STUDY & RECOMMENDATIONS ON PROHIBITIONS ON PROPRIETARY TRADING

& CERTAIN RELATIONSHIPS WITH HEDGE FUNDS & PRIVATE EQUITY FUNDS

FINANCIAL STABILITY OVERSIGHT COUNCIL

Completed pursuant to section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act

January 2011
TABLE OF CONTENTS

OVERVIEW OF STUDY AND RECOMMENDATIONS.......................................................................... 1

THE STATUTORY MANDATE AND OBJECTIVES OF THE STUDY .................................................... 8

PUBLIC OUTREACH AND COMMENTS.......................................................................................... 10

PROPRIETARY TRADING .............................................................................................................. 15

Introduction ............................................................................................................................... 15

Statutory Overview ................................................................................................................... 15

Implementation Considerations................................................................................................. 17

Principles for Implementation of the Volcker Rule .................................................................. 25

Delineation of Proprietary Trading and Certain Permitted Activities....................................... 27

Implementation of the Proprietary Trading Prohibition............................................................ 31

Overview.............................................................................................................................................................31

Programmatic Compliance Regime ....................................................................................................................33

Analysis and Reporting of Quantitative Metrics.................................................................................................36

Supervisory Review and Oversight.....................................................................................................................43

Enforcement Procedures for Violations..............................................................................................................45

Application to Other Related Activities..............................................................................................................46

Statutory Limitations on Permitted Activities........................................................................... 47

How the Volcker Rule Relates to Existing and Pending Regulation ........................................ 52

HEDGE FUND AND PRIVATE EQUITY FUND INVESTMENT RESTRICTIONS ................................. 56

Statutory Overview ................................................................................................................... 57

Principles for Implementation................................................................................................... 60

Implementation of Prohibited Activities................................................................................... 61

Implementation of Permitted Activities.................................................................................... 63

THE ACCOMMODATION OF THE BUSINESS OF INSURANCE......................................................... 71

ANNEX A....................................................................................................................................... 76
OVERVIEW OF STUDY AND RECOMMENDATIONS 1

OVERVIEW OF STUDY AND RECOMMENDATIONS

INTRODUCTION

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and 

Consumer Protection Act (the ―Dodd-Frank Act‖).1 The Dodd-Frank Act is intended to 

strengthen the financial system and constrain risk taking at banking entities. Section 619 of the 

Dodd-Frank Act, also known as the Volcker Rule, is a key component of this effort. The 

Volcker Rule prohibits banking entities, which benefit from federal insurance on customer 

deposits or access to the discount window, from engaging in proprietary trading and from 

investing in or sponsoring hedge funds and private equity funds, subject to certain exceptions.

2

The proprietary trading provisions prohibit a banking entity

3

from engaging in trading activity in 

which it acts as a principal in order to profit from near-term price movements. 4 The hedge fund 

and private equity fund provisions generally prohibit a banking entity from investing in, or 

having certain relationships with, any fund that is structured under exclusions commonly used by 

hedge funds and private equity funds under the Investment Company Act of 1940 (the 

―Investment Company Act‖).5

However, to ensure that the economy and consumers continue to benefit from robust and liquid 

capital markets and financial intermediation, the Volcker Rule provides for certain ―permitted 

activities‖ that represent core banking functions such as certain types of market making, asset 

management, underwriting, and transactions in government securities. These permitted activities 

– in particular, market making, hedging, underwriting, and other transactions on behalf of 

customers – often evidence outwardly similar characteristics to proprietary trading, even as they 

pursue different objectives, and it will be important for Agencies6to carefully weigh all 

 

1 Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010).

2

Section 619 amends the Bank Holding Company Act of 1956, 12 U.S.C. § 1841 et seq. (to be codified at 12 U.S.C. 

§ 1851), by adding at the end the following: 

―SEC. 13.PROHIBITIONS ON PROPRIETARY TRADING AND CERTAIN RELATIONSHIPS WITH HEDGE 

FUNDS AND PRIVATE EQUITY FUNDS.

(a) IN GENERAL.—

(1) PROHIBITION.—Unless otherwise provided in this section, a banking entity shall not—

(A) engage in proprietary trading; or 

(B) acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private 

equity fund . . .‖

3

12 U.S.C. § 1851(h)(1).

4

Id. at § 1851(a) and (h)(4).

5 The Investment Company Act of 1940, 15 U.S.C. § 80a-1 et seq.

6 The Office of the Comptroller of the Currency (the ―OCC‖), the Federal Deposit Insurance Corporation (the 

―FDIC‖), the Board of Governors of the Federal Reserve System (the ―Board‖), the Securities and Exchange 

Commission (the ―SEC‖) and the Commodity Futures Trading Commission (the ―CFTC‖) (collectively, 

―Agencies‖).
OVERVIEW OF STUDY AND RECOMMENDATIONS 2

characteristics of permitted and prohibited activities as they design the Volcker Rule

implementation framework. 

These permitted activities are subject to a prudential ―backstop‖ that prohibits such activity if it 

would result in a material conflict of interest, material exposure to high-risk assets or high-risk 

trading strategies, a threat to the safety and soundness of the banking entity, or a threat to the 

financial stability of the United States. 

For nonbank financial companies that are supervised by the Board, the Volcker Rule does not 

expressly prohibit or limit any activities. Instead, the Volcker Rule requires that the Board adopt 

rules imposing additional capital charges or other restrictions on such companies to address the 

risks and conflicts of interest that the Volcker Rule was designed to address.7 

Since the enactment of the Dodd-Frank Act, a number of banking entities have shut down, or 

announced plans to shut down, their operationally distinct, dedicated proprietary trading 

operations (― ̳bright line‘ proprietary trading‖) and hedge fund and private equity fund businesses

that were a source of losses during the crisis. While these actions have reduced proprietary 

trading activity, impermissible proprietary trading may continue to occur, including within 

permitted activities that are not organized solely to conduct impermissible proprietary trading. 

As Paul Volcker, former Chairman of the Board of Governors of the Federal Reserve System, 

explained in his testimony to the Senate Banking Committee when he urged adoption of this 

provision: 

What we can do, what we should do, is recognize that curbing the proprietary 

interests of commercial banks is in the interest of fair and open competition as 

well as protecting the provision of essential financial services. Recurrent 

pressures, volatility and uncertainties are inherent in our market-oriented, profitseeking financial system. By appropriately defining the business of commercial 

banks . . . we can go a long way toward promoting the combination of 

competition, innovation, and underlying stability that we seek.8

 

7

12 U.S.C. § 1851(a)(2).

8 Prohibiting Certain High-Risk Investment Activities by Banks and Bank Holding Companies before the S. Comm. 

on Banking, Housing & Urban Affairs, 111th Cong. 5 (2010) (testimony of the Honorable Paul Volcker, Chairman, 

President‘s Economic Recovery Advisory Board).
OVERVIEW OF STUDY AND RECOMMENDATIONS 3

RECOMMENDED ACTIONS TO EFFECTIVELY IMPLEMENT THE VOLCKER RULE

The Council strongly supports the robust implementation of the Volcker Rule and 

recommends that Agencies consider taking the following actions: 

1. Require banking entities to sell or wind down all impermissible proprietary trading 

desks. 

2. Require banking entities to implement a robust compliance regime, including public 

attestation by the CEO of the regime‘s effectiveness. 

3. Require banking entities to perform quantitative analysis to detect potentially 

impermissible proprietary trading without provisions for safe harbors. 

4. Perform supervisory review of trading activity to distinguish permitted activities from 

impermissible proprietary trading. 

5. Require banking entities to implement a mechanism that identifies to Agencies which 

trades are customer-initiated.

6. Require divestiture of impermissible proprietary trading positions and impose 

penalties when warranted. 

7. Prohibit banking entities from investing in or sponsoring any hedge fund or private 

equity fund, except to bona fide trust, fiduciary or investment advisory customers.

8. Prohibit banking entities from engaging in transactions that would allow them to ―bail 

out‖ a hedge fund or private equity fund.

9. Identify ―similar funds‖ that should be brought within the scope of the Volcker Rule 

prohibitions in order to prevent evasion of the intent of the rule.

10. Require banking entities to publicly disclose permitted exposure to hedge funds and 

private equity funds.
OVERVIEW OF STUDY AND RECOMMENDATIONS 4

SUMMARY OF CONCLUSIONS AND RECOMMENDATIONS

In this study, the Council sets forth recommendations that seek to identify and eliminate 

prohibited proprietary trading activities and investments in or sponsorships of hedge funds and 

private equity funds by banking entities. The proprietary trading section of the study outlines 

criteria for defining prohibited activities, rigorous tests to identify permitted activities, and 

grounds to prohibit activities that would involve or result in a material conflict of interest, result 

in a material exposure to a high-risk asset or high-risk trading strategies, pose a threat to the 

safety and soundness of such banking entity, or pose a threat to the financial stability of the 

United States.

The private funds section of the study focuses on key issues raised in the implementation of the 

Volcker Rule‘s hedge fund and private equity funds provisions, and recommends certain 

substantive criteria that Agencies should use to guide legal interpretations in the rulemaking. It 

also recommends a compliance and supervisory framework.

PROPRIETARY TRADING

The Volcker Rule mandates that banking entities cease proprietary trading, subject to certain

exceptions for ―permitted activities,‖ such as market making, trading in government 

securities, hedging, and underwriting. Although ―bright line‖ proprietary trading desks are 

readily identifiable, in current practice, significant proprietary trading activity can take place 

in the context of activities that would otherwise be permitted by the statute. Therefore, an 

essential part of implementing the statute is the creation of rules and a supervisory 

framework that effectively prohibit proprietary trading activities throughout a banking entity

– not just within certain business units – and that appropriately distinguish prohibited 

proprietary trading from permitted activities. 

In developing these rules, the study recommends that Agencies‘ rulemaking and 

implementation efforts be guided by five fundamental principles: 

1. The regulations should prohibit improper proprietary trading activity using whatever 

combination of tools and methods are necessary to monitor and enforce compliance with 

the Volcker Rule.

2. The regulations and supervision should be dynamic and flexible so Agencies can identify 

and eliminate proprietary trading as new products and business practices emerge.

3. The regulations and supervision should be applied consistently across similar banking 

entities (e.g., large banks, hedge fund advisers, investment banks) and their affiliates to

facilitate comparisons. The regulations and supervision should endeavor to provide 

banking entities with clarity about criteria for designating trading activity as 

impermissible proprietary trading. 
OVERVIEW OF STUDY AND RECOMMENDATIONS 5

4. The regulations and supervision should facilitate predictable evaluations of outcomes so 

Agencies and banking entities can discern what constitutes a prohibited and a permitted 

trading activity. 

5. The regulations and supervision should be sufficiently robust to account for differences 

among asset classes as necessary, e.g., cash and derivatives markets. 

The recommendations also identify indicia of permitted activities that will help prevent 

banking entities from migrating proprietary trading activities into areas of the banking entity 

that otherwise conduct permitted activities. Implementing these indicia-based tests would 

require certain banking entities to change their business practices to bring trading activities 

into compliance with the statutory definitions of the permitted activities. However, these 

tests are also designed to preserve banking entities‘ ability to engage in critical financial 

intermediation in financial markets. 

To effectively apply and monitor these substantive tests, the Council recommends a four-part 

implementation and supervisory framework that would assist Agencies in identifying 

proprietary trading activities that must be eliminated, consisting of: 

1. Programmatic compliance regime: The Council recommends that banking entities be 

required to develop robust internal controls and programmatic compliance regimes (that 

will include strong investment and risk oversight) designed to ensure that proprietary 

trading does not migrate into permitted activities. The compliance regime may require:

 The establishment of internal policies and procedures to detect and eliminate 

proprietary trading;

 The development and implementation of a program of controls to monitor trading 

activity and to ensure that the types and levels of risk taken are appropriate and 

consistent with articulated Volcker Rule policies and procedures.

 The creation of recordkeeping and reporting systems to enable internal 

compliance reviews and supervisory examinations;

 The implementation of independent testing of the compliance regime by a 

banking entity‘s internal audit department or by outside auditors, consultants or 

other qualified independent parties; and

 Robust review of permitted activities to ensure that internal policies and 

procedures are being followed, combined with engagement by the Board of 

Directors and public attestation of compliance by the Chief Executive Officer

(―CEO‖).

2. Analysis and reporting of quantitative metrics: This study outlines four categories of 

metrics that banking entities could be required to analyze and report to Agencies to help 

identify impermissible proprietary trading, including:

 Revenue-based metrics;

 Revenue-to-risk metrics;

 Inventory metrics; and
OVERVIEW OF STUDY AND RECOMMENDATIONS 6

 Customer-flow metrics.

The use of appropriate metrics to identify possible proprietary trading should be 

important for management and supervisors to ensure compliance with the Volcker 

Rule. Although this study puts forth specific metrics that Agencies should consider for 

these purposes, Agencies may also consider other metrics they identify in the future.

3. Supervisory review and oversight: Agencies can engage in supervisory review and 

oversight of trading operations to review and test internal controls, monitor for 

potentially problematic trends or incidents, and investigate specific trading activity, 

including position-level data, where warranted. 

4. Enforcement procedures for violations: If a violation is identified through the 

examination process, the statute requires that the activity be terminated and that the 

investment be liquidated. This remedy should not preclude Agencies from considering 

other potential supervisory or enforcement actions such as increased oversight, 

reductions in risk limits, increased capital charges, or monetary penalties. Also, it 

should not insulate proprietary trading from other applicable provisions of law. The 

statute also provides for an adjudication process, including notice and opportunity for 

hearing, which supervisors must develop as part of the implementation process. 

This section also outlines key issues in the application of the prudential ―backstop‖

provisions that limit the scope of permitted activities. The section closes by outlining other 

important elements of the U.S. financial regulatory system that will further support the 

objectives of the Volcker Rule, including more stringent capital standards, comprehensive 

supervision of derivatives markets and stronger ―firewalls‖ between depository institutions 

and their affiliates. 

SPONSORSHIP OF AND INVESTMENTS IN HEDGE FUNDS

AND PRIVATE EQUITY FUNDS

In addition to the restrictions on proprietary trading, the Volcker Rule generally prohibits 

banking entities from making investments in or sponsoring hedge funds or private equity 

funds that are not connected to the provision of bona fide trust, fiduciary, or investment 

advisory services to its customers. The purpose of this additional prohibition is to: 

1. Ensure that banking entities do not invest in or sponsor such funds as a way to 

circumvent the Volcker Rule‘s restrictions on proprietary trading;

2. Confine the private fund activities of banking entities to customer-related services; and

3. Eliminate incentives and opportunities for banking entities to ―bail out‖ funds that they 

sponsor, advise, or where they have a significant investment. 

The Volcker Rule prohibits hedge fund and private equity fund sponsorship or investment by 

banking entities except in narrow circumstances. A banking entity is allowed to organize and 

offer a fund to its bona fide trust, fiduciary, and investment advisory customers. Further, 
OVERVIEW OF STUDY AND RECOMMENDATIONS 7

banking entities are not permitted to invest in these types of funds beyond a specified de 

minimis amount in order to establish funds and attract unaffiliated investors in connection 

with its customer-related business. 

The Volcker Rule relies on two commonly-used exclusions from the definition of the term 

―investment company‖ under section 3(c) of the Investment Company Act to define hedge 

funds and private equity funds. Although widely used by traditional hedge funds and private 

equity funds, these statutory exclusions were not designed to apply only to such funds. As 

such, they do not specifically address or closely relate to the activities or characteristics that 

are typically associated with hedge funds or private equity funds. In implementing the 

Volcker Rule, Agencies should consider criteria for providing exceptions with respect to 

certain funds that are technically within the scope of the ―hedge fund‖ and ―private equity 

fund‖ definition in the Volcker Rule but that Congress may not have intended to capture in 

enacting the statute.

The study makes recommendations in three areas below:

1. Customer requirement: The Volcker Rule requires that organized or sponsored funds 

only be offered to ―customers‖ of a banking entity. The term ―customer‖ is not 

defined in the statute. The study outlines factors that Agencies should consider in 

determining who is a customer and the necessary nature of that relationship. 

2. Calculation of de minimis investment: The de minimis investment calculation applies 

both to restrict the exposure of a banking entity to 3% of any single fund and to limit 

the banking entity‘s aggregate exposure to 3% of Tier 1 capital. Agencies should 

consider calculating these limits in a manner that will require full accounting of the 

banking entity‘s risk and requiring ongoing monitoring of these limits through the life 

of the fund. 

3. Monitoring compliance, attestation, and public reporting: Agencies should consider 

requiring banking entities to establish internal programmatic compliance regimes that 

will involve strong investment and risk oversight of permissible hedge fund and 

private equity fund activities with engagement by the Board of Directors and public 

attestation of the adequacy of such compliance regime by the CEO. In addition, in the 

limited instances in which a banking entity is permitted to invest in a hedge fund or 

private equity fund to facilitate customer-related business, Agencies should consider 

requirements for banking entities to disclose the nature and amount of any such 

investment.
THE STATUTORY MANDATE AND OBJECTIVES OF THE STUDY 8

THE STATUTORY MANDATE AND OBJECTIVES OF THE STUDY

The Dodd-Frank Act requires the Council to conduct a study and make recommendations on 

effectively implementing the Volcker Rule not later than six months after the date of enactment: 

(1) STUDY.—Not later than 6 months after the date of enactment of this section, the Financial 

Stability Oversight Council shall study and make recommendations on implementing the 

provisions of this section so as to—

(A) promote and enhance the safety and soundness of banking entities;

(B) 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;

(C) limit the inappropriate transfer of Federal subsidies from institutions that benefit from 

deposit insurance and liquidity facilities of the Federal Government to unregulated entities;

(D) reduce conflicts of interest between the self-interest of banking entities and nonbank 

financial companies supervised by the Board, and the interests of the customers of such 

entities and companies;

(E) limit activities that have caused undue risk or loss in banking entities and nonbank 

financial companies supervised by the Board, or that might reasonably be expected to create 

undue risk or loss in such banking entities and nonbank financial companies supervised by the 

Board;

(F) appropriately accommodate the business of insurance within an insurance company, 

subject to regulation in accordance with the relevant insurance company investment laws, 

while protecting the safety and soundness of any banking entity with which such insurance 

company is affiliated and of the United States financial system; and

(G) appropriately time the divestiture of illiquid assets that are affected by the implementation 

of the prohibitions under subsection (a) [of Section 13 of the Bank Holding Company Act of 

1956].

Agencies are required, not later than nine months after the completion of this study, to adopt 

rules to implement the Volcker Rule and must consider the recommendations of the Council in 

developing and adopting such regulations. In so doing, Agencies are required to consult and 

coordinate with each other so that, to the extent possible, these regulations are comparable across 

Agencies and provide for consistent application and implementation of the Volcker Rule. The 

Chairperson of the Council is responsible for coordination of the regulations issued under 

Section 619 of the Dodd-Frank Act. 

The recommendations in this study are designed to assist Agencies in effectively implementing

the prohibition on proprietary trading in line with the study‘s statutory objectives. Key 

objectives of the study are to make recommendations related to reducing risk and promoting 

safety and soundness of banking entities and nonbank financial companies designated for 
THE STATUTORY MANDATE AND OBJECTIVES OF THE STUDY 9

heightened supervision by the Board.9 These recommendations directly address the objectives of 

the study by proposing a framework that would: 

 Require a comprehensive compliance and oversight regime focused on monitoring and 

enforcing (i) the prohibition on impermissible proprietary trading and (ii) impermissible 

investments in and sponsorship of hedge fund and private equity fund activities, thereby 

minimizing unsafe and unsound activities; 

 Build on existing risk management and supervisory tools by integrating the particular risk 

characteristics of proprietary trading into Agencies‘ existing framework for safety and 

soundness, and recommending an oversight and risk monitoring structure for hedge fund 

and private equity fund activities; and

 Implement the statutory requirement to prohibit proprietary trading and investment in or 

sponsorship of impermissible hedge funds and private equity funds, so as to limit the 

transfer of subsidies from the federal support provided to depository institutions to 

speculative activities.

The study also includes explicit recommendations to address conflicts of interest and 

accommodations for the insurance industry. 

With respect to appropriately timing the divestiture of illiquid assets required by the ban, the 

Volcker Rule provides for a conformance period during which banking entities and nonbank 

financial companies supervised by the Board must bring their activities and investments into 

compliance with the Volcker Rule, and requires the Board to issue rules not later than 6 months 

after the enactment of the Dodd-Frank Act to implement the conformance period. The Board 

recently issued a Notice of Proposed Rulemaking in the Federal Register requesting comment on 

a proposed rule, which includes the Board‘s position on the appropriate conformance period for 

the divestiture of illiquid funds.10 

 

9

12 U.S.C. § 1851(b)(1).

10 Conformance Period for Entities Engaged in Prohibited Proprietary Trading or Private Equity Fund or Hedge 

Fund Activities, 75 Federal Register 72741 (November 26, 2010). 
PUBLIC OUTREACH AND COMMENTS 10

PUBLIC OUTREACH AND COMMENTS 

To assist the Council in conducting the study and formulating its recommendations, the 

Council published a Notice and Request for Information in the Federal Register on 

October 6, 2010.11 An excerpt from the Notice and Request for Information containing 

the questions posed is attached as Annex A. At the time the comment period closed on 

November 5, 2010, the Council had received more than 8,000 comments. Approximately 

6,550 of these comments were substantially the same letter arguing for strong 

implementation of the Volcker Rule. The remaining 1,450 comments each set forth 

individual perspectives from financial services market participants, Congress, and the 

public. Further, staff of the Council‘s member agencies conducted meetings with parties 

representing a wide range of perspectives on the issues raised by implementation of the 

Volcker Rule. 

