Federal Register, Volume 77 Issue 30 (Tuesday, February 14, 2012)[Federal Register Volume 77, Number 30 (Tuesday, February 14, 2012)]

[Proposed Rules]

[Pages 8332-8447]

From the Federal Register Online via the Government Printing Office [www.gpo.gov]

[FR Doc No: 2012-935]

[[Page 8331]]

Vol. 77

Tuesday,

No. 30

February 14, 2012

Part II

Commodity Futures Trading Commission

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17 CFR Part 75

Prohibitions and Restrictions on Proprietary Trading and Certain

Interests in, and Relationships With, Hedge Funds and Covered Funds;

Proposed Rule

Federal Register / Vol. 77 , No. 30 / Tuesday, February 14, 2012 /

Proposed Rules

[[Page 8332]]

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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 75

RIN 3038-AD05

Prohibitions and Restrictions on Proprietary Trading and Certain

Interests in, and Relationships With, Hedge Funds and Covered Funds

AGENCY: Commodity Futures Trading Commission.

ACTION: Notice of proposed rulemaking.

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SUMMARY: The Commodity Futures Trading Commission (“CFTC” or

“Commission”) is requesting comment on a proposed rule that would

implement Section 619 of the Dodd-Frank Wall Street Reform and Consumer

Protection Act (“Dodd-Frank Act”) which contains certain prohibitions

and restrictions on the ability of a banking entity and nonbank

financial company supervised by the Board of Governors of the Federal

Reserve System (the “Board”) to engage in proprietary trading and

have certain interests in, or relationships with, a hedge fund or

private equity fund (“CFTC Rule”).

On November 7, 2011, the Office of the Comptroller of the Currency,

Treasury (“OCC”); the Board; the Federal Deposit Insurance

Corporation (“FDIC”); and the Securities and Exchange Commission

(“SEC”) published a joint proposed rule implementing Section 619 of

the Dodd-Frank Act (the “Joint Release”).1 The CFTC is adopting the

entire text of the proposed common rules section from the Joint Release

(the “Joint Rule”) as part of its proposed rule.2 Similar to the

OCC, the Board, the FDIC, and the SEC in the Joint Release, the CFTC is

modifying the Joint Rule with CFTC-specific rule text. The CFTC Rule

also contains additional questions specific to the CFTC in Section III

and does not include Subpart E of the Joint Release because Subpart E

deals exclusively with the Board. The Commission solicits comments on

all aspects of this proposed rule.

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1 See Prohibitions and Restrictions on Proprietary Trading and

Certain Interests in, and Relationships With, Hedge Funds and

Private Equity Funds, 76 FR 68846, (Nov. 7, 2011).

2 See 76 FR 68944-68967 for the Joint Rule text adopted by the

Board, the OCC, the FDIC, and the SEC.

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DATES: Comments should be received on or before April 16, 2012.

ADDRESSES: Interested parties are encouraged to submit written comments

to either the CFTC individually or jointly to the OCC, Board, FDIC

(collectively, the “Federal Banking Agencies” or “FBA”); SEC, and

together with the CFTC, (the “Agencies”).3 Commenters are

encouraged to use the title “Restrictions on Proprietary Trading and

Certain Interests in, and Relationships with, Hedge Funds and Private

Equity Funds” to facilitate the organization and distribution of

comments to the CFTC and among the Agencies. Commenters are also

encouraged to identify the number of the specific question for comment

to which they are responding.

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3 See id. at 68846 for instructions on submitting comments to

the OCC, the Board, the FDIC, and the SEC.

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You may submit comments, identified by RIN number 3038-AD05, by any

of the following methods:

Agency Web site, via its Comments Online process: http://comments.cftc.gov. Follow the instructions for submitting comments

through the Web site.

Mail: David A. Stawick, Secretary of the Commission,

Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st

Street NW., Washington, DC 20581.

Hand Delivery/Courier: Same as mail above.

Federal eRulemaking Portal: http://www.regulations.gov.

Follow the instructions for submitting comments. Please submit comments

by only one method.

All comments must be submitted in English, or if not, accompanied

by an English translation. Comments will be posted as received to

http://www.cftc.gov. You should submit only information that you wish

to make available publicly. If you wish the Commission to consider

information that may be exempt from disclosure under the Freedom of

Information Act (“FOIA”), a petition for confidential treatment of

the exempt information may be submitted according to the procedures

established in 17 CFR 145.9. The Commission reserves the right, but

shall have no obligation, to review, prescreen, filter, redact, refuse,

or remove any or all of your submission from http://www.cftc.gov that

it may deem to be inappropriate for publication, such as obscene

language. All submissions that have been redacted or removed that

contain comments on the merits of the rulemaking will be retained in

the public comment file and will be considered as required under the

Administrative Procedure Act and other applicable laws, and may be

accessible under FOIA.

FOR FURTHER INFORMATION CONTACT: Steven E. Seitz, Counsel, Office of

the General Counsel, 202-418-5615, [email protected]; Gary Barnett,

Director, Division of Swap and Intermediary Oversight, (202) 418-5977,

[email protected]; Beverly Loew, Assistant General Counsel, Office of

the General Counsel, (202) 418-5648, [email protected]; Adedayo Banwo,

Counsel, Office of the General Counsel, (202) 418-6249,

[email protected]; Mathew Hargrow, Attorney Advisor, Office of the

General Counsel, (202) 418-5267, [email protected]; Todd Prono,

Financial Economist, Office of the Chief Economist, (202) 418-5640,

[email protected]; Commodity Futures Trading Commission, Three Lafayette

Centre, 1155 21st Street NW., Washington, DC 20581.

SUPPLEMENTARY INFORMATION:

I. Background

The Dodd-Frank Act was enacted on July 21, 2010.4 Section 619 of

the Dodd-Frank Act added a new section 13 to the Bank Holding Company

Act of 1956 (“BHC Act”) (to be codified at 12 U.S.C. 1851) that

generally prohibits any banking entity 5 from engaging in proprietary

trading or from acquiring or retaining an ownership interest in,

sponsoring, or having certain relationships with a hedge fund or

private equity fund (“covered fund”), subject to certain

exemptions.6 New section 13 of the BHC Act also provides for nonbank

financial companies supervised by the Board that engage in such

activities or have such interests or relationships to be subject to

additional capital requirements, quantitative limits, or other

restrictions.7

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4 Dodd-Frank Wall Street Reform and Consumer Protection Act,

Public Law 111-203, 124 Stat. 1376 (2010).

5 Application of the proposed rule to smaller, less-complex

banking entities is discussed below in Part II.G of this

Supplemental Information.

6 The term “banking entity” is defined in section 13(h)(1)

of the BHC Act, as amended by section 619 of the Dodd-Frank Act. See

12 U.S.C. 1851(h)(1). The statutory definition includes any insured

depository institution (other than certain limited purpose trust

institutions), any company that controls an insured depository

institution, any company that is treated as a bank holding company

for purposes of section 8 of the International Banking Act of 1978

(12 U.S.C. 3106), and any affiliate or subsidiary of any of the

foregoing. Section 13 of the BHC Act defines the terms “hedge

fund” and “private equity fund” as an issuer that would be an

investment company, as defined under 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 any such similar funds as the appropriate Federal

banking agencies (i.e., the Board, OCC, and FDIC), the SEC, and the

CFTC may, by rule, determine should be treated as a hedge fund or

private equity fund. See 12 U.S.C. 1851(h)(2). The term banking

entity that is used throughout this Supplemental Information only

pertains to those banking entities that are relevant to the CFTC

under the CFTC Rule.

7 See 12 U.S.C. 1851(a)(2) and (f)(4). A “nonbank financial

company supervised by the Board” is a nonbank financial company or

other company that the Financial Stability Oversight Council

(“Council”) has determined, under section 113 of the Dodd-Frank

Act, shall be subject to supervision by the Board and prudential

standards. The Board is not proposing at this time any additional

capital requirements, quantitative limits, or other restrictions on

nonbank financial companies pursuant to section 13 of the BHC Act,

as it believes doing so would be premature in light of the fact that

the Council has not yet finalized the criteria for designation of,

nor yet designated, any nonbank financial company.

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[[Page 8333]]

A. Rulemaking Framework

Section 13 of the BHC Act requires that implementation of its

provisions occur in several stages. First, the Council was required to

conduct a study (“Council study”) and make recommendations by January

21, 2011 on the implementation of section 13 of the BHC Act. The

Council study was issued on January 18, 2011, and included a detailed

discussion of key issues related to implementation of section 13 and

recommended that the Agencies consider taking a number of specified

actions in issuing rules under section 13 of the BHC Act.8 The

Council study also recommended that the Agencies adopt a four-part

implementation and supervisory framework for identifying and preventing

prohibited proprietary trading, which included a programmatic

compliance regime requirement for banking entities, analysis and

reporting of quantitative metrics by banking entities, supervisory

review and oversight by the Agencies, and enforcement procedures for

violations.9 The CFTC has carefully considered the Council study and

its recommendations, and has consulted with staff of the other

Agencies, in formulating this proposal.10

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8 See Financial Stability Oversight Counsel, Study and

Recommendations on Prohibitions on Proprietary Trading and Certain

Relationships with Hedge Funds and Private Equity Funds (Jan. 18,

2011), available at http://www.treasury.gov/initiatives/Documents/Volcker%20sec%20619%20study%20final%201%2018%2011%20rg.pdf. See 12

U.S.C. 1851(b)(1). Prior to publishing its study, the Council

requested public comment on a number of issues to assist the Council

in conducting its study. See 75 FR 61,758 (Oct. 6, 2010).

Approximately 8,000 comments were received from the public,

including from members of Congress, trade associations, individual

banking entities, consumer groups, and individuals. As noted in the

issuing release for the Council Study, these comments were carefully

considered by the Council when drafting the Council study.

9 See Council study at 5-6. The CFTC has implemented this

recommendation through the proposed compliance program requirements

contained in Subpart D of this proposal with respect to both

proprietary trading and covered fund activities and investments.

10 The CFTC also received a number of comment letters

concerning implementation of section 13 of the BHC Act in advance of

this proposal. The CFTC has carefully considered these comments in

formulating this proposal.

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The CFTC is adopting the entire text of the proposed common rules

from the Joint Release (the “Joint Rule”) as part of its proposed

rule.11 Similar to the other Agencies in the Joint Release, the CFTC

is modifying the text of proposed common rules section from the Joint

Release with CFTC-specific rule text.

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11 See 76 FR 68944 through 68967 for the Joint Rule.

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Sections II and III of the CFTC Rule are substantively consistent

with Sections II and III of the Joint Release, with the following

exceptions: (a) Sections II of the CFTC Rule also includes the

following additional questions: 8.1, 14.1, 30.1, 30.2, 64.1, 87.1,

88.1, 168.1, 168.2, 177.1, 218.1, 227.1, 296.1, and 302.1 12 and (b)

the CFTC Rule does not include Subpart E of the Joint Release because

Subpart E only applies to the Board.13 The CFTC Rule includes these

additional questions to ask whether certain provisions of the Joint

Rule should be applicable to CFTC-regulated banking entities. In these

questions, the CFTC generally asks whether the proposed CFTC Rule

should adopt such provisions and requests an explanation of the

rationale for either including or excluding such provision in the

proposed CFTC Rule.

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12 Section VI of the proposed CFTC Rule also contains the

additional question 348.1.

13 The CFTC believes that Sections II and III of both the CFTC

Rule and the Joint Release are substantively consistent with the

exception of the additional questions and the deletion of Subpart E.

Any other discrepancies between Sections II and III of the CFTC Rule

and the Joint Release are solely for stylistic purposes and are not

intended to create any substantive differences between these

sections of the CFTC Rule and the Joint Release.

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Authority for developing and adopting regulations to implement the

prohibitions and restrictions of section 13 of the BHC Act is divided

between the Agencies in the manner provided in section 13(b)(2) of the

BHC Act.14 The statute also requires the Agencies, in developing and

issuing implementing rules, to consult and coordinate with each other,

as appropriate, for the purposes of assuring, to the extent possible,

that such rules are comparable and provide for consistent application

and implementation of the applicable provisions of section 13 of the

BHC Act.15 The CFTC believes that such coordination will assist in

ensuring that advantages are not unduly provided to, and that

disadvantages are not unduly imposed upon, companies affected by

section 13 of the BHC Act and that the safety and soundness of banking

entities and nonbank financial companies supervised by the Board are

protected. The statute requires the CFTC to implement rules under

section 13 not later than 9 months after the Council completes its

study (i.e., not later than October 18, 2011).16 The restrictions and

prohibitions of section 13 of the BHC Act become effective 12 months

after issuance of final rules by the CFTC, or July 21, 2012, whichever

is earlier.17

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14 See 12 U.S.C. 1851(b)(2). Under section 13(b)(2)(B) of the

BHC Act, rules implementing section 13’s prohibitions and

restrictions must be issued by: (i) the appropriate Federal banking

agencies (i.e., the Board, the OCC, and the FDIC), jointly, with

respect to insured depository institutions; (ii) the Board, with

respect to 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, any nonbank

financial company supervised by the Board, and any subsidiary of any

of the foregoing (other than a subsidiary for which an appropriate

Federal banking agency, the SEC, or the CFTC is the primary

financial regulatory agency); (iii) the CFTC with respect to any

entity for which it is the primary financial regulatory agency, as

defined in section 2 of the Dodd-Frank Act; and (iv) the SEC with

respect to any entity for which it is the primary financial

regulatory agency, as defined in section 2 of the Dodd-Frank Act.

See id.

15 See 12 U.S.C. 1851(b)(2)(B)(ii). The Secretary of the

Treasury, as Chairperson of the Council, is responsible for

coordinating the Agencies’ rulemakings under section 13 of the BHC

Act. See id.

16 See id. at 1851(b)(2)(A).

17 See id. at 1851(c)(1).

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In addition, the statute required the Board, acting alone, to adopt

rules to implement the provisions of section 13 of the BHC Act that

provide a banking entity or a nonbank financial company supervised by

the Board a period of time after the effective date of section 13 of

the BHC Act to bring the activities, investments, and relationships of

the banking entity into compliance with that section and the Agencies’

implementing regulations.18 The Board issued its final conformance

rule as required under section 13(c)(6) of the BHC Act on February 8,

2011 (“Board’s Conformance Rule”).19 As noted in the issuing

release for the Board’s Conformance Rule, this period is intended to

give markets and firms an opportunity to adjust to section 13 of the

BHC Act.20

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18 See id. at 1851(c)(6).

19 See Conformance Period for Entities Engaged in Prohibited

Proprietary Trading or Private Equity Fund or Hedge Fund Activities,

76 FR 8265 (Feb. 14, 2011).

20 See id. (citing 156 Cong. Rec. S5898 (daily ed. July 15,

2010) (statement of Sen. Merkley)).

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B. Section 13 of the BHC Act

Section 13 of the BHC Act generally prohibits banking entities from

engaging in proprietary trading or from acquiring or retaining any

ownership interest in, or sponsoring, a covered fund.21 However,

section 13(d)(1) of that Act expressly includes exemptions from

[[Page 8334]]

these prohibitions for certain permitted activities, including:

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21 12 U.S.C. 1851(a)(1)(A) and (B).

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Trading in certain government obligations;

Underwriting and market making-related activities;

Risk-mitigating hedging activity;

Trading on behalf of customers;

Investments in Small Business Investment Companies

(“SBICs”) and public interest investments;

Trading for the general account of insurance companies;

Organizing and offering a covered fund (including limited

investments in such funds);

Foreign trading by non-U.S. banking entities; and

Foreign covered fund activities by non-U.S. banking

entities.22

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22 See id. at 1851(d)(1). As described in greater detail in

Part III.B.4 of this SUPPLEMENTARY INFORMATION, the proposed rule

applies some of these statutory exemptions only to the proprietary

trading prohibition or the covered fund prohibitions and

restrictions, but not both, where it appears either by plain

language or by implication that the exemption was intended only to

apply to one or the other.

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For purposes of this Supplementary Information, trading activities

subject to section 13 of the BHC Act, including those permitted under a

relevant exemption, are sometimes referred to as “covered trading

activities.” Similarly, activities and investments with respect to a

covered fund that are subject to section 13 of the BHC Act, including

those permitted under a relevant exemption, are sometimes referred to

as “covered fund activities or investments.”

Additionally, section 13 of the BHC Act permits the CFTC to grant,

by rule, other exemptions from the prohibitions on proprietary trading

and acquiring or retaining an ownership interest in, or acting as

sponsor to, a covered fund if the CFTC determines that the exemption

would promote and protect the safety and soundness of the banking

entity and the financial stability of the United States.23

Furthermore, under the statute, no banking entity may engage in a

permitted activity if that activity would (i) involve or result in a

material conflict of interest or material exposure of the banking

entity to high-risk assets or high-risk trading strategies, or (ii)

pose a threat to the safety and soundness of the banking entity or to

the financial stability of the United States.24

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23 Id. at 1851(d)(1)(J).

24 See id. at 1851(d)(2).

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Section 13(f) of the BHC Act separately prohibits a banking entity

that serves, directly or indirectly, as the investment manager,

investment adviser, or sponsor to a covered fund, and any affiliate of

such a banking entity, from entering into any transaction with the

fund, or any other covered fund controlled by such fund, that would be

a “covered transaction” as defined in section 23A of the Federal

Reserve Act (“FR Act”),25 as if such banking entity or affiliate

were a member bank and the covered fund were an affiliate thereof,

subject to certain exceptions.26 Section 13(f) also provides that a

banking entity may enter into certain prime brokerage transactions with

any covered fund in which a covered fund managed, sponsored, or advised

by the banking entity has taken an equity, partnership, or other

ownership interest, but any such transaction (and any other permitted

transaction with such funds) must be on market terms in accordance with

the provisions of section 23B of the FR Act.27

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25 See 12 U.S.C. 371c.

26 12 U.S.C. 1851(f).

27 12 U.S.C. 371c-1.

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Section 13 of the BHC Act does not prohibit a nonbank financial

company supervised by the Board from engaging in proprietary trading,

or from having the types of ownership interests in or relationships

with a covered fund that a banking entity is prohibited or restricted

from having under section 13 of the BHC Act. However, section 13 of the

BHC Act provides for the Board or other appropriate Agency to impose

additional capital charges, quantitative limits, or other restrictions

on a nonbank financial company supervised by the Board or their

subsidiaries and affiliates that are engaged in such activities or

maintain such relationships.28

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28 See 12 U.S.C. 1851(a)(2), (d)(4).

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II. Overview of Proposed Rule

A. General Approach

In formulating the proposed rule, the CFTC attempted to reflect the

structure of section 13 of the BHC Act, which is to prohibit a banking

entity from engaging in proprietary trading or acquiring or retaining

an ownership interest in, or having certain relationships with, a

covered fund, while permitting such entities to continue to provide

client-oriented financial services. However, the delineation of what

constitutes a prohibited or permitted activity under section 13 of the

BHC Act often involves subtle distinctions that are difficult both to

describe comprehensively within regulation and to evaluate in practice.

The CFTC appreciates that while it is crucial that rules under section

13 of the BHC Act clearly define and implement its requirements, any

rule must also preserve the ability of a banking entity to continue to

structure its businesses and manage its risks in a safe and sound

manner, as well as to effectively deliver to its clients the types of

financial services that section 13 expressly protects and permits.

These client-oriented financial services, which include underwriting,

market making, and traditional asset management services, are important

to the U.S. financial markets and the participants in those markets,

and the CFTC endeavored to develop a proposed rule that does not unduly

constrain banking entities in their efforts to safely provide such

services. At the same time, providing appropriate latitude to banking

entities to provide such client-oriented services need not and should

not conflict with clear, robust, and effective implementation of the

statute’s prohibitions and restrictions. Given these complexities, the

CFTC requests comment on the potential impacts the proposed approach

may have on banking entities and the businesses in which they engage.

In particular, and as discussed further in Part VII of this

Supplemental Information, the CFTC recognizes that there are economic

impacts that may arise from the proposed rule and its implementation of

section 13 of the BHC Act, and the CFTC requests comment on such

impacts, including quantitative data or studies, where possible.

In light of these larger challenges and goals, the CFTC’s proposal

takes a multi-faceted approach to implementing section 13 of the BHC

Act. In particular, the proposed rule includes a framework that: (i)

Clearly describes the key characteristics of both prohibited and

permitted activities; (ii) requires banking entities to establish a

comprehensive programmatic compliance regime designed to ensure

compliance with the requirements of the statute and rule in a way that

takes into account and reflects the unique nature of a banking entity’s

businesses; and (iii) with respect to proprietary trading, requires

certain banking entities to calculate and report meaningful

quantitative data that will assist both banking entities and the CFTC

in identifying particular activity that warrants additional scrutiny to

distinguish prohibited proprietary trading from otherwise permissible

activities. This multi-faceted approach, which is consistent with the

implementation and supervisory framework recommended in the Council

study, is intended to strike an appropriate balance between

accommodating prudent risk

[[Page 8335]]

management and the continued provision of client-oriented financial

services by banking entities while ensuring that such entities do not

engage in prohibited proprietary trading or restricted covered fund

activities or investments.29

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29 In recognition of economic impacts that may arise from the

proposed rule and its implementation of section 13 of the BHC Act,

the CFTC is requesting comment on the relative costs and benefits of

the proposal in Part VI of this Supplemental Information.

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In addition, and consistent with the statutory requirement that the

CFTC’s rule under section 13 of the BHC Act be, to the extent possible,

comparable and provide for consistent application and implementation,

the CFTC is proposing the Joint Rule (i.e., common rule and appendices)

that was proposed by the other Agencies. This uniform approach to

implementation is intended to provide the maximum degree of clarity to

banking entities and market participants and ensure that section 13’s

prohibitions and restrictions are applied consistently across different

types of regulated entities.30

—————————————————————————

30 Under this uniform approach, the CFTC is proposing the same

rule provisions under section 13 of the BHC Act as the Joint Rule.

The CFTC’s proposed rule would apply only to banking entities for

which it has regulatory authority under section 13(b)(2)(B) of the

BHC Act.

—————————————————————————

As a matter of structure, the proposed rule is generally divided

into four subparts and contains three appendices, as follows:

Subpart A of the proposed rule describes the authority,

scope, purpose, and relationship to other authorities of the rule and

defines terms used commonly throughout the rule;

Subpart B of the proposed rule prohibits proprietary

trading, defines terms relevant to covered trading activity,

establishes exemptions from the prohibition on proprietary trading and

limitations on those exemptions, and requires certain banking entities

to report quantitative measurements with respect to their trading

activities;

Subpart C of the proposed rule prohibits or restricts

acquiring or retaining an ownership interest in, and certain

relationships with, a covered fund, defines terms relevant to covered

fund activities and investments, as well as establishes exemptions from

the restrictions on covered fund activities and investments and

limitations on those exemptions;

Subpart D of the proposed rule generally requires banking

entities to establish an enhanced compliance program regarding

compliance with section 13 of the BHC Act and the proposed rule,

including written policies and procedures, internal controls, a

management framework, independent testing of the compliance program,

training, and recordkeeping;

Appendix A of the proposed rule details the quantitative

measurements that certain banking entities may be required to compute

and report with respect to their trading activities;31

—————————————————————————

31 A banking entity must comply with proposed Appendix A’s

reporting and recordkeeping requirements only if it has, together

with its affiliates and subsidiaries, trading assets and liabilities

the average gross sum of which (on a worldwide consolidated basis)

is, as measured as of the last day of each of the four prior

calendar quarters, equal to or greater than $1 billion.

—————————————————————————

Appendix B of the proposed rule provides commentary

regarding the factors the Agencies propose to use to help distinguish

permitted market making-related activities from prohibited proprietary

trading; and

Appendix C of the proposed rule details the minimum

requirements and standards that certain banking entities must meet with

respect to their compliance program, as required under subpart D.32

—————————————————————————

32 In particular, a banking entity must comply with the

minimum standards specified in Appendix C of the proposed rule (i)

with respect to its covered trading activities, if it engages in any

covered trading activities and has, together with its affiliates and

subsidiaries, trading assets and liabilities the average gross sum

of which (on a worldwide consolidated basis), as measured as of the

last day of each of the four prior calendar quarters, (X) is equal

to or greater than $1 billion or (Y) equals 10 percent or more of

its total assets; and (ii) with respect to its covered fund

activities and investments, if it engages in any covered fund

activities and investments and either (X) has, together with its

affiliates and subsidiaries, aggregate investments in covered funds

the average value of which is, as measured as of the last day of

each of the four prior calendar quarters, equal to or greater than

$1 billion or (Y) sponsors and advises, together with its affiliates

and subsidiaries, covered funds the average total assets of which

are, as measured as of the last day of each of the four prior

calendar quarters, equal to or greater than $1 billion.

—————————————————————————

B. Proprietary Trading Restrictions

Subpart B of the proposed rule implements the statutory prohibition

on proprietary trading and the various exemptions to this prohibition

included in the statute. Section —-.3 of the proposed rule contains

the core prohibition on proprietary trading and defines a number of

related terms, including “proprietary trading” and “trading

account.” The proposed rule’s definition of proprietary trading

generally parallels the statutory definition, and includes engaging as

principal for the trading account of a banking entity in any

transaction to purchase or sell certain types of financial

positions.33

—————————————————————————

33 See proposed rule Sec. —-.3(b)(1).

—————————————————————————

The proposed rule’s definition of trading account generally

parallels the statutory definition, and provides further guidance

regarding the circumstances in which a position will be considered to

have been taken principally for the purpose of short-term resale or

benefiting from actual or expected short-term price movements,

recognizing the importance of providing as much clarity as possible

regarding this term, which ultimately defines the scope of accounts

subject to the prohibition on proprietary trading.34 In particular,

the proposed definition of trading account identifies three classes of

positions that would cause an account to be a trading account. First,

the definition includes positions taken principally for the purpose of

short-term resale, benefitting from short-term price movements,

realizing short-term arbitrage profits, or hedging another trading

account position.35 As described in this notice, this language is

substantially similar to language for a “trading position” used in

the Federal banking agencies’ current market risk capital rules, as

proposed to be revised (“Market Risk Capital Rules”),36 and the

CFTC proposes to interpret this language in a similar manner. Second,

with respect to a banking entity subject to the Federal banking

agencies’ Market Risk Capital Rules, the definition includes all

positions in financial instruments subject to the prohibition on

proprietary trading that are treated as “covered positions” under

those capital rules, other than certain foreign exchange and

commodities positions. Third, the definition includes all positions

acquired or taken by certain registered securities and derivatives

dealers (or, in the case of financial institutions 37 that are

government securities dealers, that have filed notice with an

appropriate regulatory agency) in connection with their activities that

require such registration or notice.38 The definition of trading

account also contains clarifying exclusions for certain positions that

do not appear to involve the requisite short-term trading intent, such

as positions arising under certain repurchase and reverse repurchase

arrangements or securities lending transactions, positions acquired or

taken for bona fide liquidity

[[Page 8336]]

management purposes, and certain positions of derivatives clearing

organizations or clearing agencies.39

—————————————————————————

34 See proposed rule Sec. —-.3(b)(2).

35 See proposed rule Sec. —-.3(b)(2)(i)(A).

36 See 76 FR 1890 (Jan. 11, 2011).

37 In the context of regulation of government securities

dealers under the Securities Exchange Act of 1934 (“Exchange

Act”), the term “financial institution” as defined in section

3(a)(46) of the Exchange Act includes a bank (as defined in section

3(a)(36) of the Exchange Act) and a foreign bank (as defined in the

International Banking Act of 1978). See 15 U.S.C. 78c(a)(46).

38 See proposed rule Sec. —-.3(b)(2)(i)(B).

39 See proposed rule Sec. —-.3(b)(2)(iii).

—————————————————————————

Section —-.3 of the proposed rule also defines a number of other

relevant terms, including the term “covered financial position.” This

term is used to define the scope of financial instruments subject to

the prohibition on proprietary trading. Consistent with the statutory

language, such covered financial positions include positions (including

long, short, synthetic and other positions) in securities, derivatives,

commodity futures, and options on such instruments, but do not include

positions in loans, spot foreign exchange or spot commodities.40

—————————————————————————

40 See proposed rule Sec. —-.3(b)(3).

—————————————————————————

Section —-.4 of the proposed rule implements the statutory

exemptions for underwriting and market making-related activities. For

each of these permitted activities, the proposed rule provides a number

of requirements that must be met in order for a banking entity to rely

on the applicable exemption. These requirements are generally designed

to ensure that the activities, revenues and other characteristics of

the banking entity’s trading activity are consistent with underwriting

and market making-related activities, respectively, and not prohibited

proprietary trading.41 These requirements are intended to support and

augment other parts of the proposed rule’s approach to implementing the

prohibition on proprietary trading, including the compliance program

requirement and the reporting of quantitative measurements, in order to

assist banking entities and the CFTC in identifying prohibited trading

activities that may be conducted in the context of, or mischaracterized

as, permitted underwriting or market making-related activities.

—————————————————————————

41 See proposed rule Sec. —-.4(a), (b).

—————————————————————————

Section —-.5 of the proposed rule implements the statutory

exemption for risk-mitigating hedging. As with the underwriting and

market-making exemptions, proposed Sec. —-.5 contains a number of

requirements that must be met in order for a banking entity to rely on

the exemption. These requirements are generally designed to ensure that

the banking entity’s trading activity is truly risk-mitigating hedging

in purpose and effect.42 Proposed Sec. —-.5 also requires banking

entities to document, at the time the transaction is executed, the

hedging rationale for certain transactions that present heightened

compliance risks.43 As with the exemptions for underwriting and

market making-related activity, these requirements form part of a

broader implementation approach that also includes the compliance

program requirement and the reporting of quantitative measurements.

—————————————————————————

42 See proposed rule Sec. Sec. —-.5(b)(1), (2).

43 See proposed rule Sec. —-.5(b)(3).

—————————————————————————

Section —-.6 of the proposed rule implements statutory exemptions

for trading in certain government obligations, trading on behalf of

customers, trading by a regulated insurance company, and trading by

certain foreign banking entities outside the United States. Section —

–.6(a) of the proposed rule describes the government obligations in

which a banking entity may trade notwithstanding the prohibition on

proprietary trading, which include U.S. government and agency

obligations, obligations and other instruments of certain government

sponsored entities, and State and municipal obligations.44 Section —

–.6(b) of the proposed rule describes permitted trading on behalf of

customers and identifies three categories of transactions that would

qualify for the exemption.45 These categories include: (i)

Transactions conducted by a banking entity as investment adviser,

commodity trading advisor, trustee, or in a similar fiduciary capacity

for the account of a customer where the customer, and not the banking

entity, has beneficial ownership of the related positions; (ii)

riskless principal transactions; and (iii) transactions conducted by a

banking entity that is a regulated insurance company for the separate

account of insurance policyholders, subject to certain conditions.

Section —-.6(c) of the proposed rule describes permitted trading by a

regulated insurance company for its general account, and generally

parallels the statutory language governing this exemption.46 Finally,

Sec. —-.6(d) of the proposed rule describes permitted trading

outside of the United States by a foreign banking entity.47 The

proposed exemption clarifies when a foreign banking entity will be

considered to engage in such trading pursuant to sections 4(c)(9) or

4(c)(13) of the BHC Act, as required by the statute, including with

respect to a foreign banking entity not currently subject to section 4

of the BHC Act. The exemption also clarifies when trading will be

considered to have occurred solely outside of the United States, as

required by the statute, and provides a number of specific criteria for

determining whether that standard is met.

