The Volcker rule limits two main types of activities by large institutional banks. Banks are prohibited from engaging in proprietary trading activities and from owning interest in covered funds, generally defined as hedge funds and private equity funds. The rule is listed in Section 609 of the Dodd-Frank Act, and is part of the larger financial reforms contained in that legislation.
The rule was designed to prevent banks that receive federal and taxpayer backing in the form of deposit insurance and other support from engaging in risky trading activities. The rule was named after Paul Volcker, a former chairman of the Federal Reserve Board.
Proprietary Trading Prohibited
The Volcker rule prohibits banks from engaging in proprietary trading activities. Proprietary trading is defined by the rule as a bank serving as a principal of a trading account in buying or selling a financial instrument. The regulations expand on the definition of what qualifies as a trading account and whether the trade involves a financial instrument.
The regulations define a trading account based upon three criteria: a purpose test for the account, the market risk capital rule test and the status test. The rules states that trades are presumed to be for the trading account of a bank if the bank held the position for 60 days.
Due to the broad definition of a trading account, certain trading activities are exempted from this prohibition, such as clearing activities, liquidity management, market making, hedging, trades to satisfy delivery obligations and trades through a profit sharing or pension plan of the bank. However, very strenuous compliance requirements are placed on these trading activities, which include internal controls and extensive documentation.
Prohibition on Covered Fund Investments
The Volcker rule further prohibits banks from having an ownership interest in a covered fund. The rule defines covered funds with a three-pronged test. A covered fund is exempt from the definition of an investment company as defined by the Investment Company Act of 1940, commodity pools with characteristics similar to hedge funds or private equity funds and foreign covered funds.
The rule sets forth a number of exceptions to these prohibitions, such as foreign public funds, wholly owned subsidiaries and joint ventures.
Extension of Deadlines for Compliance
Banks were supposed to liquidate their holdings in covered funds by July 2015. However, in December 2014, the Federal Reserve Board granted extensions to banks to get out of these positions until 2017, and until 2022 in some cases.
The banks argued that many of their positions were in illiquid investments on which they would have to take significant losses to exit. The banks stated that their ownership interests in hedge funds and private equity funds were at risk of losing substantial value if they were forced to liquidate them quickly.