In general, many commenters urged Agencies to implement the Volcker Rule so as to:

 Unambiguously prohibit banking entities from engaging in speculative proprietary 

trading or sponsoring or investing in hedge funds or private equity funds;

 Define terms and eliminate potential loopholes; and

 Provide clear guidance to banking entities as to the definition of permitted and 

prohibited activities.

Selected written and oral comments are summarized below.

PROPRIETARY TRADING

A large number of commenters recommended that the Volcker Rule regulations prescribe 

clear and predictable rules that distinguish prohibited proprietary trading from permitted 

activities and noted that ambiguity would hinder compliance and potentially reduce 

market liquidity. Several commenters drew a distinction between impermissible 

proprietary trading and ―principal trading,‖ including asset-liability, liquidity, interestrate and treasury management and similar core banking activities.

With respect to ―market making,‖ which is a statutorily-permitted activity, several 

commenters expressed concern that market making could be defined so broadly as to 

allow proprietary trading to be disguised as market making and suggested that Agencies 

seek to limit the potential breadth of this exemption. Many commenters advocated for a 

narrow and clear definition that would clearly distinguish genuine market making for the 

 

11 Public Input for the Study Regarding the Implementation of the Prohibitions on Proprietary Trading and 

Certain Relationships With Hedge Funds and Private Equity Funds, 75 Federal Register 61758 (October 6, 

2010).
PUBLIC OUTREACH AND COMMENTS 11

benefit of customers from impermissible proprietary trading. Some commenters 

advocated for a broad definition, arguing that market makers engage in a wide variety of 

activities that provide liquidity and enhance efficiency in the market. These commenters 

noted that market making often requires the assumption of principal risk, as market 

makers take on liquidity and inventory risk for the benefit of customers. Further, some 

commenters voiced strong concern that a restrictive definition of market making might 

damage U.S. markets and place U.S. banking entities and their customers at a competitive 

disadvantage internationally. 

In addition, some commenters argued that implementation of the underwriting exception, 

another statutorily-permitted activity, should permit a broad range of ―traditional‖

underwriting activities, including related price stabilization and overallotment activities. 

Commenters advanced a number of approaches for distinguishing between permitted and 

prohibited activities and for testing compliance. Many commenters noted that trading 

activity varies by asset class and, as a result, implementation of the Volcker Rule should 

be tailored to particular markets and asset classes. A number of commenters emphasized 

the importance of using specific, quantitative risk metrics to assess the extent of risk in 

banking entities. Other commenters observed that existing risk management tools may 

provide a useful guide, but that such tools are currently used and designed to predict and 

limit losses and not to identify proprietary trading. 

Some commenters proposed that Agencies test compliance with the Volcker Rule as part 

of their established supervisory review process, while others contended that supervisors 

should have the ability to closely scrutinize trading books if and when there is reason to 

suspect that a banking entity is engaging in impermissible proprietary activity. Some 

commenters suggested that there should be a ―supervisory conversation,‖ in which the 

banking entity would explain the intent of trading activity, rather than a forced unwind of 

the relevant position, if a banking entity‘s trading activity appears to violate Agencyadopted standards, guidelines, or metrics. Other commenters recommended that banking 

entities establish internal policies and procedures designed to ensure compliance with the 

Volcker Rule. 

Further, certain commenters advocated for a ―circuit breaker‖ mechanism for relaxing or 

lifting the Volcker Rule‘s restrictions during periods of market stress or if certain 

Volcker-related limitations were found to be inconsistent with normal market 

functioning. Other commenters suggested that Agencies consider setting broader ranges 

of permissible behavior at the outset and narrowing and refining these ranges over time as 

the requisite trading data is analyzed. 

With respect to risk-mitigating hedging, another statutorily-permitted activity, some 

commenters stated that transactions that reduced identifiable risks should be permitted 

but that the direct relationship to the underlying exposure should be clear. Several 

commenters noted that, in practice, banking entities often manage and hedge risks on an 

aggregate basis (i.e., at the portfolio level), instead of on an individual trade basis. 

Several commenters stated that such hedging reduces risk and facilitates customer trading 
PUBLIC OUTREACH AND COMMENTS 12

activity by allowing banking entities to profit from capturing the ―spread‖ in market 

making without being exposed to general price movements. 

Further, commenters representing the insurance industry argued that investment activities 

are essential to the insurance industry and should be excluded from the scope of the 

Volcker Rule‘s restrictions. These commenters noted that the statute defines certain 

investment activities by regulated insurance companies and their affiliates as permitted 

activities. 

A number of commenters also cautioned that proprietary trading creates potentially 

hazardous exposures and conflicts of interest, especially at institutions that operate with 

explicit or implicit government guarantees. To avoid such conflicts, many commenters 

recommended that the terms ―material conflicts of interest,‖ ―high-risk assets,‖ and 

―high-risk trading strategies‖ be defined. Specifically, some commenters expressed 

concern that conflicts of interest might continue to exist on market making desks if 

proprietary trading activity were only prohibited on non-customer facing desks. 

Commenters expressed a range of opinions regarding the definition of ―trading account,‖

which is an element of the Volcker Rule‘s definition of proprietary trading. Some 

commenters advocated in favor of a very clear definition to reduce compliance costs and 

uncertainty. Several commenters argued that there are several types of accounts that are 

used to conduct traditional banking activities that should be expressly exempted from any 

restrictions under the Volcker Rule. Other commenters indicated that the definition of 

trading account should be broad to ensure that any account that may be used to conduct 

proprietary trading is covered. 

The Volcker Rule‘s definition of ―trading account‖ references the term ―near term.‖

Several commenters advocated for detailed tests or specific timeframes that should be 

used to define ―near term.‖ Some commenters argued that any restrictions on proprietary 

trading should be limited to very short-term activities. Other commenters observed that 

turnover is not necessarily a good proxy for risk. Lastly, some commenters indicated that 

the definition should be broad enough to capture the full range of activities targeted by 

the statute while still permitting traditional banking activities. 

SPONSORSHIP OF AND INVESTMENTS IN HEDGE FUNDS 

AND PRIVATE EQUITY FUNDS

A number of commenters focused on the broad definitions used for private equity funds 

and hedge funds in the Volcker Rule. Specifically, many commenters expressed concern 

that unless the definition of ―private equity fund‖ and ―hedge fund‖ is narrowed, the 

Volcker Rule‘s prohibitions would capture funds that Congress did not intend to bring 

within the scope of the Rule; in other words, there are a number of entities that rely on 

exclusions from the definition of an investment company under sections 3(c)(1) or 3(c)(7) 

of the Investment Company Act that the commenters do not consider to be ―hedge funds‖

or ―private equity funds.‖ In addition, some commenters noted that the words ―such 
PUBLIC OUTREACH AND COMMENTS 13

similar funds‖ should be construed to encompass funds that are functionally similar to 

―hedge funds‖ and ―private equity funds‖ and requested a clear definition to address what 

―similar funds‖ means.

Many commenters also argued that venture capital funds should be excluded from the 

definition of ―private equity fund‖ and ―hedge fund.‖ In arguing for this exclusion, these 

commenters focused on ways in which the venture capital business model is distinct, the 

potential economic impact of curtailing investments in venture capital, and congressional 

intent. 

With respect to the statutory provision allowing de minimis investments in private equity 

funds and hedge funds, commenters recommended that Agencies provide more clarity 

regarding how and when the de minimis calculation would be applied. Also, a number of 

commenters recommended that restrictions be coupled with an effective disclosure 

regime that clearly delineates each banking entity‘s relationship with hedge funds and 

private equity funds. 

Commenters also addressed one of the statutory limitations on permitted activities—

material conflicts of interest. Some commenters maintained that the Volcker Rule‘s 

restrictions on transactions between a banking entity and any hedge fund or private equity 

fund, if appropriately implemented in conjunction with existing disclosure and consent 

requirements, should ensure that material conflicts of interest are appropriately addressed. 

Other commenters argued that disclosure requirements need to be supplemented by 

additional limitations.

In general, commenters stated that among the key considerations in implementing the 

provisions of the Volcker Rule that restrict the ability of banking entities to invest in, 

sponsor or have certain other covered relationships with private equity and hedge funds 

are: preventing banks from using their relationships with hedge funds and private equity 

funds to evade the prohibitions on proprietary trading, and prohibiting banks from bailing 

out affiliated hedge funds and private equity funds. 

OTHER COMMENTS

Commenters addressed the scope of the term ―banking entity,‖ in particular whether 

depository institution affiliates and foreign banking entities are covered. A number of 

commenters expressed concerns that if the term is not properly defined, the activities of 

certain banking entities, such as employee pension funds, funds of funds, and asset 

managers, would be curtailed due to their affiliation with an insured depository 

institution. 

Several commenters suggested that the regulations provide transition provisions to give 

banking entities sufficient time to conform to new rules, particularly with respect to 

illiquid funds because the contractual term of illiquid hedge funds and private equity 

funds may extend for 15 years or more. Commenters contend that a transition period is 
PUBLIC OUTREACH AND COMMENTS 14

essential to minimizing the economic impact of divestiture and avoiding disruption to the 

markets.

A number of commenters pointed out that extensive and ongoing data collection is a key 

tool to limit the inappropriate transfer of federal subsidies to unregulated entities. A 

subset of commenters asserted that further recommendations on how to limit the spread 

of the subsidy from deposit insurance are not necessary due to existing provisions of law, 

including sections 23A and 23B of the Federal Reserve Act and the anti-guarantee 

provision of the Volcker Rule that prohibits the guarantee of the obligations and 

performance of hedge funds or private equity funds.12

Some commenters argued that proprietary trading and investments in hedge funds and 

private equity funds provide important income diversification for banking entities. These 

commenters also argued that banking entities provide an important source of capital for 

private equity and venture capital, and an important source of liquidity to financial 

markets. However, the vast majority of comments asserted that a robust implementation 

of the Volcker Rule, limiting banking entities‘ ability to engage in speculative proprietary 

trading with customer deposits, is essential to the safety and soundness of the banking 

industry. In addition, many commenters supported strong anti-evasion provisions to 

prevent unanticipated tactics from undermining the intent of the Volcker Rule. 

 

12 12 U.S.C. § 1851(d)(1)(G)(v).
PROPRIETARY TRADING 15

PROPRIETARY TRADING

INTRODUCTION 

The Volcker Rule requires banking entities to cease prohibited proprietary trading 

activities. The Council recommends that Agencies implement the Volcker Rule in a 

manner that both places compliance obligations on banking entities and establishes 

supervisory programs for monitoring, identifying, and responding to potential violations. 

The purpose of the Volcker Rule is three-fold: 

1. Separate federal support for the banking system from speculative trading 

activity with the banking entity‘s own capital;

2. Reduce potential conflicts of interest between a banking entity and its 

customers; and

3. Reduce risk to banking entities and nonbank financial companies designated for 

supervision by the Board. 

This section of the study outlines recommendations for Agencies to consider when 

implementing the Volcker Rule. These recommendations are designed to eliminate 

prohibited proprietary trading activities, prevent evasion of the Volcker Rule‘s 

prohibition under the guise of permitted activities, and minimize any related capital 

markets disruption. 

Many of the key considerations in implementation arise from the potential for proprietary 

trading and permitted activities to be commingled. The study recommends Agencies 

consider a four-part supervisory framework to assist banking entities and Agencies in 

distinguishing prohibited proprietary trading from permitted activities, consisting of:

1. Programmatic compliance regime;

2. Analysis and reporting quantitative metrics;

3. Supervisory review and oversight; and

4. Enforcement procedures for violations.

STATUTORY OVERVIEW

Under the Volcker Rule, banking entities are prohibited from engaging in proprietary 

trading, with certain exceptions for permitted activities.13 Congress intended to strictly 

restrain speculative risk taking in the form of proprietary trading by banking entities, 

 

13 Id. at § 1851(a)(1)(A) and (d)(1).
PROPRIETARY TRADING 16

which benefit from the support of federal deposit insurance and access to discount 

window borrowing. 

The statute defines ―proprietary trading‖ as:

[E]ngaging as a principal for the trading account of [a] banking entity or [systemically 

important nonbank financial company] in any transaction to purchase or sell, or otherwise 

acquire or dispose 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 instrument that the appropriate Federal banking agencies, the [SEC], 

and the [CFTC] may, by rule . . . determine.14

The statute defines ―trading account‖ as:

[A]ny account used for acquiring or taking positions in the securities and instruments 

described in [the definition of ―proprietary trading‖] 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 appropriate Federal banking 

agencies, the [SEC], and the [CFTC] may, by rule . . . determine.15

The statute also provides limited and narrow exceptions for ―permitted activities.‖

16

 

These permitted activities are limited to important forms of financial intermediation that 

Congress concluded are permissible in the context of entities that have the support of 

federal deposit insurance and discount window access. The enumerated permitted 

activities suggest a consistent view that activities of banking entities should be for the 

ultimate benefit of the broader economy while maintaining the safety and soundness of 

the institutions. Permitted activities related to trading under the Volcker Rule, in general 

terms, include the following: 

 Market making-related activity;

 Risk-mitigating hedging;

 Underwriting;

 Transactions on behalf of customers;

 Transacting in government securities;

 Certain insurance activity;

 Investments in small business investment companies, public welfare investments 

and certain qualified rehabilitation expenditures under federal or state tax laws;

 Certain offshore activities; and

 Other activities that Agencies determine would promote and protect the safety and 

soundness of banking entities and U.S. financial stability.

 

14 Id. at § 1851(h)(4).

15 Id. at § 1851(h)(6).

16 Id. at § 1851(d)(1).
PROPRIETARY TRADING 17

Under the Volcker Rule, permitted activities are subject to a ―backstop‖ that prohibits 

these permitted activities if they result in a material conflict of interest, result in material 

exposure to high-risk assets or high-risk trading strategies, pose a threat to safety and 

soundness of the banking entity, or pose a threat to financial stability.17 Additionally, the 

Volcker Rule requires the appropriate agencies to impose additional capital requirements 

and quantitative limitations if necessary to protect the safety and soundness of these 

banking entities.

The statute also recognizes the critical function that loan creation plays in the nation‘s 

economy and provides that the Volcker Rule shall not 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 otherwise permitted by law.18

Under the statute, Agencies are also required to impose rules that ensure compliance with 

and prevent evasion of the Volcker Rule.19 The Volcker Rule specifies that in 

implementing these requirements, Agencies should require banking entities to terminate 

any activity or investment that ―functions as an evasion‖ or ―otherwise violates the 

restrictions‖ of the Volcker Rule. 20 This provision is in addition to other enforcement 

powers that Agencies have through their existing authorities.

IMPLEMENTATION CONSIDERATIONS

Of the permitted activities listed in the prior section that relate to trading, the first four 

present the greatest challenge in distinguishing impermissible proprietary trading 

activities from permissible activities. Key to implementing the Volcker Rule is the 

creation of rules that prevent prohibited proprietary trading activities from occurring 

throughout a banking entity – not just within certain business units. Absent robust rules 

and protections, banking entities may have the opportunity to migrate existing proprietary 

trading activities from the standalone business units that are presently recognized as 

―proprietary trading operations‖ into more mainstream ―sales and trading‖ or other 

operations that otherwise engage in permitted activities. 

Following the enactment of the Volcker Rule, major banking entities have taken or 

announced steps to sell, spin off, or close down their standalone ―bright line‖ proprietary 

trading businesses. Certain market making and underwriting businesses, as permitted 

activities under the Volcker Rule, will continue to operate even after the Volcker Rule‘s 

prohibitions become effective. These businesses require banking entities to maintain an 

active presence in the capital markets, often to assume principal risk, and, in the case of 

market making, to hold inventory for sale. 

 

17 Id. at § 1851(d)(2).

18 Id. at § 1851(g)(2).

19 Id. at § 1851(b)(2).

20 Id. at § 1851(e)(2).
PROPRIETARY TRADING 18

During the Council‘s outreach process, several banking entities noted that some 

individuals employed in the proprietary trading operations have been transferred to those 

capital markets roles, such as market making, that are defined as permitted activities. 

Some commenters expressed concern that individuals may be able to continue to engage 

in proprietary trading in their new roles and suggested the need for a regulatory 

framework that ensures a thorough prohibition on impermissible proprietary trading, 

irrespective of where such activity may take place within an organization. Other 

commenters indicated that proprietary trading already occurs within existing market 

making and other activities.

PERMITTED ACTIVITIES THAT ARE DIFFICULT TO DISTINGUISH FROM 

PROPRIETARY TRADING ACTIVITIES

The challenge inherent in creating a robust implementation framework is that certain 

classes of permitted activities – in particular, market making, hedging, underwriting, 

and other transactions on behalf of customers – often evidence outwardly similar 

characteristics to proprietary trading, even as they pursue different objectives. In 

addition, 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).

Broadly gauged restrictions on proprietary trading may deter permitted market 

making, hedging, and underwriting activities. However, more loosely defined 

restrictions are likely to provide an opportunity for prohibited proprietary trading. 

MARKET MAKING

Section 619 designates ―market making-related‖ activity as a permitted activity, 

provided that it is ―designed not to exceed the reasonably expected near term 

demands of clients, customers or counterparties.‖ Current ―market making‖

businesses often include elements of proprietary trading. Agencies therefore must 

be vigilant to ensure that banking entities do not conceal impermissible 

proprietary trading activities within larger market making operations. 

The size of the exposure and the amount of risk required to perform market 

making vary widely. At one end of the spectrum lie those activities in which the 

market maker assumes very little risk in a transaction (―agency‖ or ―riskless 

principal‖ transactions). At the other end of the spectrum lie those activities in 

which the market maker commits capital to complete transactions (―principal 

transactions‖).

In the simple form of agency or riskless principal transactions, market making 

involves the market maker either matching a buyer and seller, who then transact 
PROPRIETARY TRADING 19

together, or securing commitments from both the buyer and the seller and then 

purchasing the financial instrument21 from the seller and immediately selling it to 

the buyer. These activities present minimal opportunity for impermissible 

proprietary trading. However, the ―riskless‖ form of market making is limited in 

practice to highly active and liquid markets that are characterized by a consistent, 

large and diverse pool of willing buyers and sellers. Even within these activities, 

however, the results of the Council‘s outreach suggest that the majority of trading 

utilizes some broker capital commitments in a principal transaction model as 

described below. 

In principal transactions, market makers are asked to assume the role of 

counterparty in the absence of a ready buyer or seller on the other side of the 

transaction. In such transactions, market makers commit capital to provide 

liquidity to their customers and ensure market continuity. In doing so, the market 

maker assumes risk by holding the purchased position on its balance sheet as 

―inventory‖ until such time that the transaction can be completed. Moreover, as 

some prior transactions are completed, other new transactions will be initiated 

such that the market maker will always be taking risk as long as the market 

making activity is performed. This activity is especially complex in illiquid 

markets or in a liquid market where an order is very large, as a market maker may 

be required to assume significant market risk between the time that the large order 

is purchased and sold back into the market.

For example, in the case of over-the-counter derivatives markets, which are 

structured differently from liquid securities markets, market making typically 

entails a customer-initiated transaction involving a bespoke financial instrument. 

The trading desk provides the customer with a price and upon execution will hold 

the financial instrument in its portfolio. As these are customized derivatives, they 

do not typically have a matching offset (i.e., matched book). The market making 

desk will typically dynamically hedge to offset the exposures. 

The ability to hold inventory in this context is a principal complexity: the same 

inventory built with the intention of facilitating liquidity for clients could also be 

built with the intention of engaging in impermissible proprietary trading. 

Consequently, a key challenge is the identification of inventory levels that are 

appropriate to facilitate client-driven transactions but not to take prohibited 

proprietary risks. 

 

21 For purposes of this study, the definition of a financial instrument includes ―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 [Agencies] may, by rule as provided... 

determine.‖ 12 U.S.C. § 1851(h)(4).
PROPRIETARY TRADING 20

HEDGING

Banking entities utilize hedging as a risk mitigation tool. Hedging is an integral 

part of the market making function that is permitted under the Volcker Rule. 

Hedging is also an important tool of firm-wide risk management.

With respect to market making, client-driven transactions create an unbalanced 

book of positions temporarily held for disposal. A market maker must then find a 

way to reduce the risk of these positions while they remain on their balance sheet. 

As a specific example, a market maker in equity options may fill a number of buy 

orders for call options on a particular stock without receiving any offsetting sell 

orders for the same call option. As a result, the market maker will be exposed to 

upside risk in the stock. A market maker will often seek to hedge this risk by 

purchasing shares to reduce its exposure to the underlying stock until offsetting 

sell orders can be found or the options expire.

On a firm-wide basis, banking entities often need to hedge interest rate risk and 

credit risk. Banking entities create substantial amounts of credit risk by 

originating loans to businesses and households. In addition, banking entities face 

substantial interest rate risk as the maturity of their interest bearing assets (loans) 

and obligations (deposits and debt) often do not match. Accordingly, banking 

entities often seek to use credit and interest rate derivatives to reduce their 

exposure. Many banking entities use hedging as part of their traditional assetliability, credit and business risk management functions. 

However, hedging, or alternatively, the flexibility not to hedge a position, also 

presents a potential avenue to evade the proprietary trading prohibition if hedges 

do not correlate with owned assets or if a banking entity seeks an independent 

return through the application of a hedge.

To address this concern, a banking entity‘s hedging strategy should be clearly 

defined and directly related to an underlying set of fundamental risk factors to 

which the entity is exposed. 