—————————————————————————

44 See proposed rule Sec. —-.6(a).

45 See proposed rule Sec. —-.6(b).

46 See proposed rule Sec. —-.6(c).

47 See proposed rule Sec. —-.6(d).

—————————————————————————

Section —-.7 of the proposed rule requires certain banking

entities with significant covered trading activities to comply with the

reporting and recordkeeping requirements specified in Appendix A of the

proposed rule. In addition, Sec. —-.7 requires that a banking entity

comply with the recordkeeping requirements in Sec. —-.20 of the

proposed rule, including, where applicable, the recordkeeping

requirements in Appendix C of the proposed rule. Section —-.7 of the

proposed rule also requires a banking entity to comply with any other

reporting or recordkeeping requirements that the CFTC may impose to

evaluate the banking entity’s compliance with the proposed rule.48

Proposed Appendix A requires those relevant banking entities with

significant covered trading activities to furnish periodic reports to

the CFTC regarding a variety of quantitative measurements of its

covered trading activities and maintain records documenting the

preparation and content of these reports. These proposed reporting and

recordkeeping requirements vary depending on the scope and size of

covered trading activities, and a banking entity must comply with

proposed Appendix A’s reporting and recordkeeping requirements only if

it has, together with its affiliates and subsidiaries, trading assets

and liabilities the average gross sum of which (on a worldwide

consolidated basis) is, as measured as of the last day of each of the

four prior calendar quarters, equal to or greater than $1 billion.

These thresholds are designed to reduce the burden on smaller, less

complex banking entities, which generally engage in limited market-

making and other trading activities. Other provisions of the proposal,

and in particular the compliance program requirement in Sec. —-.20

of the proposed rule, are likely to be less burdensome and equally

effective methods for ensuring compliance with section 13 of the BHC

Act by smaller, less complex banking entities.

—————————————————————————

48 See proposed rule Sec. —-.7.

—————————————————————————

The quantitative measurements that must be furnished under the

proposed rule are generally designed to reflect, and provide meaningful

information regarding, certain characteristics of trading activities

that appear to be particularly useful to help differentiate permitted

market making-related activities from prohibited proprietary trading

and to identify whether certain trading activities result in a material

[[Page 8337]]

exposure to high-risk assets or high-risk trading strategies. In

addition, proposed Appendix B contains a detailed commentary regarding

identification of permitted market making-related activities and

distinguishing such activities from trading activities that constitute

prohibited proprietary trading.

As described in Part II.B.5 of the Supplementary Information below,

the CFTC expects to utilize the conformance period provided in section

13(c)(2) of the BHC Act to further refine and finalize the reporting

requirements, reflecting the substantial public comment, practical

experience, and revision that will likely be required to ensure

appropriate, effective use of reported quantitative data in practice.

Section —-.8 of the proposed rule prohibits a banking entity from

relying on any exemption to the prohibition on proprietary trading if

the permitted activity would involve or result in a material conflict

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

risk trading strategies, or pose a threat to the safety and soundness

of the banking entity or to the financial stability of the United

States.49 This section also defines material conflict of interest,

high-risk asset, and high-risk trading strategy for these purposes.

—————————————————————————

49 See proposed rule Sec. —-.8.

—————————————————————————

C. Covered Fund Activities and Investments

Subpart C of the proposed rule implements the statutory prohibition

on, as principal, directly or indirectly, acquiring and retaining an

ownership interest in, or having certain relationships with, a covered

fund, as well as the various exemptions to this prohibition included in

the statute. Section —-.10 of the proposed rule contains the core

prohibition on covered fund activities and investments and defines a

number of related terms, including “covered fund” and “ownership

interest.” The proposed rule’s definition of covered fund generally

parallels the statutory definition of “hedge fund” and “private

equity fund,” and explains the universe of entities that would be

considered a “covered fund” (including those entities determined by

the CFTC to be “such similar funds”) and, thus, subject to the

general prohibition.50

—————————————————————————

50 See proposed rule Sec. —-.10(b)(1).

—————————————————————————

The definition of “ownership interest” provides further guidance

regarding the types of interests that would be considered to be an

ownership interest in a covered fund.51 As described in this

Supplementary Information, these interests may take various forms. The

definition of ownership interest also explicitly excludes from the

definition “carried interest” whereby a banking entity may share in

the profits of the covered fund solely as performance compensation for

services provided to the covered fund by the banking entity (or an

affiliate, subsidiary, or employee thereof).52

—————————————————————————

51 See proposed rule Sec. —-.10(b)(3).

52 See proposed rule Sec. —-.10(b)(3)(ii).

—————————————————————————

Section —-.10 of the proposed rule also defines a number of other

relevant terms, including the terms “prime brokerage transaction,”

“sponsor,” and “trustee.”

Section —-.11 of the proposed rule implements the exemption for

organizing and offering a covered fund provided for under section

13(d)(1)(G) of the BHC Act. Section —-.11(a) of the proposed rule

outlines the conditions that must be met in order for a banking entity

to organize and offer a covered fund under this authority. These

requirements are contained in the statute and are intended to allow a

banking entity to engage in certain traditional asset management and

advisory businesses in compliance with section 13 of the BHC Act.53

The requirements are discussed in detail in Part III.C.2 of this

Supplementary Information.

—————————————————————————

53 See 156 Cong. Rec. S5889 (daily ed. July 15, 2010)

(statement of Sen. Hagan).

—————————————————————————

Section —-.12 of the proposed rule permits a banking entity to

acquire and retain, as an investment in a covered fund, an ownership

interest in a covered fund that the banking entity organizes and offers

under Sec. —-.11.54 This section implements section 13(d)(4) of

the BHC Act and related provisions. Section 13(d)(4) of the BHC Act

permits a banking entity to make an investment in a covered fund that

the banking entity organizes and offers pursuant to section

13(d)(1)(G), or for which it acts as sponsor, for the purposes of (i)

establishing the covered fund and providing the fund with sufficient

initial equity for investment to permit the fund to attract

unaffiliated investors, or (ii) making a de minimis investment in the

covered fund in compliance with applicable requirements. Section —

–.12 of the proposed rule implements this authority and related

limitations, including limitations regarding the amount and value of

any individual per-fund investment and the aggregate value of all such

permitted investments.55 Proposed Sec. —-.12 also clarifies how a

banking entity must calculate its compliance with these investment

limitations (including by deducting such investments from applicable

capital, as relevant), as well as sets forth how a banking entity may

request an extension of the period of time within which it must conform

an investment in a single covered fund.56

—————————————————————————

54 See proposed rule Sec. —-.12.

55 See proposed rule Sec. —-.12(a)(2).

56 See proposed rule Sec. Sec. —-.12(b), (c), and (d).

—————————————————————————

Section —-.13 of the proposed rule implements the statutory

exemptions described in sections 13(d)(1)(C), (E), and (I) of the BHC

Act that permit a banking entity: (i) to acquire and retain an

ownership interest in, or act as sponsor to, one or more SBICs, a

public welfare investment, or certain qualified rehabilitation

expenditures; (ii) to acquire and retain an ownership interest in a

covered fund as a risk-mitigating hedging activity; and (iii) in the

case of a non-U.S. banking entity, to acquire and retain an ownership

interest in, or act as sponsor to, a foreign covered fund.57 Section

—-.13(a) of the proposed rule permits a banking entity to acquire and

retain an ownership interest in, or act as sponsor to, an SBIC or

certain public interest investments, without limitation as to the

amount of ownership interests it may own, hold, or control with the

power to vote.58

—————————————————————————

57 See proposed rule Sec. —-.13(a)-(c).

58 See proposed rule Sec. —-.13(a).

—————————————————————————

Section —-.13(b) of the proposed rule permits a banking entity to

use an ownership interest in a covered fund to hedge, but only with

respect to individual or aggregated obligations or liabilities of a

banking entity that arise from: (i) The banking entity acting as

intermediary on behalf of a customer that is not itself a banking

entity to facilitate the customer’s exposure to the profits and losses

of the covered fund (similar to acting as a “riskless principal”); or

(ii) a compensation arrangement with an employee of the banking entity

that directly provides investment advisory or other services to that

fund.59 Additionally, Sec. —-.13(b) of the proposed rule requires

that the hedge represent a substantially similar offsetting exposure to

the same covered fund and in the same amount of ownership interest in

the covered fund arising out of the transaction that the acquisition or

retention of an ownership interest in the covered fund is intended to

hedge or otherwise mitigate.60 Proposed Sec. —-.13(b) also

requires a banking entity to document, at the time the transaction is

executed, the hedging rationale for all hedging transactions

[[Page 8338]]

involving an ownership interest in a covered fund.61

—————————————————————————

59 See proposed rule Sec. —-.13(b)(1).

60 See proposed rule Sec. Sec. —-.13(b)(2)(ii)(C) and (D).

61 See proposed rule Sec. —-.13(b)(3).

—————————————————————————

Section —-.13(c) of the proposed rule implements section

13(d)(1)(I) of the BHC Act and permits certain foreign banking entities

to acquire or retain an ownership interest in, or to act as sponsor to,

a covered fund so long as such activity occurs solely outside of the

United States and the entity meets the requirements of sections 4(c)(9)

or 4(c)(13) of the BHC Act. This statutory exemption limits the

extraterritorial application of the statutory restrictions on covered

fund activities and investments to foreign firms that, in the course of

operating outside of the United States, engage in activities permitted

under relevant foreign law outside of the United States, while

preserving national treatment and competitive equality among U.S. and

foreign firms within the United States.62 The proposed rule defines

both the type of foreign banking entities that are eligible for the

exemption and the circumstances in which covered fund activities or

investments by such an entity will be considered to have occurred

solely outside of the United States (including clarifying when an

ownership interest will be considered to have been offered for sale or

sold to a resident of the United States). Section —-.13(d) of the

proposed rule also implements in part the rule of construction

contained in section 13(g)(2) of the BHC Act, which permits the sale

and securitization of loans.63 Proposed Sec. —-.13(d) clarifies

that a banking entity may acquire and retain an ownership interest in,

or act as sponsor to, a covered fund that is an issuer of asset-backed

securities, the assets or holdings of which are solely comprised of:

(i) Loans; (ii) contractual rights or assets directly arising from

those loans supporting the asset-backed securities; and (iii) a limited

amount of interest rate or foreign exchange derivatives that materially

relate to such loans and that are used for hedging purposes with

respect to the securitization structure.64 The authority contained in

this section of the proposed rule would therefore allow a banking

entity to acquire and retain an ownership interest in a loan

securitization vehicle (which would be a covered fund for purposes of

section 13(h)(2) of the BHC Act and the proposed rule) that the banking

entity organizes and offers, or acts as sponsor to, in excess of the

three percent limits specified in section 13(d)(4) of the BHC Act and

Sec. —-.12 of the proposed rule.

—————————————————————————

62 See 156 Cong. Rec. S5897 (daily ed. July 15, 2010)

(statement of Sen. Merkley).

63 See 12 U.S.C. 1851(g)(2).

64 See proposed rule Sec. —-.13(d).

—————————————————————————

Section —-.14 of the proposed rule implements section 13(d)(1)(J)

of the BHC Act 65 and permits a banking entity to engage in any

covered fund activity or investment that the CFTC and the Agencies

determine promotes and protects the safety and soundness of banking

entities and the financial stability of the United States.66 The CFTC

has proposed to permit three activities at this time under this

authority. These activities involve acquiring and retaining an

ownership interest in, or acting as sponsor to, certain bank owned life

insurance (“BOLI”) separate accounts, investments in and sponsoring

of certain asset-backed securitizations, and investments in and

sponsoring of certain entities that rely on the exclusion from the

definition of investment company in section 3(c)(1) and/or 3(c)(7) of

the Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.)

(“Investment Company Act”) but that are, in fact, common corporate

organizational vehicles.67 Additionally, the CFTC has proposed to

permit a banking entity to acquire and retain an ownership interest in,

or act as sponsor to, a covered fund, if such acquisition or retention

is done (i) in the ordinary course of collecting a debt previously

contracted, or (ii) pursuant to and in compliance with the conformance

or extended transition periods implemented under section 13(c)(6) of

the BHC Act.68

—————————————————————————

65 Section 13(d)(1)(J) of the BHC Act provides the Agencies

discretion to determine that activities not specifically identified

by sections 13(d)(1)(A)-(I) of the BHC Act are also exempted from

the general prohibitions contained in section 13(a) of that Act, and

are thus permitted activities. In order to make such a

determination, the Agencies must find that such activity or

activities promote and protect the safety and soundness of banking

entities, as well as promote and protect the financial stability of

the United States. See 12 U.S.C. 1851(d)(1)(J).

66 See 12 U.S.C. 1851(d)(1)(J).

67 See proposed rule Sec. —-.13(a)(1)-(2).

68 See proposed rule at Sec. —-.14(b).

—————————————————————————

Section —-.15 of the proposed rule, which implements section

13(e)(1) of the BHC Act,69 requires a relevant banking entity engaged

in covered fund activities and investments to comply with (i) the

internal controls, reporting, and recordkeeping requirements required

under Sec. —-.20 and Appendix C of the proposed rule, as applicable

and (ii) such other reporting and recordkeeping requirements as the

CFTC may deem necessary to appropriately evaluate the banking entity’s

compliance with subpart C.70

—————————————————————————

69 Section 13(e)(1) of the BHC Act requires the CFTC to issue

regulations regarding internal controls and recordkeeping to ensure

compliance with section 13. See 12 U.S.C. 1851(e)(1).

70 See proposed rule Sec. —-.15.

—————————————————————————

Section —-.16 of the proposed rule implements section 13(f) of

the BHC Act and generally prohibits a banking entity from entering into

certain transactions with a covered fund that would be a covered

transaction as defined in section 23A of the FR Act.71 Section —

–.16(a)(2) of the proposed rule clarifies that, for reasons explained

in part III.C.7 of this SUPPLEMENTARY INFORMATION, certain transactions

between a banking entity and a covered fund remain permissible. Section

—-.16(b) of the proposed rule implements the statute’s requirement

that any transaction permitted under section 13(f) of the BHC Act

(including a prime brokerage transaction) between the banking entity

and a covered fund is subject to section 23B of the FR Act,72 which,

in general, requires that the transaction be on market terms or on

terms at least as favorable to the banking entity as a comparable

transaction by the banking entity with an unaffiliated third party.

—————————————————————————

71 See proposed rule Sec. —-.16.

72 12 U.S.C. 371c-1.

—————————————————————————

Section —-.17 of the proposed rule prohibits a banking entity

from relying on any exemption to the prohibition on acquiring and

retaining an ownership interest in, acting as sponsor to, or having

certain relationships with, a covered fund, if the permitted activity

or investment would involve or result in a material conflict of

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

risk trading strategies, or pose a threat to the safety and soundness

of the banking entity or to the financial stability of the United

States.73 This section also defines material conflict of interest,

high-risk asset, and high-risk trading strategy for these purposes.

—————————————————————————

73 See proposed rule Sec. —-.17.

—————————————————————————

D. Compliance Program Requirement

Subpart D of the proposed rule requires a banking entity engaged in

covered trading activities or covered fund activities to develop and

implement a program reasonably designed to ensure and monitor

compliance with the prohibitions and restrictions on covered trading

activities and covered fund activities and investments set forth in

section 13 of the BHC Act and the proposed rule.74

[[Page 8339]]

Section —-.20(b) of the proposed rule specifies six elements that

each compliance program established under subpart D must, at a minimum,

include:

—————————————————————————

74 See proposed rule Sec. —-.20. If a banking entity does

not engage in covered trading activities and/or covered fund

activities and investments, it need only ensure that its existing

compliance policies and procedures include measures that are

designed to prevent the banking entity from becoming engaged in such

activities and making such investments, and which require the

banking entity to develop and provide for the required compliance

program prior to engaging in such activities or making such

investments.

—————————————————————————

Internal written policies and procedures reasonably

designed to document, describe, and monitor the covered trading

activities and covered fund activities and investments of the banking

entity to ensure that such activities comply with section 13 of the BHC

Act and the proposed rule;

A system of internal controls reasonably designed to

monitor and identify potential areas of noncompliance with section 13

of the BHC Act and the proposed rule in the banking entity’s covered

trading and covered fund activities and to prevent the occurrence of

activities that are prohibited by section 13 of the BHC Act and the

proposed rule;

A management framework that clearly delineates

responsibility and accountability for compliance with section 13 of the

BHC Act and the proposed rule;

Independent testing for the effectiveness of the

compliance program, conducted by qualified banking entity personnel or

a qualified outside party;

Training for trading personnel and managers, as well as

other appropriate personnel, to effectively implement and enforce the

compliance program; and

Making and keeping records sufficient to demonstrate

compliance with section 13 of the BHC Act and the proposed rule, which

a relevant banking entity must promptly provide to the CFTC upon

request and retain for a period of no less than 5 years.

For a banking entity with significant covered trading activities or

covered fund activities and investments, the compliance program must

also meet a number of minimum standards that are specified in Appendix

C of the proposed rule.75 The application of detailed minimum

standards for these types of banking entities is intended to reflect

the heightened compliance risks of large covered trading activities and

covered fund activities and investments and to provide clear, specific

guidance to such banking entities regarding the compliance measures

that would be required for purposes of the proposed rule. For banking

entities with smaller, less complex covered trading activities and

covered fund activities and investments, these detailed minimum

standards are not applicable, though the CFTC expects that such smaller

entities will consider these minimum standards as guidance in designing

an appropriate compliance program.

—————————————————————————

75 A banking entity must comply with the minimum standards

specified in Appendix C of the proposed rule (i) with respect to its

covered trading activities, if it engages in any covered trading

activities and has, together with its affiliates and subsidiaries,

trading assets and liabilities the average gross sum of which (on a

worldwide consolidated basis), as measured as of the last day of

each of the four prior calendar quarters, (X) is equal to or greater

than $1 billion or (Y) equals 10 percent or more of its total

assets; and (ii) with respect to its covered fund activities and

investment, if it engages in any covered fund activities and

investments and either (X) has, together with its affiliates and

subsidiaries, aggregate investments in covered funds the average

value of which is, as measured as of the last day of each of the

four prior calendar quarters, equal to or greater than $1 billion or

(Y) sponsors and advises, together with its affiliates and

subsidiaries, covered funds the average total assets of which are,

as measured as of the last day of each of the four prior calendar

quarters, equal to or greater than $1 billion.

—————————————————————————

E. Conformance Provisions

Subpart E of the Board’s proposed rule, as set forth in the Joint

Release, is not included in the proposed CFTC Rule because this Subpart

E only applies to the Board.

F. Treatment of Smaller, Less-Complex Banking Entities

In formulating the proposed rule, the CFTC has carefully considered

and taken into account the potential impact of the proposed rule on

small banking entities and banking entities that engage in little or no

covered trading activities or covered fund activities and investments,

including the burden and cost that might be associated with such

banking entities’ compliance with the proposed rule. In particular, the

CFTC has proposed to reduce the effect of the proposed rule on such

banking entities by limiting the application of certain requirements,

such as the reporting and recordkeeping requirements of Sec. —-.7

and Appendix A of the proposed rule and the compliance program

requirements contained in subpart D and Appendix C of the proposed

rule, to those banking entities that engage in little or no covered

trading activities or covered fund activities and investments. The CFTC

also requested comment (i) throughout this SUPPLEMENTARY INFORMATION on

a number of questions related to the costs and burdens associated with

particular aspects of the proposal, as well as (ii) in Part VII.B of

this Supplementary Information on any significant alternatives that

would minimize the impact of the proposal on small banking entities.

G. Application of Section 13 of the BHC Act to Securitization Vehicles

or Issuers of Asset-Backed Securities

Many issuers of asset-backed securities may be included within the

definition of covered fund since they would be an investment company

but for the exclusions contained in section 3(c)(1) or 3(c)(7) of the

Investment Company Act.76 If an issuer of asset-backed securities is

considered to be a covered fund, then a banking entity would not be

permitted to acquire or retain any ownership interest issued by such

issuer except as otherwise permitted under section 13 of the BHC Act

and the proposed rule.77 Separately, issuers of asset-backed

securities may be included within the definition of banking entity, as

noted in Part III.A.2 of this Supplementary Information. Although the

proposed definition of banking entity would not include any entity that

is a covered fund, an issuer of asset-backed securities that is both

(i) an affiliate or subsidiary of a banking entity,78 and (ii) does

not rely on an exclusion contained in section 3(c)(1) of 3(c)(7) of the

Investment Company Act, would be a banking entity and thus subject to

the requirements of section 13

[[Page 8340]]

of the BHC Act and the proposed rule, including: (i) the prohibition on

proprietary trading; (ii) limitations on investments in and

relationships with a covered fund; (iii) the establishment and

implementation of a compliance program as required under the proposed

rule; and (iv) recordkeeping and reporting requirements. Given the

breadth of the definition of “affiliate,” these requirements may

apply to a significant portion of the outstanding securitization

market, including issuers of asset-backed securities that rely on rule

3a-7 or section 3(c)(5) of the Investment Company Act.

—————————————————————————

76 For purposes of the proposed rule, any securitization

entity that meets the requirements for an exclusion under Rule 3a-7

or section 3(c)(5) of the Investment Company Act, or any other

exclusion or exemption from the definition of “investment company”

under the Investment Company Act (other than sections 3(c)(1) or

3(c)(7) of the Investment Company Act), would not be a covered fund

under the proposed definition. Additionally, an issuer of asset-

backed securities that is subject to legal documents mandating

compliance with the conditions of section 3(c)(1) of 3(c)(7) of the

Investment Company Act would not be a covered fund if such issuer

also can satisfy all the conditions of an alternative exclusion or

exemption for which it is eligible.

77 For example, under the proposed rule, a banking entity

would be able to acquire or retain an interest or security of an

issuer of asset-backed securities that is a covered fund if: (i) The

interest or security of the issuer does not qualify as an

“ownership interest” under Sec. —-.10(b)(3) of the proposed

rule; (ii) the issuer of asset-backed securities is comprised solely

of loans, contractual rights or assets directly arising from those

loans, and certain specified interest rate or foreign exchange

derivatives used for hedging purposes, as permitted under Sec. —

–.13(d) or —-.14(a)(2)(v) of the proposed rule; (iii) the banking

entity is a “securitizer” or “originator” and acquires and

retains such interest in compliance with the minimum requirements of

section 15G of the Exchange Act and any implementing regulations

issued thereunder, as provided under Sec. —-.14(a)(2)(iii) of the

proposed rule; or (v) the banking entity organizes and offers the

issuer and the ownership interest is a permitted investment under

Sec. —-.12 of the proposed rule. The circumstances where a

banking entity may acquire or retain an ownership interest in a

covered fund are discussed in detail in Part III.C of this

SUPPLEMENTAL INFORMATION.

78 The definitions of “affiliate” and “subsidiary” are

discussed in detail in Part III.A.2 of this Supplemental

Information.

—————————————————————————

In recognition of these concerns, the CFTC, similar to the Agencies

in the Joint Rule, has requested comment throughout this Supplementary

Information on the potential effects of section 13 of the BHC Act and

the proposed rule on the securitization industry and issuers of asset-

backed securities.

III. Section by Section Summary of Proposed Rule

A. Subpart A–Authority and Definitions

1. Section —-.1: Authority, Purpose, Scope, and Relationship to Other

Authorities

a. Authority and Scope

Section —-.1 of the proposed rule describes the authority under

which the CFTC is issuing the proposed rule, the purpose of the

proposed rule, and the banking entities to which the CFTC’s rule

applies. In addition, Sec. —-.1(d) of the proposed rule implements

section 13(g)(1) of the BHC Act, which provides that the prohibitions

and restrictions of section 13 apply to the activities of a banking

entity regardless of whether such activities are authorized for a

banking entity under other applicable provisions of law.79

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79 See proposed rule Sec. —-.1(d).

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b. Effective Date

Section 13(c)(1) of the BHC Act provides that section 13 will take

effect on the earlier of (i) 12 months after the date of issuance of

final rules implementing that section, or (ii) 2 years after the date

of enactment of section 13, which is July 21, 2012.80 Because the

CFTC did not issue final rules implementing section 13 of the BHC Act

by July 21, 2011, Sec. —-.1 of the proposed rule specifies that the

effective date for its provisions will be July 21, 2012.

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80 See 12 U.S.C. 1851(c)(1).

—————————————————————————

The CFTC notes that the proposed effective date will impact not

only the date on which the proposed rule’s prohibitions and

restrictions on proprietary trading and covered fund activities and

investments go into effect (subject to the conformance period or

extended transition period provided by section 13(c) of the BHC

Act),81 but also the date on which a banking entity must comply with

(i) the reporting and recordkeeping requirements of Sec. —-.7 and

Appendix A of the proposed rule and (ii) the compliance program mandate

of Sec. —-.20 and Appendix C of the proposed rule. As proposed,

Sec. —-.1 would require a banking entity subject to either the

reporting and recordkeeping or compliance program requirements to begin

complying with these requirements as of July 21, 2012.82 With respect

to the compliance program requirement of the proposed rule, Sec. —

–.1 would require a banking entity to have developed and implemented

the required program by the proposed effective date, though the CFTC

notes that prohibited activities and investments may not be fully

conformed by that date. The CFTC expects a banking entity to fully

conform all investments and activities to the requirements of the

proposed rule as soon as practicable within the conformance periods

provided in section 13 of the BHC Act and the Board’s rules thereunder,

which define the conformance periods. With respect to the reporting and

recordkeeping requirements of the proposed rule, Sec. —-.1 of the

proposed rule would require a banking entity to begin furnishing these

reports for all trading units or asset management units as of the

effective date, though the quantitative measurements furnished for

proprietary trading activities that are conducted in reliance on the

authority provided by the conformance period would not be used to

identify prohibited proprietary trading until such time as the relevant

trading activities must be conformed.

—————————————————————————

81 See id. at 1851(c)(2)–(6).

82 See proposed rule Sec. —-.1.

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The CFTC expects that a banking entity may need a period of time to

prepare for effectiveness of the proposed rule and, in particular, to

implement both the compliance program and the reporting and

recordkeeping requirements provided under the proposed rule.

Accordingly, in order to help assess the effects and impact of the

proposed effective date and any alternative compliance dates, the CFTC

requests comment on the following questions:

Question 1. Does the proposed effective date provide banking

entities with sufficient time to prepare to comply with the

prohibitions and restrictions on proprietary trading and covered fund

activities and investments? If not, what other period of time is needed

and why? 83

—————————————————————————

83 Note that each additional question asked by the CFTC in the

CFTC Rule retains the same base question number as in the Joint

Release (e.g. when the CFTC has included a question on whether

question number 168 may be applicable to the CFTC, the new

additional question is listed as question 168.1).

—————————————————————————

Question 2. Does the proposed effective date provide banking

entities with sufficient time to implement the proposal’s compliance

program requirement? If not, what are the impediments to implementing

specific elements of the compliance program and what would be a more

effective time period for implementing each element and why?

Question 3. Does the proposed effective date provide banking

entities sufficient time to implement the proposal’s reporting and

recordkeeping requirements? If not, what are the impediments to

implementing specific elements of the proposed reporting and

recordkeeping requirements and what would be a more effective time

period for implementing each element and why?

Question 4. Should the CFTC use a gradual, phased in approach to

implement the statute rather than having the implementing rules become

effective at one time? If so, what prohibitions and restrictions should

be implemented first? Please explain.

2. Section —-.2: Definitions

Section —-.2 of the proposed rule defines a variety of terms used

throughout the proposed rule, including “banking entity,” which

defines the scope of entities to which the proposed rule applies.

Consistent with the statutory definition of that term, Sec. —-.2(e)

of the proposed rule provides that a “banking entity” includes: (i)

Any insured depository institution; (ii) any company that controls an

insured depository institution; (iii) any company that is treated as a

bank holding company for purposes of section 8 of the International

Banking Act of 1978 (12 U.S.C. 3106); and (iv) any affiliate or

subsidiary of any of the foregoing.84 In addition, in order to avoid

application of section 13 of the BHC Act in a way that appears

unintended by the statute and would create internal inconsistencies in

the statutory scheme,

[[Page 8341]]

the proposed rule also clarifies that the term “banking entity” does

not include any affiliate or subsidiary of a banking entity, if that

affiliate or subsidiary is (i) a covered fund, or (ii) any entity

controlled by such a covered fund.85 This clarification is proposed

because the definition of “affiliate” and “subsidiary” under the

BHC Act is broad, and could include a covered fund that a banking

entity has permissibly sponsored or made an investment in because, for

example, the banking entity acts as general partner or managing member

of the covered fund as part of its permitted sponsorship

activities.86 If such a covered fund were considered a “banking

entity” for purposes of the proposed rule, the fund itself would

become subject to all of the restrictions and limitations of section 13

of the BHC Act and the proposed rule, which would be inconsistent with

the purpose and intent of the statute. For example, such a covered fund

would then generally be prohibited from investing in other covered

funds, notwithstanding the fact that section 13(f)(3) of the BHC Act

specifically contemplates such investments. Accordingly, the proposed

rule would exclude from the definition of banking entity any fund that

a banking entity may invest in or sponsor as permitted by the proposed

rule.

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84 See proposed rule Sec. —-.2(e). Sections —-.2(a) and

(bb) of the proposed rule clarify that the terms “affiliate” and

“subsidiary” have the same meaning as in sections 2(d) and (k) of

the BHC Act (12 U.S.C. 1841(d) and (k)).

85 The CFTC notes that since the proposed rule implements

section 13 of the BHC Act, it incorporates that Act’s definition of

“affiliate” and “subsidiary.” See proposed rule Sec. Sec. —

–.2(a) and (bb). The terms affiliate and subsidiary are generally

defined in section 2 of the BHC Act according to whether such entity

controls or is controlled by another relevant entity. See 12 U.S.C.

1841(d), (k). The concept of control under the proposed rule, in

turn, is as defined in section 2 of the BHC Act and as implemented

by the Board. See 12 U.S.C. 1841(a)(2); 12 CFR 225.2(e).

86 Under section 2 of the BHC Act and the Board’s Regulation Y

(12 CFR part 225), a banking entity acting as general partner or

managing member of another company would be deemed to control that

company and, as such, the company would be both an “affiliate” and

“subsidiary” of the banking entity for purposes of the BHC Act.

See 12 U.S.C. 1841(d), (k).

—————————————————————————

An entity such as a mutual fund would generally not be a subsidiary

or affiliate of a banking entity under this definition if the banking

entity only provides advisory or administrative services to, has

certain limited investments in, or organizes, sponsors, and manages a

mutual fund (which includes a registered investment company) in

accordance with BHC Act rules.87

—————————————————————————

87 See, e.g., 12 U.S.C. 1483(c)(6), (c)(8), and (k); 12 CFR

225.28(b)(6), 225.86(b)(3).

—————————————————————————

Section —-.2(j) of the proposed rule defines the term “covered

banking entity,” which is used to describe the specific types of

banking entities to which the CFTC’s rule applies. In addition, a

number of other definitions contained in Sec. —-.2 are discussed in

further detail below in connection with the separate sections of the

proposed rule in which they are used.

The proposed rule also defines the terms “buy and purchase” and

“sell and sale,” which are used throughout the proposed rule to

describe the scope of transactions that are subject to subparts B and C

of the proposed rule. These definitions are substantially similar to

the definitions of the same terms under the Exchange Act, except that

the proposed definitions provide additional clarity regarding the types

of transactions that would be considered the purchase or sale of a

commodity future or derivative or ownership interest in a covered

fund.88 These definitions are purposefully broad in scope, and are

intended to include a wide range of transaction types that would permit

a banking entity to gain or eliminate, or increase or reduce, exposure

to a covered financial position or ownership interest in a covered

fund.

—————————————————————————

88 See proposed rule Sec. Sec. —-.2(g), (v); 15 U.S.C.

78c(a)(13), (14).

—————————————————————————

Request for comment.

The CFTC requests comment on the proposed rule’s definition of

“banking entity.” In particular, the CFTC requests comment on the

following questions:

Question 5. Is the proposed rule’s definition of banking entity

effective? What alternative definitions might be more effective in

light of the language and purpose of the statute?

Question 6. Are there any entities that should not be included

within the definition of banking entity since their inclusion would not

be consistent with the language or purpose of the statute or could

otherwise produce unintended results? Should a registered investment

company be expressly excluded from the definition of banking entity?

Why or why not?

Question 7. Is the proposed rule’s exclusion of a covered fund that

is organized, offered and held by a banking entity from the definition

of banking entity effective? Should the definition of banking entity be

modified to exclude any covered fund? Why or why not?

Question 8. Banking entities commonly structure their registered

investment company relationships and investments such that the

registered investment company is not considered an affiliate or

subsidiary of the banking entity. Should a registered investment

company be expressly excluded from the definition of banking entity?

