What Is the Volcker Rule?
The Volcker Rule prohibits large banks from engaging in risky trading and owning interests in covered funds. Certain trading activities are exempt, and some banks were granted extensions to liquidate holdings in covered funds.
Basics
The Volcker rule, found in Section 619 of the Dodd-Frank Act, imposes restrictions on large institutional banks. It aims to prevent these banks from participating in two main activities: proprietary trading and owning interests in covered funds, such as hedge funds and private equity funds. The rule's purpose is to safeguard against risky trading by banks that receive federal and taxpayer support through deposit insurance and other means. It is named after Paul Volcker, a former chair of the Federal Reserve Board.
Volcker Rule & Proprietary Trading
The Volcker rule strictly prohibits banks from engaging in proprietary trading activities, which involve a bank buying or selling a financial instrument as a principal. The rule defines a trading account using three criteria: a purpose test, the market risk capital rule test, and the status test. If a bank holds a position for 60 days, it is presumed to be for the trading account.
Certain trading activities are exempt from this prohibition, including clearing activities, liquidity management, market making, hedging, trades to meet delivery obligations, and trades through a profit-sharing or pension plan of the bank. However, these exempted trading activities must comply with rigorous requirements, which include implementing internal controls and maintaining extensive documentation.
Restrictions Imposed by the Volcker Rule
The Volcker rule enforces two main restrictions on banks. Firstly, it prohibits banks from engaging in proprietary trading, which involves a bank buying or selling a financial instrument as a principal. The rule defines a trading account using three criteria, and if a bank holds a position for 60 days, it is presumed to be for the trading account.
Secondly, the rule restricts banks from having an ownership interest in covered funds, which are defined based on exemptions from the Investment Company Act of 1940, commodity pools resembling hedge funds or private equity funds, and foreign covered funds. Despite these prohibitions, certain exceptions exist for foreign public funds, wholly owned subsidiaries, and joint ventures.
Deadline Extension for Covered Funds Liquidation
Initially, banks were required to liquidate their holdings in covered funds by July 2015. However, in December 2014, the Federal Reserve Board granted extensions to some banks, allowing them to exit these positions until 2017, and in certain cases, until 2022. The banks presented their case, stating that a significant portion of their holdings comprised illiquid investments, and selling them quickly would result in substantial losses. They also argued that liquidating their ownership interests in hedge funds and private equity funds could jeopardize the substantial value of those investments.
Conclusion
The Volcker Rule, part of the Dodd-Frank Act, aims to prevent large institutional banks from engaging in risky trading activities and owning interests in covered funds such as hedge funds and private equity funds. It enforces restrictions on proprietary trading, ownership interest, and liquidation of holdings in covered funds. Despite certain exemptions, the rule requires rigorous compliance with internal controls and documentation.