Busy Day in Washington Leads to Raft of Rule Changes

On Thursday, June 25, five federal regulatory agencies finalised a rule modifying the Volcker rule’s prohibition on banking entities investing in or sponsoring hedge funds or private equity funds – known as covered funds. The rule takes effect on October 1.

The agencies included the Federal Reserve Board, the Commodity Futures Trading Commission (CFTC), the Securities and Exchange Commission (SEC), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC).

The Volcker rule generally prohibits banking entities from engaging in proprietary trading and from acquiring or retaining ownership interests in, sponsoring, or having certain relationships with a hedge fund or private equity fund.

Like the proposed rule from January, the final rule modifies three areas of the Volcker rule by: streamlining the covered funds portion of the rule; addressing the extraterritorial treatment of certain foreign funds; and permitting banking entities to offer financial services and engage in other activities that don’t raise concerns that the Volcker rule was intended to address.

Commenting on that last area of changes, Randal Quarles, FRB’s vice chair for supervision, noted that “today’s final rule simply allows banking entities to engage in already permitted activities, such as venture capital investment, through a fund structure”.

“While these activities are appropriate generally, ensuring the ability of the financial sector to support the real economy through the broadest means possible under the law is particularly important today,” Quarles said, “And to mitigate any risks present with activity through a fund, the final rule does not allow banking entities to engage in proprietary trading through a fund structure, restricts a banking entity from bailing out the funds it sponsors, limits conflicts of interest between the banking entity and fund, and of course, the activity remains subject to robust capital charges even if it is conducted through a fund structure.”

Adding his support, CFTC chair Heath Tarbert, said: “As I have previously remarked, the Volcker Rule is ‘among the most well-intentioned but poorly designed regulations in the history of American finance’. While today’s final rule does not fix the fundamental flaws of the Volcker Rule – only congressional action can do that – it at least represents a more accurate reading of the law Congress actually passed and brings us a step closer to a reasonable implementation of the rule.”

Specifically, notes Tarbert, the Volcker Rule will no longer be applied to investments that he says “Congress never intended to be included in the first place”, such as credit funds, venture capital funds, customer facilitation vehicles, and family wealth management vehicles.

The final rule also contains what Tarbert deems as important modifications to several existing exclusions from the prohibition on activities related to private equity and hedge funds (the “covered funds” provisions) – for foreign public funds, loan securitisations, and small business investment companies. “In these ways, the final rule begins to address the over-breadth of the covered funds definition and related requirements,” Tarbert adds.

In a statement outlining her dissent, the Federal Reserve Board’s (FRB) governor, Lael Brainard, noted that with the Volcker rule, Congress put in place strong protections to limit banks’ exposure to speculative trading activity directly and indirectly through risky funds. Specifically, she added, the covered fund provisions of the Volcker rule restrict banking entities’ investment in risky, complex investment funds and limit how a banking entity can sponsor such funds as well as the transactions between a banking entity and the funds it sponsors.

“These protections serve an important purpose,” Brainard said. “They reduce risk-taking by banking entities and banks’ incentives to bail out funds in times of stress. They also constrain indirect proprietary trading. The covered fund provisions decrease risks to the large banks at the core of our financial system, to taxpayers, and to the federal safety net.

“I supported exempting community banks from the Volcker rule, and I support addressing the unintended application of the Volcker rule to certain funds organised outside of the United States and offered to foreign investors, known as foreign excluded funds. However, I am concerned key changes in the final rule weaken core protections in the Volcker rule and will permit banking entities to return to risky activities seen in the 2008 financial crisis,” she continued.

“Specifically, the final rule would open the door for firms to invest in a broad set of venture capital funds without limit. The test used to define venture capital funds imposes no size restrictions on the companies in which a venture capital fund may invest and permits 20% of a fund to be invested in any portfolio company. The test relies on a 2011 Securities and Exchange Commission definition of venture capital funds related to the Investment Advisers Act of 1940. This definition was rejected in the 2013 Volcker rule. Under the proposed definition, venture capital funds are indistinguishable from private equity funds. In the preamble to the 2013 rule, the agencies stated that the statutory language does not support excluding venture capital funds from the definition of covered fund, and there have been no changes to the statutory language that would provide a basis for excluding them now,” Brainard said.