Why or why not? Are there circumstances in which such companies should

be treated as banking entities subject to section 13 of the BHC Act?

How many such companies would be covered by the proposed definition?

Question 8.1. What is the best method for the CFTC and the other

regulators to coordinate regarding the allocation of supervisory

responsibilities under the proposed CFTC Rule?

Question 9. Under the proposed rule, would issuers of asset-backed

securities be captured by the proposed definition of “banking

entity”? If so, are issuers of asset-backed securities within certain

asset classes particularly impacted? Are particular types of

securitization vehicles (trusts, LLCs, etc.) more likely than others to

be included in the definition of banking entity? Should issuers of

asset-backed securities be excluded from the proposed definition of

“banking entity,” and if so, why? How would such an exclusion be

consistent with the language and purpose of the statute?

Question 10. What would be the potential impact of including

existing issuers of asset-backed securities 89 in the proposed

definition of “banking entity” on existing issuers of asset-backed

securities and the securitization market generally? How many existing

issuers of asset-backed securities might be included in the proposed

definition of “banking entity”? Are there ways in which the proposed

rule could be amended to mitigate or eliminate potential impact, if

any, on existing asset-backed securities 90 without compromising the

intent of the statute?

—————————————————————————

89 For purposes of this SUPPLEMENTAL INFORMATION, “existing

issuers of asset-backed securities” means issuers that issued

asset-backed securities prior to the effective date of the proposed

rule.

90 For purposes of this SUPPLEMENTAL INFORMATION, “existing

asset-backed securities” means asset-backed securities that were

issued prior to the effective date of the proposed rule.

—————————————————————————

Question 11. What would be the legal and economic impact to an

issuer of asset-backed securities of being considered a “banking

entity”? What additional costs would be incurred in the establishment

and implementation of a compliance program related to the provisions of

the proposed rule as required by Sec. —-.20 of the proposed rule

(including Appendix C, where applicable)? Who would pay those

additional costs?

Question 12. If the ownership requirement under the proposed rule

for credit risk retention (section 15G of the Exchange Act) combined

with the control inherent in the position of servicer or investment

manager means that more securitization vehicles would be considered

affiliates of banking

[[Page 8342]]

entities, would fewer banking entities be willing to (i) serve as the

servicer or investment manager of securitization transactions and/or

(ii) serve as the originator or securitizer (as defined in section 15G

of the Exchange Act) of securitization transactions? What other impact

might the potential interplay between these rules have on future

securitization transactions? Could there be other potential unintended

consequences?

Question 13. Are the proposed rule’s definitions of buy and

purchase and sale and sell appropriate? If not, what alternative

definitions would be more appropriate? Should any other terms be

defined? If so, are there existing definitions in other rules or

regulations that could be used in this context? Why would the use of

such other definitions be appropriate?

B. Subpart B–Proprietary Trading Restrictions

1. Section —-.3: Prohibition on Proprietary Trading

Section —-.3 of the proposed rule describes the scope of the

prohibition on proprietary trading and defines a number of terms

related to proprietary trading. The CFTC notes that the definition of

“proprietary trading” in the statute and under the proposed rule is

broad. This definition must be viewed in light of the exemptions

described later in the proposed rule, which reflect statutory

provisions permitting a number of activities.

a. Prohibition on Proprietary Trading

Section —-.3(a) of the proposed rule implements section

13(a)(1)(A) of the BHC Act and prohibits a banking entity from engaging

in proprietary trading unless otherwise permitted under Sec. Sec. —

–.4 through —-.6 of the proposed rule. Section —-.3(b)(1) of the

proposed rule defines proprietary trading in accordance with section

13(h)(4) of the BHC Act.91 This definition is a key element of the

proposal because, unless an activity covered by the definition is

specifically permitted under one of the exemptions contained in

Sec. Sec. —-.4 through —-.6 of the proposed rule, a banking entity

is prohibited from engaging in that activity. Specifically, the

proposal largely restates the statutory definition of proprietary

trading, defining that term to mean engaging in the purchase or sale of

one or more covered financial positions as principal for the trading

account of the banking entity.92 The terms “trading account” and

“covered financial position” are defined in Sec. Sec. —-.3(b)(2)

and —-.3(b)(3) of the proposed rule, respectively. The proposed

definition of proprietary trading also clarifies that proprietary

trading does not include acting as agent, broker, or custodian for an

unaffiliated third party, because acting in these types of capacities

does not involve trading as principal, which is one of the requisite

aspects of the statutory definition.

—————————————————————————

91 See proposed rule Sec. —-.3(b)(1).

92 See 12 U.S.C. 1851(h)(4); see also proposed rule Sec. —

–.3(b)(1). Although the statutory definition refers to the

“purchase, sale, acquisition, or disposition of” covered financial

positions, the proposed rule uses the simpler terms “purchase” and

“sale,” which are defined broadly in Sec. Sec. —-.2(g) and (v)

of the proposed rule.

—————————————————————————

b. “Trading Account”

i. Definition of “Trading Account”

Section 13(h)(6) of the BHC Act defines the term “trading

account” as “any account used for acquiring or taking positions in

securities [or other enumerated instruments] 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),” as well

as any such other accounts that the CFTC by rule determine.93 As an

initial matter, the CFTC notes that it is often difficult to clearly

identify the purpose for which a position is acquired or taken and

whether that purpose is short-term in nature, particularly since

identification of that purpose generally depends on the intent with

which the position is acquired or taken. Moreover, the statute does not

define the terms “near-term” or “short-term” for these purposes.

—————————————————————————

93 See 12 U.S.C. 1851(h)(6).

—————————————————————————

In implementing the statutory definition of trading account, the

proposed rule generally restates the statutory definition, with the

addition of certain details intended to provide banking entities with

greater clarity regarding the scope of positions that fall within the

definition of trading account.94 The proposed definition of trading

account has three prongs. First, under the proposed rule, a trading

account includes any account that is used by a banking entity to

acquire or take one or more covered financial positions for the purpose

of: (i) Short-term resale; (ii) benefitting from actual or expected

short-term price movements; (iii) realizing short-term arbitrage

profits; or (iv) hedging one or more such positions.95 Second, the

proposed definition of trading account also includes any account used

by a banking entity that is subject to the Market Risk Capital Rules to

acquire or take one or more covered financial positions that are

subject to those rules, other than certain foreign exchange and

commodity positions.96 Third, the proposed definition of trading

account also includes any account used by a banking entity that is a

securities dealer, swap dealer, or security-based swap dealer to

acquire or take positions in connection with its dealing

activities.97 To provide additional clarity and guidance regarding

the trading account definition, the proposed rule also includes a

rebuttable presumption that any account used to acquire or take a

covered financial position that is held for sixty days or less is a

trading account under the first prong, unless the banking entity can

demonstrate that the position was not acquired principally for short-

term trading purposes. The proposed definition also clarifies that no

account will be a trading account to the extent that it is used to

acquire or take certain positions under repurchase or reverse

repurchase arrangements or securities lending transactions, positions

for bona fide liquidity management purposes, or certain positions held

by derivatives clearing organizations or clearing agencies. Each of the

three definitional prongs is independent of the others–any one prong

would, if met, cause the relevant account to fall within the definition

of “trading account.”

—————————————————————————

94 The CFTC notes that the structure of the proposed

definition, which defines a trading account by reference to the

positions that the account is used to acquire or take, is consistent

with the structure of the statutory language used in section

13(h)(6) of the BHC Act.

95 See proposed rule Sec. —-.3(b)(2)(i)(A).

96 See proposed rule Sec. —-.3(b)(2)(i)(B).

97 See proposed rule Sec. –.3(b)(2)(i)(C).

—————————————————————————

The CFTC has drawn on existing rules, in particular the Market Risk

Capital Rules and various securities and commodities laws, in

identifying trading accounts and defining related terms in the

proposal.

ii. Positions Acquired or Taken for Short-Term Trading Purposes

The first prong of the proposed trading account definition refers

to positions that a banking entity acquires or takes principally for

short-term purposes–that is, for one of the following enumerated

purposes described in Sec. Sec. —-.3(b)(2)(i)(A)(1) through (4) of

the proposed rule:

Short-term resale;

Benefitting from actual or expected short-term price

movements;

Realizing short-term arbitrage profits; or

Hedging one or more such positions.

This prong reflects the statutory definition’s reference to

positions acquired or taken “principally for the

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purpose of selling in the near-term (or otherwise with the intent to

resell in order to profit from short-term price movements).” 98

—————————————————————————

98 See 12 U.S.C. 1851(h)(6); see also proposed rule Sec. —

–.3(b)(2)(i).

—————————————————————————

Section —-.3(b)(2)(i)(A)(1) of the proposed rule’s definition of

trading account includes covered financial positions acquired or taken

principally for the purpose of short-term resale.99 This part of the

trading account definition restates language contained in the statutory

definition of trading account and describes one class of positions that

are acquired or taken for short-term trading purposes.

—————————————————————————

99 See proposed rule Sec. —-.3(b)(2)(i)(A)(1).

—————————————————————————

Section —-.3(b)(2)(i)(A)(2) of the proposed rule includes covered

financial positions acquired or taken principally for the purpose of

benefitting from actual or expected short-term price movements.100

This part of the trading account definition does not require the resale

of the position; rather, it requires only an intent to engage in any

form of transaction on a short-term basis (including a transaction

separate from, but related to, the initial acquisition of the position)

for the purpose of benefitting from a short-term movement in the price

of the underlying position. This part of the proposed definition would,

for example, include a derivative or other position where the banking

entity enters into (or intends to enter into) a subsequent transaction

in the near-term to simply offset or “close out,” rather than sell,

all or a portion of the risks of the initial position, in order to

benefit from a price movement occurring between the acquisition of the

underlying position and the subsequent offsetting transaction.

Similarly, it would also include a derivative, commodity future, or

other position that, regardless of the term of that position, is

subject to the exchange of short-term variation margin through which

the banking entity intends to benefit from short-term price movements.

The proposed definition would also capture the acquisition of a debt

instrument where the banking entity intends to enter into a short-term

transaction to simply offset, rather than sell, the credit, interest

rate and/or other material risk elements of the initial position so as

to benefit from a price movement occurring between acquisition of the

underlying position and the subsequent offsetting transaction.

—————————————————————————

100 See proposed rule Sec. —-.3(b)(2)(i)(A)(2).

—————————————————————————

Section —-.3(b)(2)(i)(A)(3) of the proposed rule’s definition of

trading account includes covered financial positions acquired or taken

principally to lock in short-term arbitrage profits.101 Although

similar to the positions described in Sec. —-.3(b)(2)(i)(A)(2) of

the proposed definition (i.e., those acquired for the purpose of

benefitting from actual or expected short-term price movements), this

part of the definition focuses on short-term arbitrage profits more

generally, without regard to whether the transaction is predicated on

expected or actual movements in price. Rather, a position acquired to

lock in arbitrage profits would include positions acquired or taken

with the intent to benefit from differences in multiple market prices,

even in cases in which no movement in those prices is necessary to

realize the intended profit. Such arbitrage-based transactions might

involve profiting from the difference in the market price of multiple

related positions or assets, or might instead involve the difference in

market price for particular price or risk elements associated with

positions or assets. This would include, for example, arbitrage profits

resulting from the convergence or divergence in prices between

different positions held by a banking entity engaged in relative value

convergence arbitrage, which involves marrying a long and short

position to benefit from a convergence or divergence in price between

the two, or any similar strategy, because such convergence or

divergence could happen at any time (i.e., in one day, in sixty-one

days, or some other time period).

—————————————————————————

101 See proposed rule Sec. —-.3(b)(2)(i)(A)(3).

—————————————————————————

Section —-.3(b)(2)(i)(A)(4) of the proposed rule’s definition of

trading account includes covered financial positions acquired or taken

for the purpose of hedging another position that is itself held in a

trading account.102 In particular, the CFTC assumes that, with

respect to any position the purpose of which is to hedge another

covered financial position in the trading account, the banking entity

generally intends to hold the hedging position, whatever its nominal

duration, for only so long as the underlying position is held.

Accordingly, the proposed rule makes clear that such hedging positions

fall within the definition of trading account.

—————————————————————————

102 See proposed rule Sec. —-.3(b)(2)(i)(A)(4).

—————————————————————————

iii. Overview of Current Market Risk Capital Rules Approach to Short-

Term Trading Positions

The first prong of the proposed trading account definition, which

references positions acquired principally for short-term trading

purposes, is, like the statutory definition it implements,

substantially similar to a key portion of the definition of a “covered

position” under the Market Risk Capital Rules.103 For the reasons

discussed below, the CFTC has taken this similarity into account and

propose to construe the first prong of the definition of trading

account under the proposed rule–and in particular its reference to

“short-term”–in a manner that is consistent with the Market Risk

Capital Rules’ approach to identifying positions taken with short-term

trading intent.

—————————————————————————

103 The Federal banking agencies’ current Market Risk Capital

Rules are located at 12 CFR 3, Appendix B (OCC), 12 CFR 208,

Appendix E and 12 CFR 225, Appendix E (Board), and 12 CFR 325,

Appendix C (FDIC), and apply on a consolidated basis to banks and

bank holding companies with trading activity (on a worldwide

consolidated basis) that equals 10 percent or more of the

institution’s total assets, or $1 billion or more. On January 11,

2011, the Federal banking agencies proposed revisions to the Market

Risk Capital Rules that include, inter alia, changes to the

definition of covered position. Proposed revisions to the Market

Risk Capital Rules include (i) changes to portions of the covered

position definition not relevant to the statutory definition of

trading account in section 13 of the BHC Act and (ii) the addition

of a requirement that any position in a trading account also be a

“trading position” in order to be considered a covered position.

See 76 FR 1890 (Jan. 11, 2011). The revised definition of “trading

position” that has been proposed for those purposes is generally

identical to this proposed rule’s definition of trading account

(i.e., a position acquired or taken: (i) For the purpose of short-

term resale; (ii) with the intent of benefitting from actual or

expected short-term price movements; (iii) to lock in short-term

arbitrage profits; or (iv) to hedge another trading position). The

CFTC also notes that the first prong of the proposed rule’s trading

account definition is also substantially similar to the Basel

Committee’s definition of “trading book.” See Basel Committee on

Banking Supervision, Amendment to the Capital Accord to Incorporate

Market Risks, available at http://bis.org/publ/bcbs119.pdf.

—————————————————————————

The Market Risk Capital Rules define a covered position to include

all positions in a bank’s “trading account,” as that term is defined,

in part, in the Report of Condition and Income that banks are required

to file periodically with respect to their financial condition (“Call

Report”). Under the Market Risk Capital Rules, a covered position is

one that is subject to a risk-based capital charge that is based, at

least in part, on the banking organization’s internal risk management

models for purposes of calculating the banking organization’s risk-

based capital requirement.104 In

[[Page 8344]]

defining the term “trading account,” the Call Report notes that

trading activities typically include, among other activities,

“acquiring or taking positions in such items 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.” 105 This

language is substantially identical to the statutory definition of

trading account in section 13 of the BHC Act in that it refers to

acquiring or taking positions (i) principally for the purpose of

selling in the near-term or (ii) otherwise with the intent to resell in

order to profit from short-term price movements.

—————————————————————————

104 The CFTC notes that the Market Risk Capital Rules, both in

their current and proposed form, also (i) include within the

definition of covered position other positions not captured by the

reference to positions acquired for the purpose of short-term resale

or with the intent of benefitting from actual or expected short-term

price movements (e.g., all commodity and foreign exchange positions,

regardless of the intended holding period) and (ii) exclude from

that definition certain positions otherwise acquired with short-term

trading intent for a variety of policy reasons. The CFTC has not

proposed to incorporate such inclusions or exclusions for purposes

of the proposed rule’s definition of trading account; rather, the

Market Risk Capital Rules and related concepts have been referred to

only to the extent that they pertain to positions acquired for the

purpose of short-term resale or with the intent of benefitting from

actual or expected short-term price movements.

105 Report of Condition and Income at A78a (also including, in

the definition of “trading account,” “regularly underwriting or

dealing in securities; interest rate, foreign exchange rate,

commodity, equity, and credit derivative contracts; other financial

instruments; and other assets for resale * * * and * * * acquiring

or taking positions in such items as an accommodation to customers

or for other trading purposes.”). Accordingly, given its broader

scope, the Call Report “trading account” includes trading

positions that fall outside the statutory “trading account” for

purposes of determining what is prohibited and permitted covered

trading activity under section 13 of the BHC Act.

—————————————————————————

In providing guidance regarding the application of “trading

account,” the Call Report also states that trading account positions

include any position that is classified as “trading securities” under

relevant U.S. Generally Accepted Accounting Principles (“GAAP”)

standards for accounting.106 Under the referenced accounting

standards, trading securities are defined as those “that are bought

and held principally for the purpose of selling them in the near-term”

and “generally used with the objective of generating profits on short-

term differences in price.” 107 The CFTC notes that the definition

of a trading security under the relevant U.S. GAAP accounting standards

is similar to both (i) the financial positions described in the second

prong of the Call Report’s definition of trading account and (ii) the

financial positions described in the statutory definition of trading

account under section 13 of the BHC Act.

—————————————————————————

106 See Report of Condition and Income at A78a, referring to

ASC Topic 320, Investments-Debt and Equity Securities (formerly FASB

Statement of Financial Accounting Standards No. 115, “Accounting

for Certain Investments in Debt and Equity Securities”).

107 See id. In formulating the proposed rule, the CFTC

carefully considered whether to define trading account for purposes

of the proposed rule in a manner that formally incorporated the

accounting standards governing trading securities. The CFTC has not

proposed this approach because: (i) The statutory proprietary

trading prohibition under section 13 of the BHC Act applies to

financial instruments, such as derivatives, to which the trading

security accounting standards may not apply; (ii) these accounting

standards permit companies to classify, at their discretion, assets

as trading securities even where the assets would not otherwise meet

the definition of trading security; and (iii) these accounting

standards could change in the future without consideration of the

potential impact on section 13 of the BHC Act.

—————————————————————————

Although neither the Market Risk Capital Rules, the Call Report,

nor relevant accounting standards provide a precise definition of what

constitutes “near-term” or “short-term” for purposes of evaluating

whether a position is of the type held in a trading account or is a

trading security, guidance provided under relevant accounting standards

notes that “near-term” for purposes of classifying trading activities

is “generally measured in hours and days rather than months or

years.” 108 The CFTC expects that the precise period of time that

may be considered near-term or short-term for purposes of evaluating

any particular covered financial position would depend on a variety of

factors, including the facts and circumstances of the covered financial

position’s acquisition, the banking entity’s trading and business

strategies, and the nature of the relevant markets. In considering the

purpose for which a covered financial position is acquired or taken and

evaluating whether such position is acquired or taken for short-term

purposes, the CFTC intends to rely on a variety of information,

including quantitative measurements of banking entities’ covered

trading activities (as described below in Part II.B.5 of this

SUPPLEMENTARY INFORMATION), supervisory review of banking entities’

compliance practices and internal controls, and supervisory review of

individual transactions.

—————————————————————————

108 See FASB ASC Master Glossary definition of “trading.”

Although Sec. —-.3(b)(2)(ii) of the proposed rule includes a

rebuttable presumption that an account used to acquire or take

certain covered financial positions that are held for 60 days or

less is a trading account, the CFTC notes that U.S. GAAP does not

include a presumption that securities sold within 60 days of

acquisition were held for the purpose of selling them in the near

term.

—————————————————————————

In order to better reinforce the general consistency between the

proposal’s approach to defining a trading account and the “trading

account” concept embedded in the Market Risk Capital Rules, the second

prong of the proposed definition of trading account, contained in Sec.

—-.3(b)(2)(i)(B) of the proposed rule, provides that a trading

account includes any account used to acquire or take one or more

covered financial positions, other than positions that are foreign

exchange derivatives, commodity derivatives, or contracts of sale of a

commodity for future delivery (unless the position is otherwise held

with short-term intent), that are also market risk capital rule covered

positions, if the banking entity, or any affiliate of the banking

entity that is a bank holding company, calculates risk-based capital

ratios under the Market Risk Capital Rules.109 For these purposes, a

“market risk capital rule covered position” is defined as any covered

position as that term is defined for purposes of (i) in the case of a

banking entity that is a bank holding company or insured depository

institution, the market risk capital rule that is applicable to the

banking entity, and (ii) in the case of a banking entity that is

affiliated with a bank holding company, other than a banking entity to

which a market risk capital rule is applicable, the market risk capital

rule that is applicable to the affiliated bank holding company.110 In

particular, for banking entities already subject to the Market Risk

Capital Rules, it appears that positions subject to trading account

treatment under those rules because they involve short-term trading

intent are generally the type of positions to which the proprietary

trading restrictions of section 13 of the BHC Act were intended to

apply. In addition, including all covered financial positions that

receive trading account treatment under the Market Risk Capital Rules

because they meet a nearly identical standard regarding short-term

trading intent would also eliminate the potential for inconsistency or

regulatory arbitrage in which a banking entity might characterize a

position as

[[Page 8345]]

“trading” for capital purposes but not for purposes of the proposed

rule.

—————————————————————————

109 The CFTC has excluded positions that are foreign exchange

derivatives, commodity derivatives, or contracts of sale of a

commodity for future delivery from this prong of the proposed

trading account definition because all foreign exchange and

commodity positions are considered “covered positions” under the

Market Risk Capital Rules regardless of whether they involve the

short-term trading intent required under the statutory definition of

trading account in section 13(h)(6) of the BHC Act.

110 See proposed rule Sec. —-.3(c)(8). Accordingly, in the

context of a subsidiary of a bank holding company (other than a

subsidiary, such as a bank, to which a market risk capital rule is

already directly applicable), if that bank holding company is

subject to a market risk capital rule, any position of that

subsidiary that meets the definition of a “covered position” under

the market risk capital rule applicable to the bank holding company

would be subject to Sec. —-.3(b)(2)(i)(B) of the proposed rule.

—————————————————————————

The CFTC emphasizes that this second prong of the trading account

definition is being proposed in contemplation of the proposed revisions

to the Market Risk Capital Rules and, in particular, the proposed

definition of “covered position” under those proposed revisions. To

the extent that those proposed revisions with respect to the definition

of “covered position” are not adopted, or adopted in a form other

than as proposed, the CFTC would expect to take that into account in

determining whether or how to include the proposed second prong of the

trading account definition for purposes of the final rule to implement

section 13 of the BHC Act. 111

—————————————————————————

111 In particular, the CFTC notes that under the proposed

revisions to the Market Risk Capital Rules, but not the existing

Market Risk Capital Rule, the term “covered position” expressly

includes, other than with respect to commodity and foreign exchange

positions, only positions taken with short-term trading intent. See

76 FR 1890 (Jan. 11, 2011). The CFTC does not intend to incorporate

“covered positions” under the Market Risk Capital Rules in a way

that includes positions lacking short-term trading intent.

—————————————————————————

iv. Positions Acquired or Taken by Securities Dealers, Swap Dealers,

and Security-Based Swap Dealers

The third prong of the proposed definition of trading account is

contained in Sec. —-.3(b)(2)(i)(C) of the proposed rule and provides

that a trading account includes any account used to acquire or take one

or more covered financial positions by a banking entity that is: (i) A

SEC-registered securities or municipal securities dealer; (ii) a

government securities dealer that registered, or that has filed notice,

with an appropriate regulatory agency; 112 (iii) a CFTC-registered

swap dealer; or (iv) a SEC-registered security-based swap dealer, in

each case to the extent that the covered financial position is acquired

or taken in connection with the activities that require the banking

entity to be registered, or to file notice, as such.113 Similarly

included is any covered financial position acquired or taken by a

banking entity that is engaged in the business of a dealer, swap

dealer, or security-based swap dealer outside of the United States, if

such position is acquired or taken in connection with the activities of

such business.114 As a result of this third prong, all covered

financial positions acquired or taken by a registered dealer, swap

dealer or security-based swap dealer, a government securities dealer

that has filed notice with an appropriate regulatory agency, or a

banking entity engaged in the same type of dealing activities outside

the United States, are automatically included within the scope of

positions described in the trading account definition, if they are

acquired or taken in connection with the activities that require the

banking entity to be registered, or file notice, as such (or, in the

case of a banking entity engaged in the business of a dealer, swap

dealer, or security-based swap dealer outside of the United States, in

connection with the activities of such business). As discussed below,

the proposed rule contains exemptions that permit a variety of covered

trading activity in which these types of entities typically engage,

notwithstanding the inclusion of all covered financial positions of

such entities within the definition of trading account.

—————————————————————————

112 See 15 U.S.C. 78c(a)(42)(E); 15 U.S.C. 78o-5(a)(1)(B); 17

CFR 400.5(b); 17 CFR 449.1. Section 15C(a)(1)(A) of the Exchange Act

requires any government securities dealer, other than a registered

broker-dealer or a financial institution, to register with the SEC

pursuant to section 15C(a)(2). Registered broker-dealers and

financial institutions are required to file written notice with

their appropriate regulatory agency, as defined in section 3(a)(34)

of the Exchange Act, prior to acting as a government securities

dealer. See 15 U.S.C. 78o-5(a)(1)(B). The proposed definition of

trading account would cover positions of all three forms of

government securities dealers: (i) those registered with the SEC;

(ii) registered broker-dealers; and (iii) financial institutions

that have filed notice with an appropriate regulatory agency.

113 See proposed rule Sec. —-.3(b)(2)(i)(C)(1)-(4). The

CFTC emphasizes that this provision applies only to positions taken

in connection with the activities that require the banking entity to

be registered as one of the listed categories of dealer, not to all

of the activities of that banking entity. For example, an insured

depository institution may be registered as a swap dealer, but only

the swap dealing activities that require it to be so registered

would be covered by the second prong of the trading account

definition. A position taken in connection with other activities of

the insured depository institution that do not trigger registration

as a swap dealer, such as lending, deposit-taking, the hedging of

business risks, or other end-user activity, would only be included

within the trading account if the position met one of the other

prongs of the trading account definition (i.e., Sec. Sec. —

–.3(b)(2)(i)(A) or (B) of the proposed rule).

114 See proposed rule Sec. —-.3(b)(2)(i)(C)(5).

—————————————————————————

The CFTC has proposed this third prong of the trading account

definition because all assets or other positions held by firms that

register or file notice as securities or derivatives dealers as part of

their dealing activity are generally held for sale to customers upon

request or otherwise support the firm’s trading activities (e.g., by

hedging its dealing positions), and so would appear to involve the

requisite short-term intent and be captured within the statutory

definition of trading account. To the extent that a covered financial

position is acquired or taken by such a banking entity outside the

scope of the dealing activities that require the banking entity to be

registered, or to file notice, as a dealer, swap dealer, or security-

based swap dealer, that position may still cause the relevant account

to be a trading account under the proposed rule if the account holding

such a position otherwise meets the terms of the first or second prong

of the trading account definition (i.e., positions acquired or taken

for short-term trading purposes or certain Market Risk Capital Rules

positions).

v. Rebuttable Presumption for Certain Positions

In order to provide greater clarity and guidance on the application

of the trading account definition, and in particular for those banking

entities with no experience in evaluating short-term trading intent or

that are not subject to the Market Risk Capital Rules, the proposed

rule also includes a rebuttable presumption regarding certain positions

that, by reason of their holding period, are presumed to be trading

account positions. In particular, Sec. —-.3(b)(2)(ii) of the

proposed rule provides that an account would be presumed to be a

trading account if it is used to acquire or take a covered financial

position, other than dealing positions or certain Market Risk Capital

Rules covered positions that are automatically considered part of the

trading account, that the banking entity holds for a period of sixty

days or less. However, the presumption does not apply if the banking

entity can demonstrate, based on all the facts and circumstances, that

the covered financial position, either individually or as a category,

was not acquired or taken principally for the purpose of short-term

resale, benefitting from short-term price movements, realizing short-

term arbitrage profits, or hedging another trading account

position.115 Because it appears likely that most positions held for

sixty days or less would have been acquired with short-term trading

intent, the proposal presumes such positions are trading account

positions unless the banking entity can demonstrate otherwise. The

purpose of the proposed rebuttable presumption is to simplify the

process of evaluating whether individual positions are included in the

definition of trading account. The proposal does not apply this

rebuttable presumption to positions described in Sec. —

–.3(b)(2)(i)(B) or (C) of the proposed rule (i.e., certain Market Risk

Capital Rules positions and dealing positions), because these positions

are automatically part of the trading account, and cannot be rebutted.

—————————————————————————

115 See proposed rule Sec. —-.3(b)(2)(ii).

—————————————————————————

[[Page 8346]]

However, the CFTC recognizes that, for a variety of reasons, a

banking entity may acquire a covered financial position for purposes

other than short-term trading but nonetheless dispose of that position

within the sixty-day period covered by the presumption. Accordingly,

Sec. —-.3(b)(2)(ii) is only a presumption, and may be rebutted by

reference to all the facts and circumstances surrounding the

acquisition of a particular position. For example, if a banking entity

acquired a covered financial position with the demonstrable intent of

holding it for investment or other non-trading purposes but, because of

developments not expected or anticipated at the time of acquisition

(e.g., increased customer demand, an unexpected increase in its

volatility or a need to liquidate the position to meet unexpected

liquidity demands), held it for less than sixty days, those facts and

circumstances would generally suggest that the position was not

acquired with short-term trading intent, notwithstanding the

presumption.116 The proposed rule also makes clear that this rebuttal

may be made not only with respect to a particular transaction, but also

with respect to a particular category of transactions, recognizing that

it may be possible to identify a category of similar transactions that

clearly do not involve short-term trading, notwithstanding the typical

holding period of the related positions.

—————————————————————————

116 In such cases, the documented intention for acquiring or

taking the position should be consistent with the intention

articulated for financial reporting and other purposes.

—————————————————————————

It is important to note that these presumptions are designed to

help determine whether a transaction is within the definition of

“proprietary trading,” not whether a transaction is permissible under

section 13 of the BHC Act. A transaction may fall within the definition

of “proprietary trading” and yet be permissible if it meets one of

the exemptions provided in the proposed rule, such as the exemption for

market making-related activities.

vi. Request for Comment

The CFTC requests comment on the proposed rule’s approach to

defining trading account. In particular, the CFTC requests comment on

the following questions:

Question 14. Is the proposed rule’s definition of trading account

effective? Is it over- or under-inclusive in this context? What

alternative definition might be more effective in light of the language

and purpose of the statute? How would such definition better identify

the accounts that are intended to be covered by section 13 of the BHC

Act?

Question 14.1. Should the CFTC Rule’s proposed definition of

trading account include: (i) Sec. —-.3(b)(2)(i)(B), relating to

Federal Banking Agencies’ Market Risk Capital Rules; or (ii) Sec. Sec.

—-.3(b)(2)(i)(C)(1),(2) and/or (4), relating to SEC registered

dealers and dealers who have filed notice with the appropriate

regulatory agency? Please explain the rationale for including or

excluding the provisions in the proposed CFTC Rule.

Question 15. Is the proposed rule’s approach for determining when a

position falls within the definition of “trading account” for

purposes of the proposed rule from when it must be reported in the

“trading account” for purpose of filing the Call Report effective?

What additional guidance could the CFTC provide on this distinction?

Are there alternative approaches that would be more effective in light

of the language and purpose of the statute? Is this approach workable

for affiliates of bank holding companies that are not subject to the

Federal banking agencies’ Market Risk Capital Rules (e.g., affiliated

investment advisers)? If not, why not? Are affiliates of bank holding

companies familiar with the concepts from the Market Risk Capital Rules

that are being incorporated into the proposed rule? If not, what steps

would an affiliate of a bank holding company have to take to become

familiar with these concepts and what would be the costs and/or

benefits of such actions? Is application of the trading account concept

from the Federal banking agencies’ Market Risk Capital Rules to

affiliates of bank holding companies necessary to promote consistency

and prevent regulatory arbitrage? Please explain.

Question 16. Is the manner in which the CFTC intends to take into

account, and substantially adopt, the approach used in the Market Risk

Capital Rules and related concepts for determining whether a position

is acquired with short-term trading intent effective?

