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Grappling with the Volcker Rule

March 18, 2015 Presented By

Julian Hammar Daniel Nathan

James Schwartz

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Timeline • Today is March 18, 2015 • Conformance is required by July 21, 2015 (with

exceptions) • Today we will discuss:

• where you should be by now • what you still have to do

• We will not summarize the entire rule today – will just focus on some key touch points

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To Start • Are you covered by the Volcker Rule? • Are you a banking entity or an affiliate? • Have you identified all business operations that could be

covered by the Volcker Rule? • Are you subject to Metrics Reporting under Appendix A?

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Trading Desks • Have you inventoried all trading desks? • Have you determined whether the current configuration of

trading desks makes sense from a compliance standpoint?

• Best application of exclusions and exemptions • Best marrying of trading activities with hedging • Challenge – determining the ideal configuration

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Trading Desks • Note: Office of the Comptroller of the Currency (OCC) Volcker Rule

Interim Examination Procedures (discussed below) state that: • Some banks may combine previously delineated trading desks

into a single trading desk, and this may be acceptable provided the desks have similar strategies, the combination has a legitimate business purpose, and the combination allows the bank to more accurately reflect the positions and fluctuations of its proprietary trading; but

• Multiple units with disparate strategies being combined into a single desk could suggest a bank’s attempt to dilute the ability of the metrics to monitor proprietary trading. Relevant factors for identifying trading desks include whether the trading desk is managed and operated as an individual unit and whether the profit and loss of employees engaged in a particular activity is attributed at that level.

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Proprietary Trading • Have you determined whether trading is for a trading

account? • Challenge – does a foreign dealer, swap dealer or

security-based swap dealer satisfy the trading account definition?

• Challenge – how to determine if derivatives trade is “short-term”?

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Funds • Have you inventoried all funds? • Have you determined whether you have any non-legacy

funds subject to the conformance date? • Do you have any foreign funds that are excluded from the

funds definition? • Challenge – such foreign funds might constitute banking

entities, subject to Volcker Rule prohibitions.

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Compliance Program • Have you determined at what levels of the banking entity

the compliance program will operate? • If the banking entity is not subject to the enhanced

program requirements, have you determined what elements of Appendix B should nevertheless be applied?

• Have you considered prudential backstops?

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Adopting a Compliance Program • Big question now being considered in many banks: what

are the mechanics of adopting and implementing a Volcker Compliance Program?

• The regulators considered, but rejected, requiring a detailed policy to be adopted at the enterprise level.

• They ultimately stated that a banking entity could, but would not be required to, establish a compliance program on an enterprise-wide basis, so long as the program satisfied applicable requirements.

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Adopting a Compliance Program • Most banks seem to be leaning toward a layered

approach: • Relatively thin top-level policy • Thicker policy at the business platform level • At the bottom, policies and procedures for specific

business units or trading desks • For those banks that are subject to enhanced standards

for compliance programs, the compliance program must be approved by the board of directors or an appropriate committee of the board (or equivalent governance body) and senior management.

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Adopting a Compliance Program • At top enterprise-wide level, banks seem to be leaning toward a

relatively thin policy that speaks to most requirements in general terms.

• But certain matters requiring a significant level of detail seem well suited for enterprise-wide policy:

• Example: Volcker governance requirements, which must “clearly delineate[] responsibility and accountability for compliance… and include[] appropriate management review of trading limits, strategies, hedging activities, investments, incentive compensation and other matters identified in this part…”

• The requirement to keep records sufficient to demonstrate compliance with the Volcker Rule also seems to invite an enterprise-wide policy.

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Adopting a Compliance Program • A bank 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 are incorporated in the compliance program and effectively administered.

• Similarly, to the extent that any of the applicable standards may be appropriately met by policies and procedures that are common to more than one trading desk, a bank may satisfy the requirements by implementing such common requirements with respect to any such desks.

• 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 bank must document the differences and adopt policies and procedures and implement internal controls specific to each of the different trading desks.

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Additional Compliance Considerations

• Some advisors have been recommending that banks, in addition to drafting and adopting applicable policies and procedures, also assemble a detailed list of the steps that they have taken to achieve compliance.

