lacking adequate resources, the CFTC staff has

diligently sorted through nearly 60,000 public comment letters. They

have met with members of the public more than 2,200 times to discuss

reform.

These common-sense reforms have been truly transformative.

Bright lights of transparency now are shining on the $380

trillion swaps market. The public can see the price and volume of

every transaction, like a modern-day tickertape. Transparent,

regulated trading platforms are trading a quarter of a trillion

dollars in swaps each day.

A majority of the swaps market is now being centrally cleared--

lowering risk and bringing access to anyone wishing to compete.

Ninety-one swap dealers have registered and--for the first

time--are being overseen for their swaps activity.

I couldn't be more proud of this dedicated group of public

servants.

I am honored to have served along with them during such a

remarkable time in the history of this agency.

Appendix 3--Statement of Commissioner Bart Chilton

High Roller's Room

I'm pleased to be voting on a final Volcker Rule. Frankly, two-

and-a-half weeks ago, I had grave doubts about getting this done in

a meaningful fashion. It had become weaker than the original

proposal. But, thankfully, and I thank the Chairman for his tireless

efforts, we have a rigorous and robust rule before us.

If you've ever been to a casino, many of them have a high

roller's room. There's usually a sign about a $1000 minimum bet.

Many have ornate gaming tables and heavy draperies. If you walk

around, you can catch a glimpse inside. But other than betting a lot

of money, I'm not sure what goes on in there. And, that's fine . . .

some high rollers lose and some win.

But, what if what the high rollers did in that room impacted all

of us? What if it impacted consumers, our economy and our country?

What if what the high rollers did in that room cost us $417 billion

dollars (in a big bank bailout) because the games they were playing

were tanking the economy?

That's why we need a strong Volcker Rule. We should never again

be put in a circumstance where too big to fail high rollers play

games of chance with our nation. This rule takes a heavy velvet rope

with brass ends across the doorway and closes the high roller's

room. (Maybe they'll put in more Blazing 7s or Wheel of Fortunes.)

The dilemma in drafting the final rule has been that there are

certain permitted forms of trading that have been difficult to

define. Fortunately, the language has been solidified tightly to

avoid loopholes.

First, the key parts of the law, and what I have focused on for

a very long time, are the words surrounding hedging. Proprietary

hedging is allowed under the law, but speculative trading--risky

gambles for the house--are exactly what Volcker sought to end. This

rule does that by requiring hedges be designed to mitigate and

reduce actual risk, and not just by an accidental or collateral

effect of the trade. We also have better correlation language in the

rule, correlation that shows that the hedging ``activity

demonstrably reduces or otherwise significantly mitigates the

specific, identifiable risk(s) being hedged.'' This is key--the risk

has to be specific and identifiable. You can't just say, ``Ah, oh,

that? Hmm, it was a hedge.'' Nope, we aren't going to let ya play

that game. The position needs to be correlated with the risk.

Furthermore, there is now an ongoing requirement to recalibrate

the position, the

[[Page 6074]]

hedge, in order to ensure that the position remains a hedge and does

not become speculative. When people say this version of the Volcker

Rule will stop circumstances like the London Whale, this ongoing

recalibration provision is exactly what will help avoid similar

debacles.

Second, the same goes for market making. Yes, market making is

allowed, but only for the benefit of the banks' customers--for their

customers and not solely in order to collect market maker fees

provided by the exchange or for any proprietary speculative reason.

Full stop.

Third, on portfolio hedging: One of the changes that has been

made is that we have defined what a portfolio is NOT--it can't be

some amorphous set of excuses for doing a trade. You can't call

deuces and one-eyed jacks wild after the hand has been dealt. You

can't do an after-the-fact extract of a set of trades as a rationale

for a hedge.

Fourth, I've spoken many times about perverse bonus structures

that reward the macho macho men traders. The idea, and it is

contained in actual rule text language, is that big bonuses and

rewards in banking should not be tied to flyer bets. Our first

proposal was fairly poorly drafted on this. It didn't differentiate

between prohibited proprietary trading and permitted proprietary

trading very well. My view of the language that compensation should

be ``designed'' not to reward or incentivize prohibited trading is

that this is a sufficiently narrow test. One of the ways we will

determine if something is designed in this way is how, in fact,

traders are paid. So we will look after-the-fact at the payouts.

Finally, the Volcker Rule won't be implemented until July of

2015. That's ages in these morphing markets where new games seem to

be played all the time. I guarantee there will be efforts to find

loopholes, figure out ways around what has been written. That's the

way of the world. So, my final thought is that this rule must not be

static. Regulators need to continue to monitor what is taking place.

