Daniel K Tarullo: The Volcker Rule
Testimony by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal
Reserve System, before the Subcommittee on Capital Markets and Government Sponsored
Enterprises and the Subcommittee on Financial Institutions and Consumer Credit,
Committee on Financial Services, US House of Representatives, Washington DC,
18 January 2012.
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Chairman Capito, Chairman Garrett, Ranking Member Maloney, Ranking Member Waters,
and other members of the subcommittees, thank you for the opportunity to testify on the
interagency proposal to implement the requirements of section 619 of the Dodd-Frank Wall
Street Reform and Consumer Protection Act (Dodd-Frank Act), commonly known as the
Volcker Rule. My remarks today will focus on some of the issues faced in developing the
interagency proposal. As I have previously noted in Congressional testimony, the goal of the
Federal Reserve with respect to this and all other provisions of the Dodd-Frank Act, is to
implement the statute in a manner that is faithful to the language of the statute and that
maximizes financial stability and other social benefits at the least cost to credit availability
and economic growth.
The Federal Reserve, the Office of the Comptroller of the Currency (OCC), the Federal
Deposit Insurance Corporation (FDIC), and the Securities and Exchange Commission (SEC)
(collectively, the "agencies") in November sought public comment on a proposal to
implement the Volcker Rule. The Commodities Futures Trading Commission (CFTC) recently
issued its substantially similar proposal for comment. Because of the importance and
complexity of the issues raised by the statutory provisions that make up the Volcker Rule, the
agencies initially provided the public a 90-day opportunity to submit comments. We recently
extended the comment period for an additional 30 days, until February 13, 2012. The Federal
Reserve welcomes comments on Volcker Rule implementation and has had numerous
meetings with members of the public on this subject. We continue to post on our website all
the comments that we receive and a summary of all the meetings that the Federal Reserve
has had with members of the public about the Volcker Rule and all other provisions of the
Dodd-Frank Act.
Summary of statute and proposal
The statutory provisions that make up the Volcker Rule generally prohibit banking entities
from engaging in two types of activities: 1) proprietary trading and 2) acquiring an ownership
interest in, sponsoring, or having certain relationships with a hedge fund or private equity
fund (each a covered fund). These statutory provisions apply, in general, to insured
depository institutions; companies that control an insured depository institution; and foreign
banks with a branch, agency, or subsidiary bank in the United States, as well as to an
affiliate of one of these entities.
Under the statute, proprietary trading is defined as taking a position as principal in any
security, derivative, option, or contract for sale of a commodity for future delivery for the
purpose of selling that position in the near term or otherwise with the intent to resell to profit
from short-term price movements. The statute applies only to positions taken by a banking
entity as principal for the purpose of making short-term profits; it does not apply to positions
taken for long-term or investment purposes. Moreover, the statute contains a number of
exemptions, including for underwriting, market making-related activities, and risk-mitigating
hedging activities. The implementing rule proposed by the agencies incorporates all of these
statutory definitions and exemptions. The statute also authorizes the relevant regulatory
agencies to permit additional activities if they would promote and protect safety and
soundness of the banking entity and the financial stability of the United States.
The second major prohibition in the statute forbids any banking entity from acquiring or
retaining an ownership interest in, or having certain relationships with, a covered fund. Again,
the statute contains a number of exceptions, including for organizing and offering a covered
fund, making limited investments in a covered fund, sponsoring and investing in loan
securitizations, and risk-mitigating hedging activities. The statutory definition of a fund
covered under the Volcker Rule is quite broad. The statute also quite broadly prohibits any
banking entity that serves as the investment manager, adviser, or sponsor to a covered fund,
or that organizes and offers a covered fund, from engaging in certain transactions with the
fund, including lending to, or purchasing assets from, the fund.
The statute also prohibits otherwise permissible trading and investment activities when there
is a material conflict of interest with customers, clients, or counterparties, or when the activity
results in an exposure to high-risk assets or trading strategies. These are significant
provisions and the agencies have specifically solicited comment on disclosure requirements
and other approaches to implementing these parts of the statute.
Differentiating proprietary trading from market making
One of the more difficult tasks in implementing the statutory prohibitions is distinguishing
between prohibited proprietary trading activities and permissible market-making activities.
This distinction is important because of the key role that market makers play in facilitating
liquid markets in securities, derivatives, and other assets.
At the ends of the spectrum, the distinction between pure proprietary trading and market
making is straightforward. At one end, for instance, trading activities that are organized within
a discrete business unit, and that are conducted solely for the purpose of executing trading
strategies that are expected to produce short-term profits without any connection to customer
facilitation or intermediation, are not difficult to identify. These "internal hedge fund"
operations existed at many bank affiliates for quite some time before the Volcker Rule was
enacted. Firms that either are or were engaged in these non-client-oriented, purely
proprietary trading businesses can readily identify and wind down these activities. Indeed,
some have already done so for a number of reasons, including anticipatory compliance with
the Volcker Rule.
At the other end of the spectrum, a textbook example would be a pure agency-based market
maker that acts as an intermediary, instantaneously matching a large pool of buyers and
sellers of an underlying asset without ever having to take a position in the asset itself. Profits
are earned either solely by charging buyers a higher price than is paid to sellers of the asset,
or in some cases by charging a commission. Buyers and sellers willingly pay this "spread"
fee or commission because the market maker is able to more quickly and efficiently match
buyers with sellers than if they were left to find each other on their own.