Question 17. Should the proposed rule’s definition of trading

account, or its use of the term “short-term,” be clarified? Are there

particular transactions or positions to which its application would be

unclear? Should the proposed rule define “short-term” for these

purposes? What alternative approaches to construing the term “short-

term” should the CFTC consider and/or adopt?

Question 18. Are there particular transactions or positions to

which the application of the proposed definition of trading account is

unclear? Is additional regulatory language, guidance, or clarity

necessary?

Question 19. Is the exchange of variation margin as a potential

indicator of short-term trading in derivative or commodity future

transactions appropriate for the definition of trading account? How

would this impact such transactions or the manner by which banking

entities conduct such transactions? For instance, would banking

entities seek to avoid the use of variation margin to avoid this rule?

What are the costs and benefits of referring to the exchange of

variation margin to determine if positions should be included in a

banking entity’s trading account? Please explain.

Question 20. Are there particular transactions or positions that

are included in the definition of trading account that should not be?

If so, what transactions or positions and why?

Question 21. Are there particular transactions or positions that

are not included in the definition of trading account that should be?

If so, what transactions or positions and why?

Question 22. Is the proposed rule of construction for positions

acquired or taken by dealers, swap dealers and security-based swap

dealers appropriate and consistent with the purpose and language of

section 13 of the BHC Act? Is its application to any particular type of

entity, such as an insured depository institution engaged in

derivatives dealing activities, sufficiently clear and effective? If

not, what alternative would be clearer and/or more effective?

Question 23. Is the rebuttable presumption included in the proposed

rule appropriate and effective? Are there more effective ways in which

to provide clarity regarding the determination of whether or not a

position is included within the definition of trading account? If so,

what are they?

Question 24. Are records currently created and retained that could

be used to demonstrate investment or other non-trading purposes in

connection with rebutting the presumption in the proposed rule? If yes,

please identify such records and explain when they are created and

whether they would be useful in connection with a single transaction or

a category of similar transactions. If no, we seek commenter input

regarding the manner in which banking entities might demonstrate

investment or other non-trading intent. Should the CFTC require banking

entities to create and keep records to demonstrate investment or non-

trading intent with respect to their covered financial positions?

[[Page 8347]]

Question 25. How should the proposed trading account definition

address arbitrage positions? Should all arbitrage positions be included

in the definition of trading account, unless the timing of such profits

is long-term and established at the time the arbitrage position is

acquired or taken? Please explain in detail, including a discussion of

different arbitrage trading strategies and whether subjecting such

strategies to the proposed rule would be consistent with the language

and purpose of section 13 of the BHC Act.

Question 26. Is the holding period referenced in the rebuttable

presumption appropriate? If not, what holding period would be more

appropriate, and why?

Question 27. Should the proposed rule include a rebuttable

presumption regarding positions that are presumed not to be within the

definition of trading account? If so, why, and what would the

presumption be?

Question 28. Should any additional accounts be included in the

proposed rule pursuant to the authority granted under section 13(h)(6)

of the BHC Act? If so, what accounts and why? For example, should

accounts used to acquire or take certain long-term positions be

included in the definition? If so, how would subjecting such accounts

to the proposed rule’s prohibitions and restrictions be consistent with

the language and purpose of section 13 of the BHC Act?

Question 29. Do any of the activities currently engaged in by

issuers of asset-backed securities that would be considered a banking

entity constitute proprietary trading as defined by Sec. —-.3(b) of

this rule proposal? Would any activities relating to investment of

funds in accounts held by issuers of asset-backed securities (e.g.,

reserve accounts, prefunding accounts, reinvestment accounts, etc.) or

the purchase and sale of securities as part of the management of a

collateralized debt obligation portfolio be considered proprietary

trading under the proposed rule? What would be the potential impact of

the prohibition on proprietary trading on the use of such accounts in

(i) existing securitization transactions and (ii) future securitization

transactions? Would any of the securities typically acquired and

retained using these accounts be considered an ownership interest in a

covered fund under the proposed rule? Does the exclusion of trading in

certain government obligations in Sec. —-.6(a) of the proposed rule

mitigate the impact of the proposed rule on such issuers of asset-

backed securities and their activities? Why or why not?

c. Excluded Positions

i. Excluded Positions Under Certain Repurchase and Reverse Repurchase

Arrangements

Section —-.3(b)(2)(iii)(A) of the proposed rule’s definition of

trading account provides that an account will not be a trading account

to the extent that such account is used to acquire or take one or more

covered financial positions that arise under a repurchase or reverse

repurchase agreement pursuant to which the banking entity has

simultaneously agreed, in writing at the start of the transaction, to

both purchase and sell a stated asset, at stated prices, and on stated

dates or on demand with the same counterparty.117 This clarifying

exclusion is proposed because positions held under a repurchase or

reverse repurchase agreement operate in economic substance as a secured

loan, and are not based on expected or anticipated movements in asset

prices. Accordingly, these types of asset purchases and sales do not

appear to be the type of transaction intended to be covered by the

statutory definition of trading account.

—————————————————————————

117 See proposed rule Sec. —-.3(b)(2)(iii)(A).

—————————————————————————

ii. Excluded Positions Under Securities Lending Transactions

Section —-.3(b)(2)(iii)(B) of the proposed rule’s definition of

trading account provides that an account will not be a trading account

to the extent that such account is used to acquire or take one or more

covered financial positions that arise under a transaction in which the

banking entity lends or borrows a security temporarily to or from

another party pursuant to a written securities lending agreement under

which the lender retains the economic interests of an owner of such

security, and has the right to terminate the transaction and to recall

the loaned security on terms agreed to by the parties.118 This

clarifying exclusion is proposed because a position held under a

securities lending arrangement can be used, for example, to operate in

economic substance and function, as a means to facilitate settlement of

securities transactions, and is not based on expected or anticipated

movements in asset prices. Accordingly, securities lending transactions

do not appear to be the type of transaction intended to be covered by

the statutory definition of trading account.

—————————————————————————

118 See proposed rule Sec. –.3(b)(2)(iii)(B). The language

describing securities lending transactions in the proposed rule

generally mirrors that contained in Rule 3a5-3 under the Exchange

Act. See 17 CFR 240.3a5-3.

—————————————————————————

iii. Excluded Positions Acquired or Taken for Liquidity Management

Purposes

Section —-.3(b)(2)(iii)(C) of the proposed definition of trading

account provides that an account will not be a trading account to the

extent that such account is used to acquire or take a position for the

purpose of bona fide liquidity management, so long as important

criteria are met.119

—————————————————————————

119 See proposed rule Sec. —-.3(b)(2)(iii)(C).

—————————————————————————

This proposed clarifying exclusion is intended to make clear that,

where the purpose for which a banking entity acquires or takes a

position is to ensure that it has sufficient liquid assets to meet its

short-term cash demands, and the related position is held as part of

the banking entity’s liquidity management process, that transaction

falls outside of the types of transactions described in the proposed

rule’s definition of trading account. Maintaining liquidity management

positions is a critical aspect of the safe and sound operation of

certain banking entities, and does not involve the requisite short-term

trading intent that forms the basis of the statutory definition of

“trading account.” In the context of bona fide liquidity management

activity that would qualify for the clarifying exclusion, a banking

entity’s purpose for acquiring or taking these types of positions is

not to benefit from short-term profit or short-term price movements,

but rather to ensure that it has sufficient, readily-marketable assets

available to meet its expected short-term liquidity needs.

However, the CFTC is concerned with the potential for abuse of this

clarifying exclusion–specifically, that a banking entity might attempt

to improperly mischaracterize positions acquired or taken for

prohibited proprietary trading purposes as positions acquired or taken

for liquidity management purposes. To address this, the proposed rule

requires that the transaction be conducted in accordance with a

documented liquidity management plan that meets five criteria. First,

the plan would be required to specifically contemplate and authorize

any particular instrument used for liquidity management purposes, its

profile with respect to market, credit and other risks, and the

liquidity circumstances in which the position may or must be used.

Second, the plan would have to require that any transaction

contemplated and authorized by the plan be principally for the purpose

of managing the liquidity of

[[Page 8348]]

the banking entity, and not for the purpose of short-term resale,

benefitting from actual or expected short-term price movements,

realizing short-term arbitrage profits, or hedging a position acquired

or taken for such short-term purposes. Third, the plan would have to

require that any positions acquired or taken for liquidity management

purposes be highly liquid and limited to financial instruments the

market, credit and other risks of which are not expected to give rise

to appreciable profits or losses as a result of short-term price

movements.120 Fourth, the plan would be required to limit any

position acquired or taken for liquidity management purposes, together

with any other positions acquired or taken for such purposes, to an

amount that is consistent with the banking entity’s near-term funding

needs, including deviations from normal operations, as estimated and

documented pursuant to methods specified in the plan. Fifth, the plan

would be required to be consistent with the CFTC’s supervisory

requirements, guidance and expectations regarding liquidity management.

The CFTC would review these liquidity plans and transactions effected

in accordance with these plans through supervisory and examination

processes to ensure that the applicable criteria are met and that any

position acquired or taken in reliance on the clarifying exclusion for

liquidity management transactions is fully consistent with such plans.

—————————————————————————

120 Any instance in which positions characterized as taken for

liquidity purposes do give rise to appreciable profits or losses as

a result of short-term price movements will be subject to

significant CFTC scrutiny and, absent compelling explanatory facts

and circumstances, would be viewed as prohibited proprietary trading

under the proposal.

—————————————————————————

iv. Excluded Positions of Derivatives Clearing Organizations and

Clearing Agencies

Section —-.3(b)(2)(iii)(D) of the proposed rule’s definition of

trading account provides that an account will not be a trading account

to the extent that such account is used to acquire or take one or more

covered financial positions that are acquired or taken by a banking

entity that is a derivatives clearing organization registered under

section 5b of the Commodity Exchange Act (7 U.S.C. 7a-1) or a clearing

agency registered with the SEC under section 17A of the Exchange Act

(15 U.S.C. 78q-1) in connection with clearing derivatives or securities

transactions.121 This clarifying exclusion is proposed because, in

the case of a banking entity that acts as a registered, central

counterparty in the securities or derivatives markets, these types of

transactions do not appear to be the type of transaction intended to be

covered by the statutory definition of trading account, as the purpose

of such transactions is to provide a clearing service to third parties

and not to profit from short-term resale or short-term price movements.

—————————————————————————

121 See proposed rule Sec. —-.3(b)(2)(iii)(D).

—————————————————————————

v. Request for Comment

The CFTC requests comment regarding the proposed clarifying

exclusions and whether any other types of activity or transactions

should be excluded from the proposed definition of trading account for

clarity. In particular, the CFTC requests comment on the following

questions:

Question 30. Are the proposed clarifying exclusions for positions

under certain repurchase and reverse repurchase arrangements and

securities lending transactions over- or under-inclusive and could they

have unintended consequences? Is there an alternative approach to these

clarifying exclusions that would be more effective? Are the proposed

clarifying exclusions broad enough to include bona fide arrangements

that operate in economic substance as secured loans and are not based

on expected or anticipated movements in asset prices? Are there other

types of arrangements, such as open dated repurchase arrangements, that

should be excluded for clarity and, if so, how should the proposed rule

be revised? Alternatively, are the proposed clarifying exclusions broad

enough to not inadvertently exclude from coverage any similar

arrangements or transactions that have these characteristics?

Question 30.1. Should the proposed CFTC Rule include the clarifying

exclusion for certain positions taken by clearing agencies that are

registered with the SEC under section 17A of the Exchange Act? Please

explain the rationale for including or excluding the provision in the

proposed CFTC Rule.

Question 30.2. The CFTC notes that only the actual repurchase or

reverse repurchase arrangements would be exempt from the definition of

trading account, and not the collateral or position that is being

financed by the repurchase or reverse repurchase arrangement. The CFTC

further notes that if a banking entity used a repurchase arrangement to

finance a purchase of a covered financial position, that covered

financial position would be considered in the trading account if it

satisfied, at the time of its purchase, one of the three prongs set

forth in the definition of trading account. Is this treatment of

repurchase and reverse repurchase arrangements appropriate for the

proposed CFTC Rule?

Question 31. Are repurchase and reverse repurchase arrangements and

securities lending transactions sufficiently similar such that they

should be treated in the same way for purposes of the proposed rule?

Are there aspects of repurchase and reverse repurchase arrangements or

securities lending transactions that should be highlighted in

considering the application of the proposed rule? Do repurchase and

reverse repurchase arrangements or securities lending transactions

raise any additional or heightened concerns regarding risk? Please

identify and explain how these concerns should be reflected in the

proposed rule.

Question 32. Are the proposed exclusions for repurchase and reverse

repurchase arrangements and securities lending transactions appropriate

or are there conditions that commenters believe would be appropriate as

a pre-requisite to relying on these exclusions? Please identify such

conditions and explain. Alternatively, we seek commenter input

regarding why repurchase and reverse repurchase arrangements and

securities lending transactions do not present the potential for abuse,

namely, that a banking entity might attempt to improperly

mischaracterize prohibited proprietary trading as activity that

qualifies for the proposed exclusions.

Question 33. Is the proposed clarifying exclusion for liquidity

management transactions effective and appropriate? If not, what

alternative would be more effective and appropriate, and why? Is the

proposed exclusion under- or over-inclusive? Does the proposed

clarifying exclusion place sufficient limitations on liquidity

management transactions to prevent abuse of the clarifying exclusion?

If not, what additional limitations should be specified? Are any of the

limitations contained in the proposed rule inappropriate or

unnecessary? If so, how could such limitations be eliminated or altered

in a way that does not permit abuse of the clarifying exclusion?

Question 34. Is the proposed exclusion for liquidity management

positions necessary? If not excluded, would such activity otherwise

qualify for an exemption contained in the proposed rule (e.g., the

exemptions contains in Sec. Sec. —-.5 and —-.6(a) of the proposed

rule)? What types of banking entities are likely to engage in the

liquidity management activities described in the proposed exclusion?

[[Page 8349]]

Question 35. What types of instruments do particular types of

banking entities currently use in connection with liquidity management

activities (e.g., Treasuries)? Why are such instruments chosen for

liquidity management purposes? Would such instruments meet the proposed

requirement that the position be highly liquid and limited to financial

instruments the market, credit and other risk of which are not expected

to give rise to appreciable profits or losses as a result of short-term

price movements? Why or why not?

Question 36. What methodologies do banking entities currently use

for estimating deviations from normal operations in connection with

liquidity management programs?

Question 37. Which unit or units within a banking entity are

typically responsible for liquidity management? What is the typical

reporting line structure used to control and supervise that unit or

units? Are the responsibilities of personnel in the unit limited to

liquidity management or do they perform other functions in addition to

liquidity management? How is compensation determined for personnel in

the unit of the banking entity responsible for liquidity management?

Question 38. Would current liquidity management programs meet the

five proposed criteria for liquidity management programs? If not which

criteria would not be met, and why? What effect would the proposed

liquidity management exclusions have on current liquidity management

programs and banking entities in general?

Question 39. Are liquidity management programs used for purposes

other than ensuring the banking entity has sufficient assets available

to it that are readily marketable to meet expected short-term liquidity

needs? If so, for what purposes, and why?

Question 40. What costs or other burdens would arise if the

proposal did not contain an exclusion for positions acquired or taken

for liquidity management purpose? Please explain and quantify these

costs or other burdens in detail.

Question 41. Is the proposed liquidity management exclusion

sufficiently clear? If not, why is the exclusion unclear and how should

the CFTC clarify the terms of this exclusion?

Question 42. Is the proposed clarifying exclusion for certain

positions taken by derivatives clearing organizations and clearing

agencies effective and appropriate? If not, what alternative would be

more effective and appropriate, and why?

Question 43. Are any additional clarifying exclusions warranted? If

so, what clarifying exclusion, and why?

Question 44. Should the proposed definition exclude any position

the market risk of which cannot be hedged by the banking entity in a

two-way market? 122 If so, what would be the basis for concluding

that such positions are clearly not within the statutory definition of

trading account?

—————————————————————————

122 The CFTC also notes that such an exclusion would be

similar to the express exclusion of similar positions under the

Federal banking agencies’ most recent proposed revisions to the

Market Risk Capital Rules. See 76 FR 1890, 1912 (Jan. 11, 2011)

(excluding from the definition of a covered position any position

the material risk elements of which the holder is unable to hedge in

a two-way market).

—————————————————————————

Question 45. Should the proposed definition include a clarifying

exclusion for any position in illiquid assets? If so, what would be the

basis for concluding that such positions are clearly not within the

statutory definition of trading account? How should “illiquid assets”

be defined for these purposes? Should the definition be consistent with

the definition given that term in the Board’s Conformance Rule under

section 13 of the BHC Act (12 CFR 225.180 et seq.)? 123

—————————————————————————

123 See 76 FR 8265 (Feb. 14, 2011). The Board’s conformance

rule defines “illiquid asset” as “any real property, security

obligation, or other asset that (i) is not a liquid asset; (ii)

because of statutory or regulatory restrictions applicable to the

hedge fund, private equity fund or asset, cannot be offered, sold,

or otherwise transferred by the hedge fund or private equity fund to

a person that is unaffiliated with the relevant banking entity; or

(iii) because of contractual restrictions applicable to the hedge

fund, private equity fund or asset, cannot be offered, sold, or

otherwise transferred by the hedge fund or private equity fund for a

period of 3 years or more to a person that is unaffiliated with the

relevant banking entity.” 12 CFR 225.180(g). A “liquid asset” is

defined in paragraph (h) of the conformance rule. See 12 CFR

225.180(h).

—————————————————————————

d. Covered Financial Position

i. Definition of “Covered Financial Position”

Section —-.3(b)(3)(i) of the proposed rule defines a covered

financial position as any long, short, synthetic or other position

124 in: (i) A security, including an option on a security; (ii) a

derivative, including an option on a derivative; or (iii) a contract of

sale of a commodity for future delivery, or an option on such a

contract. The types of financial instruments described in the proposed

definition are consistent with those referenced in section 13(h)(4) of

the BHC Act as part of the statutory definition of proprietary

trading.125

—————————————————————————

124 The proposed definition’s reference to any “long, short,

synthetic or other position” is intended to make clear that a

position in an identified category of financial instrument qualifies

as a covered financial position regardless of whether the position

is (i) an asset or liability or (ii) is acquired through acquisition

or sale of the financial instrument or synthetically through a

derivative or other transaction.

125 Section 13(h)(4) of the BHC Act also permits the CFTC to

extend the scope of the proprietary trading restrictions to other

financial instruments. The CFTC has not proposed to do so at this

time.

—————————————————————————

To provide additional clarity, Sec. —-.3(b)(3)(ii) of the

proposed rule provides that, consistent with the statute, the term

covered financial position does not include any position that is itself

a loan, a commodity, or foreign exchange or currency.126 The

exclusion of these types of positions is intended to eliminate

potential confusion by making clear that the purchase and sale of

loans, commodities and foreign exchange–none of which are referred to

in section 13(h)(4) of the BHC Act–are outside the scope of

transactions to which the proprietary trading restrictions apply. The

reference in Sec. —-.3(b)(3)(ii) to a position that is, rather than

a position that is in, a loan, a commodity, or foreign exchange or

currency is intended to capture only the purchase and sale of these

instruments themselves. This reflects the fact that, consistent with

section 13(h)(4) of the BHC Act and the proposed rule, although a

position that is a foreign exchange derivative or commodity derivative

is included in the definition of covered financial position and

therefore subject to the prohibition on proprietary trading, a position

that is a commodity or foreign currency is not.127 For example, the

spot purchase of a commodity would meet the terms of the exclusion, but

the acquisition of a futures position in the same commodity would not.

The CFTC requests comment on the proposed rule’s definition of covered

financial position. In particular, the CFTC requests comment on the

following questions:

—————————————————————————

126 See proposed rule Sec. —-.3(b)(ii).

127 The types of commodity- and foreign exchange-related

derivatives that are included within the definition of

“derivative” under the proposed rule are discussed in detail below

in Part III.B.2.d.ii of this Supplementary Information.

—————————————————————————

Question 46. Is the proposed rule’s definition of covered financial

position effective? Is the definition over- or under-inclusive? What

alternative approaches might be more effective in light of the language

and purpose of section 13 of the BHC Act, and why?

Question 47. Are there definitions in other rules or regulations

that might inform the proposed definition of covered financial

position? If so, what rule or regulation? How should that approach be

incorporated into the proposed definition? Why would that approach be

more appropriate?

[[Page 8350]]

Question 48. Are there particular transactions or positions to

which the application of the proposed definition of covered financial

position is unclear? Is additional regulatory language, guidance, or

clarity necessary?

Question 49. The proposal would apply to long, short, synthetic, or

other positions in one of the listed categories of financial

instruments. Does this language adequately describe the type of

positions that are intended to fall within the proposed definition of

covered financial position? If not, why not? Are there different or

additional concepts that should be specified in this context? Please

explain.

Question 50. Should the CFTC expand the scope of covered financial

positions to include other transactions, such as spot commodities or

foreign exchange or currency, or certain subsets of transaction (e.g.,

spot commodities or foreign exchange or currency traded on a high-

frequency basis)? If so, which instruments and why?

Question 51. What factors should the CFTC consider in deciding

whether to extend the scope of the proprietary trading restriction to

other financial instruments under the authority granted in section

13(h)(4) of the BHC Act? Please explain.

Question 52. Is the proposed exclusion of any position that is a

loan, a commodity, or foreign exchange or currency effective? If not,

what alternative approaches might be more effective in light of the

language and purpose of section 13 of the BHC Act? Should additional

positions be excluded? If so, why and under what authority?

ii. Other Terms Used in the Definition of Covered Financial Position

The proposal also defines a number of terms used in the proposed

definition of covered financial position. The term “security” is

defined by reference to that same term under the Exchange Act.128 The

terms “commodity” and “contract of sale of a commodity for future

delivery” are defined by reference to those same terms under the

Commodity Exchange Act.129 The CFTC has proposed to reference these

existing definitions from the securities and commodities laws because

these existing definitions are generally well-understood by market

participants and have been subject to extensive interpretation in the

context of securities and commodities trading activities.

—————————————————————————

128 See proposed rule Sec. —-.2(w).

129 See proposed rule Sec. Sec. —-.3(c)(1), (2).

—————————————————————————

The proposed rule also defines the term “derivative.” 130 In

particular, the definition of “derivative” under the proposed rule

includes any “swap” (as that term is defined in the Commodity

Exchange Act) and any “security-based swap” (as that term is defined

in the Exchange Act), in each case as further defined by the CFTC and

SEC by joint regulation, interpretation, guidance, or other action, in

consultation with the Board pursuant to section 712(d) of the Dodd-

Frank Act. The CFTC has proposed to incorporate these definitions of

“swap” and “security-based swap” under the Federal securities and

commodities laws because those definitions: (i) Govern the primary

Federal regulatory scheme applicable to exchange-traded and over-the-

counter derivatives; (ii) will be frequently evaluated and applied by

banking entities in the course of their trading activities; and (iii)

capture agreements and contracts that are, or function as,

derivatives.131 The proposed rule also includes within the definition

of derivative certain other transactions that, although not included

within the definition of “swap” or “security-based swap.”

Specifically, the proposed definition of derivative also includes: (i)

any purchase or sale of a nonfinancial commodity for deferred shipment

or delivery that is intended to be physically settled; (ii) any foreign

exchange forward or foreign exchange swap (as those terms are defined

in the Commodity Exchange Act); 132 (iii) any agreement, contract, or

transaction in foreign currency described in section 2(c)(2)(C)(i) of

the Commodity Exchange Act (7 U.S.C. 2(c)(2)(C)(i)); 133 (iv) any

agreement, contract, or transactions in a commodity other than foreign

currency described in section 2(c)(2)(D)(i) of the Commodity Exchange

Act (7 U.S.C. 2(c)(2)(D)(i)); and (v) any transaction authorized under

section 19 of the Commodity Exchange Act (7 U.S.C. 23(a) or (b)). The

CFTC is requesting comment on whether including these five types of

transactions within the proposed definition of derivative is

appropriate.

—————————————————————————

130 See proposed rule Sec. —-.2(l).

131 The CFTC notes that it has not included a variety of

security-related derivatives within the proposed definition of

derivative, as such transactions are “securities” for purposes of

both the Exchange Act and the proposed rule and, as a result,

already included in the broader definition of “covered financial

position” to which the prohibition on proprietary trading applies.

132 The CFTC notes that foreign exchange swaps and foreign

exchange forwards are considered swaps for purposes of the Commodity

Exchange Act definition of that term unless the Secretary of the

Treasury determines, pursuant to section 1a(47)(E) of that Act (7

U.S.C. 1a(47)(E)), that foreign exchange swaps and forwards should

not be regulated as swaps under the Commodity Exchange Act and are

not structured to evade certain provisions of the Dodd-Frank Act. On

May 5, 2011, the Treasury Secretary proposed to exercise that

authority to exclude foreign exchange forwards and foreign exchange

swaps from the definition of “swap.” See Determination of Foreign

Exchange Swaps and Foreign Exchange Forwards Under the Commodity

Exchange Act, 76 FR 25774 (May 5, 2011). If the Secretary of the

Treasury issues a final determination, as proposed, a “foreign

exchange swap” and “foreign exchange forward” would be excluded

from the definition of “swap” under the Commodity Exchange Act

and, therefore, would fall outside of the proposed rule’s definition

of “derivative.” Accordingly, the CFTC has proposed to expressly

include such transactions in the proposed definition of derivative,

but have requested comment on a variety of questions related to

whether foreign exchange swaps and forwards should be included or

excluded from the definition of derivative. The CFTC notes that,

aside from foreign exchange swaps and forwards, the Commodity

Exchange Act’s definition of “swap” (and therefore the proposed

definition of “derivative”) also includes other types of foreign

exchange derivatives, including non-deliverable foreign exchange

forwards (NDFs), foreign exchange options, and currency options,

which fall outside of the Secretary of the Treasury’s authority to

issue a determination to exclude certain transactions from the

“swap” definition.

133 Section 2(c)(2)(C)(i) was added to the Commodity Exchange

Act in 2008 to address retail foreign exchange transactions that

were documented as automatically renewing spot contracts (so-called

rolling spot transactions) and therefore not futures contracts

subject to the Commodity Exchange Act, but which were functionally

and economically similar to futures. See Retail Foreign Exchange

Transactions, 76 FR 41375, 47376-77 (July 15, 2011). However,

section 2(c)(2)(C)(i) of the Commodity Exchange Act does not apply

to transactions entered into by U.S. financial institutions,

including insured depository institutions, brokers, dealers, and

certain retail foreign exchange dealers. See 7 U.S.C.

2(c)(2)(C)(i)(I)(aa). To apply this definitional prong to such

banking entities, the definition of derivative includes a

transaction “described in” section 2(c)(2)(C)(i) of the Commodity

Exchange Act. In other words, the use of this phrase is intended to

capture any transaction described in section 2(c)(2)(C)(i) without

regard to the identity of the counterparty.

—————————————————————————

To provide additional clarity, the proposed definition of

derivative also clarifies two types of transactions that are outside

the scope of the definition. First, the proposed definition of

derivative would not include any consumer, commercial, or other

agreement, contract, or transaction that the CFTC and SEC have further

defined by joint regulation, interpretation, guidance, or other action

as not within the definition of swap, as that term is defined in the

Commodity Exchange Act, or security-based swap, as that term is defined

in the Exchange Act. The SEC and CFTC have, in proposing rules further

defining the terms “swap” and “security-based swap,” proposed to

not include a variety of agreements, contracts, and transactions within

those definitions by joint regulation or interpretation, and the CFTC

has proposed to expressly reflect such

[[Page 8351]]

exclusions in the proposed rule’s definition in order to avoid the

potential application of its restrictions to transactions that are not

commonly thought to be derivatives.134 Second, the proposed

definition of derivative also does not include any identified banking

product, as defined in section 402(b) of the Legal Certainty for Bank

Products Act of 2000 (7 U.S.C. 27(b)), that is subject to section

403(a) of that Act (7 U.S.C. 27a(a)). This provision is proposed to

clearly exclude identified banking products that are expressly excluded

(i) from the definition of “security-based swap” and (ii) from

Commodity Exchange Act and CFTC jurisdiction pursuant to section 403(a)

of the Legal Certainty for Bank Products Act of 2000.135

—————————————————————————

134 See 76 FR 29818 (May 23, 2011). For example, the SEC and

CFTC have proposed to not include (i) certain insurance products

within the definitions of “swap” and “security-based swap” by

regulation and (ii) certain consumer agreements (e.g., agreements to

acquire or lease real property or purchase products at a capped

price) and commercial agreements (e.g., employment contracts or the

purchase of real property, intellectual property, equipment or

inventory) by joint interpretation. See id. at 29832-34. The CFTC

has proposed to define “derivative” in the proposed rule by

reference to the definition of ”swap” and “security-based swap”

under the Federal securities and commodities laws in contemplation

of the SEC and CFTC’s proposed regulatory and interpretative

exclusions; to the extent that such exclusions are not included in

any final action taken by the SEC and CFTC, the CFTC will consider

whether to state such exclusions expressly within the proposed

rule’s definition of derivative.

135 Examples of excluded identified banking products are

deposit accounts, savings accounts, certificates of deposit, or

other deposit instruments issued by a bank.

—————————————————————————

The proposed rule defines a “loan” as any loan, lease, extension

of credit, or secured or unsecured receivable.136 The CFTC notes that

the proposed definition of loan is expansive, and includes a broad

array of loans and similar credit transactions, but does not include

any asset-backed security that is issued in connection with a loan

securitization or otherwise backed by loans.

—————————————————————————

136 See proposed rule Sec. —-.2(q).

—————————————————————————

The CFTC requests comment on the proposed rule’s definition of

terms used in the definition of covered financial position. In

particular, the CFTC requests comment on the following questions:

Question 53. Are the proposed rule’s definitions of commodity and

contract of sale of a commodity for future delivery appropriate? If

not, what alternative definitions would be more appropriate?

Question 54. Is the proposed definition of derivative effective? If

not, what alternative definition would be more effective? Should the

proposed rule expressly incorporate the definition of “swap” and

“security-based swap” under the Federal commodities and securities

laws? If not, what alternative approach should be taken? Are there

transactions included in those incorporated definitions that should not

be included in the proposed rule’s definition? If so, what transactions

and why? Are there transactions excluded from those incorporated

definitions that should be included within the proposed rule’s

definition? If so, what transactions and why?

Question 55. Is the proposed inclusion of foreign exchange forwards

and swaps in the definition of derivative effective? If not, why not?

On what basis would the CFTC conclude that such transactions are not

derivatives? Are these transactions economically or functionally more

similar to secured loans or repurchase arrangements than to commodity

forwards and swaps? Would there be any unintended consequences to

banking entities if such transactions are included in the proposal’s

definition of derivative? What effect is including foreign exchange

swaps and forwards in the definition of derivative likely to have on

banking entities, participants in the foreign exchange markets, and the

liquidity and efficiency of foreign exchange markets generally? If

included within the definition of derivative, should transactions in

foreign exchange swaps and forwards be permitted under section

13(d)(1)(J) of the BHC Act? If so, why and on what basis? Please

quantify your responses, to the extent feasible.

Question 56. Is the proposed inclusion of any purchase or sale of a

nonfinancial commodity for deferred shipment or delivery that is

intended to be physically settled in the definition of derivative

effective? If not, why not? Would there be any unintended consequences

to banking entities if such transactions are included in the proposal’s

definition of derivative?

Question 57. Is the proposed inclusion of foreign currency

transactions described in section 2(c)(2)(C)(i) of the Commodity

Exchange Act in the definition of derivative effective? If not, why

not? Would there be any unintended consequences to banking entities if

such transactions are included in the proposal’s definition of

derivative?

Question 58. Is the proposed inclusion of commodity transactions

described in section 2(c)(2)(D)(i) of the Commodity Exchange Act in the

definition of derivative effective? If not, why not? Would there be any

unintended consequences to banking entities if such transactions are

included in the proposal’s definition of derivative?