We need our regulatory eyes in the sky, but also to look around the

corner for what's coming next, and be nimble and quick, to ensure

that what we do today holds up and that the high roller's room isn't

re-opened.

While this may be the end of part of the rulemaking process, it

is, and must be, the beginning of a process, that continues.

Thank you.

Appendix 4--Dissenting Statement of Commissioner Scott D. O'Malia

I respectfully dissent from today's Commission vote on the final

rule implementing Sec. 619 of the Dodd-Frank Act,\1\ commonly known

as the ``Volcker Rule.'' I cannot support a rulemaking that

undermines the regulatory process, nor clearly delineates the

Commission's new jurisdiction and enforcement authority under Sec.

13 of the Bank Holding Company Act of 1956 (``BHC Act'') \2\ and

fails to include procedures that afford due process to market

participants.

---------------------------------------------------------------------------

\1\ Dodd-Frank Wall Street Reform and Consumer Protection Act,

Public Law 111-203, 124 Stat. 1376 (2010).

\2\ 12 U.S.C. 1851.

---------------------------------------------------------------------------

Former Supreme Court Justice Louis D. Brandeis, who earlier in

his career was instrumental in establishing the Federal Reserve

System, stated: ``If we desire respect for the law, we must first

make the law respectable.'' But respect--and integrity of process--

is what has been most lacking in the Commission's approach to

rulemaking.

I believe the Commission must get back to the basics of good

government and proper rulemaking. I cannot vote for a final rule

that is hardly the product of meaningful consideration by the full

Commission, but instead was negotiated exclusively by the Chairman.

In addition, I cannot vote for a final rule where the Commission has

not devoted enough attention to providing sufficient clarity and due

process in the enforcement of new and untested regulatory authority,

but still imposes significant obligations upon market participants

at an unknown--but surely considerable--cost.

Abuse of Process

Throughout the Commission's rulemakings under the Dodd-Frank

Act, I have urged the Commission to act faithfully in accordance

with the applicable statutory authorities and the Administrative

Procedure Act (``APA'').\3\ However, in the implementation of one of

the most important mandates issued by Congress in response to the

financial crisis, the Commission seems to have forgotten the basics

of agency rulemaking. I am deeply troubled by the egregious abuse of

process in this rulemaking. Without a doubt, it far surpasses all

other previous transgressions to date.

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\3\ 5 U.S.C. 500 et seq.

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The first opportunity each Commissioner had to review a partial

draft of the nearly 1,000-page final rule came only three weeks

prior to today's vote. Further, because the Commission was operating

in an information vacuum, the fact that the Commissioners were not

reviewing the working interagency draft--but instead had the ``CFTC-

preferred'' version of the rule--only came to light a few days

later.\4\ The Commission did not receive a near-final draft of the

rule (with language agreed to by all five agencies) until just six

days prior to the vote, despite repeated requests by Commissioners

for a version of the draft then in circulation amongst the

responsible agencies. This six-day draft was not even accompanied by

the courtesy of a summary or term sheet in order to aid the

Commission in digesting, at the last minute, this incredibly complex

and dense final rule.

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\4\ Gina Chon, ``CFTC Goes Its Own Way Over Volcker Rule,'' Fin.

Times, November 23, 2013.

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I am disappointed that today's vote on the final rule is

besmirched by the purposeful circumvention of measured review by

each Commissioner's office. It is simply not possible to carefully

weigh a final rule--particularly one with as much detail and

consequence as the Volcker Rule--in the briefest of timeframes.

Accordingly, I am concerned that the lack of meaningful

participation by the full Commission in the rulemaking process has

therefore seriously impaired the ability of the Commission, as a

deliberative body, to engage in reasoned decision-making.

Congress established the CFTC as an independent agency led by a

Commission--not a director--to act as steward to the futures and

swaps markets. In doing so, Congress entrusted each of the

Commissioners to independently use his or her experience and

expertise to carefully review and deliberate upon all Commission

action, including rulemaking. Final rules should reflect the input

and collective opinion of the Commission as a whole, but today's

vote falls far short of that fundamental standard.

It is imperative that the Commission respect the letter and

spirit of the law and adhere faithfully to APA requirements in our

implementation of this new statutory authority granted by Congress

under the BHC Act. Unfortunately, the Commission's rulemaking over

the past three years has been aptly referred to as ``regulation by

fiat.'' \5\ We cannot continue down this path of reflexive, knee-

jerk regulation that fails to provide clarity and certainty to

market participants. The Commission must get back to the basics and

return to a thoughtful, measured approach to regulating our markets

in an open and transparent manner.

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\5\ See SIFMA, ISDA & IIB v. CFTC, No. 13-CV-1916 (D.D.C.).

