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Volcker Urges SEC to Use Dodd-Frank's Anti-Evasive Authority to Thwart Attempts to Evade Ban on Proprietary Trading and Hedge Fund Sponsoring

By Jim Hamilton

In a letter to the SEC and other regulators comprising the Financial Stability Oversight Council, former Fed Chair Paul Volcker said that clear and concise definitions, firmly worded prohibitions, and specificity in describing permissible activities will be of prime importance as they implement the Dodd-Frank Act ban on financial institutions conducting proprietary trading and sponsoring hedge funds. He said that the plain intent of Section 619 of Dodd-Frank, codifying the Volcker Rule, is to restrict certain high risk, proprietary trading activities by financial institutions that receive government protection and support. The former Fed Chair also emphasized that hedge and private equity funds should be aligned with and support established customer-focused asset management business.

He also advised that the anti-evasion clause of Section 619 provides ample authority for regulators to detect attempts to circumvent the Volcker Rule. Dodd-Frank clearly states that regulators may look beyond the trading account into any such other accounts as the SEC and CFTC may determine. In practice, he noted, particularly active trading relative to peer institutions in the guise of ?market making? should be a signal for regulatory interest, especially if further reflected in relatively wide fluctuations in trading results. He advised the SEC and other federal financial regulators that such signals of potential proprietary trading should be tested against direct visits to trading desks and specific trading records.

In his view, defining the term ?market making? will be especially important since it is this function where trading presumptively in response to customers? initiative might disguise essentially proprietary wagers on the direction of individual securities or markets. Other important terms which deal with scope, such as ?trading account?, should be defined broadly so as not to limit regulatory examination of trading activities that may or may not in a particular institution be labeled as ?trading account?.

In addition, insuring the proper implementation and enforcement of Section 619 requires that the de minimis exemptions and other permissible activities be defined clearly. Federal financial regulators must recognize that the thrust of Dodd-Frank is that certain of those activities be confined only to customer related activities within the firm. Rules that determine whether an action by a financial institution is in response to customers? initiative and needs are critical, said the former Fed Chair.

In providing a de minimis provision for sponsorship and temporary seed investments in hedge funds and private equity funds, explained Chairman Volcker, Dodd-Frank endeavors to isolate the risk and to protect against conflicts of interest by prohibiting guarantees or bail-outs of such funds by the organizations and other safeguards against advertising and director or employee investment. Crucially, said Mr. Volcker, such funds should be organized only by institutions with established trust and investment management services, and should be offered only to persons that were customers of such services.

Finally, Chairman Volcker said that tone at the top will be very important in implementing Section 619. Effective compliance must start with a clear understanding at the top of the regulated institution. The first step for regulators should be the ?corner office,? noted the central banker, and the CEO?s understanding and instructions to other executives and staff regarding the prohibition on proprietary trading and compliance procedures for the new rules should be carefully reviewed. The directors and the audit committee, should understand their own responsibilities to insure effective procedures for compliance with Section 619, he added, and meetings with the firm?s risk management vehicles should include surveillance with respect to compliance with the Section 619.

Full post as published by Jim Hamilton's World of Securities Regulation on November 11, 2010 (boomark / email).