Question 59. Is the proposed inclusion of any transaction

authorized under section 19 of the Commodity Exchange Act (7 U.S.C.

23(a) or (b)) in the definition of derivative effective? If not, why

not? Would there be any unintended consequences to banking entities if

such transactions are included in the proposal’s definition of

derivative?

Question 60. Is the manner in which the proposed definition of

derivative excludes any transaction that the CFTC or SEC exclude by

joint regulation, interpretation, guidance, or other action from the

definition of “swap” or “security-based swap” effective? If not,

what alternative approach would be more appropriate? Should such

exclusions be restated in the proposed rule’s definition? If so, why?

Question 61. Is the proposed rule’s definition of loan appropriate?

If not, what alternative definition would be more appropriate? Should

the definition of “loan” exclude a security? Should other types of

traditional banking products be included in the definition of “loan”?

If so, why?

iii. Definition of Other Terms Related to Proprietary Trading

Section —-.3(d) of the proposed rule defines a variety of other

terms used throughout subpart B of the proposed rule. These definitions

are discussed in further detail below in the relevant summary of the

separate sections of the proposed rule in which they are used.

The CFTC requests comment on the proposed rule’s definition of

other terms used in subpart B of the proposed rule. In particular, the

CFTC requests comment on the following questions:

Question 62. Are the proposed rule’s definitions of other terms in

Sec. —-.3(d) appropriate? If not, what alternative definitions would

be more appropriate?

Question 63. Is the definition of additional terms for purposes of

subpart B of the proposed rule necessary? If so, what terms should be

defined? How should those terms be defined?

2. Section —-.4: Permitted Underwriting and Market Making-related

Activities

Section —-.4 of the proposed rule implements section 13(d)(1)(B)

of the BHC Act, which permits banking entities to engage in certain

underwriting and market making-related activities, notwithstanding the

prohibition on proprietary trading.137

[[Page 8352]]

Section —-.4(a) addresses permitted underwriting activities, and

Sec. —-.4(b) addresses permitted market making-related activities.

—————————————————————————

137 See 12 U.S.C. 1851(d)(1)(B).

—————————————————————————

a. Permitted Underwriting Activities

Section —-.4(a) of the proposed rule permits a banking entity to

purchase or sell a covered financial position in connection with the

banking entity’s underwriting activities to the extent that such

activities are designed not to exceed the reasonably expected near-term

demands of clients, customers, or counterparties (the “underwriting

exemption”). In order to rely on this exemption, a banking entity’s

underwriting activities must meet all seven of the criteria listed in

Sec. —-.4(a)(2). These seven criteria are intended to ensure that

any banking entity relying on the underwriting exemption is engaged in

bona fide underwriting activities, and conducts those activities in a

way that is not susceptible to abuse through the taking of speculative,

proprietary positions as a part of, or mischaracterized as,

underwriting activity.

First, the banking entity must have established the internal

compliance program required by subpart D of the proposed rule, as

further described below in Part III.D of this SUPPLEMENTARY

INFORMATION. This requirement is intended to ensure that any banking

entity relying on the underwriting exemption has reasonably designed

written policies and procedures, internal controls, and independent

testing in place to support its compliance with the terms of the

exemption.

Second, the covered financial position that is being purchased or

sold must be a security. This requirement reflects the common usage and

understanding of the term “underwriting.” 138

—————————————————————————

138 The CFTC notes, however, that a derivative or commodity

future transaction may be otherwise permitted under another

exemption (e.g., the exemptions for market making-related or risk-

mitigating hedging activities).

—————————————————————————

Third, the transaction must be effected solely in connection with a

distribution of securities for which the banking entity is acting as an

underwriter. This prong is intended to give effect to the essential

element of the underwriting exemption–i.e., that the transaction be in

connection with underwriting activity. For these purposes, the proposed

rule defines both (i) a distribution of securities and (ii) an

underwriter. The definitions of these terms are generally identical to

the definitions provided for the same terms in the SEC’s Regulation

M,139 which governs the activities of underwriters, issuers, selling

security holders, and others in connection with offerings of securities

under the Exchange Act.140 The CFTC has proposed to use similar

definitions because the meanings of these terms under Regulation M are

generally well-understood by market participants and define the scope

of underwriting activities in which banking entities typically engage,

including underwriting of SEC-registered offerings, underwriting of

unregistered distributions, and acting as a placement agent in private

placements.

—————————————————————————

139 17 CFR 242.100 et seq.

140 See proposed rule Sec. Sec. —-.4(a)(3), (4); 17 CFR

242.100(b).

—————————————————————————

With respect to the definition of distribution, the CFTC notes that

Regulation M defines a distribution of securities as “an offering of

securities, whether or not subject to registration under the Securities

Act that are distinguished from ordinary trading transactions by the

magnitude of the offering and the presence of special selling

efforts.” 141 The manner in which this Regulation M definition

distinguishes a distribution of securities from other transactions

appears to be relevant in the context of the underwriting exemption and

useful to address potential evasion of the general prohibition on

proprietary trading, while permitting bona fide underwriting

activities. Accordingly, in order to qualify as a distribution for

purposes of the proposal, as with Regulation M, the offering must meet

the two elements–“magnitude” and “special selling efforts and

selling methods.” The CFTC has not defined the terms “magnitude” and

“special selling efforts and selling methods” in the proposed rule,

but would expect to rely on the same factors considered under

Regulation M in assessing these elements. For example, the number of

shares to be sold, the percentage of the outstanding shares, public

float, and trading volume that those shares represent are all relevant

to an assessment of magnitude.142 In addition, delivering a sales

document, such as a prospectus, and conducting road shows are generally

indicative of special selling efforts and selling methods.143 Another

indicator of special selling efforts and selling methods is

compensation that is greater than that for secondary trades but

consistent with underwriting compensation for an offering. Similar to

the approach taken under Regulation M, the CFTC notes that

“magnitude” does not imply that a distribution must be large;

instead, this factor is a means to distinguish a distribution from

ordinary trading, and therefore does not preclude small offerings or

private placements from qualifying for the underwriting exemption.

—————————————————————————

141 17 CFR 242.100.

142 See Review of Antimanipulation Regulation of Securities

Offering, Exchange Act Release No. 33924 (Apr. 19, 1994), 59 FR

21681, 21684 (Apr. 26, 1994) (“Regulation M Concept Release”).

143 See Regulation M Concept Release, 59 FR at 21684-85.

—————————————————————————

The definition of “underwriter” in the proposed rule is generally

similar to that under the SEC’s Regulation M, except that the proposed

rule’s definition would also include, within that definition, a person

who has an agreement with another underwriter to engage in a

distribution of securities for or on behalf of an issuer or selling

security holder.144 Consistent with current practices and the Council

study, the CFTC proposes to take into consideration the extent to which

the banking entity is engaged in the following activities when

determining whether a banking entity is acting as an underwriter as

part of a distribution of securities:

—————————————————————————

144 See proposed rule Sec. —-.4(a)(4)(ii).

—————————————————————————

Assisting an issuer in capital raising;

Performing due diligence;

Advising the issuer on market conditions and assisting in

the preparation of a registration statement or other offering

documents;

Purchasing securities from an issuer, a selling security

holder, or an underwriter for resale to the public;

Participating in or organizing a syndicate of investment

banks;

Marketing securities; and

Transacting to provide a post-issuance secondary market

and to facilitate price discovery.

The CFTC notes that the precise activities performed by an

underwriter may vary depending on the liquidity of the securities being

underwritten and the type of distribution being conducted. For example,

each factor need not be present in a private placement.

There may be circumstances in which an underwriter would hold

securities that it could not sell in the distribution for investment

purposes. If the acquisition of such unsold securities were in

connection with the underwriting pursuant to the permitted underwriting

activities exemption, the underwriter would also be able to dispose of

such securities at a later time.145

—————————————————————————

145 The CFTC notes, however, that such sale would have to be

made in compliance with other applicable provisions of the Federal

securities laws and regulations.

—————————————————————————

[[Page 8353]]

Fourth, to the extent that the transaction involves a security for

which a person must generally be a registered securities dealer,

municipal securities dealer or government securities dealer in order to

underwrite the security, the banking entity must have the appropriate

dealer registration (or in the case of a financial institution that is

a government securities dealer, has filed notice of that status as

required by section 15C(a)(1)(B) of the Exchange Act) or otherwise be

exempt from registration or excluded from regulation as a dealer.146

Similarly, if the banking entity is engaged in the business of a dealer

outside the United States in a manner for which no U.S. registration is

required, the banking entity must be subject to substantive regulation

of its dealing business in the jurisdiction in which the business is

located. This requirement is intended to ensure that (i) any

underwriting activity conducted in reliance on the exemption is subject

to appropriate regulation and (ii) banking entities are not

simultaneously characterizing the transaction as underwriting for

purposes of the exemption while characterizing it in a different manner

for purposes of applicable securities laws.

—————————————————————————

146 See proposed rule Sec. —-.4(a)(2)(iv). For example, if

a banking entity is a bank engaged in underwriting asset-backed

securities for which it would be required to register as a

securities dealer but for the exclusion contained in section

3(a)(5)(C)(iii) of the Exchange Act, the proposed rule would not

require that banking entity be a registered securities dealer in

order to rely on the underwriting exemption for that transaction.

The proposed rule does not apply the dealer registration/notice

requirement to the underwriting of exempted securities, security-

based swaps, commercial paper, bankers acceptances or commercial

bills because the underwriting of such instruments does not require

registration as a securities dealer under the Exchange Act.

—————————————————————————

Fifth, the underwriting activities of the banking entity with

respect to the covered financial position must be designed not to

exceed the reasonably expected near-term demands of clients, customers

and counterparties.147 This requirement restates the statutory

limitation on the underwriting exemption.

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147 See proposed rule Sec. —-.4(a)(2)(v).

—————————————————————————

Sixth, the underwriting activities of the banking entity must be

designed to generate revenues primarily from fees, commissions,

underwriting spreads or other income, and not from appreciation in the

value of covered financial positions it holds related to such

activities or the hedging of such covered financial position.148 This

requirement is intended to ensure that activities conducted in reliance

on the underwriting exemption demonstrate patterns of revenue

generation and profitability consistent with, and related to, the

services an underwriter provides to its customers in bringing

securities to market, rather than changes in the market value of the

securities underwritten.

—————————————————————————

148 For these purposes, underwriting spreads would include any

“gross spread” (i.e., the difference between the price an

underwriter sells securities to the public and the price it

purchases them from the issuer) designed to compensate the

underwriter for its services.

—————————————————————————

Seventh, the compensation arrangements of persons performing

underwriting activities at the banking entity must be designed not to

encourage proprietary risk-taking. Activities for which a banking

entity has established a compensation incentive structure that rewards

speculation in, and appreciation of, the market value of securities

underwritten, rather than success in bringing securities to market for

a client, are inconsistent with permitted underwriting activities under

the proposed rule. Although a banking entity relying on the

underwriting exemption may appropriately take into account revenues

resulting from movements in the price of securities that the banking

entity underwrites to the extent that such revenues reflect the

effectiveness with which personnel have managed underwriting risk, the

banking entity should provide compensation incentives that primarily

reward client revenues and effective client service, not proprietary

risk-taking.

The CFTC requests comment on the proposed rule’s implementation of

the underwriting exemption. In particular, the CFTC requests comment on

the following questions:

Question 64. Is the proposed rule’s implementation of the

underwriting exemption effective? If not, what alternative approach

would be more effective? For example, should the exemption include

other transactions that do not involve a distribution of securities for

which the banking entity is acting as underwriter?

Question 64.1. Should the proposed CFTC Rule include the

underwriting exemption? Please explain the rationale for including or

excluding the provision in the proposed CFTC Rule.

Question 65. Are the seven requirements included in the

underwriting exemption effective? Is the application of each

requirement to potential transactions sufficiently clear? Should any of

the requirements be changed or eliminated? Should other requirements be

added in order to better provide an exemption that is not susceptible

to abuse through the taking of speculative, proprietary positions in

the context of, or mischaracterized as, underwriting? Alternatively,

are any of the proposed requirements inappropriately restrictive in

that they would be inconsistent with the statutory exemption for

certain underwriting activities? If so, how?

Question 66. Do underwriters currently have processes in place that

would prevent or reduce the likelihood of taking speculative,

proprietary positions in the context of, or mischaracterized as,

underwriting? If so, what are those processes?

Question 67. Would any of the proposed requirements cause

unintended consequences? Would the proposed requirements alter current

underwriting practices in any way? Would any of the proposed

requirements trigger an unwillingness to engage in underwriting? What

impact, if any, would the proposed exemption have on capital raising?

Please explain.

Question 68. What increased costs, if any, would underwriters incur

to satisfy the seven proposed requirements of the underwriting

exemption? Would underwriters pass the increased costs onto issuers,

selling security holders, or their customers in connection with

qualifying for the proposed exemption?

Question 69. In addition to the specific activities highlighted

above for purposes of evaluating whether a banking entity is acting as

an underwriter as part of distribution of securities (e.g., assisting

an issuer in capital raising, performing due diligence, etc.), are

there other or alternative activities that should be considered? Please

explain.

Question 70. Should the requirement that a covered financial

position be a security be expanded to include other financial

instruments? If so, why? How are such other instruments underwritten

within the meaning of section 13(d)(1)(B) of the BHC Act?

Question 71. Is the proposed definition of a “distribution” of

securities appropriate, or over- or under-inclusive in this context? Is

there any category of underwriting activity that would not be captured

by the proposed definition? If so, what are the mechanics of that

underwriting activity? Should it be permitted under the proposed rule,

and, if so, why? Would an alternative definition better identify

offerings intended to be covered by the proposed definition? If so,

what alternative definition, and why?

Question 72. Is the proposed definition of “underwriter”

appropriate, or over- or under-inclusive in this context? Would an

alternative definition, such as the statutory

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definition of “underwriter” under the Securities Act, better identify

persons intended to be covered by the proposed definition? If so, why?

Question 73. How accurately can a banking entity engaging in

underwriting predict the near-term demands of clients, customers, and

counterparties with respect to an offering? How can principal risk that

is retained in connection with underwriting activities to support near-

term client demand be distinguished from positions taken for

speculative purposes?

Question 74. Is the requirement that the underwriting activities of

a banking entity relying on the underwriting exemption be designed to

generate revenues primarily from fees, commissions, underwriting

spreads or similar income effective? If not, how should the requirement

be changed? Does the requirement appropriately capture the type and

nature of revenues typically generated by underwriting activities? Is

any further clarification or additional guidance necessary?

Question 75. Is the requirement that the compensation arrangements

of persons performing underwriting activities at a banking entity be

designed not to reward proprietary risk-taking effective? If not, how

should the requirement be changed? Are there other types of

compensation incentives that should be clearly referenced as

consistent, or inconsistent, with permitted underwriting activity? Are

there specific and identifiable characteristics of compensation

arrangements that clearly incentivize prohibited proprietary trading?

Question 76. Are there other types of underwriting activities that

should also be included within the scope of the underwriting exemption?

If so, what additional activities and why? How would an exemption for

such additional activities be consistent with the language and purpose

of section 13 of the BHC Act? What criteria, requirements, or

restrictions would be appropriate to include with respect to such

additional activities to prevent misuse or evasion of the prohibition

on proprietary trading?

Question 77. Does the proposed underwriting exemption appropriately

accommodate private placements? If not, what changes are necessary to

do so?

Question 78. The creation, offer and sale of certain structured

securities such as trust preferred securities or tender option bonds,

among others, may involve the purchase of another security and

repackaging of that security through an intermediate entity. Should the

sale of the security by a banking entity to an intermediate entity as

part of the creation of the structured security be permitted under one

of the exemptions to the prohibition on proprietary trading currently

included in the proposed rule (e.g., underwriting or market making)?

Why or why not? For purposes of determining whether an exemption is

available under these circumstances, should gain on sale resulting from

the sale of the purchased security to the intermediate entity as part

of the creation of the structured security be considered a relevant

factor? Why or why not? What other factors should be considered in

connection with the creation of the structured securities and why?

Would the analysis be different if the banking entity acquired and

retained the security to be sold to the intermediate entity as part of

the creation of the structured securities as part of its underwriting

of the underlying security? Why or why not?

Question 79. We seek comment on the application of the proposed

exemption to a banking entity retaining a portion of an underwriting.

Please discuss whether or not firms frequently retain securities in

connection with a distribution in which the firm is acting as

underwriter. Please identify the types of offerings in which this may

be done (e.g., fixed income offerings, securitized products, etc.).

Please identify and discuss any circumstances which can contribute to

the decision regarding whether or not to retain a portion of an

offering. Please describe the treatment of retained securities (e.g.,

the time period of retention, the type of account in which securities

are retained, the potential disposition of the securities). Please

discuss whether or not the retention is documented and, if so, how.

Should the CFTC require disclosure of securities retained in connection

with underwritings? Should the CFTC require specific documentation to

demonstrate that the retained portion is connected to an underwriting

pursuant to the proposed rule? If so, what kind of documentation should

be required? Please discuss how you believe retention should be

addressed under the proposal.

b. Permitted Market Making-related Activities

Section —-.4(b) of the proposed rule permits a banking entity to

purchase or sell a covered financial position in connection with the

banking entity’s market making-related activities (the “market-making

exemption”).

i. Approach to Implementing the Exemption for Market Making-Related

Activities

As the Council study noted, implementing the statutory exception

for permitted market making-related activities requires a regulatory

regime that differentiates permitted market making-related activity,

and in particular the taking of principal positions in the course of

making a market in particular financial instruments, from prohibited

proprietary trading. Although the purpose and function of these two

activities are markedly different–market making-related activities

provide intermediation and liquidity services to customers, while

proprietary trading involves the generation of profit through

speculative risk-taking–clearly distinguishing these activities may be

difficult in practice. Market making-related activities, like

prohibited proprietary trading, sometimes require the taking of

positions as principal, and the amount of principal risk that must be

assumed by a market maker varies considerably by asset class and

differing market conditions.149 It may be difficult to distinguish

principal positions that appropriately support market making-related

activities from positions taken for short-term, speculative purposes.

In particular, it may be difficult to determine whether principal risk

has been retained because (i) the retention of such risk is necessary

to provide intermediation and liquidity services for a relevant

financial instrument or (ii) the position is part of a speculative

trading strategy designed to realize profits from price movements in

retained principal risk.150

—————————————————————————

149 With respect to certain kinds of market making-related

activities, such as market making in securities, these principal

positions are often referred to as “inventory” or “inventory

positions.” However, since certain types of market making-related

activities, such as market making in derivatives, involve the

retention of principal positions arising out of multiple derivatives

transactions in particular risks (e.g., retained principal interest

rate risk), rather than retention of actual financial instruments,

the broader term “principal positions” is used in this discussion.

150 The Council study contains a detailed discussion of the

challenges involved in delineating prohibited proprietary trading

from permitted market making-related activities. See Council study

at 15-18.

—————————————————————————

In order to address these complexities, the CFTC has proposed a

multi-faceted approach that draws on several key elements. First,

similar to the underwriting exemption, the proposed rule includes a

number of criteria that a banking entity’s activities must meet in

order to rely on the exemption for market making-related

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activities. These criteria are intended to ensure that the banking

entity is engaged in bona fide market making. As described in greater

detail in Part III.D of the Supplementary Information, among these

criteria is the requirement that the banking entity have in place a

programmatic compliance regime to guide its compliance with section 13

of the BHC Act and the proposed rule. This compliance regime includes

requirements that a banking entity have effective policies, procedures,

and internal controls that are designed to ensure that prohibited

proprietary trading positions are not taken under the guise of

permitted market making-related activity. Second, as described in

greater detail in Part III.B.5 of this SUPPLEMENTARY INFORMATION:

Appendix B of the proposed rule contains a detailed commentary

regarding how the CFTC proposes to identify permitted market making-

related activities. This commentary includes six principles the CFTC

proposes to use as a guide to help distinguish market-making related

activities from prohibited proprietary trading. Third, also as

described in greater detail in Part III.B.5 of this Supplementary

Information, Sec. —-.7 and Appendix A of the proposed rule require a

banking entity with significant covered trading activities to report

certain quantitative measurements for each of its trading units.151

These quantitative measurements are intended to assist both banking

entities and the CFTC in assessing whether the quantitative profile of

a trading unit (e.g., the types of revenues it generates and the risks

it retains) is consistent with permitted market making-related

activities under the proposed rule.

—————————————————————————

151 The definition of “trading unit” for this purpose is

discussed in detail in Part III.B.5 of this SUPPLEMENTARY

INFORMATION.

—————————————————————————

The proposal’s multi-faceted approach is intended, through the

incorporation of multiple regulatory and supervisory tools, to strike

an appropriate balance in implementing the market-making exemption in a

way that articulates the scope of permitted activities and meaningfully

addresses the potential for misuse of the exemption, while not unduly

constraining the important liquidity and intermediation services that

market makers provide to their customers and to the capital markets at

large.

The CFTC requests comment on the proposed rule’s approach to

implementing the exemption for permitted market making-related

activities. In particular, the CFTC requests comment on the following

questions:

Question 80. Is the proposed rule’s approach to implementing the

exemption for permitted market making-related activities (i)

appropriate and (ii) likely to be effective? If not, what alternative

approach would be more appropriate or effective?

Question 81. Does the proposed multi-faceted approach appropriately

take into account and address the challenges associated with

differentiating prohibited proprietary trading from permitted market

making-related activities? Should the approach include other elements?

If so, what elements and why? Should any of the proposed elements be

revised or eliminated? If so, why and how?

Question 82. Does the proposed multi-faceted approach provide

banking entities and market participants with sufficient clarity

regarding what constitutes permitted market making-related activities?

If not, how could greater clarity be provided?

Question 83. What impact will the proposed multi-faceted approach

have on the market making-related services that a banking entity

provides to its customers? How will the proposed approach impact market

participants who use the services of market makers? How will the

approach impact the capital markets at large, and in particular the

liquidity, efficiency and price transparency of capital markets? If any

of these impacts are positive, how can they be amplified? If any of

these impacts are negative, how can they be mitigated? Would the

proposed rule’s prohibition on proprietary trading and exemption for

market making-related activity reduce incentives or opportunities for

banking entities to trade against customers, as opposed to trading on

behalf of customers? If so, please discuss the benefits arising from

such reduced incentives or opportunities.

Question 84. What burden will the proposed multi-faceted approach

have on banking entities, their customers, and other market

participants? How can any burden be minimized or eliminated in a manner

consistent with the language and purpose of the statute?

Question 85. Are there particular asset classes that raise special

concerns in the context of market making-related activity that should

be considered in connection with the proposed market-making exemption?

If so, what asset class(es) and concern(s), and how should the concerns

be addressed in the proposed exemption?

Question 86. Are there other market making-related activities that

the rule text should more clearly permit? Why or why not?

ii. Required Criteria for Permitted Market Making-Related Activities

As part of the proposal’s multi-faceted approach to implementing

the exemption for permitted market making-related activities, Sec. —

–.4(b)(2) of the proposed rule specifies seven criteria that a banking

entity’s market making-related activities must meet in order to rely on

the exemption, each of which are described in detail below. These

criteria are designed to ensure that any banking entity relying on the

exemption is engaged in bona fide market making-related activities and

conducts those activities in a way that is not susceptible to abuse

through the taking of speculative, proprietary positions as a part of,

or mischaracterized as, market making-related activity.

First Criterion–Establishment of Internal Compliance Program

Section —-.4(b)(2)(i) of the proposed rule requires a banking

entity to establish a comprehensive compliance program to monitor and

control its market making-related activities. Subpart D of the proposed

rule further describes the appropriate elements of an effective

compliance program. This criterion is intended to ensure that any

banking entity relying on the market-making exemption has reasonably

designed written policies and procedures, internal controls, and

independent testing in place to support its compliance with the terms

of the exemption.

Second Criterion–Bona Fide Market Making

Section —-.4(b)(2)(ii) of the proposed rule articulates the core

element of the statutory exemption, which is that the activity must be

market making-related. In order to give effect to this requirement,

Sec. —-.4(b)(2)(ii) of the proposed rule requires the trading desk

or other organizational unit that purchases or sells a particular

covered financial position to hold itself out as being willing to buy

and sell, or otherwise enter into long and short positions in, the

covered financial position for its own account on a regular or

continuous basis. Notably, this criterion requires that a banking

entity relying on the exemption with respect to a particular

transaction must actually make a market in the covered financial

position involved; simply because a banking entity makes a market in

one type of covered financial position does not permit it to rely on

the market-making exemption for another type of covered

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financial position.152 Similarly, the particular trading desk or

other organizational unit of the banking entity that is relying on the

exemption for a particular type of covered financial position must also

be the trading desk or other organizational unit that is actually

making the market in that covered financial position; market making in

a particular covered financial position by one trading desk of a

banking entity does not permit another trading desk of the banking

entity to rely on the market-making exemption for that type of covered

financial position.

—————————————————————————

152 The CFTC notes that a market maker may often make a market

in one type of covered financial positions and hedge its activities

using different covered financial positions in which it does not

make a market. Such hedging transactions would meet the terms of the

market-making exemption if the hedging transaction met the

requirements of Sec. —-.4(b)(3) of the proposed rule.

—————————————————————————

As previously noted, the CFTC is adopting the entire text of the

Joint Rule as part of its proposed rule. Similarly, the CFTC is

proposing the same criteria and considerations to determine bona-fide

market making activities as was previously proposed in the Joint

Release. Both prior to and since the issuance of the Joint Release, the

CFTC and the SEC have been working toward the issuance of a joint final

rule to further define the terms “swap dealer” and “security-based

swap dealer” (the “Entities Definition Rulemaking”). The Commodity

Exchange Act defines the term “swap dealer” to include any person who

“(i) holds itself out as a dealer in swaps; (ii) makes a market in

swaps; (iii) regularly enters into swaps with counterparties as an

ordinary course of business for its own account; or (iv) engages in any

activity causing the person to be commonly known in the trade as a

dealer or market maker in swaps.” 153 The CFTC has received a number

of comments in the Entities Definition Rulemaking regarding the

criteria for determining whether a person is engaging in market making

activity for the purposes of determining whether a person is a swap

dealer. Accordingly, the CFTC anticipates that the final rule further

defining the term “swap dealer” will provide guidance on these

criteria as to market making. Therefore, following the issuance of the

Entities Definition Rulemaking, the CFTC also may consider the extent

to which “market making” for purposes of determining whether a person

is a swap dealer should be considered “bona fide market making” for

purposes of this Rule.

—————————————————————————

153 7 U.S.C. 1a(49). The Exchange Act includes a similar test

for a security-based swap dealer. 15 U.S.C. 78c(a)(71).

—————————————————————————

The language used in Sec. —-.4(b)(2)(ii) of the proposed rule to

describe bona fide market making-related activity is similar to the

definition of “market maker” under section 3(a)(38) of the Exchange

Act.154 The CFTC has proposed to use similar language because the

Exchange Act definition is generally well-understood by market

participants and is consistent with the scope of bona fide market

making-related activities in which banking entities typically engage.

—————————————————————————

154 Section 3(a)(38) of the Exchange Act defines “market

maker” as “any specialist permitted to act as a dealer, any dealer

acting in the capacity of block positioner, and any dealer who, with

respect to a security, holds himself out (by entering quotations in

an inter-dealer quotation communications system or otherwise) as

being willing to buy and sell such security for his own account on a

regular or continuous basis.” 15 U.S.C. 78c(a)(38).

—————————————————————————

In assessing whether a particular trading desk or other

organizational unit holds itself out as being willing to buy and sell,

or otherwise enter into long and short positions in, a covered

financial position for its own account on a regular or continuous basis

in liquid markets, the CFTC expects to take an approach similar to that

used by the SEC in the context of assessing whether a person is

engaging in bona fide market making. The precise nature of a market

maker’s activities often varies depending on the liquidity, trade size,

market infrastructure, trading volumes and frequency, and geographic

location of the market for any particular covered financial position.

In the context of relatively liquid positions, such as equity

securities or other exchange-traded instruments, a trading desk or

other organizational unit’s market making-related activity should

generally include:

Making continuous, two sided quotes and holding oneself

out as willing to buy and sell on a continuous basis;

A pattern of trading that includes both purchases and

sales in roughly comparable amounts to provide liquidity;

Making continuous quotations that are at or near the

market on both sides; and

Providing widely accessible and broadly disseminated

quotes.155

—————————————————————————

155 The CFTC notes that these indicia are generally consistent

with the indicia of bona fide market making in equity markets

articulated by the SEC for purposes of describing the exception to

the locate requirement of the SEC’s Regulation SHO for market makers

engaged in bona fide market-making activities. See Exchange Act

Release No. 58775 (October 14, 2008), 73 FR 61690, 61698-61699 (Oct.

17, 2008); see also 17 CFR 242.203(b)(2)(iii).

In less liquid markets, such as over-the-counter markets for debt and

equity securities or derivatives, the appropriate indicia of market

—————————————————————————

making-related activities will vary, but should generally include:

Holding oneself out as willing and available to provide

liquidity by providing quotes on a regular (but not necessarily

continuous) basis; 156

—————————————————————————

156 The frequency of such regular quotations will itself vary;

less illiquid markets may involve quotations on a daily or more

frequent basis, while highly illiquid markets may trade only by

appointment.

—————————————————————————

With respect to securities, regularly purchasing covered

financial positions from, or selling the positions to, clients,

customers, or counterparties in the secondary market; and

Transaction volumes and risk proportionate to historical

customer liquidity and investments needs.

The CFTC would apply these indicia when evaluating when a banking

entity is eligible for the market making-related activities exemption,

but also recognize that these indicia cannot be applied at all times

and under all circumstances because some may be inapplicable to the

specific asset class or market in which the market making activity is

conducted.

The bona fide market making-related activity described in Sec. —

–.4(b)(2)(ii) of the proposed rule would include block positioning if

undertaken by a trading desk or other organizational unit of a banking

entity for the purpose of intermediating customer trading.157 In

addition, bona fide market making-related activity may include taking

positions in securities in anticipation of customer demand, so long as

any

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anticipatory buying or selling activity is reasonable and related to

clear, demonstrable trading interest of clients, customers, or

counterparties.

—————————————————————————

157 The definition of “market maker” in the Exchange Act

includes a dealer acting in the capacity of a block positioner.

Although the term “block positioner” is not defined in the

proposed rule, the Agencies note that the SEC has adopted a

definition of “qualified block positioner” in the SEC’s Rule 3b-

8(c) (17 CFR 240.3b-8(c)), which may serve as guidance in

determining whether a block positioner engaged in block positioning

is engaged in bona fide market making-related activities for

purposes of Sec. —-.4(b)(2)(ii) of the proposed rule. Under the

SEC’s Rule 3b-8(c), among other things, a qualified block positioner

must meet all of the following conditions: (i) Engages in the

activity of purchasing long or selling short, from time to time,

from or to a customer (other than a partner or a joint venture or

other entity in which a partner, the dealer, or a person associated

with such dealer participates) a block of stock with a current

market value of $200,000 or more in a single transaction, or in

several transactions at approximately the same time, from a single

source to facilitate a sale or purchase by such customer; (ii) has

determined in the exercise of reasonable diligence that the block

could not be sold to or purchased from others on equivalent or

better terms; and (iii) sells the shares comprising the block as

rapidly as possible commensurate with the circumstances. The CFTC

notes that the rule establishes a minimum dollar value threshold for

a block. The size of a block will vary among different asset

classes.

—————————————————————————

Third Criterion–Reasonably Expected Near-Term Demands of Clients,

Customers, and Counterparties

Under Sec. —-.4(b)(2)(iii) of the proposed rule, the market

making-related activities of the trading desk or other organization

unit that conducts a transaction in reliance on the market-making

exemption must be designed not to exceed the reasonably expected near-

term demands of clients, customers, and counterparties. This criterion

implements the language in section 13(d)(1)(B) of the BHC Act and is

intended to prevent a trading desk relying on the market-making

exemption from taking a speculative proprietary position unrelated to

customer needs as part of its purported market making-related

activities. As described in further detail in Parts III.B.5 and III.D

of the SUPPLEMENTARY INFORMATION, the proposed rule also includes a

programmatic compliance requirement and requires reporting of

quantitative measurements for certain banking entities, both of which

are designed, in part, to meaningfully circumscribe the principal

positions taken as part of market making-related activities to those

which are necessary to meet the reasonably expected near-term demands

of clients, customers and counterparties. The CFTC expects that the

programmatic compliance requirement and required reporting of

quantitative measurements will play an important role in assessing a

banking entity’s compliance with Sec. —-.4(b)(2)(iii)’s requirement.