One of the most basic considerations in the implementation of any hedging 

strategy is how closely to hedge the underlying risk exposure. Most trading assets 

are exposed to a number of risk factors. In the context of nonlinear derivative 

contracts, such as options, the risks are compounded by complex interactions 

among the underlying risk factors. In general, it may be uneconomical to 

completely hedge all of the risk to which a trading desk is exposed. In addition to 

factor-based risk, there is risk exposure that is created by the imperfect nature of 

the hedge. This is typically referred to as basis risk. If not properly managed, the 

unhedged portion of the factor-based risk and the basis risk can both be sources of 

large losses and also should be monitored for indications of impermissible 

proprietary trading. 
PROPRIETARY TRADING 21

At the same time, hedging activity serves a critical role by allowing banking 

entities to manage their risk exposures while they engage in a variety of market 

making and banking activities. Prudent risk management is at the core of both 

institution-specific safety and soundness, as well as macroprudential and financial 

stability. The Volcker Rule should not be applied in a way that interferes with a 

banking entity‘s ability to use risk-mitigating hedging. 

As previously noted, the statute includes an exception for ―risk-mitigating 

hedging‖ activities in recognition of banking entities‘ need to reduce the risk they 

face from exposures to ―individual‖ or ―aggregated‖ positions. Banking entities 

hedge the risks that they face in a number of ways based on the nature of the risks 

and the entity‘s exposure to these risks. For example, multiple market making 

desks in an entity may be exposed to similar risk factors. Therefore, hedging 

may be conducted at a level above that of a specific trading desk, on a portfolio 

basis, to more efficiently hedge an entity‘s exposure to the risk factors. 

Despite its utility, such portfolio hedging activities can be difficult to link to the 

rest of an entity‘s trading operations in a clear and fully transparent manner. In 

particular, it is possible that such portfolio hedging could be commingled with 

and difficult to distinguish from impermissible proprietary trading activities. This 

is because the commitment of principal risk is inherent to banks‘ hedging 

activities and therefore needs to be carefully monitored to limit the potential for 

hedging activities to mask proprietary activity.

Accordingly, the Council suggests that Agencies consider how the Volcker Rule 

should be implemented with respect to portfolio hedging. Agencies could 

consider factors such as the nature of the risks being hedged; the extent to which 

banks measure, monitor and control risks at a portfolio level; the extent to which 

portfolio hedging is part of an entity‘s formal hedging strategy; whether traders 

are compensated based on earnings generated by portfolio hedging activity; and 

the overall efficacy of portfolio hedging activities in reducing risk throughout the 

banking entity, and the methods allowing Agencies to ensure and determine 

which desk-specific positions are being hedged on an aggregate basis. 

UNDERWRITING

Like market making, underwriting requires the assumption of principal risk. 

Underwriting services provided by banking entities are essential for facilitating 

equity and debt issuance for capital raising. Most commonly, underwriting 

requires an underwriter or underwriting syndicate to make commitments in 

advance to purchase a set amount of the securities issued if they are not purchased 

fully by other market participants (known as a ―firm commitment underwriting‖). 

During and after issuance, institutions will sometimes intervene in the market as a 

mechanism for supporting the offered security. As a result, a key challenge is the 

identification of activity that is not necessary to allow for underwriters to 
PROPRIETARY TRADING 22

adequately support their clients‘ equity and debt issuances and may indicate 

impermissible proprietary trading. 

OTHER TRANSACTIONS ON BEHALF OF CUSTOMERS

The statute also allows for the ―purchase, sale, acquisition, or disposition of 

securities and other instruments ... on behalf of customers.‖

22

 This language 

recognizes the important role that banks can play in facilitating transactions on 

behalf of customers, and reflects the intent of the Volcker Rule to permit activities 

that are customer-serving, such as traditional market making or underwriting 

activities, as opposed to speculative activity with the banking entities‘ capital. 

CHALLENGES IN DELINEATING PROPRIETARY TRADING ACTIVITIES 

FROM PERMITTED ACTIVITIES

In general, a market maker seeks to earn a return by participating in the flow of 

trading – intermediating between clients who seek to purchase financial assets or 

other forms of risk and those that seek to sell them. Similarly, an underwriter 

typically purchases a large block of securities at a discount from a seller, with the 

intention to resell these securities over time in the market.

Conversely, a proprietary trader accumulates positions with the intention of 

benefiting from an expected appreciation in the value of such positions. Proprietary 

traders will generally seek to capture movements in the price of a financial 

instrument, while market makers will seek to minimize the impact of such 

movements. 

It can be difficult, however, to differentiate a position intended to make a proprietary 

profit from one designed to satisfy current or expected customer demand or to 

provide liquidity to markets. Differences among asset classes add further complexity 

as liquidity and risk varies among them, and varies even more in times of stress. 

Consequently, any implementation framework for the Volcker Rule should consider 

the following challenges:

 Inventory that is required for market making or underwriting could also be 

used to conduct proprietary trading: Banking entities may acquire inventory and 

maintain risk exposures to satisfy current or expected customer demand. 

However, proprietary traders also build inventory but do so with the expectation 

that inventory will appreciate in the near term rather than using the inventory to 

facilitate customer transactions as would a market maker. Discerning differences 

in the characteristics of inventory used to facilitate market making and 

underwriting versus inventory held for proprietary trading is a key challenge in 

implementing the Volcker Rule.

 

22 12 U.S.C. § 1851(d)(1)(D).
PROPRIETARY TRADING 23

 The amount of risk required for permitted activities varies considerably by asset 

class: Accommodating customers by trading as principal may be reasonable in 

one market, in a particular amount, or at a particular time, but not in another 

market, size, or time. For example, exchange-traded equity markets tend to have 

extensive depth and breadth and so dealers do not often need to provide 

substantial amount of liquidity to their clients. In contrast, debt markets tend to 

be less liquid and more fragmented for both buyers and sellers in the normal 

course of business. Similarly, dealing in over-the-counter derivatives is 

characterized by long-term, bilateral contracts with risks that must be hedged 

across the portfolio by a combination of other contracts and trades in other 

financial instruments.

 Accumulation of inventory in “anticipation” of customer demand can resemble 

proprietary trading: The Volcker Rule allows for the accumulation of inventory 

in anticipation of ―reasonably expected near term demands of clients...‖

23

 

Anticipating customer demand, however, can be closely correlated with a 

prediction of price movements, as financial instruments that are in high demand 

tend to appreciate in price. In this sense, building inventory in a position on the 

presumption that the position will appreciate can strongly resemble proprietary 

trading, which is likewise predicated on taking positions that a trader believes will 

increase in value in the near term. However, building inventory as part of a 

market making business is more likely to have a predictable inventory profile in 

terms of volume and in relation to customer demand than would a proprietary 

trading business. 

 Banking entities can engage in impermissible proprietary trading through 

inconsistent or incomplete hedging in the context of their market making 

activities: In executing principal transactions for which there is no natural 

subsequent buyer of the financial instrument, market makers will often hold the 

instrument in their portfolio but then hedge it using correlated instruments that 

they sell to other customers. However, banking entities do not always hedge such 

positions fully or consistently. In some cases, it may not be possible or costeffective to fully hedge a position. In other cases, however, a refusal to hedge

could indicate a proactive choice to take on a proprietary position. 

 Agencies should consider the combined effects of permitted activities: Agencies 

should consider how the combination of permitted activities might be used to 

circumvent the proprietary trading restrictions. For example, the Agencies should 

consider whether combining the underwriting and the hedging exemption to 

create an on-going proprietary trading book layered on top of an underwritten 

security held in inventory functions as an evasion of the Volcker Rule.24

 

23 Id. at § 1851(d)(1)(B).

24 For example, if a firm underwrites a set of convertible bonds and then holds those in inventory, it can 

selectively hedge in various dimensions of the bonds‘ exposure to alternative factors to create an equity 

trade (by holding all but the equity exposure hedged), a volatility trade (by keeping all components but the 

volatility exposure hedged), a credit trade or a correlation trade (by using a market index such as the S&P 

as the hedge).
PROPRIETARY TRADING 24

 Discerning the source of a market maker’s profit is challenging, especially for 

less-liquid financial instruments: Understanding the source of a market maker‘s 

profits would ordinarily provide a strong indication of whether the firm is 

profiting from bona fide market making or proprietary trading. Market making 

activities should be characterized by rapid inventory turnover and minimal profits 

on inventory held, while proprietary trading activities should evidence more 

modest turnover with the bulk of profits derived from inventory appreciation. 

However, evaluating whether a firm tends to trade at the ―bid‖ price for a 

financial instrument (an indication of providing liquidity and market making) or 

the ―offer‖ price (an indication of consuming liquidity, and potentially proprietary 

trading) has less relevance in markets where such spreads are infrequently or 

inconsistently quoted.

 Disentangling different sources of revenue is challenging: As a specific 

example, measuring the revenue that is attributable to the ―bid-ask‖ spread is 

difficult and not consistently observable especially in illiquid markets. Moreover, 

to the extent that market makers need to assume some risk to facilitate customer 

transactions, a portion of trading revenues will always derive from underlying 

market movements. 

 Market makers often deal with other intermediaries in order to manage their 

overall risk exposure and maintain market continuity: A principal goal of 

market making activity is to facilitate as many offsetting customer transactions as 

possible while earning a spread or a fee from each transaction. While end users 

are the ultimate beneficiaries of market making activities, market makers are often 

forced to trade with non-customers in order to appropriately meet the future 

expected customer demand. Market makers will often trade with other large 

financial intermediaries that can handle large trade volumes quickly and 

efficiently. This so-called inter-dealer trading is an important and necessary part 

of managing the risk exposure of a market maker. This common practice can be 

abused, however, whereby inter-dealer trading is undertaken not for the purposes 

of market making but rather proprietary trading. A challenge for implementation 

of the Volcker Rule is thus distinguishing appropriate volumes of inter-dealer 

trading for market makers.

 Measures of “near term” trading accounts and “short-term” price movements 

are dependent on market instrument characteristics: Agencies should consider 

that in the context of principal trading, the measurement of time may be more 

appropriately tied to the liquidity of a financial instrument. 25 In many instances, 

a financial instrument may have little or no immediate liquidity after it is acquired 

by a firm. What constitutes trading in the ―near term,‖ therefore, may depend on 

the characteristics and the trading volume of the particular market; as a result, a 

trading account would not preclude illiquid financial instruments, such as swaps. 

For instance, in the case of over-the-counter derivatives, a swap dealer may match 

 

25 The Council recommends that each Agency consider utilizing FAS 157 level analysis as a possible tool 

in determining the liquidity of a financial instrument and any temporal metrics utilized. 
PROPRIETARY TRADING 25

a customer transaction by entering into offsetting long-term hedges (i.e., match 

the duration of the customer contract). Alternatively, the swap dealer may also 

dynamically hedge the position (i.e., enter into a series of continuous, short-term 

hedges over the period of the customer transaction). For such types of trades, the 

effectiveness of these hedges is far more consequential than the length of the 

holding period of the customer transaction. 

Agencies should consider that proprietary trading can occur in short, mid, and 

long-term maturity financial instruments. In many instances, a financial 

instrument may have a long maturity date, e.g., a thirty-year swap, and have little 

or no immediate liquidity after it is acquired by a firm but is placed in its trading 

portfolio. 

The language regarding short-term price movements employed in the Volcker 

Rule is similar to (i) language used by FASB accounting standards to determine 

whether positions are ―held for trading‖ and (ii) a broader definition of ―covered 

positions‖ that are subject to the federal banking agencies‘ market risk capital 

rules.26 Accordingly, possible definitions of ―trading account‖ might be similar to 

these definitions. To the extent that Agencies choose to incorporate some type of 

accounting or similar term in defining ―trading account,‖ the Council 

recommends that Agencies carefully consider how they might ensure that the 

prohibition on proprietary trading cannot be avoided through changes in 

accounting designations (e.g., by designating a position as ―available for sale‖

rather than ―trading‖). Additionally, if accounting standards are used as the basis 

for the definition of ―trading account‖ for purposes of the Volcker Rule, it is 

important that Agencies monitor changes to those accounting standards. 

PRINCIPLES FOR IMPLEMENTATION OF THE VOLCKER RULE

The Council recommends that the implementation of the Volcker Rule be guided by the 

following five principles. These principles are intended to ensure that the Volcker Rule 

will strictly prohibit banking entities from engaging in impermissible proprietary trading 

while allowing them to continue to engage in permitted activities that benefit consumers 

and the economy.

RULES AND SUPERVISION SHOULD PROHIBIT IMPROPER PROPRIETARY 

TRADING USING ALL NECESSARY TOOLS 

The mandate of the Volcker Rule is clear: banking entities can no longer engage in 

impermissible proprietary trading. As discussed in this study, distinguishing 

prohibited proprietary trading from permitted activities can be challenging. 

Accordingly, effective implementation requires a programmatic compliance regime 

 

26 See e.g., 12 C.F.R. Part 3, Appendix B, § 2(a)(2010).
PROPRIETARY TRADING 26

including attestation, analytical metrics, and examination resources to evaluate 

metrics and to detect prohibited proprietary trading. 

RULES AND SUPERVISION SHOULD BE DYNAMIC AND FLEXIBLE

The Volcker Rule should be implemented with the understanding that markets, 

products and trading activity will continue to evolve. Agencies‘ supervisory 

approaches should be flexible enough to account for this evolution. As new products, 

hedging strategies, and trading platforms are introduced, supervisory methods should 

also evolve to monitor for new impermissible proprietary trading practices. 

Moreover, Agencies should work together to assess the effectiveness of the methods 

of supervision, in particular the success of different metrics in identifying 

impermissible proprietary trading activity. Agencies should also consider reviewing 

new data collection technologies that develop after the initial implementation.

RULES AND SUPERVISION SHOULD ENABLE COMPARISONS AMONG 

BANKING ENTITIES

Standards should be consistent across similar banking entities. Additionally, 

Agencies should be able to conduct horizontal reviews in which they compare 

specific attributes of similar desks at different banking entities and evaluate 

applicable metrics. Horizontal reviews of similar institutions should involve not only 

reviews of policies and data, but also the application of supervisory methods at each 

firm to ensure consistency. Standards and regulatory treatment should not result in 

uneven competitive dynamics.

RULES AND SUPERVISION SHOULD FACILITATE PREDICTABLE 

EVALUATION OF OUTCOMES

Agencies and banking entities should be able to discern what constitutes a prohibited 

and a permitted trading activity. Banking entities may refrain from essential financial 

intermediation or risk mitigation if they are unable to ascertain what constitutes 

permitted activities. Rules and supervision should allow for predictable evaluation 

outcomes, wherever possible. 

RULES AND SUPERVISION SHOULD ACCOUNT FOR DIFFERENCES AMONG 

ASSET CLASSES

The new rules and supervisory systems should account for the fact that market 

characteristics vary significantly by asset class. The differences include: the volume 

of transactions, the number of market participants, protocols for trading, strategies for 

hedging risk, and trading forums. Within an asset class, these variables will change 
PROPRIETARY TRADING 27

over time, from both normal market fluctuation (e.g., liquidity in any given market 

varies over time) as well as structural changes (e.g., introduction of new products, 

trading platforms). In addition, multiple desks within a single entity may trade in the 

same asset classes – or cross into overlapping asset classes – often with differing 

objectives (e.g., convertible bond traders will often take derivative and equity 

positions to hedge bond risk). These activities are often central to the trading 

strategies of the desk and should be properly understood within a regulatory regime.

Agencies should be cognizant that each asset class and trading desk will not 

specifically comport to all the descriptions of certain permitted activities and indicia 

that these activities may provide. Each Agency, in designing its regime, must account 

for the unique nature of the asset class, markets, and trading desks.

DELINEATION OF PROPRIETARY TRADING AND CERTAIN 

PERMITTED ACTIVITIES 

IDENTIFICATION OF “BRIGHT LINE” PROPRIETARY TRADING

Agencies should develop criteria to identify ―bright line‖ proprietary trading. There 

is a general consensus among commenters and market participants that certain types 

of trading activity, in which banking entities have historically engaged, is 

unambiguously ―proprietary trading‖ within the context of the Volcker Rule. 

Agencies should ensure that banking entities eliminate proprietary trading desks, 

while remaining vigilant thereafter for any reemergence of these operations. Indeed, 

in response to the adoption of the Volcker Rule, a number of institutions have already 

shut down or spun off their proprietary trading desks that formerly engaged in socalled ―bright line‖ proprietary trading. Although ―bright line‖ proprietary trading 

represents only a portion of banking entities‘ proprietary trades, shutting down these 

desks is an important first step in the implementation of the Volcker Rule. 

A key requisite element of ―bright line‖ proprietary trading is that the activity 

involves the use of the banking entity‘s capital and is organized and conducted for the 

purpose of benefiting from future price movements. In addition, ―bright line‖

proprietary trading is typically characterized by one or more of the following 

additional characteristics: 

 Organized to conduct trading activities for the sole purpose of generating profits 

from trading strategies;

 No formal market making responsibilities or customer exposure (or customer 

exposure that is not commensurate with the level of trading);

 Physical and/or operational separation from market making and other operations 

having customer contact;
PROPRIETARY TRADING 28

 Trades with or is provided the services of, sell side analysts, brokers, and dealers;

 Receives and utilizes research or soft dollar credits provided by other brokerdealers; and/or

 Compensation structures similar to those of hedge fund managers and other 

managers of private pools of capital.

INDICIA OF CERTAIN PERMITTED ACTIVITIES 

Banking entities assume principal risk during the normal course of their permitted 

trading activities, including market making, hedging and underwriting securities. In 

considering whether these activities are fully consistent with activities permitted 

under the Volcker Rule, Agencies should consider the following indicia of permitted 

market making, hedging, and underwriting activities. 

INDICIA OF MARKET MAKING

The Volcker Rule provides an explicit exception for market making-related 

activities but requires that they be ―designed not to exceed the reasonably 

expected near term demands of clients, customers, or counterparties.‖ To ensure 

that ―market making‖ does not mask prohibited proprietary trading, Agencies 

should provide guidance that will assist banking entities in determining what 

constitutes prohibited trading activity, and will establish the basis for considering 

subsequent determinations as to whether a violation occurred. Accordingly, set 

forth below are some of the indicia of permitted market making that could be used 

to distinguish it from impermissible proprietary trading. To ensure full 

compliance with permitted activities, banking entities would likely need to change 

their business practices and implement comprehensive compliance programs. 

The Council recommends that Agencies consider the SEC‘s guidance set forth in 

its 2008 Release, SEC Release No. 34-58775 (Oct. 14, 2008), which established 

indicia of bona fide market making in equity markets, including: 

 Making continuous, two-sided quotes and holding oneself out as willing to 

buy and sell on a continuous basis;

 Making a comparable pattern of purchases and sales of a financial 

instrument in a manner that provides liquidity;

 Making continuous quotations that are at or near the market on both sides;

and

 Providing widely accessible and broadly disseminated quotes.

In addition, the SEC has stated that, generally, market makers post quotes at a 

price above the national best bid and provide liquidity on the opposite side of the 

market. Demonstrating these indicia while conducting prohibited proprietary 
PROPRIETARY TRADING 29

trading would be extremely challenging and will likely require banking entities to 

change their business practices on trading desks to conform to the Volcker Rule. 

In its 2008 Release and a predecessor release, SEC Release No. 34-50103 (July 

28, 2004), the SEC also discussed activities that would not be considered market 

making: 

Bona-fide market making does not include activity that is related to speculative 

selling strategies or investment purposes of the broker-dealer and is 

disproportionate to the usual market making patterns or practices of the brokerdealer in that security. In addition, where a market maker posts continually at or 

near the best offer, but does not also post at or near the best bid, the market 

maker‘s activities would not generally qualify as bona-fide market making for 

purposes of the exception. Further, bona-fide market making does not include 

transactions whereby a market maker enters into an arrangement with another 

broker-dealer or customer in an attempt to use the market maker‘s exception for 

the purpose of avoiding compliance with Rule 203(b)(1) [the short sale rule] by 

the other broker-dealer or customer.27

While this guidance was developed in the context of short sale rules, it may be 

useful as a consideration for determining some elements of market making 

activity in liquid markets generally. It is important to consider, however, that the 

indicia described above represent general guidelines that cannot be applied at all 

times and under all circumstances. As a specific example, the guidelines above 

do not consider the market making role of block positioners. 

Although the SEC has not provided similar guidance for less liquid markets, such 

as debt, derivatives, or asset-backed security markets, which generally lack 

mechanisms for widely-disseminated quotations, the following indicia could be 

applied in less liquid markets to determine if market making activity is in 

compliance with the Volcker Rule: 

 Purchasing or selling the financial instrument from or to investors in the 

secondary market; 

 Holding oneself out as willing and available to provide liquidity on both 

sides of the market (i.e., regardless of the direction of the transaction);

 Transaction volumes and risk proportionate to historical customer liquidity 

and investment needs; and

 Generally does not include accumulating positions that remain open and 

exposed to gains or losses for a period of time instead of being promptly 

closed out or hedged out to the extent possible. For example, an aged open 

position taken to facilitate customer trading interest would be hedged rather 

than exposed to gains and losses for a period of time.

