Policy Documents

Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds

Financial Stability Oversight Council –
January 1, 2011

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the ―Dodd-Frank Act). 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.

The proprietary trading provisions prohibit a banking entity from engaging in trading activity in which it acts as a principal in order to profit from near-term price movements. 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).

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 Agencies to carefully weigh all 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.

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, profit-seeking 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.