• This is not required by the Volcker Rule itself, but would be helpful to present to regulators if necessary.

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Additional Compliance Considerations

• How will regulators review compliance? • Not much to go on, so far. • In June of last year the OCC issued Volcker Rule Interim Examination

Procedures (OCC Procedures). • These provide some guidance regarding what regulators might

look for in reviewing Volcker compliance plans

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OCC Volcker Rule Interim Examination Procedures

• The stated purpose of the OCC Procedures is “to help examiners determine whether banks have business activities or investments that are subject to the regulations and, if so, to guide examiners in assessing plans that banks have developed and are implementing to comply with the regulations.”

• The OCC Procedures do not appear to contain many surprises, but they do set out nicely the considerations that banks should be thinking about as they assemble their compliance programs.

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OCC Volcker Rule Interim Examination Procedures

• The OCC Procedures generally include, for each general item for examination, the general matter to be assessed, and its objective, and then the specific matters to be assessed to achieve such objective.

• For example, under the general heading of proprietary trading, the OCC Procedures state objectives including (among numerous others):

“Assess the bank’s progress toward establishing a compliance program for its risk-mitigating hedging activity and satisfying the regulations’ documentation requirements.”

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OCC Volcker Rule Interim Examination Procedures

• Sub-assessments under this general assessment include assessments of the banks’ progress toward developing:

• Written policies and procedures regarding the positions, techniques, and strategies that it may use for risk-mitigating hedging;

• Procedures and controls to continuously review, monitor, and manage risk-mitigating hedging activity to ensure that the bank meets the requirements of the risk-mitigating hedging exemption;

• Policies and procedures for satisfying applicable documentation requirements; and

• Systems and processes to create and retain the hedging documentation for at least five years and in a manner that allows the bank to produce promptly those records to the OCC.

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Hedging Issues • As it becomes phased in, the Volcker Rule seems destined to change

hedging practices at many banks. • Specifically, a risk-mitigating hedging activity must reduce or otherwise

significantly mitigate one or more specific, identifiable risks arising in connection with and related to identified positions, contracts, or other holdings of the banking entity.

• In addition, a risk-mitigating hedge must not give rise, at its inception, to any significant new or additional risk that is not itself hedged contemporaneously, and must relate to specific positions and not risks associated with assets or liabilities of the banking entity generally or risks associated with general market movements or broad economic conditions.

• Together, these requirements appear to mean that, for banks, the day of the “dirty hedge” or “macro hedge” is over, and banks will not be able use hedges to take any independent positions or to mitigate general macro risks.

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• Regardless of the liquidity, maturity, and depth of the market for a particular type of financial instrument, to satisfy the Rule’s definition of market-making activity, a trading desk should be able to show a pattern of providing (i) price indications on either side of the market and (ii) a pattern of trading with customers on each side of the market.

• In particular, with respect to relatively illiquid instruments, the trading desk would need to be able to show 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. It would not be sufficient to show that a trading desk on occasion provides a price quote in response to a customer request. For swaps and derivatives, the trading desk should stand ready to enter into a transaction at the request or demand of a counterparty “more frequently than occasionally.”

• The Agencies recognize that in some markets, such as the corporate bond market, a market-maker might regularly quote some instruments, but might 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 provides a price for those instruments upon request.

Market Making Issues

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Liquidity Management • Purchases or sales of a security for liquidity management purposes

are excluded from the Volcker prohibition if they are undertaken pursuant to a documented liquidity management plan that meets certain requirements.

• The liquidity management plan exclusion covers securities but not derivatives, such as interest rate and FX swaps.

• Review your currently liquidity management plan for Volcker Rule compliance:

• Plan must specifically authorize particular securities, describe the amount, types, and risk of securities that are consistent with liquidity management and the liquidity circumstances in which they may be used

• Should conform with requirements under the Liquidity Coverage Ratio Rule for High Quality Liquid Assets

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Questions? Daniel Nathan (202) 887-1687 dnathan@mofo.com James Schwartz (212) 336-4327 jschwartz@mofo.com Julian Hammar (202) 887-1679 jhammar@mofo.com

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• Because of the generality of this presentation, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.