 

27 SEC Release No. 34-50103 (July 28, 2004).
PROPRIETARY TRADING 30

INDICIA OF HEDGING

Hedging, like market making, presents significant challenges for the delineation 

of prohibited proprietary trading. Accordingly, the Volcker Rule imposes a clear 

limitation on hedging by requiring that it be ―risk-mitigating.‖ Risk-mitigating 

hedging is defined by two essential characteristics: (i) the hedge is tied to a 

specific risk exposure, and (ii) there is a documented correlation between the 

hedging instrument and the exposure it is meant to hedge with a reasonable level 

of hedge effectiveness at the time the hedge is put in place. When applying this 

definition it is important to recognize that risk exposure is not synonymous with 

position or transaction: much hedging is done on a portfolio basis.

In examining the activities of a trading desk to determine whether a hedge is riskmitigating or is instead proprietary trading, the following indicia should be 

considered: 

 Hedging activity should be designed to reduce the key risk factors in the 

banking entities‘ existing exposure, and should offset gains or losses that 

would arise from those exposures. Hedging activity should adjust over time 

based on changes in a banking entity‘s underlying exposures. 

 Hedging activity should also adjust over time if market conditions alter the 

effectiveness of the hedge even if the underlying positions remain 

unchanged. 

 Material changes in risk should generate a corresponding change in hedging 

activity and should be consistent with the desk‘s hedging policy.

INDICIA OF UNDERWRITING

As with market making, underwriting poses a risk of masking impermissible 

prohibited proprietary trading, and the Volcker Rule imposes the same restriction, 

i.e., that permitted underwriting activity must be ―designed not to exceed the 

reasonably expected near term demands of clients, customers, or counterparties.‖ 

The Council suggests that Agencies consider the following factors in determining 

whether a banking entity is engaged in permitted underwriting: 

 Assisting an issuer in capital raising;

 Performing due diligence;

 Advising the issuer on market conditions and assisting in preparation of 

registration statement;

 Purchasing securities from an issuer for resale to the public;

 Participating in or organizing a syndicate of investment banks; and

 Transacting to provide a post-issuance secondary market to facilitate price 

discovery.
PROPRIETARY TRADING 31

Such characteristics of underwriting activities are likely to be readily identifiable. 

For instance, when a firm is acting as an underwriter, its participation in the due 

diligence process and role as advisor to the issuer will be significant and clearly 

documented. Participation in a syndicate should be documented, including 

allocation of the securities in the offering, so that Agencies may review such 

documentation at their discretion. Subsequent trading in the issued financial 

instrument should also generally be determined by the conditions of the offering. 

If an issuance is oversubscribed, then an underwriter may need to sell the security 

short in order to provide extra liquidity. If an issuance is undersubscribed, then 

the underwriter will hold more of the security on its books. 

Agencies may wish to look to existing SEC rules that set conditions on trading 

practices in the context of underwriting for models of how to monitor whether an 

underwriting activity conforms to current regulatory practice or takes on 

characteristics of proprietary trading. 

IMPLEMENTATION OF THE PROPRIETARY TRADING 

PROHIBITION

OVERVIEW

Implementation of the prohibition of proprietary trading in the statute is not readily 

achievable using current risk management frameworks. The current risk 

infrastructure deployed by banking entities is primarily designed to predict and limit 

losses – not restrict proprietary trading. Consequently, while current risk 

management frameworks may provide one useful tool for Volcker Rule 

implementation, effective implementation of the proprietary trading prohibition will 

likely require the development over time of new, specifically-tailored regulatory and 

supervisory tools designed to meet these challenges. Beyond recommending an 

approach for identifying ―bright line‖ proprietary trading activities, this study 

recommends a framework for effectively addressing the challenge of distinguishing 

permissible market making and hedging activities from impermissible proprietary 

trading: 

 Programmatic compliance regime: Banking entities should be required to 

implement an effective, comprehensive program designed to monitor and ensure 

Volcker Rule compliance, and meet expectations to be articulated by supervisors. 

Elements of an effective Volcker Rule compliance regime may include internal 

policies and procedures, internal quantitative and other controls to ensure only 

permitted activities are transacted, recordkeeping and reporting systems, 

independent testing for compliance, and public attestation by the CEO that 

compliance standards are continually being met. 

 Analysis and reporting of quantitative metrics: As part of a compliance regime, 

banking entities should be required to maintain records and provide reports to 
PROPRIETARY TRADING 32

supervisors on a periodic basis sufficient to permit robust oversight of covered 

trading activities. Such reports would include quantitative trading metrics 

designed to assist Agencies in identifying impermissible proprietary trading 

activity that might be conducted in the context of market making or hedging 

activities.

 Supervisory review and oversight: Agencies should engage in supervisory review 

and oversight of trading operations, which might include periodic review and 

testing of the effectiveness of banking entities‘ internal controls and procedures; 

supervisory monitoring and review of trading activities for potentially 

problematic trends or incidents; interviews and other frequent dialogue with 

traders and management; review and monitoring of quantitative data and metrics 

reported by banking entities for potential red-flags; and examination and 

investigation of specific trading activity, including position-level data, on a 

random basis or in cases in which there is some indication that a violation may 

have occurred.

 Enforcement procedures for violations: Banking entities should be subject to 

strong supervisory consequences and penalties for violations, which should 

include termination of the activity or disposal of the investment, and other legal 

sanctions as appropriate. 

This framework provides a foundation for implementing the Volcker Rule‘s 

proprietary trading prohibition, and Agencies should strongly consider adopting rules 

that implement it. One benefit of these approaches is that they are likely to be 

mutually reinforcing and provide a comprehensive regulatory framework; a 

programmatic compliance regime, supplementary reporting and review of 

quantitative metrics and supervisory review might be designed to work in concert to 

constrain proprietary trading ex ante and identify potentially problematic trading 

activity ex post. Under section 13(e)(2) of the Bank Holding Company Act of 1956 

(the ―BHC Act‖)

28, there is a requirement for due notice and opportunity for a hearing 

prior to any order issued that would require the termination of any proprietary trading 

or investment activity by a banking entity or nonbank financial company supervised 

by the Board.

Although this four-part implementation framework is promising, flexible and 

dynamic adaptation of each of the four supervisory tools will be important; they 

should be viewed by Agencies as a set of options to choose from in implementing the 

Volcker Rule in a way that meets the guiding principles recommended by the 

Council. All four parts of the framework may not be relevant or helpful in 

implementing all aspects of the proprietary trading prohibition, and it may be 

desirable to place a differing degree of emphasis on each part of the framework 

depending on the specific activity or asset class in question.

 

28 12 U.S.C. § 1851(e)(2).
PROPRIETARY TRADING 33

PROGRAMMATIC COMPLIANCE REGIME 

The Council recommends that Agencies compel banking entities to develop and 

integrate into current compliance regimes a new, specifically-tailored program of 

policies, procedures and other controls designed to ensure adherence to the Volcker 

Rule and facilitate supervision. Such a programmatic compliance regime may offer a 

number of benefits by leveraging and strengthening the existing mechanisms banking 

entities use to conduct business and control risk, providing supervisors with important 

banking entity- and business-specific information to accurately identify and evaluate 

risk, allowing banking entities to continue to engage in permitted activities, and 

minimizing the potential for evasion of the rule. 

INTERNAL POLICIES AND PROCEDURES 

Agencies should strongly consider requiring banking entities to develop a robust 

and comprehensive set of internal policies and procedures to guide trading 

activity and ensure that only permitted activities are conducted. These policies 

and procedures would be required to meet supervisory expectations. Among 

these policies and procedures, Agencies could mandate that banking entities 

produce and maintain a comprehensive description of the mission and strategy for 

all permitted trading activity conducted across the banking entity, down to the 

business- and desk-level. Such statements might be required to include:

 The mandate of each trading unit or profit center;

 A description of how revenues are generated and positions are hedged;

 An enumeration of activities engaged in by the trading unit or profit center;

 Detail of the types of customers served;

 A description of the activity typical of the customer base;

 A listing of the types of products approved for transactions; and

 A description of the compensation policy for those engaged in risk-taking 

activities.

Developing such policies and procedures could prove useful in ensuring that 

internal controls and supervisory reviews are appropriately attuned to the specific 

conditions of each trading unit or profit center within the firm, thus avoiding a 

―one-size-fits-all‖ approach that might inadvertently prohibit a permitted activity 

or permit an activity that is prohibited. 

In addition, Agencies could require that the policies and procedures articulate the 

types and levels of risk that are necessary to execute the articulated mission of 

each trading unit, as well as a rationale for why the risk types and levels specified 

are appropriate and necessary in light of the Volcker Rule. Requiring firms to 

provide this type of justification could serve as an important anchor for the 
PROPRIETARY TRADING 34

supervisory assessment of the appropriateness of firms‘ overall compliance 

programs. Policies could also establish specific review and escalation procedures 

for violations of limits and controls.

INTERNAL QUANTITATIVE AND OTHER CONTROLS

Agencies should consider requiring banking entities to develop and implement a 

program of controls to monitor trading activity and to ensure that the types and 

levels of risk taken are appropriate and consistent with articulated Volcker Rule 

policies and procedures. For example, Agencies might require that each type of 

market-making business a banking entity operates have control structures attuned 

to the specific risks required to operate in that market in a manner that ensures 

supervisory expectations are met. This approach is likely to permit Agencies to 

leverage and potentially strengthen the existing control mechanisms firms—and 

supervisors—use to understand and manage risk.

Among other things, Agencies may wish to consider requiring firms to:

 Establish authorized risks, instruments and products designed to ensure 

that all covered trading activity remains consistent with approved policies 

and procedures;

 Establish procedures to analyze revenues to discern the nature of trading 

activity conducted, including the key drivers of profitability and losses. 

Sources of revenue that Agencies may wish to consider include (i) 

customer income, such as commissions, fees, bid/offer spread and 

inception booking profit & loss (―P&L‖); (ii) risk income or income 

associated with changes in market variables; (iii) volatility of daily 

revenues over time, including volatility of customer and risk income; and 

(iv) other factors, including revenues associated with changes in valuation 

model structure or assumptions;

 Establish risk limits to ensure that risk-taking is appropriately constrained 

in a way that disallows prohibited activities. Such limits may be set in 

light of trading unit mission and strategy statements enumerated in internal 

policies. Appropriate limits to be considered by Agencies may include 

constraints on risk-taking as measured by Value at Risk (VaR) models, 

portfolio stress testing and P&L sensitivities associated with changes in 

market prices. Such limits could be implemented across profit centers, 

asset classes and market segments; and

 Establish stop-loss limits in order to trigger reviews and potentially 

cessation of trading activity when such limits are met or exceeded.
PROPRIETARY TRADING 35

RECORDKEEPING AND REPORTING SYSTEMS

Agencies may wish to consider requiring banking entities to establish 

recordkeeping and reporting systems of a type that will facilitate both internal and 

supervisory monitoring of the elements described above. These may include the 

production and retention of reports analyzing data showing trends in trading 

activity that are relevant to Volcker Rule analysis. For example, trading units 

could be required to produce regular reports that show how revenues are driven 

by customer activity or changes in specified market factors. Such reports could 

be required to be provided to supervisors in order to facilitate regular monitoring 

and supervisory reviews. In addition to reports, Agencies should consider 

requiring banking entities to maintain trade-level data to facilitate internal and 

supervisory review, which would also support independent testing and attestation 

requirements, if Agencies elect to impose such requirements. 

INDEPENDENT TESTING

Another element of a programmatic compliance regime is an independent testing 

requirement. These requirements could be similar to those that the banking 

agencies have established with respect to Bank Secrecy Act/ Anti-Money 

Laundering (―BSA/AML‖) compliance, and could mandate that independent 

testing be conducted by a banking entity‘s internal audit department or by outside 

auditors, consultants, or other qualified independent parties. Expectations for the 

frequency and nature of independent testing would vary by factors such as the 

size and risk profile of the banking entity. Such independent testing might 

include an evaluation of the overall adequacy and effectiveness of the compliance 

regime; testing for specific compliance with the Volcker Rule; an analysis of 

appropriate breadth of coverage; and an evaluation of pertinent management 

information systems. The testing could assist the Board of Directors and senior 

management in identifying areas of weakness or areas where there is a need for 

enhancements or stronger controls, and could serve as a tool for supervisors to use 

in assessing a banking entity‘s compliance with the Volcker Rule. 

CEO AND BOARD ACCOUNTABILITY

Agencies should also strongly consider imposing obligations on the Board of 

Directors and the CEO of banking entities to ensure that they are effectively 

engaged in and accountable for compliance with the prohibition on impermissible 

proprietary trading. The Board of Directors and the CEO could be made 

responsible for developing and maintaining a program reasonably designed to 

achieve compliance with the Volcker Rule. For example, the Board of Directors 

could be made responsible for such matters as: approving the compliance 

program; overseeing the structure and management of the banking entity‘s 

compliance with the Volcker Rule; setting an appropriate culture of compliance; 

and ensuring that these policies are adhered to in practice. 
PROPRIETARY TRADING 36

The CEO could be made responsible for such matters as: communicating and 

reinforcing the compliance culture established by the Board of Directors; 

implementing the program; reporting to the Board of Directors and the banking 

entity‘s supervisors on the effectiveness of the program; and escalating 

compliance matters as appropriate. It is expected that programs approved by the 

Board of Directors and the CEO will designate an individual or individuals 

responsible for compliance and will include training for appropriate personnel. 

Agencies should also strongly consider requiring the CEO to attest publicly to the 

ongoing effectiveness of the internal compliance regime. This will ensure the 

highest level of accountability for the satisfaction of these expectations.

ANALYSIS AND REPORTING OF QUANTITATIVE METRICS

In addition to establishing a programmatic compliance regime as part of a 

comprehensive implementation framework, the Council recommends that Agencies 

consider requiring banking entities to report and supervisors to review quantitative 

metrics that may assist Agencies in identifying potential impermissible activities. 

Such an approach would be designed to provide Agencies with an objective set of 

data that (i) brings to supervisory attention trading trends or incidents that may 

suggest that violations have occurred and (ii) facilitates the comparison of such 

trading data across banking entities, market segments, or trading strategies to inform 

and strengthen the supervisory process. Agencies should consider utilizing an array 

of metrics when reviewing trading activity. 

Such quantitative metrics would take advantage of the fact that proprietary trading 

may evidence different quantitative characteristics than permitted activities conducted 

in response to customer demand. After studying a variety of quantitative metrics 

described by commenters and market participants, the Council has identified four 

promising categories of quantitative metrics: 

1. Revenue-Based Metrics: These metrics would attempt to measure daily 

revenue and revenue from specific trades relative to historical revenue and 

similar data for other banks (i.e., horizontal comparison). Revenues and losses 

for market making and certain other permitted activities principally derive 

from both spreads and price movement in the inventory held while 

impermissible proprietary trading revenue is generated principally from price 

movements. An analysis of revenue may allow a determination that a 

particular trade or activity was proprietary in nature. 

2. Revenue-to-Risk Metrics: These metrics would attempt to measure revenue 

generated per unit of risk assumed. Market makers and underwriters endeavor 

to mitigate risk by quickly reselling or hedging positions that are acquired, 

whereas proprietary traders actively seek to assume risk by holding positions

with the expectation that they will appreciate. Consequently, permitted 

activities are likely to have greater revenue-to-risk ratios than impermissible 

proprietary trading. 
PROPRIETARY TRADING 37

3. Inventory Metrics: Inventory turnover compares the asset value that is 

transacted each day to the value of assets that are held in inventory. This 

measure takes into account the need for market makers to hold inventory, but 

relates it to observed customer demand. A market maker that retains risk well 

in excess of customer demand is more likely to be holding an impermissible 

proprietary position in that risk. 

4. Customer-Flow Metrics: These metrics evaluate the volume of customerinitiated orders on a market making desk against those orders that are initiated 

by a trader for the purposes of building inventory or hedging. Significant 

trader-initiated, rather than customer-initiated, order volume could indicate that 

impermissible proprietary activity has occurred.

Although the Council believes that these four categories of quantitative metrics may 

be useful in helping Agencies identify impermissible proprietary trading, it is 

important to note that each category, and quantitative metrics in general, have certain 

limitations as implementation tools. Given the complexity of trading activities any 

single quantitative metric is likely to produce both ―false positives‖ and ―false 

negatives.‖ Accordingly, metrics are best utilized by Agencies as a key source of 

information for identifying potentially problematic trading activities that may require 

further study, rather than a comprehensive, dispositive tool. In addition, the relevance 

or utility of any particular metric may vary significantly depending on the asset class, 

liquidity, trading strategy and market profile of the trading activity in question. There 

may be other categories of quantitative metrics that Agencies identify over time that 

may also assist them in identifying impermissible proprietary trading.

Notwithstanding these limitations, the Council believes that quantitative metrics are 

likely to be a useful tool in implementing the Volcker Rule, and recommends that 

Agencies strongly consider incorporating the reporting and review of quantitative 

metrics as part of the comprehensive implementation framework. In particular, 

although each specific quantitative metric may have certain limitations, a 

combination of metrics, together with robust supervisory oversight, may prove a 

powerful tool in assisting Agencies in identifying impermissible proprietary trading. 

This study includes a detailed summary of the potential, specific types of metrics that 

the Council believes Agencies may find useful to consider. We note that this 

summary is intended to be descriptive, not prescriptive, in nature. Agencies should 

carefully evaluate these and other potential quantitative tools as they implement the 

Volcker Rule through their rulemaking processes or subsequent supervisory 

experience.

REVENUE-BASED METRICS

Revenue trends in market making desks are appropriate benchmarks against 

which Agencies may compare the current period‘s revenue to determine whether 

a desk is engaging in impermissible proprietary trading. 
PROPRIETARY TRADING 38

Agencies should consider the difficulties in applying some of these revenue-based 

metrics to the review of trading activities in illiquid markets as well as the 

complexity of comparing historical revenue of trading desks given the impact that 

market movements would have on desk revenue. 

Potential revenue-based metrics that have relevance in this regard might include:

 Historical Revenue Comparison: This measure compares a particular 

period‘s revenue to historical trends. If a trading desk‘s revenue from a 

particular day, month or quarter is outsized relative to recent trends, that 

desk could be implementing strategies that include impermissible 

proprietary trading. 

 Day One Profit & Loss: This measure compares the profitability of 

positions on the first day they are taken with the profitability of all positions 

held that day. This metric seeks to address the challenge of discerning the 

source of a firm‘s profitability. Day One Profit & Loss is likely to be higher 

for market makers that profit immediately from capturing the spread upfront 

than for proprietary traders that seek to profit from asset appreciation in the 

near term. 

 Bid-Offer Pay-to-Receive Ratio: This measure compares the profitability of 

positions on the first day they are taken with the total trading activity on that 

day. The metric seeks to approximate whether a trader is more likely to be 

purchasing securities at the ―bid‖ or ―offer,‖ even in the absence of 

continuously quoted markets. 

REVENUE-TO-RISK METRICS

Market making activities usually have higher levels of revenue per unit of risk 

compared with proprietary trading operations.29 For market makers, who seek to 

minimize the risk associated with a position held, revenue will derive from high 

turnover of a position rather than appreciation in the position, while the opposite 

is true of proprietary traders. 

Because revenue-to-risk measures are well-established concepts, these metrics are 

broadly applicable within a banking entity and across banking entities. Agencies 

should note that the following set of metrics may be less effective for particular 

trading strategies, such as high-frequency trading strategies or strategies that are 

predicated on non-linear trading strategies.

Potential revenue-to-risk metrics include:

 Profitable Trading Days as a Percentage of Total Days: Market makers 

will tend to evidence more consistent daily profitability than proprietary 

 

29 In the context of bank accounting, trading revenue generally refers to net profits from trading rather than 

gross notional amounts traded on a pass-through basis.
PROPRIETARY TRADING 39

traders. Market makers seek to price into each transaction an appropriate 

spread and manage inventory tightly. By design, proprietary traders tend to 

seek exposure to market fluctuations, which do not follow a defined day-today pattern. 

 Sharpe Ratios: This measure compares the annualized total revenue or 

excess return of the firm or trading desk to the annualized standard deviation 

of revenue or standard deviation of the portfolio (i.e., how much the firm‘s 

trading profit varies from day-to-day) or how much excess return is earned 

for every unit of risk taken. Similar to the measure of profitable trading 

days as a percentage of total days, established proprietary trading activities 

will generally have a lower Sharpe ratio, as proprietary trading generally 

results in higher earnings volatility.

 Revenue-to-Value at Risk: This measure evaluates the revenue per dollar of 

value-at-risk in the firm. For a given level of profitability, market making 

should entail less aggregate risk than proprietary trading as market makers 

retain the risk for a shorter period of time. 

 Value at Risk: Standard value at risk metrics (VaR) may also provide 

Agencies with a helpful guide for areas that bear further scrutiny. 

INVENTORY METRICS

The rate of inventory turnover and aging in a firm‘s portfolio can provide 

evidence that a banking entity‘s market making-related activities are intended to 

meet ―reasonably expected near term demand.‖ Such permitted market makingrelated activities seek to profit from inventory flow rather than from appreciation 

of assets held in inventory. Furthermore, a firm‘s inventory is directly 

controllable by its management, and so may be a particularly effective lever for 

management to monitor compliance. To be effective, inventory metrics should be 

calibrated by asset class so that they can measure relatively longer holding periods 

within the context of trading activities.

 Inventory Turnover: This metric calculates the ratio of assets that are 

transacted each day to assets that are retained in inventory. The metric takes 

into account the need for market makers to hold inventory (volume of 

retained assets), but relates it to the asset‘s observed customer demand 

(volume of transacted assets).

Impermissible proprietary trading seeks to profit from the appreciation of an 

asset. Retaining assets well in excess of customer demand may be an 

indicator that the trader is seeking to profit from the appreciation of 

inventory. Conversely, market makers with a near term goal of serving 

customers will acquire and sell (or, for some instruments, hedge) within as

short timeframe as possible in order to profit from the bid-ask spread. 