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Jurisdiction and Enforcement Authority

I also believe that the basics of any rulemaking are

jurisdiction and enforcement. However, the final rule fails to

provide clear and consistent procedures for both (1) the

Commission's new enforcement authority under Sec. 13 of the BHC Act

and (2) due process for market participants.

As a threshold matter, the Volcker Rule may give us concurrent,

and potentially overlapping, jurisdiction as the ``primary financial

regulatory agency'' \6\ of a Commission registrant or registered

entity, so long as there is some type of corporate relationship with

a banking entity. It is essential that the Commission continue to

work with the other responsible agencies on implementation to

further outline the scope of each agency's jurisdiction, maximize

regulatory efficiency, and provide consistency for market

participants, with a minimum of duplicative and costly requirements

and wasted resources.\7\ The Commission must also be mindful of

foreign

[[Page 6075]]

regulators and seek harmonization in the extraterritorial

application of our jurisdiction, in accordance with principles of

international comity.

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\6\ Dodd-Frank Act Sec. 2(12).

\7\ Senators Carl Levin and Jeff Merkley, co-authors of Sec.

619 of the Dodd-Frank Act, emphasized the importance of enforcement

to the success of the Volcker Rule by urging the five responsible

agencies to ``provide coordinated and consistent enforcement,

including data sharing by regulators'' in their implementation of a

final rule. Letter from Hon. Jeff Merkley, Member, United States

Senate, and Hon. Carl Levin, Member, United States Senate, to Hon.

Ben Bernanke, Chairman, Board of Governors of the Federal Reserve

System, Hon. Thomas Curry, Comptroller of the Currency, Department

of the Treasury, Hon. Gary Gensler, Chairman, Commodity Futures

Trading Commission, Hon. Martin Gruenberg, Acting Chairman, Federal

Deposit Insurance Commission, and Hon. Mary Shapiro, Chairman,

Securities and Exchange Commission (Apr. 26, 2012) (on file with the

Commission).

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I am concerned that the Commission has not devoted enough

attention to delineating our enforcement authority and procedures

under the Volcker Rule, including the implications of not

promulgating the final rule under the Commodity Exchange Act

(``CEA'').\8\ This is important because the final rule is only being

promulgated under the BHC Act. Consequently, the Commission is

limited to only the enforcement measures provided for by Sec.

13(e)(2) of the BHC Act. By not also promulgating the final rule

under the CEA, the Commission cannot use its full suite of

enforcement tools under the CEA to ensure compliance with the

Volcker Rule.

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\8\ 7 U.S.C. 1 et seq.

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If the Commission wanted to use its enforcement powers under the

CEA, the final rule must be promulgated under the CEA and undergo

cost-benefit consideration pursuant to Sec. 15(a) of the CEA.\9\

But, by choosing to forgo any cost-benefit analysis and promulgate

the Volcker Rule solely under the BHC Act, the Commission has thus

limited its enforcement powers.

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\9\ 7 U.S.C. 19(a).

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To illustrate this point, it is critical to emphasize that the

Commission's authority under the Volcker Rule is not derived from

the CEA, which established the CFTC and its jurisdiction over the

futures and swaps market. Section 619 of the Dodd-Frank Act amends

the BHC Act, which is administered by the Federal Reserve Board. The

Volcker Rule is codified as Sec. 13 of the BHC Act and confers

limited enforcement authority to the Commission under Sec. 13(e)(2)

to order an affected party to ``terminate the [violative] activity''

and ``dispose of the investment.'' \10\

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\10\ Section 619 of the Dodd-Frank Act, paragraph (e)(2), which

is entitled Anti-evasion--Termination of Activities or Investment,

provides that ``Notwithstanding any other provision of law, whenever

an appropriate Federal banking agency, the Securities and Exchange

Commission, or the Commodity Futures Trading Commission, as

appropriate, has reasonable cause to believe that a banking entity

or nonbank financial company supervised by the Board under the

respective agency's jurisdiction has made an investment or engaged

in an activity in a manner that functions as an evasion of the

requirements of this section (including through an abuse of any

permitted activity) or otherwise violates the restrictions under

this section, the appropriate Federal banking agency, the Securities

and Exchange Commission, or the Commodity Futures Trading

Commission, as appropriate, shall order, after due notice and

opportunity for hearing, the banking entity or nonbank financial

company supervised by the Board to terminate the activity and, as

relevant, dispose of the investment. Nothing in this paragraph shall

be construed to limit the inherent authority of any Federal agency

or State regulatory authority to further restrict any investments or

activities under otherwise applicable provisions of law.''

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First, although the statutory text of Sec. 13(e)(2) suggests

that the Commission may, essentially, issue a cease and desist order

to a banking entity engaging in violative activity, the Commission

has not promulgated any provisions in the final rule that would

define and delineate such an order.