In addition, as described in Part II.B.5 of the Supplementary

Information, Appendix B of the proposed rule provides additional,

detailed commentary regarding how the CFTC expects a firm relying on

the market-making exemption to manage principal positions and how the

CFTC proposes to assess whether such positions are consistent with

market making-related activities under the proposed rule.

In order for a banking entity’s expectations regarding near-term

customer demand to be considered reasonable, such expectations should

be based on more than a simple expectation of future price appreciation

and the generic increase in marketplace demand that such price

appreciation reflects. Rather, a banking entity’s expectation should

generally be based on the unique customer base of the banking entity’s

specific market-making business lines and the near-term demands of

those customers based on particular factors beyond a general

expectation of price appreciation. To the extent that a trading desk or

other organizational unit of a banking entity is engaged wholly or

principally in trading that is not in response to, or driven by,

customer demands, the CFTC would not expect those activities to qualify

under Sec. —-.4(b) of the proposed rule, regardless of whether those

activities promote price transparency or liquidity. For example, a

trading desk or other organizational unit of a banking entity that is

engaged wholly or principally in arbitrage trading with non-customers

would not meet the terms of the proposed rule’s market making

exemption. In the case of a market maker engaging in market making in a

security that is executed on an organized trading facility or exchange,

that market maker’s activities are generally consistent with reasonably

expected near-term customer demand when such activities involve

passively providing liquidity by submitting resting orders that

interact with the orders of others in a non-directional or market-

neutral trading strategy and the market maker is registered, if the

exchange or organized trading facility registers market makers.158

However, activities by such a person that primarily takes liquidity on

an organized trading facility or exchange, rather than provides

liquidity, would not qualify for the market-making exemption under the

proposed rule, even if those activities were conducted by a registered

market maker.

—————————————————————————

158 The CFTC emphasizes that the status of being a registered

market maker is not, on its own, a sufficient basis for relying on

the exemption for market making-related activity contained in Sec.

—-.4(b); however, being a registered market maker is required

under these circumstances if the applicable exchange or organized

trading facility registers market makers. Registration as a market

maker generally involves filing a prescribed form with an exchange

or organized trading facility, in accordance with its rules and

procedures, and complying with the applicable requirements for

market makers set forth in the rules of that exchange or organized

trading facility. See, e.g., Nasdaq Rule 4612, New York Stock

Exchange Rule 104, CBOE Futures Exchange Rule 515, BATS Exchange

Rule 11.5.

—————————————————————————

Fourth Criterion–Registration Under Securities or Commodities Laws

Under Sec. —-.4(b)(2)(iv) of the proposed rule, a banking entity

relying on the market-making exemption with respect to trading in

securities or certain derivatives must be appropriately registered as a

dealer, or exempt from registration or excluded from regulation as a

dealer, under applicable securities or commodities laws. With respect

to a market-making transaction in one or more covered financial

positions that are securities, other than exempted securities,

security-based swaps, commercial paper, bankers acceptances or

commercial bills, for which a person must be a registered securities

dealer, municipal securities dealer or government securities dealer in

order to deal in the security, the banking entity must have the

appropriate dealer registration (or in the case of a financial

institution that is a government securities dealer, has filed notice of

that status as required by section 15C(a)(1)(B) of the Exchange Act) or

otherwise be exempt from registration or excluded from regulation as a

dealer.159 Similarly, with respect to a market-making transaction

involving a swap or security-based swap for which a person must

generally be a registered swap dealer or security-based swap dealer,

respectively, the banking entity must be appropriately registered or

otherwise be exempt from registration or excluded from regulation as a

swap dealer or security-based swap dealer.160 If the banking entity

is engaged in the business of a securities dealer, swap dealer or

security-based swap dealer outside the United States in a manner for

which no U.S. registration is required, the banking entity must be

subject to substantive regulation of its dealing business in the

jurisdiction in which the business is located. This requirement is

intended to ensure that

[[Page 8358]]

(i) any market making-related activity conducted in reliance on the

exemption is subject to appropriate regulation and (ii) a banking

entity does not simultaneously characterize the transaction as market

making-related for purposes of the exemption while characterizing it in

a different manner for purposes of applicable securities or commodities

laws.

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159 See proposed rule Sec. Sec. —-.4(b)(2)(iv)(A), (D),

(E). For example, if a banking entity is a bank engaged in market-

making in qualified Canadian government obligations for which it

would be required to register as a securities dealer but for the

exclusion contained in section 3(a)(5)(C)(i)(I) of the Exchange Act,

the proposed rule would not require that banking entity to be a

registered securities dealer in order to rely on the market-making

exemption for that market-making transaction. Such a bank would,

however, be required to file notice that it is a government

securities dealer and comply with rules applicable to financial

institutions that are government securities dealers. See 15 U.S.C.

78c(a)(42)(E); 15 U.S.C. 78o-5(a)(1)(B); 17 CFR 400.5(b); 17 CFR

449.1. Similar to the underwriting exemption, the proposed rule does

not apply the dealer registration requirement to market making in

securities that are exempted securities, commercial paper, bankers

acceptances or commercial bills because dealing in such securities

does not require registration as securities dealer under the

Exchange Act; however, registering as a municipal securities dealer

or government securities dealer is required, if applicable.

160 See proposed rule Sec. Sec. —-.4(b)(2)(iv)(B), (C). A

banking entity may be required to be a registered securities dealer

if it engages in market-making transactions involving security-based

swaps with persons that are not eligible contract participants. See

15 U.S.C. 78c(a)(5) (the definition of “dealer” in section 3(a)(5)

of the Exchange Act, 15 U.S.C. 78c(a)(5), generally includes “any

person engaged in the business of buying and selling securities (not

including security-based swaps, other than security-based swaps with

or for persons that are not eligible contract participants), for

such person’s own account.”).

—————————————————————————

Fifth Criterion–Revenues From Fees, Commissions, Bid/Ask Spreads or

Other Similar Income

Under Sec. —-.4(b)(2)(v) of the proposed rule, the market

making-related activities of the banking entity must be designed to

generate revenues primarily from fees, commissions, bid/ask spreads or

other income not attributable to appreciation in the value of covered

financial positions it holds in trading accounts or the hedging of such

positions. This criterion is intended to ensure that activities

conducted in reliance on the market-making exemption demonstrate

patterns of revenue generation and profitability consistent with, and

related to, the intermediation and liquidity services a market maker

provides to its customers, rather than changes in the market value of

the positions or risks held in inventory. Similar to the requirement

that a firm relying on the market-making exemption design its

activities not to exceed reasonably expected near-term client,

customer, or counterparty demands, the Agencies expect that the

programmatic compliance requirement and required reporting of

quantitative measurements will play an important role in assessing a

banking entity’s compliance with Sec. —-.4(b)(2)(v)’s requirement.

In addition, as described in Part III.B.5 of this SUPPLEMENTARY

INFORMATION, Appendix B of the proposed rule provides additional,

detailed commentary regarding how the CFTC proposes to assess whether

the types of revenues generated by a banking entity relying on the

market-making exemption are consistent with market making-related

activities.

Sixth Criterion–Compensation Incentives

Under Sec. —-.4(b)(2)(vii) of the proposed rule, the

compensation arrangements of persons performing market making-related

activities at the banking entity must be designed not to encourage or

reward proprietary risk-taking. Activities for which a banking entity

has established a compensation incentive structure that rewards

speculation in, and appreciation of, the market value of a covered

financial position held in inventory, rather than success in providing

effective and timely intermediation and liquidity services to

customers, are inconsistent with permitted market making-related

activities. Although a banking entity relying on the market-making

exemption may appropriately take into account revenues resulting from

movements in the price of principal positions to the extent that such

revenues reflect the effectiveness with which personnel have managed

principal risk retained, a banking entity relying on the market-making

exemption should provide compensation incentives that primarily reward

customer revenues and effective customer service, not proprietary risk-

taking. In addition, as described in Part III.B.5 of this Supplementary

Information, Appendix B of the proposed rule provides further

commentary regarding how the CFTC proposes to assess whether the

compensation incentives provided to trading personnel performing

trading activities in reliance on the market-making exemption are

consistent with market making-related activities.

Seventh Criterion–Consistency With Appendix B Commentary

Under Sec. —-.4(b)(2)(vi) of the proposed rule, the market

making-related activities of the trading desk or other organizational

unit that conducts the purchase or sale are required to be consistent

with the commentary provided in Appendix B, which provides guidance

that the CFTC proposes to apply to help distinguish permitted market

making-related activities from prohibited proprietary trading. Appendix

B’s proposed commentary, which is described in detail below in Part

III.B.5 of this Supplementary Information, discusses various factors by

which the CFTC proposes to distinguish prohibited proprietary trading

from permitted market making-related activities (e.g., how and to what

extent a market maker hedges the risk of its market-making

transactions, including (i) further detail related directly to other

criteria in Sec. —-.4(b)(2) (e.g., the types of revenues generated

by market makers), and (ii) expectations regarding other factors not

expressly included in Sec. —-.4(b)(2)).

ii. Market Making-Related Hedging

Section —-.4(b)(3) of the proposed rule provides that certain

hedging transactions related to market-making positions and holdings

will also be deemed to be made in connection with a banking entity’s

market making-related activities for purposes of the market-making

exemption. In particular, Sec. —-.4(b)(3) provides that the purchase

or sale of a covered financial position for hedging purposes will

qualify for the market-making exemption if it meets two requirements.

First, the purchase or sale must be conducted in order to reduce the

specific risks to the banking entity in connection with and related to

individual or aggregated positions, contracts, or other holdings

acquired pursuant to the market-making exemption. Where the purpose of

a transaction is to hedge a market making-related position, it would

appear to be market making-related activity of the type described in

section 13(d)(1)(B) of the BHC Act. Second, the hedging transaction

must also meet the criteria specified in the general exemption for

risk-mitigating hedging activity for purposes of the proprietary

trading prohibition, which is contained in Sec. Sec. —-.5(b) and (c)

of the proposed rule and described in detail in Part III.B.3 of this

Supplementary Information. Those criteria are intended to clearly

define the scope of appropriate risk-mitigating hedging activities, to

foreclose reliance on the exemption for prohibited proprietary trading

that is conducted in the context of, or mischaracterized as, hedging

activity, and to require documentation regarding the hedging purpose of

certain transactions that are established at a level of organization

that is different than the level of organization establishing or

responsible for the underlying risk or risks that are being hedged,

which in the context of the market making-related activity would

generally be the trading desk.

iii. Request for Comment

The CFTC requests comment on the proposed criteria that must be met

in order to rely on the market-making exemption. In particular, the

CFTC requests comment on the following questions (as well as related

questions in Part III.B.5 of this Supplementary Information):

Question 87. Are the seven criteria included in the market-making

exemption effective? Is the application of each criterion to potential

transactions sufficiently clear? Should any of the criteria be changed

or eliminated? Should other criteria be added?

Question 87.1. Should the proposed CFTC Rule’s market making

exemption include the requirements set forth in Sec. Sec. —

–.4(b)(2)(iv)(A),(C), (D) and (E), relating to SEC registered dealers

and dealers who have filed notice with the appropriate regulatory

agency? Please explain the rationale for including or excluding the

provision in the proposed CFTC Rule.

[[Page 8359]]

Question 88. Is incorporation of concepts from the definition of

“market maker” under the Exchange Act useful for purposes of section

13 of the BHC Act and consistent with its purposes? If not, what

alternative definition would be more useful or more consistent?

Question 88.1. Alternatively, to what extent should the CFTC

incorporate concepts regarding market making from the Entities

Definitions Rulemaking for purposes of section 13 of the BHC Act?

Question 89. Is the proposed exemption overly broad or narrow? For

example, would it encompass activity that should be considered

prohibited proprietary trading under the proposed rule? Alternatively,

would it prohibit forms of market making or market making-related

activities that are permitted under other rules or regulations?

Question 90. We seek commenter input on the types of banking

entities and forms of activities that would not qualify for the

proposed market-making exemption but that commenters consider to

otherwise be market making. Please discuss the impact of not permitting

such activities under the proposed exemption (e.g., the impact on

liquidity).

Question 91. Is the requirement that a trading desk or other

organizational unit relying on the market-making exemption hold itself

out as being willing to buy and sell, or otherwise enter into long and

short positions in, the relevant covered financial position for its own

account on a regular or continuous basis effective? If not, what

alternative would be more effective? Does the proposed requirement

appropriately differentiate between market making-related activities in

different markets and asset classes? If not, how could such differences

be better reflected? Should the requirement be modified to include

certain arbitrage trading activities engaged in by market makers that

promote liquidity or price transparency, but do not serve customer,

client or counterparty demands, within the scope of market making-

related activity? If so why? How could such liquidity- or price

transparency-promoting activities be meaningfully identified and

distinguished from prohibited proprietary trading practices that also

may incidentally promote liquidity or price transparency? Do particular

markets or instruments, such as the market for exchange-traded funds,

raise particular issues that are not adequately or appropriately

addressed in the proposal? If so, how could the proposal better address

those instruments, markets or market features?

Question 92. Do the proposed indicia of market making in liquid

markets accurately reflect the factors that should generally be used to

analyze whether a banking entity is engaged in market making-related

activities for purposes of section 13 of the BHC Act and the proposed

rule? If not, why not? Should any of the proposed factors be eliminated

or modified? Should any additional factors be included? Is reliance on

the SEC’s indicia of bona fide market making for purposes of Regulation

SHO under the Exchange Act and the equity securities market appropriate

in the context of section 13 of the BHC Act and the proposed rule with

respect to liquid markets? If not, why not?

Question 93. Do the proposed indicia of market making in illiquid

markets accurately reflect the factors that should generally be used to

analyze whether a banking entity is engaged in market making-related

activities for purposes of section 13 of the BHC Act and the proposed

rule? If not, why not? Should any of the proposed factors be eliminated

or modified? Should any additional factors be included?

Question 94. How accurately can a banking entity predict the near-

term demands of clients, customers, and counterparties? Are there

measures that can distinguish the amount of principal risk that should

be retained to support such near-term client, customer, or counterparty

demand from positions taken for speculative purposes? How is client,

customer, or counterparty demand anticipated in connection with market

making-related activities, and how does such approach vary by asset

class?

Question 95. Is the requirement that a banking entity relying on

the market-making exemption be registered as a dealer (or in the case

of a financial institution that is a government securities dealer, has

filed notice of that status as required by section 15C(a)(1)(B) of the

Exchange Act), or exempt from registration or excluded from regulation

as a dealer under relevant securities or commodities laws effective? If

not, how should the requirement be changed? Does the requirement

appropriately take into account the particular registration

requirements applicable to dealing in different types of financial

instruments? If not, how could it better do so? Does the requirement

appropriately take into account the various registration exemptions and

exclusions available to certain entities, such as banks, under the

securities and commodities laws? If not, how could it better do so?

Question 96. Is the requirement that a trading desk or other

organizational unit of a banking entity relying on the market-making

exemption be designed to generate revenues primarily from fees,

commissions, bid/ask spreads or similar income effective? If not, how

should the requirement be changed? Does the requirement appropriately

capture the type and nature of revenues typically generated by market

making-related activities? Is any further clarification or additional

guidance necessary? Can revenues primarily from fees, commissions, bid/

ask spreads or similar income be meaningfully separated from other

types of revenues?

Question 97. Is the requirement that the compensation arrangements

of persons performing market making-related activities at a banking

entity not be designed to encourage proprietary risk-taking effective?

If not, how should the requirement be changed? Are there other types of

compensation incentives that should be clearly referenced as

consistent, or inconsistent, with permitted market making-related

activity? Are their specific and identifiable characteristics of

compensation arrangements that clearly incentivize prohibited

proprietary trading?

Question 98. Is the inclusion of market making-related hedging

transactions within the market-making exemption effective and

appropriate? Are the proposed requirements that certain hedging

transactions must meet in order to be considered to have been made in

connection with market making-related activity effective and

sufficiently clear? If not, what alternative requirements would be more

effective and/or clearer? Should any of the proposed requirements be

eliminated? If so, which ones, and why?

Question 99. Should the terms “client,” “customer,” or

“counterparty” be defined for purposes of the market-making

exemption? If so, how should these terms be defined? For example, would

an appropriate definition of “customer” be: (i) A continuing

relationship in which the banking entity provides one or more financial

products or services prior to the time of the transaction; (ii) a

direct and substantive relationship between the banking entity and a

prospective customer prior to the transaction; (iii) a relationship

initiated by the banking entity to a prospective customer to induce

transactions; or (iv) a relationship initiated by the prospective

customer with a view to engaging in transactions?

Question 100. Are there other types of market making-related

activities that should also be included within the

[[Page 8360]]

scope of the market-making exemption? If so, what additional activities

and why? How would an exemption for such additional activities be

consistent with the language and intent of section 13 of the BHC Act?

What criteria, requirements, or restrictions would be appropriate to

include with respect to such additional activities? How would such

criteria, requirements, or restrictions prevent circumvention or

evasion of the prohibition on proprietary trading?

Question 101. Do banking entities currently have processes in place

that would prevent or reduce the likelihood of taking speculative,

proprietary positions in the context of, or mischaracterized as, market

making-related activities? If so, what processes?

3. Section —- .5: Permitted Risk-Mitigating Hedging Activities

Section —- .5 of the proposed rule permits a banking entity to

purchase or sell a covered financial position if the transaction is

made in connection with, and related to, individual or aggregated

positions, contracts, or other holdings of a banking entity and is

designed to reduce the specific risks to the banking entity in

connection with and related to such positions, contracts, or other

holdings (the “hedging exemption”). This section of the proposed rule

implements, in relevant part, section 13(d)(1)(C) of the BHC Act, which

provides an exemption from the prohibition on proprietary trading for

certain risk-mitigating hedging activities.

a. Approach To Implementing the Hedging Exemption

Like market making-related activities, risk-mitigating hedging

activities present certain implementation challenges because of the

potential that prohibited proprietary trading could be conducted in the

context of, or mischaracterized as, a hedging transaction. This is

because it may often be difficult to identify in retrospect whether a

banking entity engaged in a particular transaction to manage or

eliminate risks arising from related positions, on the one hand, or to

profit from price movements related to the hedge position itself, on

the other. The intent with which a purported hedge position is acquired

may often be difficult to discern in practice.

In light of these complexities, the CFTC has again proposed a

multi-faceted approach to implementation. As with the underwriting and

market-making exemptions, the CFTC has proposed a set of criteria that

must be met in order for a banking entity to rely on the hedging

exemption. The proposed criteria are intended to define the scope of

permitted risk-mitigating hedging activities and to foreclose reliance

on the exemption for prohibited proprietary trading that is conducted

in the context of, or mischaracterized as, permitted hedging activity.

This includes implementation of the programmatic compliance regime

required under subpart D of the proposed rule and, in particular,

requires that a banking entity with significant trading activities

implement robust, detailed hedging policies and procedures and related

internal controls that are designed to prevent prohibited proprietary

trading in the context of permitted hedging activity.161 In

particular, a banking entity’s compliance regime must include written

hedging policies at the trading unit level and clearly articulated

trader mandates for each trader to ensure that the decision of when and

how to put on a hedge is consistent with such policies and mandates,

and not fully left to a trader’s discretion.162 In addition, to

address potential supervisory concerns raised by certain types of

hedging transactions, Sec. —- .5 of the proposed rule also requires

a banking entity to document certain hedging transactions at the time

the hedge is established. This multi-faceted approach is intended to

articulate the CFTC’s expectations regarding the scope of permitted

risk-mitigating hedging activities in a manner that limits potential

abuse of the hedging exemption while not unduly constraining the

important risk management function that is served by a banking entity’s

hedging activities.

—————————————————————————

161 These aspects of the compliance program requirement are

described in further detail in Part III.D of this Supplementary

Information.

162 See, e.g., proposed rule Appendix C.II.a.

—————————————————————————

b. Required Criteria for Permitted Risk-Mitigating Hedging Activities

Section —- .5(b) of the proposed rule describes the seven

criteria that a banking entity must meet in order to rely on the

hedging exemption. First, Sec. —- .5(b)(1) of the proposed rule

requires the banking entity to have established an internal compliance

program, consistent with the requirements of subpart D, that is

designed to ensure the banking entity’s compliance with the

requirements of this paragraph, including reasonably-designed written

policies and procedures, internal controls, and independent testing.

This criterion is intended to ensure that any banking entity relying on

the exemption has appropriate internal control processes in place to

support its compliance with the terms of the exemption.

Second, Sec. —- .5(b)(2)(i) of the proposed rule requires that a

transaction for which a banking entity is relying on the hedging

exemption have been made in accordance with written policies,

procedures and internal controls established by the banking entity

pursuant to subpart D. This criterion would preclude reliance on the

hedging exemption if the transaction was inconsistent with a banking

entity’s own hedging policies and procedures, as such inconsistency

would appear to be indicative of prohibited proprietary trading.

Third, Sec. —- .5(b)(2)(ii) of the proposed rule requires that

the transaction hedge or otherwise mitigate one or more specific risks,

including market risk, counterparty or other credit risk, currency or

foreign exchange risk, interest rate risk, basis risk, or similar

risks, arising in connection with and related to individual or

aggregated positions, contracts, or other holdings of a banking entity.

This criterion implements the essential element of the hedging

exemption–i.e., that the transaction be risk-mitigating. Notably, and

consistent with the statutory reference to mitigating risks of

individual or aggregated positions, this criterion would include the

hedging of risks on a portfolio basis. For example, it would include

the hedging of one or more specific risks arising from a portfolio of

diverse holdings, such as the hedging of the aggregate risk of one or

more trading desks. However, in each case, the CFTC would expect that

the transaction or series of transactions being used to hedge is, in

the aggregate, demonstrably risk-reducing with respect to the

positions, contracts, or other holdings that are being hedged. A

banking entity relying on the exemption should be prepared to identify

the specific position or portfolio of positions that is being hedged

and demonstrate that the hedging transaction is risk-reducing in the

aggregate, as measured by appropriate risk management tools.

In addition, this criterion would include a series of hedging

transactions designed to hedge movements in the price of a portfolio of

positions. For example, a banking entity may need to engage in dynamic

hedging, which involves rebalancing its current hedge position(s) based

on a change in the portfolio resulting from permissible activities or

from a change in the price, or other characteristic, of the individual

or aggregated positions, contracts, or other holdings. The CFTC

recognizes that, in such dynamic hedging, material

[[Page 8361]]

changes in risk may require a corresponding modification to the banking

entity’s current hedge positions.163

—————————————————————————

163 This corresponding modification to the hedge should also

be reasonably correlated to the material changes in risk that are

intended to be hedged or otherwise mitigated, as required by

proposed rule Sec. —-.5(b)(2)(iii).

—————————————————————————

The CFTC also expects that a banking entity relying on the

exemption would be able to demonstrate that the banking entity is

already exposed to the specific risks being hedged; generally, the

purported hedging of risks to which the banking entity is not actually

exposed would not meet the terms of the exemption. However, the hedging

exemption would be available in certain cases where the hedge is

established slightly before the banking entity becomes exposed to the

underlying risk if such anticipatory hedging activity: (i) Is

consistent with appropriate risk management practices; (ii) otherwise

meets the terms of the hedging exemption; and (iii) does not involve

the potential for speculative profit. For example, if a banking entity

was contractually obligated, or otherwise highly likely, to become

exposed to a particular risk and there was a sound risk management

rationale for hedging that risk slightly in advance of actual exposure,

the hedging transaction would generally be consistent with the

requirement described in Sec. —-.5(b)(2)(ii) of the proposed rule.

Fourth, Sec. —-.5(b)(2)(iii) of the proposed rule requires that

the transaction be reasonably correlated, based upon the facts and

circumstances of the underlying and hedging positions and the risks and

liquidity of those positions, to the risk or risks the transaction is

intended to hedge or otherwise mitigate. A transaction that is only

tangentially related to the risks that it purportedly mitigates would

appear to be indicative of prohibited proprietary trading. Importantly,

the CFTC has not proposed that a transaction relying on the hedging

exemption be fully correlated; instead, only reasonable correlation is

required.164 The degree of correlation that may be reasonable will

vary depending on the underlying risks and the availability of

alternative hedging options–risks that can be easily and cost-

effectively hedged with extremely high or near-perfect correlation

would typically be expected to be so hedged, whereas other risks may be

difficult or impossible to hedge with anything greater than partial

correlation. Moreover, it is important to consider the fact that

trading positions are often subject to a number of different risks, and

some risks may be hedged easily and at low cost but may only account

for a small proportion of the total risk in the position.165 More

generally, potential correlation levels between asset classes can

differ significantly, and analysis of the reasonableness of correlation

would depend on the facts and circumstances of the initial position(s),

risk(s) created, liquidity of the instrument, and the legitimacy of the

hedge. Regardless of the precise degree of correlation, if the

predicted performance of a hedge position during the period that the

hedge position and the related position are held would result in a

banking entity earning appreciably more profits on the hedge position

than it stood to lose on the related position, the hedge would appear

likely to be a proprietary trade designed to result in profit rather

than an exempt hedge position.

—————————————————————————

164 Although certain accounting standards, such as FASB ASC

Topic 815 hedge accounting, address circumstances in which a

transaction may be considered a hedge of another transaction, the

proposed rule does not refer to or rely on these accounting

standards, because such standards (i) are designed for financial

statement purposes, not to identify proprietary trading and (ii)

change often and are likely to change in the future without

consideration of the potential impact on section 13 of the BHC Act.

165 Interest rate risk in an equity derivative transaction is

one example–the hedging of interest rate risk in an equity

derivative position may only result in a small reduction in overall

risk and interest rates may only exhibit a small correlation with

the value of the equity derivative, but the lack of perfect or

significant correlation would not impair reliance on the hedging

exemption.

—————————————————————————

Fifth, Sec. —-.5(b)(2)(iv) of the proposed rule requires that

the hedging transaction not give rise, at the inception of the hedge,

to significant exposures that are not themselves hedged in a

contemporaneous transaction. A transaction that creates significant new

risk exposure that is not itself hedged at the same time would appear

to be indicative of prohibited proprietary trading. For example, over-

hedging, correlation trading, or pairs trading strategies that generate

profits through speculative, proprietary risk-taking would fail to meet

this criterion. Similarly, a transaction involving a pair of positions

that hedge each other with respect to one type of risk exposure, but

create or contain a residual risk exposure would, taken together,

constitute prohibited proprietary trading and not risk-mitigating

hedging if those positions were taken collectively for the purpose of

profiting from short-term movements in the effective price of the

residual risk exposure. However, the proposal also recognizes that any

hedging transaction will inevitably give rise to certain types of new

risk, such as counterparty credit risk or basis risk reflecting the

differences between the hedge position and the related position; the

proposed criterion only prohibits the introduction of additional

significant exposures through the hedging transaction. In addition,

proposed Sec. —-.5(b)(2)(iv) only requires that no new and

significant exposures be introduced at the inception of the hedge, and

not during the entire period that the hedge is maintained, reflecting

the fact that new, unanticipated risks can and sometimes do arise out

of hedging positions after the hedge is established. The CFTC has

proposed to address the appropriate management of risks that arise out

of a hedge position after inception through Sec. —-.5(b)(2)(v) of

the proposed rule.

Sixth, Sec. —-.5(b)(2)(v) of the proposed rule requires that any

transaction conducted in reliance on the hedging exemption be subject

to continuing review, monitoring and management after the hedge

position is established. Such review, monitoring, and management must:

(i) be consistent with the banking entity’s written hedging policies

and procedures; (ii) maintain a reasonable level of correlation, based

upon the facts and circumstances of the underlying and hedging

positions and the risks and liquidity of those positions, to the risk

or risks the purchase or sale is intended to hedge or otherwise

mitigate; and (iii) mitigate any significant exposure arising out of

the hedge after inception. In accordance with a banking entity’s

written internal hedging policies, procedures, and internal controls, a

banking entity should actively review and manage its hedging positions

and the risks that may arise out of those positions over time. A

banking entity’s internal hedging policies should be designed to ensure

that hedges remain effective as correlations or other factors change.

In particular, a risk-mitigating hedge position typically should be

unwound as exposure to the underlying risk is reduced or increased as

underlying risk increases, as selective hedging activity would appear

to be indicative of prohibited proprietary trading.166 A banking

entity’s written internal hedging policies, procedures, and internal

controls for monitoring and managing its hedges also should be

reasonably designed to prevent the occurrence of such prohibited

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proprietary trading activity and be reasonably specific about the level

of hedging that is expected to be maintained regardless of

opportunities for profit associated with over- or under-hedging.

—————————————————————————

166 The CFTC notes that in some cases, it may be appropriate

for a banking entity to unwind a hedge, even if the underlying risk

remains, if the cost of that hedge become uneconomic, better hedging

options become available, or the overall risk profile of the banking

entity has changed such that no longer hedging the risk is

consistent with appropriate risk management practices.

—————————————————————————

Seventh, Sec. —-.5(b)(2)(vi) of the proposed rule requires that

the compensation arrangements of persons performing the risk-mitigating

hedging activities are designed not to reward proprietary risk-taking.

Hedging activities for which a banking entity has established a

compensation incentive structure that rewards speculation in, and

appreciation of, the market value of a covered financial position,

rather than success in reducing risk, are inconsistent with permitted

risk-mitigating hedging activities.

c. Documentation Requirement

Section —-.5(c) of the proposed rule imposes a documentation

requirement on certain types of hedging transactions. Specifically, for

any transaction that a banking entity conducts in reliance on the

hedging exemption that involves a hedge established at a level of

organization that is different than the level of organization

establishing the positions, contracts, or other holdings the risks of

which the hedging transaction is designed to reduce, the banking entity

must, at a minimum, document the risk-mitigating purpose of the

transaction and identify the risks of the individual or aggregated

positions, contracts, or other holdings of a banking entity that the

transaction is designed to reduce.167 Such documentation must be

established at the time the hedging transaction is effected, not after

the fact. The CFTC is concerned that hedging transactions established

at a different level of organization than the positions being hedged

may present or reflect heightened potential for prohibited proprietary

trading, as a banking entity may be able, after the fact, to point to a

particular, offsetting exposure within its organization after a

position is established and characterize that position as a hedge even

when, at the time the position was established, it was intended to

generate speculative proprietary gains, not mitigate risk. To address

this concern, the CFTC has proposed to require a banking entity, when

establishing a hedge at a different level of organization than that

establishing or responsible for the underlying positions or risks being

hedged, to document the hedging purpose of the transaction and risks

being hedged so as to establish a contemporaneous, documentary record

that will assist the CFTC in assessing the actual reasons for which the

position was established.

—————————————————————————

167 For example, a hedge would be established at a different

level of organization of the banking entity if multiple market

making desks were exposed to similar risks and, to hedge such risks,

a portfolio hedge was established at the direction of a supervisor

or risk manager responsible for more than one desk rather than at

each of the market making desks that established the initial

positions, contracts, or other holdings.

—————————————————————————

d. Request for Comment

The CFTC requests comment on the proposed implementation of the

risk-mitigating hedging exemption with respect to proprietary trading.

In particular, the CFTC requests comment on the following questions:

Question 102. Is the proposed rule’s approach to implementing the

hedging exemption effective? If not, what alternative approach would be

more effective?

Question 103. Does the proposed multi-faceted approach

appropriately take into account and address the challenges associated

with differentiating prohibited proprietary trading from permitted

hedging activities? Should the approach include other elements? If so,

what elements and why? Should any of the proposed elements be revised

or eliminated? If so, why and how?

Question 104. Does the proposed approach to implementing the

hedging exemption provide banking entities and market participants with

sufficient clarity regarding what constitutes permitted hedging

activities? If not, how could greater clarity be provided?