 Inventory Aging: Inventory aging measures how long inventory has resided 

on the balance sheet rather than simply how large it is. Retaining inventory
PROPRIETARY TRADING 40

where near term customer demand fails to appear rather than selling such 

inventory could indicate impermissible proprietary trading. 

CALCULATING INVENTORY TURNOVER AND AGING

For highly liquid financial instruments, inventory turnover and aging are 

relatively straightforward to measure as banking entities will have both 

significant daily volume and measurable inventories of each discrete asset. 

Such financial instruments include most cash equities, high volume foreign 

exchange rate pairs, commercial paper, and other financial instruments for 

which risk can be offloaded quickly. For such assets, banking entities may 

compare the gross notional value traded each day against the amount retained 

in inventory. 

Less-liquid or more complex financial instruments may necessitate a more 

nuanced measure of inventory turnover. While such financial instruments 

may be correlated or hedged with other financial instruments, they may be 

individually distinct in the way in which they are valued. Likewise, two 

seemingly similar financial instruments may have very different valuation 

factors (for example, a call option that has an ―in the money‖ strike price 

versus a deep ―out of the money‖ strike price).

In these situations, it may be possible to develop ―factor-based‖ measures of 

inventory turnover that relate to the key drivers of valuation for the financial 

instruments a banking entity holds in inventory. Different asset classes will 

tend to have different valuation factors based on their underlying 

characteristics (for example, debt instruments have both credit default risk and 

interest rate risk). Likewise, for asset classes that vary in maturity, one would 

need to develop mechanisms to normalize for different tenors of maturity 

(e.g., the difference between a 1-year and a 2-year contract for a type of 

derivative). 

The specific valuation factors that affect a financial instrument‘s value are 

closely tied to the asset class, and so would likely need to be defined on a 

desk- or asset class-specific basis. Importantly, these valuation factors are 

already in widespread use in many instances, as banking entities employ them 

as essential tools for pricing financial instruments in a trading context as well 

as for inventory risk management. In this way, inventory turnover and aging 

measures may reflect a new application for previously established risk 

management tools.
PROPRIETARY TRADING 41

CUSTOMER-FLOW METRICS

Analytical reviews of trading activity may also include an analysis of the relative 

proportion of transactions that are conducted by a trading desk directly with 

customers. ―Customer-initiated‖ trades are those that come to trading desks 

unsolicited. These orders typically come to the trader through the dealer‘s sales 

force rather than directly from the customer. This includes trades executed for the 

banking entity‘s investment account if that account is operated independently of 

the trader. Banking entities are likely to be able to distinguish these trades from 

―trader-initiated‖ trades. 

Trader-initiated transactions might be solicited by the trader directly, or come 

indirectly by the trader soliciting an order through a salesperson. Trader-initiated 

transactions would include hedges that a trader will initiate in an attempt to 

reduce portfolio risk or transactions that a trader solicits to reduce inventory to 

acceptable levels. In some cases, however, where an ongoing customer dialogue 

exists, it may be difficult to establish this distinction. As described in the 

proposed compliance regime, there should be strong penalties for traders or 

salespeople that make a practice of mischaracterizing trader-initiated trades as 

customer-initiated trades.

Because trader-initiated trades are a normal part of market making and hedging 

activity, the potential metrics outlined below focus on relationships and 

correlations between these types of activities. The fact that a transaction is traderinitiated should not by itself suggest that the transaction is impermissible. 

If Agencies require banking entities to add this data field to their internal 

recordkeeping of trade ticket data, the Council believes that this information may 

significantly enrich the analytical ability of both banking entities and Agencies to 

identify impermissible proprietary trading. 

Some examples of customer flow metrics include:

 Customer-Initiated Trade Ratio: This metric compares the amount of 

customer-initiated flow relative to trader-initiated flow. Trader-initiated 

flow should be closely correlated with customer-initiated flow, as traderinitiated positions should be established primarily to hedge positions 

acquired from customers, or to manage inventory to appropriate levels such 

as in anticipation of customer demand.

 Customer-Initiated Flow to Inventory: This calculates the volume of a 

desk‘s inventory relative to the desk‘s average customer-initiated trades. 

Inventory should remain in proportion to customer-initiated trades in most 

instances.

 Revenue to Customer-Initiated Flow Ratio: This ratio measures the trading 

desk‘s revenue to the proportion of customer-initiated flow. There should 

be a strong relationship between the customer-initiated flow on the desk and 

the revenue it generates.
PROPRIETARY TRADING 42

METHODOLOGY FOR ANALYZING METRICS

Using the four types of metrics discussed above, Agencies may find it useful to 

develop a standard quantitative ―profile‖ of market making for each specific asset 

class or trading desk. This might entail developing a methodology for analyzing 

the metrics as well as data that is used to construct each metric to better 

understand the quantitative profile of different types of trading desk activities and 

banking entity-specific differences in customer activity and organizational 

structure.

This study recommends Agencies consider three approaches as a means to 

developing this ―profile.‖ While each of these approaches carries advantages and 

drawbacks, they could also be combined to apply this analysis on a banking 

entity-specific basis.

Agencies should consider requiring banking entities to allocate sufficient 

resources for the application and testing for these metrics:

 Cross-Industry Review: This approach may enable a comparison on a deskby-desk basis across banking entities by Agencies to determine appropriate 

ranges for each trading operation and a common measurement methodology.

Such an approach would help create a consistent standard by which banking 

entities are evaluated, and allow for a fair application of the Volcker Rule 

across banking entities. 

 Firm-Specific Operating Experience: This approach would rely on firmspecific historical data to define appropriate parameters for trading 

operations. Such an approach would help capture differences in business 

mix and organization across banking entities. However, if applied in 

isolation, an inconsistent application of the Volcker Rule, and a potential 

―race to the bottom‖ among banking entities may result.

 Comparisons to Standalone Proprietary Trading Operations: This 

approach would to the extent possible compare appropriate ranges for hedge 

funds or other independent proprietary trading operations matched by asset 

class. 

Within all of these constructs, it will be important to account for the fact that 

banking entities often have different customer mixes resulting in different types of 

trading strategies, volumes as well as risk exposures. Any analysis of metrics will 

need to take these structural variations among banking entities into account.

In using metrics such as those described above, it is important to carefully define 

the segmentation of the banking entity to which such metrics apply and the period 

over which they are measured. Key considerations in considering how best to 

define this segmentation include:

 Banking Entity Segmentation: In general, a more granular segmentation 

(e.g., at a trading desk level versus a line of business level) will be more 
PROPRIETARY TRADING 43

likely to identify proprietary trading activities, but may also be more likely 

to generate false positive results as well as more volatile results. By 

extension, a segmentation that is insufficiently granular will be less likely to 

identify proprietary trading activities, as these will be subsumed by the 

broader portfolio effects of the banking entity‘s larger market making 

activities. 

 Measurement Frequency: Conducting ―real time‖ assessments or ―point-intime‖ measurements is likely to generate false positives given general 

variability in market conditions. Further, the fact that proprietary trading 

requires time to allow for asset appreciation means that most proprietary 

activities will extend over a longer time period. Consequently, metrics may 

be measured on a trailing basis – with the period of time to vary by the 

liquidity of the asset class – provided that the recordkeeping and 

management supervisory review period is as short as is necessary for the 

asset class. In addition, Agencies may consider using a time series to 

analyze changing patterns over time.

 Additional Metrics: Importantly, the quantitative metrics employed to 

identify proprietary trading should not be limited to the metrics explored in 

this study. If other quantitative metrics are developed, either by banking 

entities, Agencies or through exogenous research, Agencies should consider 

exploring the viability and practicality of employing other quantitative 

metrics.

ROLE OF THE OFFICE OF FINANCIAL RESEARCH

The newly-established Office of Financial Research (―OFR‖), when fully 

operational, might serve a helpful role in assisting Agencies in enforcing the 

Volcker Rule‘s prohibitions. For instance, the SEC and CFTC will have access to 

significant amounts of new data that must be reported as part of oversight of the 

derivatives markets. Further, by utilizing this trade data, OFR may be able to help 

analyze effective metrics over time as a key research project. If support is 

provided by the OFR, it should be used to augment Agencies‘ ongoing efforts. 

SUPERVISORY REVIEW AND OVERSIGHT

The Council‘s expectation is that the programmatic compliance regime, together with 

the reporting of certain quantitative metrics, will provide a strong foundation for 

robust supervisory review and oversight of compliance with the Volcker Rule. 

Supervisory review is likely to be the ultimate lynchpin in effective implementation 

by Agencies.

In particular, the Council recommends that Agencies strongly consider incorporating 

some or all of the following supervisory components in implementation of the 

Volcker Rule, as Agencies determine appropriate. The Council recognizes, however, 
PROPRIETARY TRADING 44

that some Agencies face significant resource constraints and that incorporation of 

these components, which include a review of trading practices to identify prohibited 

trading and distinguish permissible trading, would require significant new and 

specialized resources. For instance, Agencies would need to develop appropriate data 

points, build infrastructure to obtain and review information, and hire and train 

additional staff with substantial quantitative and market expertise to identify and 

investigate outliers and questionable trades.

The application of metrics across an evolving range of products, strategies and market 

dynamics will require substantial quantitative and market expertise. Therefore, 

Agencies will also need to develop appropriate experience.

PERIODIC REVIEW AND TESTING OF INTERNAL CONTROLS AND PROCEDURES

Periodic review and testing by supervisors of banking entities‘ internal 

compliance regimes will likely be a key part of any program of supervisory 

review and oversight. Such reviews could serve as a means for Agencies to 

develop confidence in the integrity of the banking entities‘ programs for 

eliminating prohibited activities and in the data produced to the supervisors. The 

frequency and scope of specific reviews should be conducted as Agencies deem 

appropriate, in light of factors such as the size, risk profile, and business mix of 

each banking entity and/or profit center within such banking entity. In order to 

focus on the most relevant program elements, Agencies will likely need to engage 

in supervisory review planning that incorporates analysis conducted through their 

ongoing monitoring activities, including the review of trading metrics and 

communication with trading and management of regulated firms. 

As part of this review and testing, Agencies would need to elaborate and 

promulgate the applicable set of standards upon which firms‘ practices will be 

evaluated in order to increase the transparency of the review process. Program 

deficiencies that do not meet specified standards should be remediated within a 

timeframe deemed appropriate by Agencies. Remediation actions and time 

frames should be commensurate with the nature of the program deficiency, with 

special consideration given to repeated deficiencies.

ONGOING SUPERVISORY MONITORING AND REVIEW OF TRADING ACTIVITIES 

Agencies should also strongly consider conducting regular monitoring of trading 

activity in order to identify impermissible activity and to inform the scope and 

frequency of periodic targeted supervisory reviews. This monitoring may take the 

form of the regular collection, review, and analysis by supervisors of trading data 

relevant to Volcker Rule compliance, such as trading exposures and revenues. It 

may be useful for such data to be aligned with the metrics tracked and used 

internally by firms, including those used by business, risk management and 

compliance personnel, as well as those that may be identified by Agencies as part 
PROPRIETARY TRADING 45

of the Volcker Rule implementation. Where it is appropriate in light of the risk 

profile of the banking entity or specific profit centers within the banking entity, 

Agencies may consider analyzing data at varying levels of aggregation (that is, 

from firm-wide to specific desks) and across asset classes. Agencies will need to 

consider how frequently to require reporting of data from banking entities. In the 

case of banking entities with sophisticated trading operations, Agencies may 

decide to collect data on a daily basis for significant firm-wide metrics, such as 

revenues and VaR, while collecting and analyzing other relevant data on a more 

periodic basis. 

FREQUENT COMMUNICATION WITH TRADING PERSONNEL 

The Council recommends that Agencies will strongly consider engaging in 

regular dialogue with relevant management, trading and control personnel in 

order to understand and evaluate specific trading behavior by banking entities in 

light of the Volcker Rule. Such dialogue may prove important to understanding a 

firm‘s business model (and the conformance of that business model with Volcker 

Rule permitted activities) as well as the market context of trading activity. 

Such dialogue might occur both through ongoing monitoring efforts as well as in 

the course of periodic, targeted on- or off-site examinations of trading activity. In 

establishing the frequency and nature of the examinations that will be desirable to 

implement the Volcker Rule, Agencies will need to consider the size, risk profile, 

and business mix of banking entities and available supervisory resources. 

REVIEW OF QUANTITATIVE METRICS FOR RED FLAGS

As part of the ongoing monitoring and examinations that Agencies may decide to 

undertake, the Council recommends that Agencies strongly consider making use 

of quantitative metrics reported to them by banking entities in order to identify 

issues that require additional review. Quantitative metrics, such as those 

discussed above, may prove useful for identifying prohibited activities or 

weaknesses in banking entity programs, and may be an important mechanism for 

achieving consistency in Volcker Rule application across banking entities. 

The analysis of such quantitative metrics may best be conducted within the 

context of banking entity compliance programs, and against the backdrop of 

supervisory oversight plans for the relevant institution. 

ENFORCEMENT PROCEDURES FOR VIOLATIONS

Another key aspect of supervisory review and oversight is likely to be the 

investigation process that supervisors undertake when they identify evidence of a 

potential violation – whether identified in the context of ongoing monitoring 
PROPRIETARY TRADING 46

activity or a targeted examination, through review of metrics, or as a result of 

reporting done pursuant to compliance programs. 

As a part of establishing this investigation process, Agencies should consider how 

to ensure its consistency with the mechanisms prescribed by section 13(e)(2) of 

the Volcker Rule, which provides that Agencies shall take steps to order the 

termination or disposition of non-compliant activities or investments after 

providing notice and opportunity for a hearing. Agencies should also consider 

what other types of enforcement actions they may take to penalize banking 

entities who engage in impermissible activities, or whose compliance programs 

are found insufficient by their supervisors. 

APPLICATION TO OTHER RELATED ACTIVITIES

The Volcker Rule allows banking entities to engage in certain other permitted 

activities, which are enumerated below. 

 Government securities: The statute allows for the purchase, sale, acquisition, or 

disposition of federal government debt, federal agency debt, and municipal debt. 

In contrast to more limited descriptions of particular activities provided in other 

permitted activities, the statute broadly permits all transactions in these 

government securities, subject to the statutory ―backstop‖ provisions discussed 

below. (Please see ―Statutory Limitations on Permitted Activities‖ below.) 

Banks serve as a critical source of liquidity in these markets. In addition, these 

instruments have historically served a significant role in traditional banking 

activities, providing a low-risk, short-term liquidity position and are a commonly 

utilized source of collateral in transactions.

 Small business and public welfare: In addition to direct lending, banks also 

provide capital to small businesses through small business investment companies. 

Such investments are permitted activities, as are public welfare investments. 

These activities benefit the broader economy. 

 Insurance: There are specific allowances for investments made by insurance 

companies for their general account. This provision reflects the investment 

method of the insurance industry by which their policies and contracts are funded 

by a central fund, with risk managed on a portfolio basis. This permitted activity 

reflects the differing structural nature of banking and insurance, and the nature of 

the proprietary investments. The industries are also traditionally subjected to 

different but stringent regulatory treatment and oversight. (Please see 

―Accommodating the Business of Insurance‖ below.)

 Offshore activities: The Volcker Rule applies to domestic banking operations of 

foreign institutions. However, because of U.S. extra-territorial regulatory 

constraints, the statute does not restrict proprietary trading conducted by non-U.S. 

entities outside the United States. These entities are not eligible for discount 

window loans or federal depository insurance.
PROPRIETARY TRADING 47

In addition, the Volcker Rule has a rule of construction with respect to securitization 

of loans. Commenters also discussed the application of the Volcker Rule with respect 

to asset-liability management.

 Securitization of loans: The Volcker Rule provides that ―Nothing in this section 

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 

otherwise permitted by law.‖ In other words, this inviolable rule of construction 

ensures that the economically essential activity of loan creation is not infringed 

upon by the Volcker Rule. The creation and securitization of loans is a basic and 

critical mechanism for capital formation and distribution of risk in the banking 

system. While these activities involve the assumption of principal risk, the 

broader benefits to the economy reflect the intent of federal borrowing subsidies 

and protections. Accordingly, Congress determined that none of the restrictions 

of the Volcker Rule, nor the ―backstop‖ restrictions on permitted activities, will 

apply to the sale or securitization of loans. However, Agencies should carefully 

consider the scope of this exclusion and ensure that its implementation does not 

undermine the prohibition on proprietary trading.

 Asset-Liability Management: One of the more significant scope issues related to 

the Volcker Rule is whether the prohibitions should apply to non-trading 

positions. All commercial banks, regardless of size, conduct asset-liability 

management (―ALM‖) that help the institution manage to a desired interest rate 

risk and liquidity risk profile. This study recognizes that ALM activities are 

clearly intended to be permitted activities, and are an important risk mitigation 

tool. In particular, banks use their investment portfolios as liquidity buffers. A 

finding that these are impermissible under the Volcker Rule would adversely 

impact liquidity and interest rate risk management capabilities as well as 

exacerbating excess liquidity conditions. These activities also serve important 

safety and soundness objectives. However, given that active trading can occur in 

an asset liability management portfolio, Agencies should consider whether to 

verify as part of their ordinary supervisory activity that there is no prohibited 

proprietary trading occurring in ALM portfolios.

STATUTORY LIMITATIONS ON PERMITTED ACTIVITIES

While the Volcker Rule permits certain activities involving principal risk, the statute also 

imposes limits on these activities. In relevant part, the statute reads: 
PROPRIETARY TRADING 48

(2) LIMITATION ON PERMITTED ACTIVITIES.—

(A) IN GENERAL.—No transaction, class of transactions, or activity may be 

deemed a permitted activity under paragraph (1) if the transaction, class of 

transactions, or activity—

(i) would involve or result in a material conflict of interest (as such term shall be 

defined by rule as provided in subsection (b)(2)) between the banking entity and 

its clients, customers, or counterparties; 

(ii) would result, directly or indirectly, in a material exposure by the banking 

entity to high-risk assets or high-risk trading strategies (as such terms shall be 

defined by rule as provided in subsection (b)(2)); 

(iii) would pose a threat to the safety and soundness of such banking entity; or

(iv) would pose a threat to the financial stability of the United States.30

MATERIAL CONFLICTS OF INTEREST

Under the Volcker Rule, permitted activities are prohibited if they involve or would 

result in a material conflict of interest.31 Indeed, such conflicts of interest were 

among the central concerns motivating the Volcker Rule‘s proprietary trading 

prohibition, and a companion provision, section 621 of the Dodd-Frank Act, which 

calls for SEC rulemaking on certain material conflicts of interest of the underwriter, 

placement agent, initial purchaser, or sponsor of an asset-backed securities 

transaction.32 In particular, there was concern that banking entities could actively 

trade against the positions of their customers, or could profit from betting against 

financial instruments the firm had assembled and sold to customers. 

Proprietary trading presents potentially serious conflicts of interest between a firm‘s 

activities that take a directional view and the customer-serving activities that should 

facilitate proper functioning of markets. A customer could unknowingly suffer 

financial injury if, for example, the firm were to trade ahead of customer orders or 

anticipated orders for financial instruments and profit from changes in the market 

price resulting from the customer‘s order. Or the firm could trade based on 

information about a future underwriting deal for the customer, or knowledge of a 

customer‘s portfolio of securities.33 

 

30 12 U.S.C. § 1851(d)(2)(A).

31 Id. at § 1851(d)(2)(A)(i).

32 156 CONG. REC. S4100 (daily ed. May 24, 2010) (Floor statement of Sen. Levin); 156 CONG. REC. 

S5897 (daily ed. July 15, 2010) (Floor statement of Sen. Merkley); 15 U.S.C. § 77z-2a. See also DoddFrank Act section 989(b)(1)(C) (directing GAO study on proprietary trading, including whether proprietary 

trading creates material conflicts between firms and customers of the firm who use the firm to execute 

trades or manage customer assets).

33 See REMARKS BEFORE THE SECURITIES INDUSTRY ASSOCIATION COMPLIANCE AND LEGAL DIVISION, 

(SEC Division of Market Regulation Director Annette Nazareth, July 19, 2005) (at 

http://www.sec.gov/news/speech/spch071905aln.htm).
PROPRIETARY TRADING 49

Additionally, the combination of banking and trading may present particular conflicts 

of interest. Most notably, commercial banking operations acquire substantial 

amounts of nonpublic information about the financial condition of the companies to 

which they lend. Moreover, banking entities frequently advise corporate customers 

on debt and equity transactions and other corporate activities through which they 

accumulate nonpublic information. If information is transmitted from the lending and 

advising units of banking entities to trading operations, trading desks could use this 

inside information to make profitable trades, thus creating material distortions in the 

capital markets at customers‘ expense. Although firms instituted information barriers 

designed to prevent information flow between customer-serving activities and 

proprietary trading desks, the statute goes further with respect to banking entities and 

imposes a prohibition on proprietary trading.

In imposing a prohibition on proprietary trading, the Volcker Rule directly cuts off a 

banking entity‘s opportunity to profit from conflicted proprietary trading, thereby 

protecting customers from financial injury arising from such conflicts. In 

implementing the Volcker Rule, Agencies should consider the extent to which the 

permitted activities present risks that banking entities will conduct transactions that 

place the banking entity‘s own interests ahead of its obligations to its customers and 

counterparties, and where such conflicts might arise, and what steps can be designed 

to prevent the banking entity from proceeding with the transaction in a manner 

contrary to those obligations. 