“The final rule also would open the door for firms to invest without limit in credit funds. Some credit funds played a material role in the financial crisis. These funds were not transparent in their activities, misled investors, and contributed to the financial abuses Congress intended to address in the Dodd-Frank Act,” she added.

In conclusion, Brainard said: “Many of the changes that will be finalised today were considered and rejected in the 2013 rule. The rulemaking does not present compelling analysis that would warrant their reversal. When Congress amended the Volcker rule two years ago, it did not choose to make any of the changes reflected in the final rule. Congress chose not to add any new exclusions to the definition of covered fund or to expand any of the existing exclusions. Moreover, the covered fund provisions of the Volcker rule have been in place for seven years and the market has adapted well to them. During that time, US banks have been very profitable and have remained competitive with their foreign counterparts. For these reasons, I do not support the final rule.”

CFTC Rule Changes

Meanwhile, during an open commission meeting yesterday, the CFTC approved two final rules, withdrew a previously proposed rule and supplemental proposal, as well as advanced two proposed rules.

On a 4-1 vote, CFTC commissioners approved a proposal to amend Part 38 of CFTC regulations to address the risk of electronic trading causing a market disruption on a designated contract market’s (DCM) trading platform. The proposed regulations include three principles applicable to DCMs, and concern (i) the implementation of exchange rules applicable to market participants to prevent, detect and mitigate market disruptions and system anomalies associated with electronic trading; (ii) the implementation of exchange-based, pre-trade risk controls for all electronic orders; and (iii) the prompt notification of the Commission by DCMs of any significant disruptions to their electronic trading platforms.

On a 3-2 vote, the Commission approved the withdrawal of the Regulation Automated Trading Proposed Rule and Supplemental Proposed Rule and rejected certain policy approaches relating to the regulation of automated trading.

In a statement explaining his dissent against these changes, commissioner Rostin Behnam suggested the rule change may lead to confusion, stating “…when there is a technology failure – and there will be – will the Commission stand by its principles or will it fashion an enforcement action around a black swan event so that everyone walks away bruised, but not harmed?

“For market participants, this may be extremely confusing. What precisely are DCMs being asked to do, and what will they be asked to do in the future?  Frankly, I am not sure. But it could be more than they bargained for,” he said in a statement.

Additionally, the Commission unanimously approved a proposal to amend the margin requirements for uncleared swaps for swap dealers and major swap participants for which there is no prudential regulator (CFTC Margin Rule). The proposal would delay the compliance date for the initial margin requirements for smaller entities not covered by the May 28, 2020 interim final rule, which delayed certain entities’ compliance date of September 1, 2020, to September 1, 2021, in recognition of the challenges faced by the entities as a result of the COVID-19 (coronavirus) pandemic.

The proposal would delay the smaller entities’ compliance date of September 1, 2021, to September 1, 2022, to mitigate the potential for a market disruption that could result from a large number of entities that would come into the scope of compliance by September 1, 2021, under the revised compliance schedule.

Further, the Commission unanimously approved a final rule that adopts amendments that prohibit post-trade name give-up for swaps executed, pre-arranged, or pre-negotiated anonymously on or pursuant to the rules of a swap execution facility (SEF) and intended to be cleared. The final rule provides an exception for package transactions that include a component transaction that is not a swap intended to be cleared, including but not limited to US Treasury swap spreads.

This final rule is effective 60 days after publication in the Federal Register, however, to give SEFs time to modify their operations to comply with the new rule, the CFTC is implementing a phased compliance schedule based on the regulatory treatment of different swaps.

Finally, the Commission unanimously approved a final rule that adopts amendments to the inter-affiliate exemption conditions under CFTC regulation 50.52, which exempts certain affiliated entities within a corporate group from the swap clearing requirement under the applicable provision of the CEA. The amendments make permanent certain temporary alternative compliance frameworks intended to make an anti-evasionary condition workable for international corporate groups in the absence of foreign clearing regimes determined to be comparable to CFTC requirements. This final rule is effective 30 days after publication in the Federal Register.



Julie Ros

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