The Volcker rule was adopted on Tuesday, December 10, 2013 by five regulatory agencies including the Securities and Exchange Commission (the “SEC”). The original proposal was drafted in 2010 and received more that 19,000 comment letters from industry participants. The final rule was adopted by the SEC with a narrow 3 to 2 vote. It is interesting to read the strong dissenting opinions by Commissioners Gallagher and Piwowar who thought that the rule was so substantially different than the proposal that it should have been re-submitted for comment and not presented to the SEC for adoption in the rushed manner that it was presented at year-end. Commissioner Gallagher mentioned that the SEC received the final draft on December 5 which left little time for careful consideration.
The Volcker Rule prohibits banking entities from:
- engaging in short-term proprietary trading of securities, derivatives, commodity futures and options on these instruments for their own account.
- owning more than 3% of, or investing more than 3% of their equity in, hedge funds or private equity funds, referred to as ‘covered funds’. Sponsoring and investing in private funds is considered risky.
What is of relevance to fund managers is that banking entities are allowed to invest in or sponsor a covered fund in connection with organizing and offering that fund to investors. “Covered funds” include all 3(c)(1) or 3(c)(7) funds but exclude certain foreign funds publicly offered abroad, insurance company accounts, certain corporate vehicles and commodity pools as well as loan securitizations.
Regarding the ban on proprietary trading, the rule allows exceptions for, among others, underwriting, hedging, trading in government securities and, most importantly, market-making. It should be noted, however, that Commissioner Gallagher believes that the final rule will undermine essential market-making activities. In Commissioner Gallagher’s words “pure prop trading by banking entities has almost completely disappeared, and what remains is to define and regulate the grey area activities that may or may not constitute prop trading – activities which encompass, crucially, virtually the entire field of market-making. What we face, therefore, is the prospect of banning the market-making practices so central to our capital markets in order to make sure we capture every last activity that could potentially be characterized as prop trading”. It remains to be seen if his fears will prove correct.
The final rule becomes effective April 1, 2014, but banks have until July 21, 2015 to prepare.
We will write more about the rule in subsequent communiques. In the meantime, the text of the rule can be found here and the dissenting opinions of commissioners Gallagher and Piwowar can be found here and here.