Agencies should consider all types of transactions, structures and roles in connection 

with permitted activities that pose a heightened risk for material conflicts of interest, 

including cases when the banking entity has a customer‘s business in two different 

areas and the transaction could adversely affect the customer or when the banking 

entity holds an informational advantage over its customers and positions itself to 

benefit financially from transactions that are financially harmful to customers. 

Agencies should also consider situations where the financial incentives associated 

with a banking entity‘s relationship with one customer might create circumstances 

under which particular benefits might accrue to the bank as a result of treating another 

customer less favorably. Agencies should also consider whether particular attention 

needs to be paid to situations when different departments or units have differing 

interests and incentives with respect to a customer. 

In general, concerns regarding conflicts of interest are elevated when transactions are 

complex, highly structured, or opaque; involve illiquid or hard-to-value instruments 

or assets; require the coordination of multiple internal groups (such as multiple 

trading desks or affiliated entities); involve a significant asymmetry of information; 

or transactional data among participants.

In considering these issues, Agencies should take into consideration existing conflict 

of interest laws applicable to banking entities engaged in permitted activities. There 

are many different laws imposing conflict of interest restrictions in the context of 

banking entities and their customers, but they tend to fall into three main categories. 

The broadest form is the duty of loyalty attributable to a full ―fiduciary‖ under state 
PROPRIETARY TRADING 50

law. A similar duty of loyalty attaches to investment and commodity trading advisers 

under federal and state securities and commodities laws, and to benefit plan 

fiduciaries under ERISA. The third main category arises under provisions of the 

securities laws that prohibit an institution from obtaining an advantage in the 

securities markets by using nonpublic information it acquires about a customer or 

issuer. These categories are not exclusive, of course. 

An institution‘s options for dealing appropriately with a potential conflict of interest 

will vary depending on the particulars of the law establishing the existence of the 

conflict. In some instances, as in the case of prohibitions on insider trading, the 

institution may establish information barriers within the firm, to wall off the 

information from business units for which the information could create a conflict. In 

other instances, such as laws governing investment and commodity trading advisers, 

obtaining the informed consent of the customer may resolve the conflict. State 

fiduciary law may factor in the terms of the fiduciary engagement, or provide resort 

to specialized protective measures. For any gaps Agencies identify in the existing 

protections for customers of banking entities with respect to permitted activities under 

the Volcker Rule, Agencies should consider whether these protections and remedies 

provide an effective model that can be extended to address the gap, or whether 

outright bans are necessary.

Agencies have required institutions subject to their supervision to develop policies 

and procedures that identify all obligations on the part of the institution to avoid 

conflicts of interest, monitor the activities of the institution to identify whenever such 

an obligation is triggered, and establish controls to avoid or resolve the conflict in 

compliance with applicable law. Agencies evaluate the effectiveness of these policies 

and procedures as part of the supervisory process. In implementing the Volcker Rule, 

Agencies should give consideration to applying the same approach.

In addition, all financial companies including banking entities should take 

precautionary measures to minimize and mitigate conflicts of interest, including the 

appearance of conflicts of interest, in business conduct. 

MATERIAL EXPOSURE TO HIGH-RISK ASSETS 

OR HIGH-RISK TRADING STRATEGIES

The Volcker Rule provides for an additional limitation on permitted activities if the 

activity ―would result, directly or indirectly, in a material exposure by the banking 

entity to high-risk assets or high-risk trading strategies.‖

34

 

As noted above, the primary risk control in existing risk management is through the 

limit setting process. All trading risk is subject to, among other things, the 

institution‘s VaR limit. The VaR limit is small, typically about 1% of a banking 

 

34 12 U.S.C. § 1851(d)(2)(A)(ii).
PROPRIETARY TRADING 51

entity‘s capital. On an annual basis, independent market risk management personnel 

should review limits assigned to trading desks for proper coverage (type of risk) and 

size. These limits are assigned at the desk, business, and firm-wide levels. Many 

desks also employ stop-loss mechanisms that require positions to be closed at 

predetermined loss thresholds. 

Agencies should consider ways to provide guidance on what constitutes a high-risk 

asset or high-risk trading strategy. One possible approach would be to incorporate 

risk analyses into the supervisory framework to monitor permitted activities. These 

analyses could assist Agencies in identifying exposure to high-risk assets and highrisk trading strategies and metrics should be developed in a manner that allows 

Agencies to focus their supervisory and examination efforts in areas of particular 

concern. We note that section 620 of the Dodd-Frank Act also requires the banking 

agencies to conduct a study of bank permissible activities, which can also help define 

those assets and investments that may pose excessive risk. 

Because, as demonstrated during the financial crisis, innovative financial products 

and strategies will be developed and the risk associated with certain assets and 

strategies will change over time, Agencies should consider adopting a flexible 

framework rather than rigid definitions of ―high-risk assets‖ and ―high-risk trading 

strategies.‖ The focus, of course, is on the risk that an asset or strategy could cause a 

banking entity to fail or sustain serious losses.

In particular, the following characteristics, among others, may be indicative of a highrisk asset or high-risk trading strategy:

 The introduction of new products with rapid growth;

 Assets or strategies that include embedded leverage;

 Historical volatility of the asset or strategy;

 Total VaR of the asset or strategy;

 Assets whose values cannot be externally priced or whose exposure cannot be 

quantified;

 Assets whose risk cannot be adequately mitigated by effective hedging; and

 The application of capital and liquidity standards would not adequately account 

for the risk of an asset.

Agencies should also consider requiring banking entities to establish, or integrate into 

their existing risk management processes, a committee with relevant expertise to 

assess the firm‘s potential exposure to high-risk assets and high-risk trading 

strategies. 
PROPRIETARY TRADING 52

POSES A THREAT TO SAFETY AND SOUNDNESS OF BANKING ENTITY

The third statutory limitation requires that Agencies assess whether any permitted 

activity would pose a threat to the safety and soundness of a banking entity.35 The 

metrics and frameworks adopted for the prohibition of proprietary trading and the 

monitoring of broader risks should be utilized by Agencies to address the financial 

soundness of banking entities.

POSES A THREAT TO FINANCIAL STABILITY OF UNITED STATES

The fourth statutory limitation provides an outer bound for activities that are 

otherwise permitted.36 While it is unlikely that an activity would ―pose a threat to the 

financial stability of the United States‖ without running afoul of the second or third 

limitations, it is possible that Agencies would have concerns about an imbalance in 

the financial system caused by an otherwise permitted activity that would not threaten 

the safety and soundness of an individual firm or meet a regulatory test set for highrisk assets or high-risk trading strategies. In these instances, the Volcker Rule 

requires that Agencies take action to prohibit those activities.

HOW THE VOLCKER RULE RELATES TO EXISTING AND 

PENDING REGULATION

The Volcker Rule will be implemented within the context of a broader framework of 

existing and pending regulatory reform. Although the Volcker Rule is an essential piece 

of this regulatory framework designed to reduce risk-taking, it should of course be 

implemented in a way that benefits from and interacts with existing regulatory practices. 

This section will describe ongoing regulatory changes that reduce the risk to the FDIC‘s 

Deposit Insurance Fund and help prevent cross-subsidization that occurs when insured 

depository institutions or their affiliates engage in proprietary trading. 

RISK TO THE FEDERAL SAFETY NET AND CROSS-SUBSIDIZATION

The Volcker Rule prohibits banking entities from engaging in proprietary trading and 

making more than de minimis investments in hedge funds and private equity funds. It 

builds on restrictions in existing law. 

Existing federal law prohibits banks from directly engaging in many of the riskiest 

forms of trading. Banks generally are prohibited from investing in or trading equity 

securities, junk bonds, and most non-financial commodities. These limitations both 

protect the bank safety net from harm and prevent banks from using their federal 

 

35 Id. at § 1851(d)(2)(A)(iii).

36 Id. at § 1851(d)(2)(A)(iv).
PROPRIETARY TRADING 53

subsidies to fund volatile trading activities. Beyond these basic limitations, there is 

also significant reform underway related to banks‘ derivatives operations that, if 

implemented properly, should improve the safety and soundness of these operations. 

Additionally, new capital standards37 approved by the Basel Committee on Banking 

Supervision would complement the supervisory changes that the Volcker Rule will 

require.

LIMITS ON RISK TRANSFER 

For a variety of reasons, including the strict activity restrictions on banks, bank 

holding companies engage in the riskier forms of trading through non-bank 

subsidiaries of the holding company. Section 23A of the Federal Reserve Act 

strictly limits the amount of credit and certain other forms of financial support 

(―covered transactions‖) that a bank may provide to a trading affiliate. 

Specifically, Section 23A puts quantitative and qualitative restrictions on 

extensions of credit by a bank to an affiliate, investments by a bank in an affiliate, 

asset purchases by a bank from an affiliate, and the issuance of a guarantee by a 

bank on behalf of an affiliate. Section 23B of the Federal Reserve Act prevents a 

bank from engaging in almost any financial transaction with a trading affiliate on 

terms that are disadvantageous to the bank. Although these two statutory 

provisions limit the amount of harm a bank can suffer in transactions with nonbank affiliates and limit the ability of a bank to subsidize its non-bank affiliates, 

the Dodd-Frank Act will materially strengthen these important rules through:

 Mandating that all transactions in which a bank has credit exposure to an

affiliate are fully collateralized throughout the life of the transaction 

(existing collateral requirements are ―at inception‖ only);

 Requiring that repurchase agreements and reverse repurchase agreements be 

treated as covered transactions;

 Ensuring that a bank‘s credit exposures to affiliates on over-the-counter 

derivative transactions are treated as covered transactions (they are not 

today); and

 Constraining the Board‘s broad authority to provide exemptions from the 

firewalls.

DERIVATIVES REFORM

The Dodd-Frank Act brings comprehensive reform and extends robust regulation 

to all participants in the swaps markets for the first time. This reform establishes 

a framework that brings greater transparency, pricing, oversight, and reduction of 

overall risk in the derivatives market. Specifically, the Act authorizes: 

 

37 www.bis.org/press/p101216.htm
PROPRIETARY TRADING 54

 The registration and oversight of swap dealers and security-based swap 

dealers38;

 Requires standardized swaps to be centrally cleared and traded on an 

exchange or swap execution facility;

 The creation and registration of swap depositories, including data 

recordkeeping and reporting requirements, such as the reporting of real-time 

data; and

 The establishment of position limits for certain swaps.

The regulation of swap dealers and major swap participants will include 

requirements that they register with the CFTC and SEC, comply with newlyestablished capital and margin standards, adopt and comply with internal and 

external business conduct standards (dealings with counterparties), and provide 

for the segregation of customer funds for cleared and uncleared swaps.

In requiring standardized swaps to be centrally cleared and traded on an exchange 

or swap execution facility, the CFTC and SEC must promulgate rules that 

establish:

 A process for reviewing and approving swaps for standardized clearing 

(while exempting end-users from central clearing requirements);

 Governance standards, ownership, and control limits for certain types of 

clearing entities; and

 Requirements for qualifying as, and registration process for, swap execution 

facilities.

The Dodd-Frank Act also establishes the CFTC and SEC‘s responsibility for 

collecting relevant trading data. The SEC and CFTC must:

 Develop rules governing registered swap data repositories, which are newlyauthorized entities created to collect and maintain data and information 

related to swap transactions, and which must make such data and 

information directly and electronically available to Agencies;

 Require that swap transaction data be reported to a registered swap data 

repository; and

 Require certain data, such as swap price and volume data to be reported to 

the public as soon as technologically practicable after the swap has been 

executed.

 

38 If a swap dealer is a banking entity affiliate, as a result of section 716 of the Dodd-Frank Act, also known 

as the ―push-out rule,‖ that swap dealer must comply with the Volcker Rule. 
PROPRIETARY TRADING 55

STRENGTHENING CAPITAL RULES FOR BANKING ENTITIES

Existing bank-level capital requirements did not adequately protect against the 

risks of trading certain assets. These requirements are expected to be significantly 

strengthened as part of the United States‘ implementation of new rules from the 

Basel Committee intended to improve bank safety and soundness. Capital 

requirements for most positions in the trading book would be increased, and 

eligibility requirements for trading book capital treatment would be tightened. 

Trading book capital requirements today are generally lower than capital 

requirements for assets outside of the trading book, thus creating a serious 

arbitrage opportunity. The recent Basel capital reforms tighten trading book 

capital requirements in a number of ways:

 The definition of instruments that can qualify for trading book capital 

treatment would be tightened.

 The calibration of the market risk capital requirements would reflect periods 

of market distress and better reflect tail risks of positions.

 The market risk framework would impose higher capital requirements for 

the specific risks of credit-sensitive and structured trading positions. 

 Capital requirements for counterparty credit risk would be changed to reflect 

price risk associated with deteriorating creditworthiness of counterparties 

(credit valuation adjustment).

 Capital requirements for all credit exposures to large financial banking 

entities, including counterparty credit exposure to large financial banking 

entities on bilateral over-the-counter derivatives, would be increased.

The recent Basel capital reforms also include two other reforms that will likely 

increase the strength of bank holding companies:

 The proposed leverage ratio requirements could require higher levels of 

capital for entities with large trading books if not presently subject to similar 

requirements. 

 The proposed liquidity regulations discourage the use of short-term 

borrowing to fund longer-term corporate debt, private ABS/MBS, and 

equity securities – a practice common in the trading operations of large 

financial banking entities in the years leading up to the crisis.
HEDGE FUND AND PRIVATE EQUITY FUND INVESTMENT RESTRICTIONS 56

HEDGE FUND AND PRIVATE EQUITY FUND

INVESTMENT RESTRICTIONS

The Volcker Rule‘s hedge fund and private equity fund investment restrictions generally 

prohibit a banking entity from acquiring or retaining any equity, partnership, or other 

ownership interest in, or sponsoring a hedge fund or private equity fund.39 This 

prohibition is guided by the same purposes as the prohibition on proprietary trading: 

 Separate federal support for the banking system from speculative investing 

activity with the firm‘s own capital;

 Reduce potential conflicts of interest between a banking entity and its customers; 

and

 Reduce risk to banking entities and nonbank financial companies designated for 

supervision by the Board.

The government provides banking entities with a federal safety net at least in part 

supported by taxpayers to protect the important role of banking entities in the economy as 

providers of credit and other financial products and services to businesses and consumers.

Under certain circumstances, sponsorship of hedge funds and private equity funds may be 

a potential source of risk and liquidity stress to banking entities. A banking entity faced 

with the reputational risk associated with the failure of a sponsored or advised fund may 

have a strong incentive to voluntarily provide support to investors in those funds. Such 

support for hedge funds and private equity funds occurred during the recent financial 

crisis.

40

 Further, the complexity of investments in such funds has made it more difficult 

for the market, investors, and Agencies to understand, properly value, and manage the 

risks to banking entities.

Under the Volcker Rule, banking entities will generally no longer be allowed to put 

capital at risk by investing in hedge funds and private equity funds that are completely 

divorced from serving the needs of their customers. 

The statutory prohibitions on relationships with private equity funds and hedge funds 

should also be implemented to prevent banking entities from having incentives or 

opportunities to inappropriately provide support to investors in such funds or otherwise 

transfer the government subsidy inherent in the federal safety net for banks to speculative 

proprietary investments. 

 

39 12 U.S.C. § 1851(a)(1)(B).

40 Duffie, Darrell, The Failure Mechanics of Dealer Banks (March 1, 2010). BIS Working Paper No. 301, 

page 9. Available at SSRN: http://ssrn.com/abstract=1599482.
HEDGE FUND AND PRIVATE EQUITY FUND INVESTMENT RESTRICTIONS 57

This section of the study identifies key issues in implementing the provisions relating to 

hedge fund and private equity funds. 

STATUTORY OVERVIEW

PROHIBITED ACTIVITIES

Under the Volcker Rule, a banking entity shall not ―acquire or retain any equity, 

partnership, or other ownership interest in or sponsor a hedge fund or a private equity 

fund.‖

41

 

As noted below, the Volcker Rule generally defines both hedge funds and private 

equity funds to include any issuer that relies on the exclusion from the definition of 

investment company under sections 3(c)(1) or 3(c)(7) of the Investment Company 

Act. A hedge fund and private equity fund is: 

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, or such similar funds as the appropriate Federal banking agencies, the 

Securities and Exchange Commission, and the Commodity Futures Trading 

Commission may, by rule, as provided in subsection (b)(2), determine.42

PERMITTED ACTIVITIES

As with the proprietary trading provisions, there are a number of ―permitted 

activities‖ that constitute exemptions from the broad prohibition described above. In 

particular, Congress recognized that banking entities serve an important role as 

financial intermediaries, including as providers of bona fide trust, fiduciary and 

investment advisory services (collectively, ―customer-focused advisory services‖). 

Therefore, the Volcker Rule reflects the basic principle that hedge funds and private 

equity funds sponsored by a banking entity should be aligned with and supportive of 

customer-focused advisory services. 

In February 2010, Paul Volcker testified to the Senate Banking Committee that 

certain key customer services should remain permissible, including ―prime 

brokerage‖ for independent hedge funds and private equity funds; investment 

management and investment advisory services, including ―fund of funds‖ structure as 

a means of efficiently providing customers with access to independent hedge funds or 

 

41 12 U.S.C. § 1851(a)(1)(B).

42 Id. at § 1851(h)(2).
HEDGE FUND AND PRIVATE EQUITY FUND INVESTMENT RESTRICTIONS 58

private equity funds; trust and estate planning and administration; and custody and 

safekeeping arrangements for securities and valuables.43

A banking entity is permitted to organize and offer or invest in hedge funds and 

private equity funds (up to a de minimis investment limit) to facilitate customerfocused advisory services.44

 Explicitly, a banking entity is permitted to organize and 

offer a hedge fund or private equity fund if: 

 The banking entity provides bona fide trust, fiduciary, or investment advisory 

services as part of its business; 

 The fund is organized and offered only in connection with such services and only 

to customers of such services; 

 The banking entity does not acquire or retain an equity interest, partnership 

interest, or other ownership interest in the funds except for a de minimis

investment;

 The banking entity does not guarantee or otherwise assume or insure the 

obligations or performance of the fund; 

 The banking entity does not share the same name, or variation of the same name, 

with the fund; 

 No director or employee of the banking entity has an ownership interest in the 

fund unless he or she is directly engaged in providing services to the fund; and 

 Certain other conditions are met.45 

The statute also details the nature of the de minimis investments that are permitted. A 

banking entity may make or retain an investment in a hedge fund or private equity 

fund that it organizes and offers in connection with bona fide trust, fiduciary and 

investment advisory functions: (i) for the purpose of establishing the fund; or (ii) to 

make a de minimis investment. Such investments may not represent more than 3% of 

the total ownership interest of such fund after one year from the fund‘s establishment, 

and all aggregated investments of the banking entity in such funds may not represent 

more than 3% of the Tier 1 capital of the banking entity.46

The statute does not prohibit a banking entity from offering prime brokerage services 

to an independent hedge fund or private equity fund. This activity alone is not 

considered to be sponsoring or investing in a hedge fund or private equity fund. A 

banking entity may offer prime brokerage services to a hedge fund or private equity 

fund in which a hedge fund or private equity fund managed, sponsored or advised by 

 

43 Prohibiting Certain High-Risk Investment Activities by Banks and Bank Holding Companies before the S. 

Comm. on Banking, Housing & Urban Affairs, 111th Cong. 2 (February 2, 2010) (testimony of the 

Honorable Paul Volcker, Chairman, President‘s Economic Recovery Advisory Board).

44 12 U.S.C. § 1851(d)(1)(G).

45 Other conditions include that the banking entity complies with the restrictions on affiliate transactions 

with any fund it sponsors consistent with sections 23A and 23B of the Federal Reserve Act.

46 12 U.S.C. § 1851(d)(4).
HEDGE FUND AND PRIVATE EQUITY FUND INVESTMENT RESTRICTIONS 59

the banking entity has taken an interest subject to certain limitations. These 

limitations included in the ―arm‘s length‖ requirements of section 23B of the Federal 

Reserve Act as if the banking entity were a member bank and the fund were an 

affiliate thereof.

LIMITATIONS ON PERMITTED ACTIVITIES 

Pursuant to the permitted activities provisions in the Volcker Rule, the banking 

entities are allowed to invest in or organize and offer hedge funds and private equity 

funds subject to the same statutory ―backstop‖ as proprietary trading permitted 

activities. In the limited circumstances in which a banking entity is permitted to 

organize and offer or invest in a hedge fund or private equity fund, the Volcker Rule 

prohibits such a banking entity from engaging in any activity that would result in a 

material conflict of interest, material exposure to high-risk assets or high-risk trading 

strategies, a threat to the safety and soundness of the banking entity, or a threat to 

financial stability of the United States: 

(A) IN GENERAL.—No transaction, class of transactions, or activity may be 

deemed a permitted activity under paragraph (1) if the transaction, class of 

transactions, or activity—

(i) would involve or result in a material conflict of interest (as such term shall be 

defined by rule as provided in subsection (b)(2)) between the banking entity and 

its clients, customers, or counterparties;

(ii) would result, directly or indirectly, in a material exposure by the banking 

entity to high-risk assets or high-risk trading strategies (as such terms shall be 

defined by rule as provided in subsection (b)(2));

(iii) would pose a threat to the safety and soundness of such banking entity; or

(iv) would pose a threat to the financial stability of the United States.47

For further discussion of these limitations, please see ―Proprietary Trading – Statutory 

Limitations on Permitted Activities‖ above.