I refer to this as a textbook example because instances of such riskless market making in our
trading markets are rare. In actual markets, buyers and sellers arrive at different times, in
staggered numbers and often have demands for similar but not identical assets. Market
makers hold inventory and manage exposures to the assets in which they make markets to
ensure that they can continuously serve the needs of their customers.
Accordingly, in the broad middle that exists between these two clear examples, the
distinction between prohibited proprietary trading and permissible market making can be
difficult to draw, because these activities share several important characteristics. In both
activities, the banking entity generally acts as principal in trading the underlying position,
holds that position for only a relatively short period of time, and enjoys profits (and suffers
losses) from any price variation in the position over the period the position is held. Thus, the
purchase or sale of a specific block of securities is not obviously permissible or forbidden
based solely on the features of the transaction itself. The statute instead distinguishes
between these activities by looking to the purpose of the trade and the intent of the trader.
These subjective characteristics can be difficult to discern in practice, particularly in the
context of complex global trading markets in which a firm may engage in thousands or more
transactions per day. A similar challenge attaches to efforts to distinguish a hedging trade
from a proprietary trade.
Implementation framework
The agencies have proposed a framework for implementation of the Volcker Rule that
combines: 1) an explanation of the factors the agencies expect to use to differentiate
prohibited activities from permitted activities, 2) a requirement that banking entities with
significant trading activities implement a program to monitor their activities to ensure
compliance with the statute, and 3) data collection and reporting requirements, to facilitate
both compliance monitoring and the development of more specific guidance over time. In
addition, the agencies will use their supervisory and examination processes to monitor
compliance with the statute.
The third element of the interagency proposal bears some additional comment. In order to
help differentiate between permitted market-making activities and prohibited proprietary
trading activities, the agencies have proposed to collect data from trading firms on a number
of quantitative measurements. These metrics are designed to assist both the agencies and
banking entities in identifying the risks and characteristics of prohibited proprietary trading
and exempt activities. The proposal makes clear that metrics would be used as a tool, but
not as a dispositive factor for defining permissible activities. The agencies instead propose to
use metrics to identify activity that merits special scrutiny by banking entities and examiners
in their evaluation of the activities of firms. The proposed rule does not include specific
thresholds to trigger further scrutiny for individual metrics, but requests comment on whether
thresholds would be useful, and notes that the agencies expect to propose them in the
future. The proposal also makes clear that the agencies expect to take a heuristic approach
to metrics, revising and refining them over time as greater experience is gained in reviewing,
analyzing, and applying these measurements for purposes of identifying prohibited
proprietary trading.
Additionally, since some banking entities engage in few or no activities covered by the
statute, the proposal also includes a number of elements intended to reduce the burden of
the proposed rule on smaller, less-complex banking entities. In particular, the agencies have
proposed very limited compliance programs and have reduced or eliminated the data
collection requirements for these banking entities.
Potential effects of the proposal
The proprietary trading prohibition in the Volcker Rule statute itself will undoubtedly affect the
trading behavior of banking entities. Indeed, that is what Congress intended in enacting
these provisions. Congress has itself made the judgment that this prohibition will enhance
financial stability and is socially desirable. The task of the agencies is to implement
Congressional intentions, as manifest in the statute itself, as efficiently and effectively as
possible.
The approach taken in the proposed rulemaking is concededly not a simple one. But, at least
to date, it has seemed the most feasible. Two alternative approaches have been suggested,
and we considered each prior to issuing the proposed regulation. One considerably simpler
approach would be to articulate high-level principles for differentiating prohibited and
permitted activities and then leave it to the firms to self-report violations based on internal
models or other devices, presumably with compliance and systems monitoring by regulatory
agencies. While having the virtue of simplicity at the outset, this approach would provide little
clarity about whether an activity is permitted or prohibited. It seems quite likely that, either
formally or informally, the regulatory agencies would regularly be asked to offer guidance or
approve specific practices. Otherwise, this approach would essentially rely on self-policing by
banking entities.
A second alternative would be to establish definitive bright lines for determining whether an
activity is permitted or prohibited. This approach would be very difficult in practice, at least
with current information and data, because of the many asset classes, business models, and
transaction types covered by the statutory provisions. Hard-and-fast rules would also run the
risk of being either too restrictive, and thus inadvertently classifying legitimate,
customerdriven market-making or hedging activity as prohibited, or too narrow, and thus failing
adequately to capture the full range of activities that are prohibited under the statute.
The more nuanced framework contained in our proposal was designed to realize some of the
advantages of both of these approaches while minimizing their potential adverse effects. The
Dodd-Frank Act provides a long conformance period for firms that are subject to the Volcker
Rule. The agencies have proposed to use that conformance period to study the effects of the
statutory prohibitions on the activities of banking entities before the Volcker Rule is fully
implemented. To assist in this undertaking, the agencies have proposed to begin collecting
and reviewing trading data that should help firms subject to the statutory provisions, as well
as the agencies in our efforts, to monitor and understand the contours of the activities that
are prohibited, permitted, and affected by the statutory provisions that make up the Volcker
Rule. As I mentioned earlier, we are hopeful that the data collection and reporting required in
our proposal will eventually facilitate more specific guidance on market-making, hedging, and
other exemptions from the general prohibition. After the Volcker Rule becomes fully effective,
we would continue to monitor the effects of the rule and look for opportunities to refine it.
Having said all this, the Federal Reserve is more than open to alternatives that would be
superior to the approach proposed. Indeed, the agencies requested comment on alternative
approaches in the Federal Register notice.
Thank you for your attention. I would be pleased to answer any questions you might have.