The issue of enforcement action is not a problem for the banking

agencies, who have broad supervisory powers over the safety and

soundness of banking entities, and considerable enforcement powers

under Sec. 8 of the BHC Act, or Sec. Sec. 8 or 39 of the Federal

Deposit Insurance Act \11\ (as described in the preamble to the

final rule). Those powers are conferred to the banking agencies as

prudential regulators. The Commission, however, is not a prudential

regulator of its registrants or registered entities and does not

have the same powers as the banking agencies.

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\11\ See, e.g., 12 U.S.C. 1818(i).

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Second, I have serious concerns that by not including specific

procedures in the final rule for an enforcement action taken by the

Commission pursuant to Sec. 13(e)(2), the Commission is not

affording due process to any party that might be the subject of a

future enforcement action. The statutory text in Sec. 13(e)(2)

explicitly states that ``due notice and opportunity for hearing''

must be provided. But, the final rule does not contain any

procedures for notice or hearing, and in fact does not even mention

that statutory requirement.

Third, I am also concerned that the Commission may nevertheless

try to read its enforcement powers under the CEA into its limited

enforcement authority under the BHC Act. The final rule, in new

Sec. 75.21(b), states that ``the Commission may take any action

permitted by law to enforce compliance with section 13 of the BHC

Act and this part, including directing the banking entity to

restrict, limit, or terminate any or all activities under this part

and dispose of any investment.''

That provision, without being promulgated under the CEA and

undergoing cost-benefit consideration, cannot permit the use of

enforcement powers provided for in the CEA. The enforcement powers

the Commission has under the CEA explicitly only apply to violations

of ``this Act'' (the CEA), including ``any rule, regulation, or

order of the Commission promulgated in accordance with . . . this

Act'' (emphasis added).\12\

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\12\ 7 U.S.C. 9(c)(4)(A).

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Although it would be possible for the Commission to exercise its

power over registration of a Commission registrant or registered

entity as a matter of right, it is unclear to me whether the

Commission has actually promulgated rules that permit the revocation

of registration for a swap dealer.

Section 4s of the CEA \13\ governs the registration and

regulation of swap dealers and major swap participants, but does not

explicitly address revocation of registration. Section 8a of the CEA

\14\ explicitly applies to the registration of an exclusive list of

Commission registrants (intermediaries), but does not include swap

dealers. Section 8a of the CEA authorizes the Commission to revoke

registration, but only in certain circumstances as described in, for

example, Sec. Sec. 8a(2)(A)-(H), 8a(3), and 8a(4).

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\13\ 7 U.S.C. 6s.

\14\ 7 U.S.C. 12a.

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Although some of those provisions may permit the revocation of

registration of a swap dealer, it is secondary to, for example,

either a finding by a court of law or another Federal or State

agency that a violation of the CEA occurred,\15\ or that the

principal of a swap dealer was statutorily disqualified from

registration,\16\ or that the swap dealer willfully aided or abetted

in the violation of the CEA by another person, or failed to

supervise a person that violated the CEA.\17\ Because these powers

over registration only apply where there has been a violation of the

CEA, I do not see how they can be applied to a violation of Sec. 13

of the BHC Act.

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\15\ 7 U.S.C. 8a(2)(E).

\16\ 7 U.S.C. 8a(2)(H).

\17\ 7 U.S.C. 8a(3).

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Commission regulation Sec. 3.60 \18\ provides procedures for

revocation of registration, but only pursuant to Sec. Sec. 8a(2),

8a(3), and 8a(4), which do not directly apply to swap dealers as

just discussed.

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\18\ 17 CFR 3.60.

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I am concerned that, because there does not appear to be any

Commission regulation that permits the revocation of registration

for a swap dealer, and because Sec. 75.21 of the final rule does

not include any procedures for an enforcement action taken by the

Commission pursuant to Sec. 13(e)(2) of the BHC Act, the Commission

would not able to effectively enforce the Volcker Rule. Further, the

Commission's enforcement powers under the CEA are not available to

enforce the Volcker Rule because the final rule was not promulgated

under the CEA. I also reiterate that I am deeply troubled by the

omission of procedures to afford due process to market participants.

Conclusion

As the Commission moves towards finalizing the last of the rules

mandated by the Dodd-Frank Act, I believe it's about time that it

got back to the basics of good government and proper rulemaking. The

final rule does neither because of the abuse of process in its

rulemaking and the lack of due process and clarity in its

enforcement procedures. Because of these fundamental flaws in the

final rule, I cannot support it.

[FR Doc. 2013-31476 Filed 1-30-14; 8:45 am]

BILLING CODE 6351-01-P

Last Updated: January 31, 2014