RESTRICTIONS ON RELATIONSHIPS AND TRANSACTIONS WITH PRIVATE 

EQUITY FUNDS AND HEDGE FUNDS

The Volcker Rule provides that any banking entity that acts as the investment 

manager or advisor or sponsor of a permitted private equity fund or hedge fund, and 

any affiliate of such an entity, is prohibited from entering into a transaction that 

would be a ―covered transaction‖ as defined in section 23A of the Federal Reserve 

Act (e.g., making loans, purchasing assets, extending guarantees, etc.)48 with any such 

fund.49

 

47 Id. at § 1851(d)(2).

48 12 C.F.R. 223.3(h) [Regulation W].

49 12 U.S.C. § 1851(f).
HEDGE FUND AND PRIVATE EQUITY FUND INVESTMENT RESTRICTIONS 60

That section states: 

(1) IN GENERAL.—No banking entity that serves, directly or indirectly, as the 

investment manager, investment adviser, or sponsor to a hedge fund or private equity 

fund, or that organizes and offers a hedge fund or private equity fund pursuant to 

paragraph (d)(1)(G), and no affiliate of such entity, may enter into a transaction with 

the fund, or with any other hedge fund or private equity fund that is controlled by 

such fund, that would be a covered transaction, as defined in section 23A of the 

Federal Reserve Act (12 U.S.C. 371-c), with the hedge fund or private equity fund, 

as if such banking entity and the affiliate thereof were a member bank and the hedge 

fund or private equity fund were an affiliate thereof.

ARM’S LENGTH TRANSACTIONS 

Terms of any transaction between a banking entity and a permitted private equity 

fund or hedge fund for which that entity has organized and offered or acts as the 

investment manager or advisor or sponsor, must be determined to be ―at arm‘s 

length‖ on market terms and conditions in accordance with section 23B of the Federal 

Reserve Act. The relevant section of the Volcker Rule reads:

(2) TREATMENT AS MEMBER BANK.—A banking entity that serves, directly or 

indirectly, as the investment manager, investment adviser, or sponsor to a hedge fund 

or private equity fund, or that organizes and offers a hedge fund or private equity 

fund pursuant to paragraph (d)(1)(G), 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 hedge fund or private equity fund were an affiliate thereof.50

PRINCIPLES FOR IMPLEMENTATION

The recommendations set out in this study regarding investments in or sponsorship of 

hedge funds and private equity funds are advanced on the basis of three principles for 

implementation: 

1. Significant limits should be placed on the ability of banking entities to invest in 

hedge funds and private equity funds in order to reduce the risks banking 

entities face.

2. A banking entity is permitted to organize and offer, or invest in, a hedge fund 

or private equity fund in connection with the provision of bona fide trust, 

fiduciary or investment advisory services to its customers.

3. The relationships between banking entities and the hedge funds and private 

equity funds they organize and offer should not allow those funds to be used to 

circumvent the prohibition on proprietary trading.

 

50 Id. at § 1851(f)(2).
HEDGE FUND AND PRIVATE EQUITY FUND INVESTMENT RESTRICTIONS 61

IMPLEMENTATION OF PROHIBITED ACTIVITIES

OVERVIEW

As noted above, the Volcker Rule generally prohibits a banking entity from investing 

in or sponsoring hedge funds and private equity funds unrelated to the banking 

entity‘s bona fide trust, fiduciary, or investment advisory business. In implementing 

this prohibition, Agencies should consider addressing two key issues with respect to 

implementing the prohibition: 

 the scope of the definition of ―private equity fund‖ and ―hedge fund‖; and 

 the restriction of existing investment authorities that currently allow banking 

entities to invest in third-party hedge funds and private equity funds.

ISSUES REGARDING IMPLEMENTATION OF PROHIBITED ACTIVITIES

SCOPE OF PROHIBITED INVESTMENTS

The Volcker Rule defines a hedge fund and a private equity fund as any ―issuer 

that would be an investment company . . . but for sections 3(c)(1) or 3(c)(7)‖ of 

the Investment Company Act or ―such similar funds‖ as the federal banking 

agencies, the SEC and the CFTC shall determine.51 In other words, under the 

Volcker Rule, hedge funds and private equity funds are defined only as issuers 

that rely on the exclusion from the definition of investment company under 

sections 3(c)(1) or 3(c)(7) of the Investment Company Act or such similar funds 

as Agencies determine. 

Sections 3(c)(1) and 3(c)(7) of the Investment Company Act provide exclusions 

from the definition of investment company for an issuer that is not making and 

does not presently propose to make a public offering of its securities and either (i) 

has outstanding securities that are beneficially owned by not more than one 

hundred persons or (ii) has outstanding securities that are owned exclusively by 

qualified purchasers.52 

Many hedge fund and private equity fund investments are made through an 

investment vehicle that relies on section 3(c)(1) or 3(c)(7) of the Investment 

Company Act.

53

 However, these exclusions are used by a wide variety of funds 

 

51 Id. at § 1851(h)(2).

52 15 U.S.C. § 80a-3(c).

53 U.S. GOVERNMENT ACCOUNTABILITY OFFICE. PUB. NO. GAO-08-885, PRIVATE EQUITY: RECENT 

GROWTH IN LEVERAGED BUYOUTS EXPOSED RISKS THAT WARRANT CONTINUED ATTENTION 39 n.59 

(2003); see also U.S. GOVERNMENT ACCOUNTABILITY OFFICE, PUB. NO. GAO-09-677T, HEDGE FUNDS:
HEDGE FUND AND PRIVATE EQUITY FUND INVESTMENT RESTRICTIONS 62

and other legal entities that rely on the exclusions contained in section 3(c)(1) or 

3(c)(7) of the Investment Company Act, including special purpose acquisition 

vehicles and certain ERISA qualified employee pension funds. Many 

commenters expressed the opinion that the statutory definition unintentionally 

includes corporate structures and entities that do not exhibit the characteristics of 

hedge funds or private equity funds, such as controlled subsidiaries and joint 

ventures used to hold ordinary course investments, or other investment vehicles. 

Specifically, a number of commenters suggested that venture capital funds should 

be excluded from the Volcker Rule‘s definition of hedge funds and private equity 

funds because the nature of venture capital funds is fundamentally different from 

such other funds and because they promote innovation. The Council believes that 

the issue raised by commenters in this respect is significant. In connection with 

implementing an exclusion from registration for advisers solely to venture capital 

funds as provided under the Dodd-Frank Act, the SEC has recently proposed rules 

that distinguish the characteristics and activities of venture capital funds from 

those of other private equity funds and hedge funds. The Council recommends 

that Agencies carefully evaluate the range of funds and other legal vehicles that 

rely on the exclusions contained in section 3(c)(1) or 3(c)(7) and consider whether 

it is appropriate to narrow the statutory definition by rule in some cases.54 

Conversely, not all investment vehicles that share the characteristics of traditional 

private equity funds or hedge funds rely on the exclusions contained in section 

3(c)(1) or 3(c)(7) of the Investment Company Act, such as commodity pools do 

not primarily hold or invest in financial instruments. Congress recognized this by 

giving Agencies authority to bring ―similar funds‖ within the scope of the Volcker 

Rule‘s applicability. It is possible to create an investment fund pursuing a ―hedge 

fund‖ or ―private equity fund‖ strategy in reliance on other sections of the 

Investment Company Act which therefore would not necessarily be captured by 

the statutory definition of hedge fund and private equity fund.

Accordingly, the Council recommends that Agencies consider using their 

authority to expand the definition by rule to funds that do not rely on the section 

3(c)(1) and 3(c)(7) exclusions, but that engage in the activities or have the 

characteristics of a traditional private equity fund or hedge fund. Agencies can 

bring such funds within the scope of the Volcker Rule by deeming them ―similar 

funds‖ within the meaning of the statute. In determining which funds should be 

brought within the scope of the Volcker Rule as ―similar funds,‖ Agencies should 

consider the investment activities and other characteristics of such funds, 

including:

 Related compensation structure: Does the fund earn an allocation based on 

fund performance including both realized and unrealized gains? 

 

OVERVIEW OF REGULATORY OVERSIGHT, COUNTERPARTY RISKS, AND INVESTMENT CHALLENGES 1 n.1 

(2009). 

54 12 U.S.C. § 1851(d)(1)(J).
HEDGE FUND AND PRIVATE EQUITY FUND INVESTMENT RESTRICTIONS 63

 Trading/Investment strategy: What trading or investment strategy does the 

fund utilize? 

 Use of leverage: Does the fund borrow or otherwise utilize material leverage 

for the purpose of increasing investment performance?

 Investor composition: Is the fund‘s capital received from a broad group of 

unaffiliated investors?

IMPLEMENTATION OF PERMITTED ACTIVITIES

OVERVIEW 

As referenced in the statutory overview above, Congress explicitly allowed certain 

permitted activities in recognition of the basic principle that banking entities should 

be able to continue their customer-focused advisory services.

ISSUES REGARDING IMPLEMENTATION OF PERMITTED ACTIVITIES 

THE ―CUSTOMER‖ REQUIREMENT

The Volcker Rule provides that a banking entity is permitted to organize and offer 

and invest in a hedge fund or private equity fund if ―the fund is organized and offered 

only in connection with the provision of bona fide trust, fiduciary, or investment 

advisory services and only to persons that are customers of such services of the 

banking entity.‖ 

The Volcker Rule does not, however, define the term ―customers.‖ Historically, 

banking entities have raised commitments for hedge funds and private equity funds 

from existing customers as well as individuals or entities that have no pre-existing 

customer relationship with the banking entity.

Agencies should consider developing and issuing regulations to clarify the meaning 

of ―customer‖ in the context of this permitted activity by banking entities. The 

statutory language suggests that there must be a ―customer‖ relationship with a 

banking entity‘s bona fide trust, fiduciary, or investment advisory business. There are 

analogous statutory definitions and regulatory concepts that seek to define a customer 

relationship in both banking law and securities law; a prescriptive definition such as 

―customer relationship‖ has been used in the context of a banking entity,55 while a 

 

55 ―Customer relationship‖ defined as a continuing relationship between a consumer and the bank under 

which the bank provides one or more financial products or services to the consumer that are to be used 

primarily for personal, family, or household purposes. See 12 CFR 216.3 (i)(1).
HEDGE FUND AND PRIVATE EQUITY FUND INVESTMENT RESTRICTIONS 64

much more nuanced definition such as ―substantive and pre-existing relationship‖ has 

been used in the context of private placements.56

In determining the nature of a customer relationship that may constitute a permitted 

activity, Agencies should consider these existing authorities and should take into 

account the following potential considerations:

 Continuing relationship versus knowledge of financial needs: 

o A continuing relationship in which the banking entity provides one or 

more financial products or services prior to the time of the offering; or

o A previous relationship that provided the banking entity with sufficient 

knowledge of the customer‘s financial needs, risk tolerance, and 

qualifications.

 Direct versus indirect customer relationships:

o A direct and substantive relationship between the banking entity and a 

prospective customer; or

o A relationship between the banking entity and the customer‘s agent or 

advisor or investment vehicle.

 Relationship initiated by the potential customer versus banking entity:

o A relationship initiated by the potential customer or its agent to inquire 

about a product or service offered by the banking entity; or

o A relationship initiated by the banking entity offering a product or service 

to the customer or its agent.

Moreover, in certain instances, the Volcker Rule refers to ―clients,‖ a term which is 

not defined. Under the federal securities laws, who may be considered a client is a 

distinct concept from who may be considered a customer of the bank. Agencies 

should take into consideration these potential issues as part of their evaluation of 

permitted activities by banking entities in relation to customers and clients.

FEEDER FUNDS

Subject to the general conditions in the statute, the Volcker Rule permits banking 

entities, in the context of their customer-focused advisory services, to provide 

customers with access to third-party private equity funds and hedge funds through 

the organizing and offering of a hedge fund or private equity fund that makes 

 

56 See e.g., Use of Electronic Media, Securities Act Release No. 7856 (Apr. 28, 2000) (citing WoodtrailsSeattle, Ltd., SEC No-Action Letter (Aug. 9, 1982), Bateman Eichler, Hill Richards, Inc. SEC No-Action 

Letter (Dec. 3, 1985) and Lamp Technologies, Inc., SEC No-Action Letter (May 29, 1998) (To be 

substantive, the relationship should involve a knowledge of the prospective investor‘s financial 

sophistication, goals and objectives. To be pre-existing, a relationship should be in place before the terms 

of the offering are developed and the offering commences.)
HEDGE FUND AND PRIVATE EQUITY FUND INVESTMENT RESTRICTIONS 65

investments in such third-party funds. Banking entities may organize and offer 

funds that act as typical feeder funds, arrangements in which one fund invests in 

the shares of another fund. 

Many banking entities ―organize and offer‖ feeder funds that pool customers‘

capital investments in third-party hedge funds and private equity funds. In this 

structure, the risks associated with a permissible banking entity-managed feeder 

fund are typically borne entirely by the customers of the banking entity who are 

the investors in that feeder fund, and none of the banking entity‘s assets are at 

risk. 

However, conflicts of interest may arise where a banking entity directs a feeder 

fund or fund of fund investment to a third-party hedge fund or private equity fund 

with which the banking entity has other business relationships. In evaluating the 

appropriateness of such relationships, Agencies should consider:

 Whether the banking entity‘s business relationships with the third-party fund 

should be subject to the Volcker Rule‘s prohibition of ―covered 

transactions‖ (e.g., making loans, purchasing assets, extending guarantees) 

as well as to the section 23B of the Federal Reserve Act ―arm‘s length‖

transactions requirements; and

 Subject to general conditions set forth in the statute, the extent to which 

such arrangements could create the opportunity and incentive for (i) banking 

entities to protect hedge funds and private equity funds from losses or (ii) 

for those funds to expose the banking entity to outsized risk.

The Volcker Rule does not place a limitation on a banking entity‘s ability to be 

the investment adviser to a third-party hedge fund or private equity fund. 

However, a banking entity should not be able to make use of contractual 

arrangements to avoid the customer requirement for hedge funds and private 

equity funds that the banking entity organizes and offers as permitted under the 

Volcker Rule.

DE MINIMIS INVESTMENTS 

The Volcker Rule permits banking entities to take or retain a 3% or lower de 

minimis investment in a hedge fund or private equity fund that such entity 

organizes and offers, subject to certain conditions and limits. The amount of any 

de minimis investment should be ―immaterial‖ to the bank and, in any case, at 

most represent up to 3% of each fund following an initial one-year ―seeding‖

period during which banks can provide up to 100% of the capital of the fund.57

Additionally, in no case can the aggregate of all of the interests of the banking 

entity in all such funds exceed 3% of the Tier 1 capital of the banking entity.

58

 

 

57 12 U.S.C. § 1851(d)(4)(B)(ii)(I). 

58 Id. at § 1851(d)(4)(B)(ii)(II). 
HEDGE FUND AND PRIVATE EQUITY FUND INVESTMENT RESTRICTIONS 66

In addition, given the need to protect against risks with respect to even 

permissible hedge fund and private equity fund investments within the statutory 

limit, the Volcker Rule effectively requires Agencies to deduct the amount of 

these investments from the banking entity‘s capital. In addition, the statute 

requires that the deduction be increased commensurate with the leverage of the 

fund. 

In providing a de minimis allowance for investments in hedge funds and private 

equity funds, the Volcker Rule permits banking entities to make certain limited 

investments in hedge funds and private equity funds while avoiding material 

conflicts of interest and any incentive or opportunity to ―bail out‖ such funds. 

The proper implementation and enforcement of the Volcker Rule, which among 

other things seeks to align a banking entity‘s investments in a hedge fund or 

private equity fund with the interest of its customers, requires that the de minimis

exemptions be connected to customer-related activities.

Because the Volcker Rule permits de minimis investments in hedge funds and 

private equity funds, Agencies should be careful to ensure that the statutory 

restrictions be carefully defined to ensure that these exceptions do not place 

banking entities at undue risk or provide loopholes for proprietary trading or other 

prohibited transactions. Agencies should consider rules that will:

 Avoid understating risk: Agencies should consider defining ―investment‖ in 

a manner that will best capture the banking entity‘s true risk exposure. 

o Invested vs. Committed: In most private equity fund structures, investors 

commit to provide a certain amount of cash, which is called over time as 

the fund executes investments. Some commenters suggested that only the 

actual cash invested, rather than the commitment, should be counted in the 

3% limit. Other observers argued that the cash commitment is a better 

measure of a banking entity‘s exposure, and therefore should be the 

amount included in the de minimis calculation.

o Carried interest: Agencies should consider the proper treatment of carried 

interest for purposes of the de minimis calculation, including whether 

carried interest that remains in the fund, at the election of the party to 

whom it is allocated, should be treated the same or differently than carried 

interest that is removed from the fund when contractually allocated or 

earned.

o Synthetic Ownership Exposure: Agencies should consider implementing 

the 3% de minimis investment and seed fund exceptions to prevent 

banking entities from subverting the intent of the legislation by structuring 

arrangements that technically comply with the 3% ownership limit while 

allowing banking entities to retain a synthetic or other interest in a fund, 

effectively exposing the banking entity to the risks and benefits of 

ownership otherwise prohibited under the Volcker Rule. 
HEDGE FUND AND PRIVATE EQUITY FUND INVESTMENT RESTRICTIONS 67

o Employee interests: Agencies should consider whether investments by 

directors and employees engaged in providing services to the fund, 

together with other investors who may be affiliated with the bank (such as 

non-ERISA qualified employee deferred compensation plans) should be 

included in the 3% cap on a banking entity‘s investment in a hedge fund or 

private equity fund.

The statute mandates that a banking entity‘s investment in a hedge fund or private 

equity fund not exceed 3% of the fund. In order to robustly monitor this limit 

Agencies should consider, among other factors:

 Whether the de minimis calculation of the banking entity‘s share of a fund 

should reflect changes in the investor base in the fund (e.g., redemptions or 

other changes in commitment levels) over time or whether a one-time test at 

the one-year mark or at the inception of a fund would be sufficient. 

 If these changes result in a change in the ownership share above 3%, in what 

period of time should banking entities that have failed the test be required to 

sell down their interest to a compliant level? 

PROHIBITING COVERED TRANSACTIONS

As noted above, under existing law, section 23A of the Federal Reserve Act 

places strict quantitative and qualitative restrictions on covered transactions 

between a bank and an affiliate, and section 23B of the Federal Reserve Act 

requires almost all financial transactions between a bank and an affiliate to be on 

market terms. The adoption of these restrictions in part acknowledges that 

transactions with affiliates can entail significant risk to an insured depository 

institution.

Where these restrictions have been applied and supervised, they have been 

effective in limiting inappropriate conflicts of interest and helping to prevent the 

transfer of the benefits of deposit insurance and the federal safety net from 

insured depository institutions to unregulated entities. However, prior to the 

Dodd-Frank Act, not all hedge funds and private equity funds sponsored by a 

bank were treated as affiliates of the bank for purposes of these restrictions.59 

Going forward, all hedge funds and private equity funds organized and offered or 

advised by a banking entity will be subject to stricter limitations than those that 

exist prior to the effectiveness of the Volcker rule. Under the Volcker Rule, a 

banking entity will not just be restricted in the amount of ―covered transactions‖ it 

can engage in with a hedge fund and private equity fund that it manages or 

sponsors, it will be prohibited from engaging in any such transaction. In addition, 

 

59 Prior to the Dodd-Frank Act, many private equity funds, foreign investment funds, and commodities 

funds escaped treatment as an affiliate because they were not registered investments companies under the 

Investment Company Act and therefore, did not qualify as an affiliate for the purposes of sections 23A and 

23B of the Federal Reserve Act unless the banking entity owned more than 5% of the capital of the fund.
HEDGE FUND AND PRIVATE EQUITY FUND INVESTMENT RESTRICTIONS 68

where a banking entity has a direct or indirect interest in a hedge fund or private 

equity fund, all other transactions between the banking entity and a hedge fund 

and private equity fund will be required to be on market terms in accordance with 

restrictions under section 23B of the Federal Reserve Act.

CLARIFYING THE TERM “BANKING ENTITY”

The statute generally defines the term ―banking entity‖ as:

[A]ny insured depository institution (as defined in section 3 of the Federal Deposit 

Insurance Act (12 U.S.C. 1813)), 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 of 1978, and any affiliate or subsidiary of any such 

entity. (emphasis added).

Under the BHC Act, the terms ―affiliate‖ and ―subsidiary‖ are both defined terms. 

Under sections 2(d) and 2(k) of that Act, ―subsidiary‖ and ―affiliate‖ are both defined 

to include any company that a bank holding company or other company ―controls.‖ 

Section 2(a)(2) of the BHC Act contains a definition of ―control,‖ which the Board 

has implemented in its Regulation Y to include, inter alia (i) ownership, control, or 

power to vote 25% or more of the outstanding shares of any class of voting securities

of a bank or other company, directly or indirectly or acting through one or more other 

persons; (ii) control in any manner over the election of a majority of the directors, 

trustees, or general partners (or individuals exercising similar functions) of a bank or 

other company; and (iii) the power to exercise, directly or indirectly, a controlling 

influence over the management or policies of a bank or other company, as determined 

by the Board after notice and opportunity for hearing. The ―banking entity‖

definition contained in the Volcker Rule includes any affiliate or subsidiary of a 

banking entity which, arguably, creates a circular definition that would subject an 

advised fund (which is considered an affiliate) to the proprietary trading and hedge 

fund and private equity fund restrictions of the Volcker Rule, even though setting up 

an advised fund is an explicitly permitted activity. 

