```

[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, eremmler@cftc.gov; Paul Schlichting, Assistant General 
Counsel, Office of the General Counsel (``OGC''), (202) 418-5884, 
pschlichting@cftc.gov; Mark Fajfar, Assistant General Counsel, OGC, 
(202) 418-6636, mfajfar@cftc.gov; Michael Barrett, Attorney-Advisor, 
DSIO, (202) 418-5598, mbarrett@cftc.gov; Stephen Kane, Research 
Economist, Office of the Chief Economist (``OCE''), (202) 418-5911, 
skane@cftc.gov; or Stephanie Lau, Research Economist, OCE, (202) 418-
5218, slau@cftc.gov; 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.
---------------------------------------------------------------------------

    \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/ucm/groups/public/@newsroom/documents/file/transcript053112.pdf.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).

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

[[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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \39\ See 77 FR 8332 (Feb 14, 2012).
    \40\ See, e.g., SIFMA (March Letter); Alfred Brock; Occupy the 
SEC.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

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

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

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

    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\
---------------------------------------------------------------------------

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

    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.
---------------------------------------------------------------------------

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

    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.
---------------------------------------------------------------------------

    \50\ See final rule Sec.  75.5.
    \51\ See final rule Sec.  75.5(c).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \57\ See final rule Sec.  75.7.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.

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

[[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.''
---------------------------------------------------------------------------

    \60\ See final rule Sec.  75.10(d)(6).
    \61\ See final rule Sec.  75.10(b)(6)(ii).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \62\ See 156 Cong. Rec. S5889 (daily ed. July 15, 2010) 
(statement of Sen. Hagan).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.

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

[[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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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).
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \295\ See proposed rule Sec.  75.4(a).
    \296\ See Joint Proposal, 76 FR at 68866; CFTC Proposal, 77 FR 
at 8352.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.

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

[[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).
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

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.''
---------------------------------------------------------------------------

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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \418\ See proposed rule Sec.  75.4(a)(2)(v); Joint Proposal, 76 
FR at 68867; CFTC Proposal, 77 FR at 8353.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \506\ 12 U.S.C. 1851(d)(1)(B).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \507\ See Joint Proposal, 76 FR at 68869; CFTC Proposal, 77 FR 
at 8354-8355.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \519\ See Wellington; Paul Volcker; Better Markets (Feb. 2012); 
Occupy.
    \520\ See Wellington.
    \521\ See Paul Volcker.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).

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

[[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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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)'').
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

     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.
---------------------------------------------------------------------------

    [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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    [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.
---------------------------------------------------------------------------

    [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.
---------------------------------------------------------------------------

     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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.

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

[[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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.

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

[[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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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).
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \899\ See final rule Sec.  75.4(b)(2)(iii)(B), (C).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \901\ See SIFMA (Asset Mgmt.) (Feb. 2012); T. Rowe Price; CIEBA; 
ICI (Feb. 2012) RBC.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.

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

[[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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    \978\ See final rule Sec.  75.4(b)(2)(iii)(E).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \979\ See ICI (Feb. 2012).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \988\ See BoA; SIFMA (Asset Mgmt.) (Feb. 2012).
    \989\ See Goldman (Prop. Trading).
    \990\ See BoA.
    \991\ See SIFMA (Asset Mgmt.) (Feb. 2012).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).

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

[[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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

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).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \1033\ See proposed rule Sec.  75.4(b)(2)(iv); Joint Proposal, 
76 FR at 68872; CFTC Proposal, 77 FR at 8357-8358.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \1201\ These aspects of the compliance program requirement are 
described in further detail in Part VI.C. of this SUPPLEMENTARY 
INFORMATION.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \1208\ See Sens. Merkley & Levin (Feb. 2012).
    \1209\ See Better Markets (Feb. 2012).
    \1210\ See Sens. Merkley & Levin (Feb. 2012); Occupy; Andrea 
Psoras.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.

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

[[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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.

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

[[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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \1506\ See proposed rule Sec.  75.6(d).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.'').
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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:
---------------------------------------------------------------------------

    \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.''
---------------------------------------------------------------------------

     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\
---------------------------------------------------------------------------

    \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:
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    [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).
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \1552\ See proposed rule Sec.  75.8(b)(1).
    \1553\ See Joint Proposal, 76 FR at 68893.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \1554\ See id.
    \1555\ See proposed rule Sec.  75.8(b)(1)(B).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.'').
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \1557\ See proposed rule Sec.  75.8(b)(2).
    \1558\ See Joint Proposal, 76 FR at 68894.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \1559\ See 12 U.S.C. 1851(g)(3).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \1560\ See Alfred Brock.
    \1561\ See Paul Volcker.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.

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

[[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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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)).
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).

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

[[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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \1899\ Commenters expressed concerns about the use of 
securitization vehicles for evasion. See, e.g., AFR et al. (Feb. 
2012); Occupy; Public Citizen.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \1900\ See Joint Proposal, 76 FR at 68912.
    \1901\ Id.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \1906\ See final rule Sec.  75.10(c)(8)(iv).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \1919\ The use of SUBIs, for example, allows the sponsor to 
avoid administrative expenses in retitling the physical property 
underlying the leases.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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.

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

[[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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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.

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

[[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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.

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

[[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).
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.

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

[[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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.

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

[[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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \2430\ See final rule Sec.  75.13(b)(4).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \2431\ See final rule Sec.  75.13(b)(5).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \2432\ See final rule Sec.  75.10(a)(2).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \2797\ See 12 U.S.C. 1851(e)(2).
    \2798\ Id.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \2826\ 76 FR at 68936.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \3\ 5 U.S.C. 500 et seq.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \4\ Gina Chon, ``CFTC Goes Its Own Way Over Volcker Rule,'' Fin. 
Times, November 23, 2013.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \5\ See SIFMA, ISDA & IIB v. CFTC, No. 13-CV-1916 (D.D.C.).
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \8\ 7 U.S.C. 1 et seq.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \9\ 7 U.S.C. 19(a).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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
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