Question 105. What impact will the proposed approach to

implementing the hedging exemption have on the hedging and risk

management activities of a banking entity and the services it provides

to its clients? If any of these impacts are positive, how can they be

amplified? If any of these impacts are negative, how can they be

mitigated?

Question 106. What burden will the proposed approach to

implementing the hedging exemption have on banking entities? How can

any burden be minimized or eliminated in a manner consistent with the

language and purpose of the statute?

Question 107. Are the criteria included in the hedging exemption

effective? Is the application of each criterion to potential

transactions sufficiently clear? Should any of the criteria be changed

or eliminated? Should other requirements be added?

Question 108. Is the requirement that a transaction hedge or

otherwise mitigate one or more specific risks, including market risk,

counterparty or other credit risk, currency or foreign exchange risk,

interest rate risk, basis risk, or similar risks, arising in connection

with and related to individual or aggregated positions, contracts, or

other holdings of a banking entity effective? If not, what requirement

would be more effective? Does the proposed approach sufficiently

articulate the types of risks that a banking entity typically hedges?

Does the proposal sufficiently address application of the hedging

exemption to portfolio hedging strategies? If not, how should the

proposal be changed?

Question 109. Does the manner in which section —-.5 of the

proposal implements the risk-mitigating hedging exemption effectively

address transactions that hedge or otherwise mitigate specific risks

arising in connection with and related to aggregated positions,

contracts, or other holdings of a banking entity? Do certain hedging

strategies or techniques that involve hedging the risks of aggregated

positions (e.g., portfolio hedging) (i) create the potential for abuse

of the hedging exemption or (ii) give rise to challenges in determining

whether a banking entity is engaged in exempt, risk-mitigating hedging

activity or prohibited proprietary trading? If so, what hedging

strategies and techniques, and how? Should additional restrictions,

conditions, or requirements be placed on the use of the hedging

exemption with respect to aggregated positions so as to limit potential

abuse of the exemption, assist banking entities and the CFTC in

determining compliance with the exemption, or otherwise improve the

effectiveness of the rule? If so, what additional restrictions,

conditions, or requirements, and why?

Question 110. Is the requirement that the transaction be reasonably

correlated to the risk or risks the transaction is intended to hedge or

otherwise mitigate effective? If not, how should the requirement be

changed? Should some specific level of correlation and/or hedge

effectiveness be required? Should the proposal specify in greater

detail how correlation should be measured? Should the proposal require

hedges to be effective in periods of financial stress? Does the

proposal sufficiently reflect differences in levels of correlation

among asset classes? If not, how could it better do so?

Question 111. Is the requirement that the transaction not give

rise, at the inception of the hedge, to significant exposures that are

not themselves hedged in a contemporaneous transaction effective? Does

the requirement establish an appropriate range for legitimate hedging

while

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constraining impermissible proprietary trading? Is this requirement

sufficiently clear? If not, what alternative would be more effective

and/or clearer? Are there types of risk-mitigating hedging activities

that may give rise to new and significant exposures that should be

permitted under the hedging exemption? If so, what activities? Should

the requirement that no significant exposure be introduced be extended

for the duration of the hedging position? If so, why?

Question 112. Is the requirement that any transaction conducted in

reliance on the hedging exemption be subject to continuing review,

monitoring and management after the transaction is established

effective? If not, what alternative would be more effective?

Question 113. Is the requirement that the compensation arrangements

of persons performing risk-mitigating hedging activities at a banking

entity be designed not to reward proprietary risk-taking effective? If

not, how should the requirement be changed? Are there other types of

compensation incentives that should be clearly referenced as

consistent, or inconsistent, with permitted risk-mitigating hedging

activity? Are there specific and identifiable characteristics of

compensation arrangements that clearly incentivize prohibited

proprietary trading?

Question 114. Is the proposed documentation requirement effective?

If not, what alternative would be more effective? Are there certain

additional types of hedging transactions that should be subject to the

documentation requirement? If so, what transactions and why? Should all

types of hedging transactions be subject to the documentation

requirement? If so, why? Should banking entities be required to

document more aspects of a particular transaction (e.g., all of the

criteria applicable to Sec. —-.5(b) of the proposed rule)? If so,

what aspects and why? What burden would the proposed documentation

requirement place on banking entities? How might such burden be reduced

or eliminated in a manner consistent with the language and purpose of

the statute?

Question 115. Aside from the required documentation, do the

substantive requirements of the proposed risk-mitigating hedging

exemption suggest that additional documentation would be required to

achieve compliance with the proposed rule? If so, what burden would

this additional documentation requirement place on banking entities?

How might such burden be reduced or eliminated in a manner consistent

with the language and purpose of the statute?

4. Section –.6: Other Permitted Trading Activities

Section —-.6 of the proposed rule permits a banking entity to

engage in certain other trading activities described in section

13(d)(1) of the BHC Act. These permitted activities include trading in

certain government obligations, trading on behalf of customers, trading

by insurance companies, and trading outside of the United States by

certain foreign banking entities. Section —-.6 of the proposed rule

does not contain all of the statutory exemptions contained in section

13(d)(1) of the BHC Act. Several of these exemptions appear, either by

plain language or by implication, to be intended to apply only to

covered fund activities and investments, and so the CFTC has not

proposed to include them in the proposed rule’s proprietary trading

provisions.168 Those exemptions are referenced in other portions of

the proposed rule pertaining to covered funds.

—————————————————————————

168 In particular, the proposed rule does not apply (i) the

exemption in section 13(d)(1)(E) of the BHC Act for SBICs and

certain public welfare or qualified rehabilitation investments, or

(ii) the exemptions in sections 13(d)(1)(G) and 13(d)(1)(I) of the

BHC Act for certain covered funds activities and investments, to the

proprietary trading provisions of subpart B.

—————————————————————————

The CFTC requests comment on the proposed rule’s approach to

implementing the exemptions contained in section 13(d)(1) of the BHC

Act to the proposed rule’s proprietary trading provisions. In

particular, the CFTC requests comment on the following questions:

Question 116. Is the proposed rule’s approach of identifying which

of the statutory exemptions contained in section 13(d)(1) of the BHC

Act apply to the proposed rule’s proprietary trading provisions

effective and/or consistent with the language and purpose of the

statute? If not, what alternative would be more effective and/or

consistent with the language and purpose of the statute?

Question 117. Are there statutory exemptions that should apply to

the proposed rule’s proprietary trading provisions that were not

included? If so, what exemptions and why?

Question 118. Are there statutory exemptions that were included in

the proposed rule’s proprietary trading provisions that should not have

been included? If so, what exemptions and why?

a. Permitted Trading in Government Obligations

Section —-.6(a) of the proposed rule, which implements section

13(d)(1)(A) of the BHC Act,169 permits the purchase or sale of a

covered financial position that is: (i) an obligation of the United

States or any agency thereof;170 (ii) an obligation, participation,

or other instrument of or issued by the Government National Mortgage

Association, the Federal National Mortgage Association, the Federal

Home Loan Mortgage Corporation, a Federal Home Loan Bank, the Federal

Agricultural Mortgage Corporation or a Farm Credit System institution

chartered under and subject to the provisions of the Farm Credit Act of

1971 (12 U.S.C. 2001 et seq.); or (iii) an obligation issued by any

State or any political subdivision thereof.171 The proposed rule also

clarifies that these obligations include limited as well as general

obligations of the relevant government entity. The CFTC notes that,

consistent with the statutory language, the types of instruments

described with respect to the enumerated government-sponsored entities

include not only obligations of such entities, but also participations

and other instruments of or issued by such entity. This would include,

for example, pass-through or participation certificates that are issued

and guaranteed by one of these government-sponsored entities (e.g., the

Federal National Mortgage Association and the Federal Home Loan

Mortgage Corporation) in connection with their securitization

activities.

—————————————————————————

169 Section 13(d)(1)(A) of the BHC Act permits a banking

entity to purchase, sell, acquire or dispose securities and other

instruments described in section 13(h)(4) of the BHC Act if those

securities or other instruments are specified types of government

obligations, notwithstanding the prohibition on proprietary trading.

See 12 U.S.C. 1851(d)(1)(A).

170 The CFTC proposes that United States “agencies” for this

purpose will include those agencies described in section 201.108(b)

of the Board’s Regulation A. See 12 CFR 201.108(b). The CFTC also

notes that the terms of the exemption would encompass the purchase

or sale of enumerated government obligations on a forward basis

(e.g., in a to-be-announced market).

171 Consistent with the statutory language, the proposed rule

does not extend the government obligations exemption to transactions

in obligations of an agency of any State or political subdivision

thereof.

—————————————————————————

The CFTC requests comment on the proposed rule’s approach to

implementing the government obligation exemption. In particular, the

CFTC requests comment on the following questions:

Question 119. Is the proposed rule’s application to trading in

government obligations sufficiently clear? Should such obligations

expressly include, for example, instruments issued by third parties but

insured or guaranteed by an enumerated government entity or

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otherwise backed by its full faith and credit?

Question 120. Should the CFTC adopt an additional exemption for

proprietary trading in State or municipal agency obligations under

section 13(d)(1)(J) of the BHC Act? If so, how would such an exemption

promote and protect the safety and soundness of banking entities and

the financial stability of the United States?

Question 121. Should the CFTC adopt an additional exemption for

proprietary trading in options or other derivatives referencing an

enumerated government obligation under section 13(d)(1)(J) of the BHC

Act? For example, should the CFTC provide an exemption for options or

other derivatives with respect to U.S. government debt obligations? If

so, how would such an exemption promote and protect the safety and

soundness of banking entities and the financial stability of the United

States?

Question 122. Should the CFTC adopt an additional exemption for

proprietary trading in the obligations of foreign governments and/or

international and multinational development banks under section

13(d)(1)(J) of the BHC Act? If so, what types of obligations should be

exempt? How would such an exemption promote and protect the safety and

soundness of banking entities and the financial stability of the United

States?

Question 123. Should the CFTC adopt an additional exemption for

proprietary trading in any other type of government obligations under

section 13(d)(1)(J) of the BHC Act? If so, how would such an exemption

promote and protect the safety and soundness of banking entities and

the financial stability of the United States?

Question 124. Are the definitions of “government security” and

“municipal security” in sections 3(a)(42) and 3(a)(29) of the

Exchange Act helpful in determining the proper scope of this exemption?

If so, please explain their utility and how incorporating such

definitions into the exemption would be consistent with the language

and purpose of section 13 of the BHC Act.

b. Permitted Trading on Behalf of Customers

Section 13(d)(1)(D) of the BHC Act permits a banking entity to

purchase or sell a covered financial position on behalf of customers,

notwithstanding the prohibition on proprietary trading. Section —

–.6(b) of the proposed rule implements this section. Because the

statute does not specifically define when a transaction would be

conducted “on behalf of customers,” the proposed rule identifies

three categories of transactions that, while they may involve a banking

entity acting as principal for certain purposes, appear to be on behalf

of customers within the purpose and meaning of the statute. As

proposed, only transactions meeting the terms of these three categories

would be considered on behalf of customers for purposes of the

exemption.

Section —-.6(b)(i) of the proposed rule provides that a purchase

or sale of a covered financial position is on behalf of customers if

the transaction (i) is conducted by a banking entity acting as

investment adviser, commodity trading advisor, trustee, or in a similar

fiduciary capacity for a customer and for the account of that customer,

and (ii) involves solely covered financial positions of which the

banking entity’s customer, and not the banking entity or any subsidiary

or affiliate of the banking entity, is beneficial owner (including as a

result of having long or short exposure under the relevant covered

financial position). This category is intended to capture a wide range

of trading activity conducted in the context of customer-driven

investment or commodity advisory, trust, or fiduciary services, so long

as that activity is structured in a way that the customer, and not the

banking entity providing those services, benefits from any gains and

suffers from any losses on such covered financial positions.172 A

transaction that is structured so as to involve a listed form of

relationship but nonetheless allows gains or losses from trading

activity to inure to the benefit or detriment of the banking entity

would fall outside the scope of this category.

—————————————————————————

172 For example, in the case of a banking entity acting as

investment adviser to a registered mutual fund, any trading by the

banking entity in its capacity of investment adviser and on behalf

of that fund would be permitted pursuant to Sec. —-.6(b)(i) of

the proposed rule, so long as the relevant criteria were met.

—————————————————————————

Section —-.6(b)(ii) of the proposed rule provides that a

transaction is on behalf of customers if the banking entity is acting

as riskless principal. These type of transactions are similarly

customer-driven and do not expose the banking entity to gains or losses

on the value of the traded positions, notwithstanding the fact that the

banking entity technically acts as principal. The CFTC notes that the

proposed language describing riskless principal transactions generally

mirrors that used in the Board’s Regulation Y, OCC interpretive

letters, and the SEC’s Rule 3a5-1 under the Exchange Act.173

—————————————————————————

173 See 12 CFR 225.28(b)(7)(ii); 17 CFR 240.3a5-1(b); OCC

Interpretive Letter 626 (July 7, 1993).

—————————————————————————

Section —-.6(b)(iii) of the proposed rule addresses trading for

the separate account of insurance policyholders by a banking entity

that is an insurance company. In particular, this part of the proposed

rule provides that a purchase or sale of a covered financial position

is on behalf of customers if:

The banking entity is an insurance company engaging in the

transaction for a separate account;

The banking entity is directly engaged in the business of

insurance and subject to regulation by a State insurance regulator or

foreign insurance regulator;174

—————————————————————————

174 The proposed rule provides definitions of the terms

“State insurance regulator” and “foreign insurance regulator.”

See proposed rule Sec. Sec. —-.3(c)(4), (13).

—————————————————————————

The banking entity purchases or sells the covered

financial position solely for a separate account established by the

insurance company in connection with one or more insurance policies

issued by that insurance company;

All profits and losses arising from the purchase or sale

of the covered financial position are allocated to the separate account

and inure to the benefit or detriment of the owners of the insurance

policies supported by the separate account, and not the banking entity;

and

The purchase or sale is conducted in compliance with, and

subject to, the insurance company investment and other laws,

regulations, and written guidance of the State or jurisdiction in which

such insurance company is domiciled.

This category is included within the exemption for transactions on

behalf of customers because such insurance-related transactions are

generally customer-driven and do not expose the banking entity to gains

or losses on the value of separate account assets, even though the

banking entity may be treated as the owner of those assets for certain

purposes. However, to limit the potential for abuse of the exemption,

the proposed rule also includes related requirements designed to ensure

that the separate account trading activity is subject to appropriate

regulation and supervision under insurance laws and not structured so

as to allow gains or losses from trading activity to inure to the

benefit or detriment of the banking entity.175 The proposed rule

defines a “separate account” as an account established or maintained

by a regulated insurance company subject to regulation by a State

insurance regulator or foreign insurance regulator under which

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income, gains, and losses, whether or not realized, from assets

allocated to such account, are, in accordance with the applicable

contract, credited to or charged against such account without regard to

other income, gains, or losses of the insurance company.176

—————————————————————————

175 The CFTC would not consider profits to inure to the

benefit of the banking entity if the banking entity were solely to

receive payment, out of separate account profits, of fees unrelated

to the investment performance of the separate account.

176 See proposed rule Sec. —-.2(z).

—————————————————————————

The CFTC requests comment on the proposed rule’s approach to

implementing the exemption for trading on behalf of customers. In

particular, the CFTC requests comment on the following questions:

Question 125. Is the proposed rule’s articulation of three

categories of transactions on behalf of customers effective and

sufficiently clear? If not, what alternative would be more effective

and/or clearer? Should any of the categories be eliminated? Should any

additional categories be added? Please explain.

Question 126. Is the proposed rule’s exemption of certain

investment adviser, commodity trading advisor, trustee or similar

fiduciary transactions effective? What other types of relationships are

or should be captured by the proposed rule’s reference to “similar

fiduciary relationships,” and why? Is application of this part of the

exemption to particular transactions sufficiently clear? Should any

other specific types of fiduciary or other relationships be specified

in the rule? If so, what types and why? What impact will the proposed

rule’s implementation of the exemption have on the investment adviser,

commodity trading advisor, trustee or similar fiduciary activities of

banking entities? If such impacts are negative, how could they be

mitigated or eliminated in a manner consistent with the purpose and

language of the statute?

Question 127. Is the proposed rule’s exemption of riskless

principal transactions effective? If not, what alternative would be

more appropriate? Is the description of qualifying riskless principal

activity sufficiently clear? If not, how should it be clarified? Should

the riskless principal transaction exemption include a requirement that

the banking entity must purchase (or sell) the covered financial

position as principal at the same price to satisfy the customer buy (or

sell) order, exclusive of any explicitly disclosed markup or markdown,

commission equivalent, or other fee? Why or why not? Should the

riskless principal exemption include a requirement with respect to the

timeframe in which the principal transaction must be allocated to a

riskless principal or customer account? Why or why not?

Question 128. Is the proposed rule’s exemption of trading for

separate accounts by insurance companies effective? If not, what

alternative would be more appropriate? Does the proposed exemption

sufficiently address the variety of customer-driven separate account

structures typically used? If not, how should it address such

structures? Does the proposed exemption sufficiently address the

variety of regulatory or supervisory regimes to which insurance

companies may be subject?

Question 129. What impact will the proposed rule’s implementation

of the exemption have on the insurance activities of insurance

companies affiliated with banking entities? If such impacts are

negative, how could they be mitigated or eliminated in a manner

consistent with the purpose and language of the statute?

Question 130. Should the term “customer” be defined for purposes

of the exemption for transactions on behalf of customers? If so, how

should it be defined? For example, would an appropriate definition be

(i) a continuing relationship in which the banking entity provides one

or more financial products or services prior to the time of the

transaction, (ii) a direct and substantive relationship between the

banking entity and a prospective customer prior to the transaction, or

(iii) a relationship initiated by the banking entity to a prospective

customer for purposes of the transaction?

Question 131. Is the exemption for trading on behalf of customers

in the proposed rule over- or under-inclusive? If it is under-

inclusive, please discuss any additional activities that should qualify

as trading on behalf of customers under the rule. What are the

mechanics of the particular trading activity and how does it qualify as

being on behalf of customers? Are there certain requirements or

restrictions that should be placed on the activity, if permitted by the

rule, to prevent evasion of the prohibition on proprietary trading? How

would permitting the activity be consistent with the purpose and

language of section 13 of the BHC Act? If the proposed exemption is

over-inclusive, please explain what aspect of the proposed exemption

does not involve trading on behalf of customers within the language and

purpose of the statute.

c. Permitted Trading by a Regulated Insurance Company

Section —-.6(c) of the proposed rule implements section

13(d)(1)(F) of the BHC Act,177 which permits a banking entity to

purchase or sell a covered financial position if the banking entity is

a regulated insurance company acting for its general account or an

affiliate of an insurance company acting for the insurance company’s

general account, subject to certain conditions. Section —-.6(d) of

the proposed rule generally restates the statutory requirements of the

exemption, which provide that:

—————————————————————————

177 See 12 U.S.C. 1851(d)(1)(F).

—————————————————————————

The insurance company must directly engage in the business

of insurance and be subject to regulation by a State insurance

regulator or foreign insurance regulator;

The insurance company or its affiliate must purchase or

sell the covered financial position solely for the general account of

the insurance company;

The purchase or sale must be conducted in compliance with,

and subject to, the insurance company investment laws, regulations, and

written guidance of the State or jurisdiction in which such insurance

company is domiciled; and

The appropriate Federal banking agencies, after

consultation with the Council and the relevant insurance commissioners

of the States, must not have jointly determined, after notice and

comment, that a particular law, regulation, or written guidance

described above is insufficient to protect the safety and soundness of

the banking entity or of the financial stability of the United

States.178

—————————————————————————

178 The Federal banking agencies have not proposed at this

time to determine, as part of the proposed rule, that the insurance

company investment laws, regulations, and written guidance of any

particular State or jurisdiction are insufficient to protect the

safety and soundness of the banking entity, or of the financial

stability of the United States. The Federal banking agencies expect

to monitor, in conjunction with the Federal Insurance Office

established under section 502 of the Dodd-Frank Act, the insurance

company investment laws, regulations, and written guidance of States

or jurisdictions to which exempt transactions are subject and make

such determinations in the future, where appropriate.

—————————————————————————

The proposed rule defines a “general account” as all of the

assets of the insurance company that are not legally segregated and

allocated to separate accounts under applicable State law.179

—————————————————————————

179 See proposed rule Sec. —-.3(c)(6).

—————————————————————————

The CFTC requests comment on the proposed rule’s approach to

implementing the exemption for general account trading by insurance

companies. In particular, the CFTC requests comment on the following

questions:

Question 132. Should any of the statutory requirements for the

exemption be further clarified in the

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proposed rule? If so, how? Should any additional requirements be added?

If so, what requirements and why?

Question 133. Does the proposed rule appropriately and clearly

define a general account for these purposes? If not, what alternative

definition would be more appropriate?

Question 134. For purposes of the exemption, are the insurance

company investment laws, regulations, and written guidance of any

particular State or jurisdiction insufficient to protect the safety and

soundness of the banking entity, or of the financial stability of the

United States? If so, why?

Question 135. What impact will the proposed rule’s implementation

of the exemption have on the insurance activities of insurance

companies affiliated with banking entities? If such impacts are

negative, how could they be mitigated or eliminated in a manner

consistent with the purpose and language of the statute?

d. Permitted Trading Outside of the United States

Section —-.6(d) of the proposed rule implements section

13(d)(1)(H) of the BHC Act,180 which permits certain foreign banking

entities to engage in proprietary trading that occurs solely outside of

the United States.181 This statutory exemption limits the

extraterritorial application of the prohibition on proprietary trading

to the foreign activities of foreign firms, while preserving national

treatment and competitive equality among U.S. and foreign firms within

the United States. Consistent with the statute, the proposed rule

defines both the type of foreign banking entities that are eligible for

the exemption and the circumstances in which proprietary trading by

such an entity will be considered to have occurred solely outside of

the United States.

—————————————————————————

180 Section 13(d)(1)(H) of the BHC Act permits a banking

entity to engage in proprietary trading, notwithstanding the

prohibition on proprietary trading, if it is conducted by a banking

entity pursuant to paragraph (9) or (13) of section 4(c) of the BHC

Act and the trading occurs solely outside of the United States and

the banking entity is not directly or indirectly controlled by a

banking entity that is organized under the laws of the United States

or of one or more States. See 12 U.S.C. 1851(d)(1)(H).

181 This section’s discussion of the concept “solely outside

of the United States” is provided solely for purposes of the

proposed rule’s implementation of section 13(d)(1)(H) of the BHC

Act, and does not affect a banking entity’s obligation to comply

with additional or different requirements under applicable

securities, banking, or other laws.

—————————————————————————

i. Foreign Banking Entities Eligible for the Exemption

Section —-.6(d)(1)(i) of the proposed rule provides that, in

order to be eligible for the foreign trading exemption, the banking

entity must not be directly or indirectly controlled by a banking

entity that is organized under the laws of the United States or of one

or more States. This requirement limits the scope of the exemption to

banking entities that are organized under foreign law and controlled

only by entities organized under foreign law. Consistent with the

statutory language, a banking entity organized under the laws of the

United States or any State and the subsidiaries and branches of such

banking entity (wherever organized or licensed) may not rely on the

exemption.182 Similarly, a U.S. subsidiary or branch of a foreign

banking entity would not qualify for the exemption.

—————————————————————————

182 Under the proposal, a “State” means any State, territory

or possession of the United States, and the District of Columbia.

See proposed rule Sec. —-.2(aa).

—————————————————————————

Section —-.6(d)(1)(ii) of the proposed rule incorporates the

statutory requirement that the banking entity must also conduct the

transaction pursuant to sections 4(c)(9) or 4(c)(13) of the BHC Act.

Section —-.6(d)(2) clarifies when a banking entity would meet that

requirement, the criteria for which vary depending on whether or not

the banking entity is a foreign banking organization.183

—————————————————————————

183 Section —-.6(d)(2) only addresses when a transaction

will be considered to have been conducted pursuant to section

4(c)(9) of the BHC Act. Although the statute also references section

4(c)(13) of the BHC Act, the Board has applied the authority

contained in that section solely to the foreign activities of U.S.

banking organizations which, by the express terms of section

13(d)(1)(H) of the BHC Act, are unable to rely on the foreign

trading exemption.

—————————————————————————

Section 4(c)(9) of the BHC Act provides that the restrictions on

interests in nonbanking organizations contained in that statute do not

apply to the ownership of shares held or activities conducted by any

company organized under the laws of a foreign country the greater part

of whose business is conducted outside the United States, if the Board

by regulation or order determines that, under the circumstances and

subject to the conditions set forth in the regulation or order, the

exemption would not be substantially at variance with the purposes of

the BHC Act and would be in the public interest.184 The Board has

implemented section 4(c)(9) as part of subpart B of the Board’s

Regulation K,185 which specifies a number of conditions and

requirements that a foreign banking organization must meet in order to

use such authority. Such conditions and requirements include, for

example, a qualifying foreign banking organization test that requires

the foreign banking organization to demonstrate that more than half of

its worldwide business is banking and that more than half of its

banking business is outside the United States. The proposed rule makes

clear that if a banking entity is a foreign banking organization, it

will qualify for the foreign trading exemption if the entity is a

qualifying foreign banking organization that conducts the transaction

in compliance with subpart B of the Board’s Regulation K, and the

transaction occurs solely outside of the United States.

—————————————————————————

184 See 12 U.S.C. 1843(c)(9).

185 See 12 CFR 211.20 et seq.

—————————————————————————

Section 13 of the BHC Act also applies to foreign companies that

control a U.S. insured depository institution but are not currently

subject to the BHC Act generally or to the Board’s Regulation K–for

example, because the foreign company controls a savings association or

an FDIC-insured industrial loan company. Accordingly, the proposed rule

also clarifies when this type of foreign banking entity would be

considered to have conducted a transaction “pursuant to section

4(c)(9)” for purposes of the foreign trading exemption.186 In

particular, the draft rule proposes that to qualify for the foreign

trading exemption, such firms must meet at least two of three

requirements that evaluate the extent to which the foreign entity’s

business is conducted outside the United States, as measured by assets,

revenues, and income. This test largely mirrors the qualifying foreign

banking organization test that is made applicable under section 4(c)(9)

of the BHC Act and Sec. 211.23(a) of the Board’s Regulation K, except

that the test does not also require such a foreign entity to

demonstrate that more than half of its banking business is outside the

United States.187

—————————————————————————

186 The CFTC notes that the Board emphasizes that this

clarification would be applicable solely in the context of section

13(d)(1) of the BHC Act. The application of section 4(c)(9) to

foreign companies in other contexts is likely to involve different

legal and policy issues and may therefore merit different

approaches.

187 See 12 U.S.C. 1843(c)(9); 12 CFR 211.23(a); proposed rule

Sec. —-.6(d)(2). This difference reflects the fact that foreign

entities subject to section 13 of the BHC Act, but not the BHC Act

generally, are likely to be, in many cases, predominantly commercial

firms. A requirement that such firms also demonstrate that more than

half of their banking business is outside the United States would

likely make the exemption unavailable to such firms and subject

their global activities to the prohibition on proprietary trading, a

result that the statute does not appear to have intended.

—————————————————————————

[[Page 8367]]

ii. Trading Solely Outside of the United States

The proposed rule also clarifies when a transaction will be

considered to have occurred solely outside of the United States for

purposes of the exemption. In interpreting this aspect of the statutory

language, the proposal focuses on the extent to which material elements

of the transaction occur within, or are conducted by personnel within,

the United States. This focus seeks to avoid extraterritorial

application of the prohibition of proprietary trading outside the

United States while preserving competitive parity within U.S. markets.

The proposed rule does not evaluate solely whether the risk of the

transaction or management or decision-making with respect to the

transaction rests outside the United States, as such an approach would

appear to permit foreign banking entities to structure transactions so

as to be “outside of the United States” for risk and booking purposes

while engaging in transactions within U.S. markets that are prohibited

for U.S. banking entities.

In particular, Sec. —-.6(d)(3) of the proposed rule provides

that a transaction will be considered to have occurred solely outside

of the United States only if four conditions are met:

The transaction is conducted by a banking entity that is

not organized under the laws of the United States or of one or more

States;

No party to the transaction is a resident of the United

States;

No personnel of the banking entity that is directly

involved in the transaction is physically located in the United States;

188 and

—————————————————————————

188 Personnel directly involved in the transaction would

generally not include persons performing purely administrative,

clerical, or ministerial functions.

—————————————————————————

The transaction is executed wholly outside the United

States.

These four criteria are intended to ensure that a transaction executed

in reliance on the exemption does not involve U.S. counterparties, U.S.

trading personnel, U.S. execution facilities, or risks retained in the

United States. The presence of any of these factors would appear to

constitute a sufficient locus of activity in the U.S. marketplace so as

to preclude availability of the exemption.

A resident of the United States is defined in Sec. —-.2(t) of

the proposed rule, and includes: (i) Any natural person resident in the

United States; (ii) any partnership, corporation or other business

entity organized or incorporated under the laws of the United States or

any State; (iii) any estate of which any executor or administrator is a

resident of the United States; (iv) any trust of which any trustee,

beneficiary or, if the trust is revocable, settlor is a resident of the

United States; (v) any agency or branch of a foreign entity located in

the United States; (vi) any discretionary or non-discretionary account

or similar account (other than an estate or trust) held by a dealer or

fiduciary for the benefit or account of a resident of the United

States; (vii) any discretionary account or similar account (other than

an estate or trust) held by a dealer or fiduciary organized or

incorporated in the United States, or (if an individual) a resident of

the United States; or (viii) any partnership or corporation organized

or incorporated under the laws of any foreign jurisdiction formed by or

for a resident of the United States principally for the purpose of

engaging in one or more transactions described in Sec. —-.6(d)(1) or

Sec. —-.13(c)(1) of the proposed rule.189 The proposed definition

is designed to capture the scope of U.S. counterparties, decision-

makers and personnel that, if involved in the transaction, would

preclude that transaction from being considered to have occurred solely

outside the United States. The Agencies note that the proposed

definition is similar but not identical to the definition of “U.S.

person” for purposes of the SEC’s Regulation S, which governs

securities offerings and sales outside of the United States that are

not registered under the Securities Act.190

—————————————————————————

189 See proposed rule Sec. —-.2(t).

190 See 17 CFR 230.902(k).

—————————————————————————

iii. Request for Comment

The CFTC requests comment on the proposed rule’s approach to

implementing the foreign trading exemption. In particular, the CFTC

requests comment on the following questions:

Question 136. Is the proposed rule’s implementation of the foreign

trading exemption effectively delineated? If not, what alternative

would be more effective and/or clearer?

Question 137. Are the proposed rule’s provisions regarding when an

activity will be considered to have been conducted pursuant to section

4(c)(9) of the BHC Act effective and sufficiently clear? If not, what

alternative would be more effective and/or clearer? Do those provisions

effectively address the application of the foreign trading exemption to

foreign banking entities not subject to the BHC Act generally? If not,

how should the proposed rule apply the exemption?

Question 138. Are the proposed rule’s provisions regarding when an

activity will be considered to have occurred solely outside the United

States effective and sufficiently clear? If not, what alternative would

be more effective and/or clearer? Should any requirements be modified

or removed? If so, which requirements and why? Should additional

requirements be added? If so, what requirements and why?

Question 139. Is the proposed rule’s definition of “resident of

the United States” effective and sufficiently clear? If not, what

alternative would be more effective and/or clearer? Is the definition

over- or under-inclusive? If so, why? Should the definition more

closely track, or incorporate by reference, the definition of “U.S.

person” under the SEC’s Regulation S under the Securities Act? If so,

why?

Question 140. Does the proposed rule effectively define a resident

of the United States for these purposes? If not, how should the

definition be altered?