Commenters argued that unless permitted hedge funds and private equity funds are 

excluded from the definition of ―banking entity‖ the following would result: 

 A banking entity could not operate a fund of funds business where the fund of 

funds invests in third party funds;

 Hedge funds and private equity funds that are controlled by a banking entity 

would not be permitted to make investments in other funds;

 Each fund in a family of controlled funds would be treated as a banking entity and 

an affiliate of each other, therefore requiring each fund to have a unique name;

 Companies (i.e., even non-financial companies) controlled by a hedge fund or 

private equity fund that is controlled by a banking entity would themselves 

become banking entities subject to the restrictions of the Volcker Rule; and
HEDGE FUND AND PRIVATE EQUITY FUND INVESTMENT RESTRICTIONS 69

 SEC-registered investment companies that are controlled by a banking entity, 

would be subject to the Volcker Rule.

The Council recommends that the relevant Agencies carefully consider the impact of 

certain BHC Act definitions on the Volcker Rule‘s definition of ―banking entity‖ and 

implement that term in a way that avoids results that Congress clearly did not intend 

in enacting the Volcker Rule.

MONITORING COMPLIANCE 

PROGRAMMATIC COMPLIANCE

Similar to the programmatic compliance regime recommended for proprietary 

trading oversight, firms should be held accountable for compliance with the 

Volcker Rule‘s restrictions on investments in and sponsorship of hedge funds and 

private equity funds. The programmatic compliance regime would have the 

following key attributes, including investment and risk oversight, public 

attestation of compliance by the CEO, and engagement by the Board of Directors. 

INVESTMENT AND RISK OVERSIGHT 

 The banking entity‘s Board of Directors should approve the objectives, 

strategies, and policies governing permissible investments in hedge 

funds and private equity funds, including the necessary relationship for 

providing customer-focused advisory services, the type and nature of the 

investments, and other elements of sound investment management 

oversight. 

 The banking entity‘s approved objectives, strategies, policies, and 

procedures should be documented and clearly communicated to all 

personnel involved in their implementation. 

 The banking entity should actively monitor the performance and risk 

profile of private equity and hedge fund investments in light of the 

established objectives, strategies, policies, and procedures.

 The banking entity‘s policies and procedures, with respect to permitted 

investments in private equity funds and hedge funds, should identify the 

aggregate exposure that the institution is willing and able, in light of the 

de minimis investment limitation, to accept by type and nature of 

investment. Adherence to such limits should take into consideration 

unfunded, as well as funded, commitments. Banking entities should 

have systems in place, consistent with applicable laws and regulations, 
HEDGE FUND AND PRIVATE EQUITY FUND INVESTMENT RESTRICTIONS 70

to ensure that impermissible investments in or transactions with hedge 

funds and private equity funds are prohibited.

 A system of internal controls, with appropriate checks and balances and 

clear audit trails, is critical to the effective conduct of investments in 

permitted private equity and hedge funds. 

MANAGEMENT AND PUBLIC ATTESTATION 

 Permitted investments in hedge funds and private equity funds should be 

subject to active oversight by the banking entity and senior management. 

The CEO should be required to attest publicly to the ongoing 

effectiveness of the internal compliance regime.

TRANSPARENCY

Given the important role that market discipline plays in controlling risk, Agencies 

should consider requiring banking entities to publicly disclose certain information 

regarding private equity funds and hedge funds that they are permitted to invest 

in, organize and offer, or sponsor so that markets and investors can better assess 

risk profiles and performance. For example, such information could include the 

type and amount of investments, portfolio concentrations, returns, and their 

contributions to reported earnings and capital, to the extent consistent with 

applicable law.
THE ACCOMMODATION OF THE BUSINESS OF INSURANCE 71

THE ACCOMMODATION OF THE BUSINESS OF INSURANCE

The statute requires the Council to put forth recommendations to ―... appropriately 

accommodate the business of insurance within an insurance company, subject to 

regulation in accordance with the relevant insurance company investment laws, while 

protecting the safety and soundness of any banking entity with which such insurance 

company is affiliated and of the United States financial system.‖ As discussed above, 

under the Volcker Rule, certain investments made by insurance companies for their 

general account are permitted activities, and thus generally exempt from the prohibitions 

of the Volcker Rule. Those activities, however, remain subject to the statutory backstop 

described above. 

Insurance companies assume risk and collect premiums and, in turn, invest those 

premiums. Investment return contributes to the company‘s net worth (i.e., policyholder 

surplus), which in turn supports underwriting and the payment of future claims to 

policyholders and claimants.

60 The investment activity of insurers is central to the overall 

insurance business model and could be unduly disrupted if certain provisions of the 

Volcker Rule applied. As such, Section 619 of the Dodd-Frank Act amends the BHC Act 

by adding Section 13(d)(1)(F), which provides specific permission for this investment 

activity:

―(F) The purchase, sale, acquisition, or disposition of securities and other specified instruments 

described in subsection (h)(4) by a regulated insurance company directly engaged in the business 

of insurance for the general account of the company and by any affiliate of such regulated 

insurance company, provided that such activities by any affiliate are solely for the general account 

of the regulated insurance company, if–

(i) the purchase, sale, acquisition, or disposition is conducted in compliance with, and 

subject to, the insurance company investment laws, regulations, and written guidance of 

the State or jurisdiction in which each such insurance company is domiciled; and

(ii) the appropriate Federal banking Agencies, after consultation with the Financial 

Stability Oversight Council and the relevant insurance commissioners of the States and 

territories of the United States, have not jointly determined, after notice and comment, 

that a particular law, regulation, or written guidance described in clause (i) is insufficient 

to protect the safety and soundness of the banking entity, or of the financial stability of 

the United States.‖

61

 

60 Insurance companies also retain assets and earnings, and in the case of stock companies, may issue 

dividends to shareholders, or in the case of mutual companies, may provide dividends or other benefits to 

members. 

61 12 U.S.C. § 1851(d)(1)(F).
THE ACCOMMODATION OF THE BUSINESS OF INSURANCE 72

ELIGIBILITY

Only two types of insurance companies are subject to the Volcker Rule: (i) insurance 

companies that are affiliates of insured banks or thrifts; and (ii) non-bank financial 

companies supervised by the Board. Among these companies, a subset is allowed to 

engage in certain permitted activities. In order to provide clarity for the banking entities 

that may engage in permitted activities and on the scope of those activities, Agencies 

should consider defining the following terms: (i) ―regulated insurance company;‖ (ii) 

―directly engaged in the business of insurance;‖ and (iii) the ―general account‖ of the 

company. In doing so, Agencies should consult relevant state insurance commissioners.

The term ―regulated insurance company‖ could be defined to include entities that are 

subject to regulation by the state insurance regulatory agencies, such as licensed and 

admitted insurance companies, surplus lines insurance companies, and admitted 

reinsurance companies. For instance, Section 2(a)(17) of the Investment Company Act 

already includes a definition of insurance company consistent with this description. 

However, under such a definition, some banking entities might not qualify to engage in 

permitted activity.62

In interpreting ―business of insurance,‖ Agencies should strive to be consistent with the 

term as already used and interpreted under the McCarran-Ferguson Act.63 For purposes 

of authorizing insurance activities for bank holding companies, section (4)(k)(4)(B) of the 

BHC Act describes the following activities: ―insuring, guaranteeing, or indemnifying 

against loss, harm, damage, illness, disability, or death, or providing and issuing annuities 

and activity as principal, agent, or broker for purposes of the foregoing, in any State.‖

64

 

Agencies, also should consider what ―directly engaging‖ in the business of insurance 

means, which should distinguish between the insurance units and the holding company 

for purposes of compliance with the Volcker Rule. 

The term ―general account‖ is not a statutorily defined term but it is a fairly well 

recognized insurance accounting term of art. A general account represents all assets of 

the insurer that are available to satisfy its overall obligations. It does not include any 

separate account assets.65

 

62 Some commenters point to the phrase ―State or jurisdiction‖ in Section 13(d)(1)(F)(i) of the BHC Act, 12 

U.S.C. § 1851(d)(1)(F)(i), and question whether ―jurisdiction‖ was meant to include other countries and, 

therefore, allow foreign insurers subject to foreign investment laws rather than domestic laws to also 

engage in permitted activity. Agencies should examine this issue and possible adverse effects carefully. 

63 15 U.S.C. §1011, et. seq. For example, see U.S. Department of Treasury v. Fabe, 508 U.S. 491 (1993) 

(defining the ―business of insurance‖ based on three factors: (1) whether the practice has the effect of 

transferring or spreading a policyholder‘s risk; (2) whether the practice is an integral part of the policy 

relationship between the insurer and insured; and (3) whether the practice is limited to entities within the 

insurance industry).

64 12 U.S.C. 1843(k)(4)(B).

65 A separate account is maintained by an insurance company and, in substance, is an investment funding 

mechanism. Assets held in separate accounts are legally segregated for the benefit of particular 

policyholder/customer.
THE ACCOMMODATION OF THE BUSINESS OF INSURANCE 73

LIMITATIONS ON QUALIFIED ACTIVITY

Activity under section 13(d)(1)(F) of the BHC Act66 is permitted provided that (i) it is 

subject to and in compliance with insurance company investment laws, regulations and 

written guidance of each insurance company‘s domiciliary state or jurisdiction; and (ii) 

the appropriate federal banking agencies, after consultation with the Council and the 

relevant state insurance commissioners, not have jointly determined, after notice and 

comment, that such investment laws, regulations and written guidance are insufficient to 

protect the safety and soundness of the banking entity, or of the financial stability of the 

United States. 

Insurance company investment is subject to relevant state investment laws which, while 

not uniform, are substantially similar and generally conform to standards set out in model 

laws and regulations developed by the National Association of Insurance Commissioners 

(―NAIC‖). State investment laws aim at limiting the amount and type of investments 

insurers can make in order to limit their investment and counterparty risk exposures. For 

example, among other limitations, investment laws limit the amount of investment an 

insurer can make in equities, low-grade securities, or in the securities of any one issuer. 

The NAIC has developed two different models which handle the issue in different 

manners.

67

 

State insurance company investment laws and regulations govern the type of investment, 

and extent of such investments, an insurance company can include as ―admitted‖ assets 

on their balance sheet for the purpose of determining whether the insurer has the ability 

to discharge its obligations and meet capital and surplus requirements. Insurers can make 

certain otherwise non-prohibited investments, but such investments are not considered 

admitted assets and still have to be reported to state insurance regulators. State insurance 

company investment laws and regulations typically do not directly govern the terms and 

conditions of the transactions themselves.68 

The activity for the general account is permitted if it is ―conducted‖ in compliance with 

such investment laws, regulations and written guidance. State agencies monitor insurer 

investments, through reporting, valuation, and examination, to ensure that such 

investments are in compliance with state insurance investment laws, regulations, and 

guidance, and, even when insurers are otherwise in compliance to ensure that such 

investments do not threaten the solvency of the insurer. The federal banking agencies 

 

66

 12 U.S.C. § 1851(d)(1)(F).

67 The Defined Limits version establishes categories and limits the amount an insurer can hold of each 

category. The Defined Standards approach establishes more of a prudent person concept without having all 

of the explicit categories and defined limits. The majority of the states utilize an approach similar to the 

Defined Limits model. Others have adopted laws that incorporate both defined limits and prudent person 

concepts. This past year, the NAIC also adopted a model law on derivatives which requires the insurer to 

have a use plan for derivatives for the regulator to consider. 

68 Laws and regulations may encourage that certain assets be disposed of upon valuation and rating 

downgrade. Also, state insurance insolvency laws and regulations (which may or may not be viewed as 

investment laws and regulations), provide regulatory authority over such transactions in the case of 

conservatorship, rehabilitation, and liquidation.
THE ACCOMMODATION OF THE BUSINESS OF INSURANCE 74

and state insurance agencies should coordinate and enhance the examination of the 

investment activities of those insurance companies that might otherwise be subject to the 

Volcker Rule to ensure that they are compliant with state law and regulation. Another 

approach would be to require such insurance companies to certify that such activity is 

compliant followed by a later audit. Under the Volcker Rule, activity for the general 

account is permitted if the appropriate federal banking agencies, after consultation with 

the Council and the relevant state insurance commissioners, have not jointly determined 

that such investment laws, regulations and written guidance are insufficient to protect the 

safety and soundness of the banking entity, or of the financial stability of the United 

States. 

At some point in the future, Agencies will need to consider the timing and approach to 

the assessment of the insurance company investment laws, regulations, and guidance 

from the states. Agencies should also consult relevant state insurance commissioners, not 

only before any joint determination is considered, but also with regard to the process. 

Should the appropriate federal banking agencies, after consultation with the Council and 

the relevant state insurance commissioners, jointly determine, that a particular state‘s 

insurance company investment laws, regulations and guidance – or some aspects thereof 

– are insufficient to protect the safety and soundness of a banking entity or the financial 

stability of the United States, the activity of all regulated insurance companies domiciled 

in that particular state could be affected. Safe harbor provisions for insurance companies, 

as well as an opportunity for a state to address the inadequacy of their law, regulation, or 

guidance should be considered. 

SEPARATE ACCOUNT ASSETS

Beyond the permitted activity under Section 13(d)(1)(F) of the BHC Act,

69 insurance 

companies also maintain investments in separate accounts that remain on the company‘s 

balance sheet but are legally separate from the assets of the insurance company itself. 

These accounts are not part of the insurance company‘s general account. Some 

commenters argued that the assets in these accounts are held for the benefit of particular 

customers, and therefore, investments tied to these separate accounts should be 

considered ―permitted activity‖ under Section 13(d)(1)(D) of the BHC Act.

70

 Agencies 

should consider how insurance companies invest separately on behalf of customers. 

OTHER ISSUES RELATED TO THE BUSINESS OF INSURANCE

Insurance companies interface with the Volcker Rule as market investors. However, they 

also provide products that are investment vehicles. The Volcker Rule may apply to 

banking entities‘ investment in insurance products.

 

69 12 U.S.C. § 1851(d)(1)(F).

70 Id. at § 1851(d)(1)(D).
THE ACCOMMODATION OF THE BUSINESS OF INSURANCE 75

Some commenters also expressed concerns that some separate account products could be 

included in the definitions of ―hedge fund‖ and ―private equity fund‖ not by virtue of 

their being ―other similar funds,‖ but because the definition includes funds required to be 

registered under the Investment Company Act, but for the exclusions under Sections 

3(c)(1) or 3(c)(7).71 Agencies should examine this carefully so as not to preclude certain 

insurance products that may not have been intended to be limited by the Volcker Rule. 

One approach may be for Agencies to design, by rule, a process by which insurance 

companies can request an interpretative determination of whether particular separate 

accounts and products qualify under the definition of hedge or private equity fund. 

Another would be to determine whether the activity promotes the safety and soundness of 

the banking entity under Section 13(d)(1)(J) of the BHC Act.

72

Finally and in general, the appropriate Agencies should carefully monitor fund flows 

between banking entities and insurance companies, to guard against ―gaming‖ the 

Volcker Rule, whether it is through innovative insurance products and financial 

instruments, like Bank Owned Life Insurance, or use of separate accounts. Agencies 

should work with the state insurance agencies in monitoring activity of bank affiliate 

insurance companies and captive insurers.73 To the extent such products become vehicles 

to enable impermissible activity, Agencies should consider procedures for designating 

such financial instruments under Section 13(h)(4) of the BHC Act.

74

 

 

 

 

71 Insurance company separate accounts are exempted from registration due to those sections, as well as 

perhaps excepted from the definition of ―investment company‖ under the Investment Company Act of 

1940. 

72 12 U.S.C. § 1851(d)(1)(J).

73 A single-parent captive is a limited-purpose, wholly owned subsidiary that can be used to insure the 

captive‘s parent or affiliates. 

74 12 U.S.C. § 1851(h)(4).
ANNEX 76

ANNEX A

The Council‘s Notice and request for information, published in the Federal Register on 

October 6, 2010, stated the following:

―To assist the Council in conducting the study and formulating its recommendations 

concerning the Volcker Rule, the Council seeks public comment on the following 

questions:

1. Commenters are invited to submit views on ways in which the implementation 

of the Volcker Rule can best serve to:

(i) Promote and enhance the safety and soundness of banking entities;

(ii) 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;

(iii) Limit the inappropriate transfer of federal subsidies from institutions that 

benefit from deposit insurance and liquidity facilities of the federal government to 

unregulated entities;

(iv) Reduce conflicts of interest between the self-interest of banking entities and 

nonbank financial companies supervised by the Board,3and the interests of the customers 

of such entities and companies;

(v) Limit activities that have caused undue risk or loss in banking entities and 

nonbank financial companies supervised by the Board, or that might reasonably be 

expected to create undue risk or loss in such banking entities and nonbank financial 

companies supervised by the Board;

(vi) Appropriately accommodate the business of insurance within an insurance 

company, subject to regulation in accordance with the relevant insurance company 

investment laws, while protecting the safety and soundness of any banking entity with 

which such insurance company is affiliated and of the United States financial system; and

(vii) Appropriately time the divestiture of illiquid assets that are affected by the 

implementation of the prohibitions under the Volcker Rule.

________________________

3 The term ―nonbank financial companies supervised by the Board‖ refers to those nonbank financial 

companies that may be designated by the Council under section 113 of the Act to be supervised by the 

Board and subject to enhanced prudential standards.
ANNEX 77

2. What are the key factors and considerations that should be taken into account in 

making recommendations on implementing the proprietary trading provisions of the 

Volcker Rule?

3. What are the key factors and considerations that should be taken into account in 

making recommendations on implementing the provisions of the Volcker Rule that 

restrict the ability of banking entities to invest in, sponsor or have certain other covered 

relationships with private equity and hedge funds?

4. With respect to proprietary trading and hedge fund and private equity fund 

activities, what factors and considerations should inform decisions on the definitions of:

(i)  ̳Banking entity ̳ [§ 619(h)(1)];

(ii)  ̳Hedge fund ̳ [§ 619(h)(2)];

(iii)  ̳Private equity fund ̳ [§ 619(h)(2)];

(iv)  ̳Such similar funds ̳ [§ 619(h)(2)];

(v)  ̳Proprietary trading ̳ [§ 619(h)(4)];

(vi)  ̳Sponsor ̳ [§ 619(h)(5)];

(vii)  ̳Trading account ̳ [§ 619(h)(6)];

(viii)  ̳Short term ̳ [§ 619(h)(6)];

(ix)  ̳Illiquid fund ̳ [§ 619(h)(7)];

(x) A transaction  ̳in connection with underwriting or market making related 

activities * * * designed not to exceed the reasonably expected near-term demands of 

clients, customers or counterparties ̳ [§ 619(d)(1)(B)];

(xi)  ̳Risk-mitigating hedging activities ̳ [§ 619(d)(1)(C)];

(xii)  ̳The purchase, sale, acquisition, disposition of securities or other instruments 

 ̳on behalf of customers‘ [§ 619(d)(1)(D)];

(xiii) Investments in  ̳small business investment companies ̳ and certain  ̳public 

welfare ̳ investments [§ 619(d)(1)(E)];

(xiv) A permitted activity by an insurance company [§ 619(d)(1)(F)]; and

(xv) Such other activities as  ̳would promote and protect the safety and soundness 

of banking entities and the financial stability of the United States ̳ [§ 619(d)(1)(J)];?
ANNEX 78

5. With respect to proprietary trading and hedge fund and private equity fund 

activities, what factors and considerations should be taken into account as indicative that 

a transaction, class of transactions or activity:

(i) Would involve or result in a material conflict of interest between a banking 

entity (or a nonbank financial company supervised by the Board) and its clients, 

customers or counterparties;

(ii) Would result, directly or indirectly, in a material exposure by a banking entity 

(or a nonbank financial company supervised by the Board) to high-risk assets or high-risk 

trading strategies; or

(iii) Would pose a threat to the safety and soundness of a banking entity (or a 

nonbank financial company supervised by the Board)?

6. What factors and considerations should be taken into account in making 

recommendations on whether additional capital and quantitative limitations are 

appropriate to protect the safety and soundness of banking entities or nonbank financial 

companies supervised by the Board engaged in activities permitted under the Volcker 

Rule?

7. With respect to proprietary trading and hedge fund and private equity fund 

activities, which practices, types of transactions or corporate structures in general have 

historically accounted for or involved increased risks or may account for or involve 

increased risks in the future?

8. With respect to proprietary trading and hedge fund and private equity fund 

activities, what practices, policies or procedures have historically been utilized that may 

have mitigated or exacerbated risks or losses? What practices, policies or procedures 

might be useful in limiting undue risk or loss in the future?

9. What factors and considerations should be taken into account in making 

recommendations to safeguard against evasion of the Volcker Rule? 

10. How should the international context be considered when implementing the 

Volcker Rule? Are there any factors or considerations that should be taken into account 

regarding the application of the Volcker Rule to banking entities or nonbank financial 

companies that operate outside the United States? What issues does implementation of 

the Volcker Rule present with respect to the following:

(i) Domestic banking entities that have access to foreign exchanges,

(ii) foreign affiliates of domestic banking entities, and

(iii) foreign non-bank financial companies
ANNEX 79

11. What timing issues are raised in connection with the divestiture of illiquid 

assets affected by the prohibitions of the Volcker Rule, and how might such issues be 

appropriately addressed? 

12. Commenters are generally invited to submit views with respect to any 

qualitative or quantitative factors that should be considered in connection with the 

Council‘s study of the Volcker Rule, as well as any analogous areas of law, economics, 

or industry practice, and any factors specific to the commenter‘s experience. Please 

comment generally and specifically, and please include empirical data and other 

information in support of such comments, where appropriate and available.‖