Question 141. Should the CFTC use the authority provided in section

13(d)(1)(J) of the BHC Act to allow U.S.-controlled banking entities to

engage in proprietary trading pursuant to section 4(c)(13) of the BHC

Act outside of the United States under certain circumstances? If so,

under what circumstances should this be permitted and how would such

activity promote and protect the safety and soundness of banking

entities and the financial stability of the United States?

e. Discretionary Exemptions for Proprietary Trading Under Section

13(d)(1)(J) of the BHC Act

Section 13(d)(1)(J) of the BHC Act permits the CFTC to grant, by

rule, other exemptions from the prohibition on proprietary trading if

the CFTC determines that the exemption would promote and protect the

safety and soundness of the banking entity and the financial stability

of the United States.191 The CFTC has not, at this time, proposed any

such discretionary exemptions with respect to the prohibition on

proprietary trading. The CFTC requests comment as follows:

—————————————————————————

191 See 12 U.S.C. 1851(d)(1)(J). In addition to permitting the

CFTC to provide additional exemptions from the prohibition on

proprietary trading, section 13(d)(1)(J) also states that the CFTC

may provide additional exemptions from the prohibition on investing

in or sponsoring a covered fund, as discussed in Part III.C.5 of

this SUPPLEMENTARY INFORMATION.

—————————————————————————

Question 142. Should the CFTC adopt any exemption from the

prohibition on proprietary trading under section 13(d)(1)(J) of the BHC

Act? If so, what

[[Page 8368]]

exemption and why? How would such an exemption promote and protect the

safety and soundness of banking entities and the financial stability of

the United States?

5. Section —-.7: Reporting and Recordkeeping Requirements Applicable

to Trading Activities

Section —-.7 of the proposed rule, which implements in part

section 13(e)(1) of the BHC Act,192 requires certain banking entities

to comply with the reporting and recordkeeping requirements specified

in Appendix A of the proposed rule. In addition, Sec. —-.7 requires

banking entities to comply with the recordkeeping requirements in Sec.

—-.20 of the proposed rule, related to the banking entity’s

compliance program,193 as well as any other reporting or

recordkeeping requirements that the CFTC may impose to evaluate the

banking entity’s compliance with the proposed rule.194 Proposed

Appendix A requires a banking entity with significant trading

activities to furnish periodic reports to the CFTC regarding various

quantitative measurements of its trading activities and create and

retain records documenting the preparation and content of these

reports. The measurements vary depending on the scope, type, and size

of trading activities. In addition, proposed Appendix B contains a

detailed commentary regarding the characteristics of permitted market

making-related activities and how such activities may be distinguished

from trading activities that, even if conducted in the context of a

banking entity’s market-making operations, would constitute prohibited

proprietary trading.

—————————————————————————

192 Section 13(e)(1) of the BHC Act requires the CFTC to issue

regulations regarding internal controls and recordkeeping to ensure

compliance with section 13. See 12 U.S.C. 1851(e)(1). Section —

–.20 and Appendix C of the proposed rule also implement section

13(e)(1) of the BHC Act.

193 See SUPPLEMENTARY INFORMATION, Part III.D.

194 See proposed rule Sec. —-.7.

—————————————————————————

A banking entity must comply with proposed Appendix A’s reporting

and recordkeeping requirements only if it has, together with its

affiliates and subsidiaries, trading assets and liabilities the average

gross sum of which (on a worldwide consolidated basis) is, as measured

as of the last day of each of the four prior calendar quarters, equal

to or greater than $1 billion.195 The CFTC has not proposed to extend

the reporting and recordkeeping requirements to banking entities with

smaller amounts of trading activity, as it appears that the more

limited benefits of applying these requirements to such banking

entities, whose trading activities are typically small, less complex,

and easier to supervise, would not justify the burden associated with

complying with the reporting and recordkeeping requirements.

—————————————————————————

195 See proposed rule Sec. —-.7(a). The CFTC notes that

this $1 billion trading asset and liability threshold is the same

standard that is used in the Market Risk Capital Rules for

determining which bank holding companies and insured depository

institutions must calculate their risk-based capital requirements

for trading positions under those rules. These banking entities

maintain large and complex portfolios of trading assets and are

therefore the most likely to be engaged in the types of trading

activities that will require significant oversight of compliance

with the restrictions on proprietary trading.

—————————————————————————

a. General Approach to Reporting and Recordkeeping Requirements

The reporting and recordkeeping requirements of Sec. —-.7 and

Appendix A of the proposed rule are an important part of the proposed

rule’s multi-faceted approach to implementing the prohibition on

proprietary trading. These requirements are intended, in particular, to

address some of the difficulties associated with (i) identifying

permitted market making-related activities and distinguishing such

activities from prohibited proprietary trading and (ii) identifying

certain trading activities resulting in material exposure to high-risk

assets or high-risk trading strategies. To do so, the proposed rule

requires certain banking entities to calculate and report detailed

quantitative measurements of their trading activity, by trading unit.

These measurements will help banking entities and the CFTC in assessing

whether such trading activity is consistent with permitted trading

activities in scope, type and profile. The quantitative measurements

that must be reported under the proposed rule are generally designed to

reflect, and to provide meaningful information regarding, certain

characteristics of trading activities that appear to be particularly

useful in differentiating permitted market making-related activities

from prohibited proprietary trading. For example, the proposed

quantitative measurements measure the size and type of revenues

generated, and the types of risks taken, by a trading unit. Each of

these measurements appears to be useful in assessing whether a trading

unit is (i) engaged in permitted market making-related activity or (ii)

materially exposed to high-risk assets or high-risk trading strategies.

Similarly, the proposed quantitative measurements also measure how much

revenue is generated per such unit of risk, the volatility of a trading

unit’s profitability, and the extent to which a trading unit trades

with customers. Each of those characteristics appears to be useful in

assessing whether a trading unit is engaged in permitted market making-

related activity.

However, the CFTC recognizes that no single quantitative

measurement or combination of measurements can accurately identify

prohibited proprietary trading without further analysis of the context,

facts, and circumstances of the trading activity. In addition, certain

quantitative measurements may be useful for assessing one type of

trading activity, but not helpful in assessing another type of trading

activity. As a result, the CFTC proposes to use a variety of

quantitative measurements to help identify transactions or activities

that warrant more in-depth analysis or review.

To be effective, this approach requires identification of useful

quantitative measurements as well as judgment regarding the type of

measurement results that suggest a further review of the trading unit’s

activity is warranted. The CFTC intends to take a heuristic approach to

implementation in this area that recognizes that quantitative

measurements can only be usefully identified and employed after a

process of substantial public comment, practical experience, and

revision. In particular, the CFTC notes that, although a variety of

quantitative measurements have traditionally been used by market

participants and others to manage the risks associated with trading

activities, these quantitative tools have not been developed, nor have

they previously been utilized, for the explicit purpose of identifying

trading activity that warrants additional scrutiny in differentiating

prohibited proprietary trading from permitted market making-related

activities. Additional study and analysis will be required before

quantitative measurements may be effectively designed and employed for

that purpose.

Consistent with this heuristic approach, the proposed rule includes

a large number of potential quantitative measurements on which public

comment is sought, many of which overlap to some degree in terms of

their informational value. Not all of these quantitative measurements

may ultimately be adopted, depending on their relative strengths,

weaknesses, costs, and benefits. The CFTC notes that some of the

proposed quantitative measurements may not be relevant to all types of

trading activities or may

[[Page 8369]]

provide only limited benefits, relative to cost, when applied to

certain types of trading activities. In addition, certain quantitative

measurements may be difficult or impracticable to calculate for a

specific covered trading activity due to differences between asset

classes, market structure, or other factors. The CFTC has therefore

requested comment on a large number of issues related to the relevance,

practicability, costs, and benefits of the quantitative measurements

proposed. The CFTC also seeks comment on whether the quantitative

measurements described in the proposal may be appropriate to use in

assessing compliance with section 13 of the BHC Act.

In addition to the proposed quantitative measurements, a banking

entity may itself develop and implement other quantitative measurements

in order to effectively monitor its covered trading activities for

compliance with section 13 of the BHC Act and the proposed rule and to

establish, maintain, and enforce an effective compliance program, as

required by Sec. —-.20 of the proposed rule and Appendix C. The CFTC

notes that the proposed quantitative measurements in Appendix A are

intended to assist banking entities and the CFTC in monitoring

compliance with the proprietary trading restrictions and, thus, are

related to the compliance program requirements in Sec. —-.20 of the

proposed rule and proposed Appendix C. Nevertheless, implementation of

the proposed quantitative measurements under Appendix A would not

necessarily provide all the data necessary for the banking entity to

establish an effective compliance program, and a banking entity may

need to develop and implement additional quantitative measurements. The

CFTC recognizes that appropriate and effective quantitative

measurements may differ based on the profile of the banking entity’s

businesses in general and, more specifically, of the particular trading

unit, including types of instruments traded, trading activities and

strategies, and history and experience (e.g., whether the trading desk

is an established, successful market maker or a new entrant to a

competitive market). In all cases, banking entities must ensure that

they have robust measures in place to identify and monitor the risks

taken in their trading activities, to ensure the activities are within

risk tolerances established by the banking entity, and to monitor for

compliance with the proprietary trading restrictions in the proposed

rule.

To the extent that data regarding measurements, as set forth in the

proposed rule, are collected, the CFTC proposes to utilize the

automatic two-year conformance period provided in section 13 of the BHC

Act to carefully review that data, further study the design and utility

of these measurements, and if necessary, propose changes to the

reporting requirements as the CFTC believes are needed to ensure that

these measurements are as effective as possible.196 This heuristic,

gradual approach to implementing reporting requirements for

quantitative measurements would be intended to ensure that the

requirements are formulated in a manner that maximizes their utility

for identifying trading activity that warrants additional scrutiny in

assessing compliance with the prohibition on proprietary trading, while

limiting the risk that the use of quantitative measurements could

inadvertently curtail permissible market making-related activities that

provide an important service to market participants and the capital

markets at large.

—————————————————————————

196 Section 13(c)(2) of the BHC Act provides banking entities

two years from the date that the proposed rule becomes effective

(with the possibility of up to three, one-year extensions) to bring

their activities, investments, and relationships into compliance

with section 13, including the prohibition on proprietary trading.

See 12 U.S.C. 1851(c)(2).

—————————————————————————

In addition, the CFTC requests comment on the use of numerical

thresholds for certain quantitative measurements that, if reported by a

banking entity, would require the banking entity to review its trading

activities for compliance and summarize that review to the CFTC. The

CFTC has not proposed specific numerical thresholds in the proposal

because substantial public comment and analysis would be beneficial

prior to formulating and proposing specific numerical thresholds.

Instead, the CFTC intends to carefully consider public comments that

are provided on this issue and to separately determine whether it would

be appropriate to propose, subsequent to finalizing the current

proposal, such numerical thresholds.

The CFTC requests comment on the proposed approach to implementing

reporting requirements for proprietary trading. In particular, the CFTC

requests comment on the following questions:

Question 143. Is the use of the proposed reporting requirements as

part of the multi-faceted approach to implementing the prohibition on

proprietary trading appropriate? Why or why not?

Question 144. Is the proposed gradual approach to implementing

reporting requirements effective? If not, what approach would be more

effective? For example, should the CFTC defer reporting of quantitative

measurements until banking entities have developed and refined their

compliance programs through the supervision and examination process?

What would be the costs and benefits of such an approach?

Question 145. What role, if any, could or should the Office of

Financial Research (“OFR”) play in receiving and analyzing banking

entities’ reported quantitative measurements? Should reporting to the

OFR be required instead of reporting to the CFTC, and would such

reporting be consistent with the composition and purpose of OFR? In the

alternative, should reporting to either (i) only the CFTC or (ii) both

the CFTC and OFR be required? If so, why? What are the potential costs

and benefits of reporting quantitative measurements to the OFR? Please

explain.

Question 146. Is there an alternative manner in which the CFTC

should develop and propose the reporting requirements for quantitative

measurements? If so, how should they do so?

Question 147. Does the proposed approach provide sufficient time

for the development and implementation of effective reporting

requirements? If not, what alternative approach would be preferable?

Question 148. Should a trading unit be permitted not to furnish a

quantitative measurement otherwise required under Appendix A if it can

demonstrate that the measurement is not, as applied to that unit,

calculable or useful in achieving the purposes of the Appendix with

respect to the trading unit’s covered trading activities? How might a

banking entity make such a demonstration?

Question 149. Is the manner in which the CFTC proposes to utilize

the conformance period for review of collected data and refinement of

the reporting requirements effective? If not, what process would be

more effective?

Question 150. Is the proposed $1 billion trading asset and

liability threshold, which is also currently used in the Market Risk

Capital Rules for purposes of identifying which banks and bank holdings

companies must comply with those rules, an appropriate standard for

triggering the reporting and recordkeeping requirements of the proposed

rule? Why or why not? If not, what alternative standard would be a

better benchmark for triggering the reporting and recordkeeping

requirements?

[[Page 8370]]

Question 151. What are the typical trading activities (e.g., market

making-related activities) of a banking entity with less than $1

billion in gross trading assets and liabilities? How complex are those

trading activities?

Question 152. Should the proposed $1 billion trading and asset

liability threshold used for triggering the reporting and recordkeeping

requirements adjust each time the thresholds for complying with the

Market Risk Capital Rules adjust, or otherwise be adjusted over time?

If not, how and when should the numerical threshold be adjusted?

Question 153. Should all banking entities be required to comply

with the reporting and recordkeeping requirements set forth in Appendix

A in order to better protect against prohibited proprietary trading,

rather than only those banking entities that meet the proposed $1

billion trading asset and liability threshold? Why or why not?

Question 154. Should banking entities that fall under the proposed

$1 billion trading asset and liability threshold be required to comply

with the reporting and recordkeeping provisions for a pilot period in

order to help inform judgment regarding the levels of quantitative

measurements at such entities and the appropriate frequency and scope

of examination by the relevant Agency for such banking entities? Why or

why not?

b. Proposed Appendix A–Purpose and Definitions

Section I of proposed Appendix A describes the purpose of the

appendix, which is to specify reporting requirements that are intended

to assist banking entities that are engaged in significant trading

activities and the CFTC in identifying trading activities that warrant

further review or examination to verify compliance with the proprietary

trading restrictions, including whether an otherwise-permitted activity

under Sec. Sec. —-.4 through —-.6(a) of the proposed rule is

consistent with the requirement that such activity not result, directly

or indirectly, in a material exposure by the banking entity to high-

risk assets and high-risk trading strategies. In particular, section I

provides that the purpose of the appendix is to assist the CFTC and

banking entities in:

Better understanding and evaluating the scope, type, and

profile of the banking entity’s covered trading activities;

Monitoring the banking entity’s covered trading

activities;

Identifying covered trading activities that warrant

further review or examination by the banking entity to verify

compliance with the proprietary trading restrictions;

Evaluating whether the trading activities of trading units

engaged in market making-related activities under Sec. —-.4(b) of

the proposed rule are consistent with the requirements governing

permitted market making-related activities;

Evaluating whether the trading activities of trading units

that are engaged in permitted trading activity under Sec. Sec. —-.4,

—-.5, or —-.6(a) of the proposed rule (e.g., permitted

underwriting, market making-related activity, risk-mitigating hedging,

or trading in certain government obligations) are consistent with the

requirement that such activity not result, directly or indirectly, in a

material exposure by the banking entity to high-risk assets and high-

risk trading strategies;

Identifying the profile of particular trading activities

of the banking entity, and the individual trading units of the banking

entity, to help establish the appropriate frequency and scope of

examination by the CFTC of such activities; and

Assessing and addressing the risks associated with the

banking entity’s trading activities.

The types of trading and market making-related activities in which

banking entities engage is often highly complex, and any quantitative

measurement is capable of producing both “false negatives” and

“false positives” that suggest that prohibited proprietary trading is

occurring when it is not, or vice versa. Recognizing this, section I of

proposed Appendix A makes clear that the quantitative measurements that

may be required to be reported would not be intended to serve as a

dispositive tool for identifying permissible or impermissible

activities.

Section II of proposed Appendix A defines relevant terms used in

the appendix. These include certain definitions that clarify how and

when certain calculations must be made, as well as a definition of

“trading unit” that governs the level of organization at which a

banking entity must calculate quantitative measurements. The proposed

definition of “trading unit” covers multiple organizational levels of

a banking entity, including:

Each discrete unit engaged in the coordinated

implementation of a revenue generation strategy that participates in

the execution of any covered trading activity; 197

—————————————————————————

197 As noted in Appendix A, the CFTC expects that this would

generally be the smallest unit of organization used by the banking

entity to structure and control its risk-taking activities and

employees, and would include each unit generally understood to be a

single “trading desk.” For example, if a banking entity has one

set of employees engaged in market making-related activities in the

equities of U.S. non-financial corporations, and another set of

employees engaged in market making-related activities in the

equities of U.S. financial corporations, the two sets of employees

would appear to be part of a single trading unit if both sets of

employees structure and control their trading activities together,

making and executing highly coordinated decisions about required

risk levels, inventory levels, sources of revenue growth and similar

features. On the other hand, if the risk decisions and revenue

strategies are considered and executed separately by the two sets of

employees, with only loose coordination, they would appear to be two

distinct trading units. In determining whether a set of employees

constitute a single trading unit, important factors would likely

include whether compensation is strongly linked to the group’s

performance, whether risk levels and trading limits are managed and

set jointly or separately, and whether trades are booked together or

separately.

—————————————————————————

Each organizational unit used to structure and control the

aggregate risk-taking activities and employees of one or more trading

units described above;

All trading operations, collectively; and

Any other unit of organization specified by the CFTC with

respect to a particular banking entity.198

—————————————————————————

198 This latter prong of the definition has been included to

ensure that the CFTC has the ability to require banking entities to

report quantitative measurements in other ways to prevent a banking

entity from organizing its trading operations so as to undermine the

effectiveness of the reporting requirement.

—————————————————————————

The definition of “trading unit” is intended to capture multiple

layers of a banking entity’s organization structure, including

individual trading desks, intermediate divisions that oversee a variety

of trading desks, and all trading operations in the aggregate. As

described below, under the proposal, the quantitative measurements

specified in section IV of proposed Appendix A must be calculated and

reported for each such “trading unit.” Accordingly, the definition of

trading unit is purposefully broad and captures multiple levels of

organization so as to ensure that quantitative measurements provide

meaningful information, at both a granular and aggregate level, to help

banking entities and the CFTC evaluate the quantitative profile of

trading operations in a variety of contexts.

The CFTC expects that the scope and nature of trading units to

which the quantitative measurements are applied would have an important

impact on the informational content and utility of the resulting

measurements. Applying a quantitative measurement to a trading unit at

a level that aggregates a variety of distinct trading activities may

obscure or “smooth” differences between distinct lines of business,

asset

[[Page 8371]]

categories and risk management processes in a way that renders the

measurement relatively uninformative, because it does not adequately

reflect the specific characteristics of the trading activities being

conducted. Similarly, applying a quantitative measurement to a trading

unit at a highly granular level could, if it captured only a narrow

portion of activity that is conducted as part of a broader business

strategy, introduce meaningless “noise” into the measure or result in

a measurement that is idiosyncratic in nature. This highly granular

application could render the measurement relatively uninformative

because it would not accurately reflect the entirety of the trading

activities being conducted. In order to address the potential

weaknesses of applying the quantitative measurements at an aggregate

and a granular level, respectively, the proposal requires reporting at

both levels. The informational inputs required to calculate any

particular quantitative measurement at either level are the same.

Consequently, it is expected that, depending on the nature of the

systems of a particular institution, there may be little, if any,

incremental burden associated with calculating and reporting

quantitative measurements at multiple levels.

The CFTC requests comment on the proposed reporting requirements in

Appendix A. In particular, the CFTC requests comment on the following

questions:

Question 155. Are the ways in which the proposed rule would make

use of reported quantitative measurements effective? If not, what uses

would be more effective? Should the proposed rule instead use

quantitative measurements as a dispositive tool for identifying

prohibited proprietary trading? If so, what types of quantitative

measurements should be employed, what numerical amount would indicate

impermissible proprietary trading activity, and why? Should the

quantitative measurements play a less prominent role than proposed in

identifying prohibited proprietary trading and why?

Question 156. Are the proposed definitions of terms provided in

Appendix A effective? If not, how should the definitions be amended?

Question 157. Is the proposed definition of “trading unit”

effective? Is it sufficiently clear? If not, what alternative

definition would be more effective and/or clearer? Should the

definition include more or less granular levels of activity? If so,

what specific criteria should be used to determine the appropriate

level of granularity?

Question 158. If you are a banking entity, how would your trading

activity be categorized, in terms of quantity and type, under the

proposed definition of trading unit in Appendix A? For each trading

unit type, what categories of quantitative measurements (e.g., risk-

management measurements) or specific quantitative measurements (e.g.,

Stressed Value-at-Risk (“Stress VaR”)) are best suited to assist in

distinguishing prohibited proprietary trading from permitted trading

activity?

Question 159. Is the proposed rule’s requirement that quantitative

measurements be reported at multiple levels of organization, including

for quantitative measurements historically reported on an aggregate

basis (e.g., Value-at-Risk (“VaR”) or Stress VaR) appropriate? If

not, what alternative would be more effective? What burdens are

associated with such a requirement? How might those burdens be reduced

or limited? Please quantify your answers, to the extent feasible.

c. Proposed Appendix A–Scope of Required Reporting

Part III of proposed Appendix A defines the scope of the reporting

requirements. The proposed rule adopts a tiered approach that requires

banking entities with the most extensive trading activities to report

the largest number of quantitative measurements, while banking entities

with smaller trading activities have fewer or no reporting

requirements. This tiered approach is intended to reflect the

heightened compliance risks of banking entities with extensive trading

activities and limit the regulatory burden imposed on banking entities

with relatively small or no trading activities, which appear to pose

significantly less compliance risk.

Banking Entities With Gross Trading Assets and Liabilities of $5

Billion or More

For any banking entity that has, together with its affiliates and

subsidiaries, trading assets and liabilities the average gross sum of

which (on a worldwide consolidated basis), as measured as of the last

day of each of the four prior calendar quarters, equals or exceeds $5

billion, the proposal would require the banking entity to furnish

quantitative measurements for all trading units of the banking entity

engaged in trading activity subject to Sec. Sec. —-.4, —-.5, or —

–.6(a) of the proposed rule (i.e., permitted underwriting and market

making-related activity, risk-mitigated hedging, and trading in certain

government obligations). The scope of data to be furnished depends on

the activity in which the trading unit is engaged. First, for the

trading units of such a banking entity that are engaged in market

making-related activity pursuant to Sec. —-.4(b) of the proposed

rule, proposed Appendix A requires that a banking entity furnish

seventeen quantitative measurements.199 Second, all trading units of

such a banking entity engaged in trading activity subject to Sec. Sec.

—-.4(a), —-.5, or —-.6(a) of the proposed rule would be required

to report five quantitative measurements designed to measure the

general risk and profitability of the trading unit.200 The CFTC

expects that each of these general types of measurements will be useful

in assessing the extent to which any permitted trading activity

involves exposure to high-risk assets or high-risk trading strategies.

These requirements would apply to all type of trading units engaged in

underwriting and market making-related activity, risk-mitigated

hedging, and trading in certain government obligations. These

additional measurements are designed to help evaluate the extent to

which the quantitative profile of a trading unit’s activities is

consistent with permissible market making-related activities.

—————————————————————————

199 See proposed rule Appendix A.III.A. These seventeen

quantitative measurements are discussed further below.

200 See proposed rule Appendix A.III.A. These five

quantitative measurements are: (i) Comprehensive Profit and Loss;

(ii) Comprehensive Profit and Loss Attribution; (iii) VaR and Stress

VaR; (iv) Risk Factor Sensitivities; and (v) Risk and Position

Limits. Each of these and other quantitative measurements discussed

in proposed Appendix A are discussed in detail below.

—————————————————————————

Banking Entities With Gross Trading Assets and Liabilities Between $1

Billion and $5 Billion

For any banking entity that has, together with its affiliates and

subsidiaries, trading assets and liabilities the average gross sum of

which (on a worldwide consolidated basis), as measured as of the last

day of each of the four prior calendar quarters, equals or exceeds $1

billion but is less than $5 billion, the proposal would require

quantitative measurements to be furnished for trading units that are

engaged in market making-related activity subject to Sec. —-.4(b) of

the proposed rule. Trading units of such banking entities that are

engaged in market making-related activities must report eight

quantitative measurements that are designed to help evaluate the extent

to which the quantitative profile of a trading unit’s activities is

consistent with permissible market making-related

[[Page 8372]]

activities.201 The proposal applies a smaller number of measurements

to a smaller universe of trading units for this class of banking

entities because they are likely to pose lesser compliance risk and

fewer supervisory and examination challenges. A less burdensome

reporting regime, coupled with other elements of the proposal (e.g.,

the compliance program requirement), is likely to be equally as

effective in ensuring compliance with section 13 of the BHC Act and the

proposed rule for banking entities with smaller trading operations.

—————————————————————————

201 See proposed rule Appendix A.III.A. These eight

quantitative measurements are (i) Comprehensive Profit and Loss;

(ii) Comprehensive Profit and Loss Attribution; (iii) Portfolio

Profit and Loss; (iv) Fee Income and Expense; (v) Spread Profit and

Loss; (vi) VaR; (vii) Volatility of Comprehensive Profit and Loss

and Volatility of Portfolio Profit and Loss; and (viii)

Comprehensive Profit and Loss to Volatility Ratio and Portfolio

Profit and Loss to Volatility Ratio.

—————————————————————————

Frequency of Calculation and Reporting

Section III.B of proposed Appendix A specifies the frequency of

required calculation and reporting of quantitative measurements. Under

the proposed rule, each required quantitative measurement must be

calculated for each trading day. Required quantitative measurements

must be reported to the CFTC on a monthly basis, within 30 days of the

end of the relevant calendar month, or on such other reporting schedule

as the CFTC may require. Section III.C of proposed Appendix A requires

a banking entity to create and retain records documenting the

preparation and content of any quantitative measurement furnished by

the banking entity, as well as such information as is necessary to

permit the CFTC to verify the accuracy of such measurements, for a

period of 5 years. This would include records for each trade and

position.

Question 160. Is the proposed tiered approach to identifying which

banking entities and trading units must comply with the reporting

requirements effective? If not, what alternative would be more

effective? Does the proposal strike the appropriate balance between the

potential benefits of the reporting requirements for monitoring and

assuring compliance and the potential costs of those reporting

requirements? If not, how could that balance be improved? Should the

relevant gross trading assets and liabilities threshold for any

category be increased or reduced? If so, why?

Question 161. Should the $1 billion and $5 billion gross trading

assets and liabilities thresholds used to identify the extent to which

a banking entity is required to furnish quantitative measurements be

increased or reduced? If so, why? Should the thresholds be indexed in

some way to account for fluctuations in capital markets activity over

time? If so, what would be an appropriate method of indexation?

Question 162. Is the proposed $5 billion trading asset and

liability threshold an appropriate standard for triggering enhanced

reporting requirements under the proposed rule? Why or why not? If not,

what alternative standard would be a better benchmark for triggering

enhanced reporting requirements?

Question 163. Should the proposed $5 billion trading and asset

liability threshold used for triggering enhanced reporting requirements

under the proposed rule be subject to adjustment over time? If so, how

and when should the numerical threshold be adjusted?

Question 164. Is there a different criterion other than gross

trading assets and liabilities that would be more appropriate for

identifying banking entities that must furnish quantitative

measurements? If so, what is the alternative criterion, and why would

it be more appropriate? Are worldwide gross trading assets and

liabilities the appropriate criterion for foreign-based banking

entities? If not, what alternative criterion would be more appropriate,

and why?

Question 165. Are the quantitative measurements specified for the

various types of banking entities and trading units effective? If not,

what alternative set of measurements would be more effective? For each

type of trading unit, does the proposal strike the appropriate balance

between the potential benefits of the reporting requirements for

monitoring and assuring compliance and the potential costs of those

reporting requirements? If not, how could that balance be improved?

Question 166. Should banking entities with gross trading assets and

liabilities between $1 billion and $5 billion also be required to

calculate and report some of the quantitative measurements proposed for

banking entities meeting the $5 billion threshold for purposes of

assessing whether the banking entity’s underwriting, market making,

risk-mitigating hedging, and trading in certain government obligations

activities involve a material exposure to high-risk assets or high-risk

trading strategies? If so, which quantitative measurements and why? If

not, why not?

Question 167. Is the proposed frequency of reporting effective? If

not, what frequency would be more effective? Should the quantitative

measurements be required to be reported quarterly, annually, or upon

the request of the CFTC and why?

d. Proposed Appendix A–Quantitative Measurements

Section IV of proposed Appendix A describes, in detail, the

individual quantitative measurements that must be furnished. These

measurements are grouped into the following five broad categories, each

of which is described in more detail below:

Risk-management measurements–VaR, Stress VaR, VaR

Exceedance, Risk Factor Sensitivities, and Risk and Position Limits;

Source-of-revenue measurements–Comprehensive Profit and

Loss, Portfolio Profit and Loss, Fee Income and Expense, Spread Profit

and Loss, and Comprehensive Profit and Loss Attribution;

Revenues-relative-to-risk measurements–Volatility of

Comprehensive Profit and Loss, Volatility of Portfolio Profit and Loss,

Comprehensive Profit and Loss to Volatility Ratio, Portfolio Profit and

Loss to Volatility Ratio, Unprofitable Trading Days based on

Comprehensive Profit and Loss, Unprofitable Trading Days based on

Portfolio Profit and Loss, Skewness of Portfolio Profit and Loss, and

Kurtosis of Portfolio Profit and Loss;

Customer-facing activity measurements–Inventory Turnover,

Inventory Aging, and Customer-facing Trade Ratio; and

Payment of fees, commissions, and spreads measurements–

Pay-to-Receive Spread Ratio.

The CFTC has proposed these quantitative measurements because,

taken together, these measurements appear useful for understanding the

context in which trading activities occur and identifying activities

that may warrant additional scrutiny to determine whether these

activities involve prohibited proprietary trading because the trading

activity either is inconsistent with permitted market making-related

activities or presents a material exposure to high-risk assets or high-

risk trading strategies. As described below, different quantitative

measurements are proposed to identify different aspects and

characteristics of trading activity for the purpose of helping to

identify prohibited proprietary trading, and the CFTC expects that the

quantitative measurements will be most useful for this purpose when

implemented and reviewed collectively, rather than in isolation. The

CFTC believes that, in the aggregate, many banking entities already

collect and review many of these

[[Page 8373]]

measurements as part of their risk management activities, and expect

that many of the quantitative measurements proposed would be readily

computed and monitored at the multiple levels of organization that are

included in proposed Appendix A’s definition of “trading unit,” to

which they would apply.

The first set of quantitative measurements relates to risk

management, and includes VaR, Stress VaR, VaR Exceedance, Risk Factor

Sensitivities, and Risk and Position Limits. These measurements are

widely used by banking entities to measure and manage trading risks and

activities. In the case of VaR, Stress VaR, VaR Exceedance, and Risk

Factor Sensitivities, these measures provide internal, model-based

assessments of overall risk, stated in terms of large but plausible

losses that may occur or changes in revenue that would be expected to

result from movements in underlying risk factors. In the case of Risk

and Position Limits, the measure provides an explicit assessment of

management’s expectation of how much risk is required to perform

permitted market-making and hedging activities. With the exception of

Stress VaR, each of these measurements are routinely used to manage and

control risk taking activities, and are also used by some banking

entities for purposes of calculating regulatory capital and allocating

capital internally. In the context of permitted market making-related

activities, these risk management measures are useful in assessing

whether the actual risk taken is consistent with the level of principal

risk that a banking entity must retain in order to service the near-

term demands of customers. Significant, abrupt or inconsistent changes

to key risk management measures, such as VaR, that are inconsistent

with prior experience, the experience of similarly situated trading

units and management’s stated expectations for such measures may

indicate impermissible proprietary trading. In addition, indicators of

unanticipated or unusual levels of risk taken, such as a significant

number of VaR Exceedance or breaches of internal Risk and Position

Limits, may suggest behavior that is inconsistent with appropriate

levels of risk and may warrant further scrutiny.

The second set of quantitative measurements relates to the source

of revenues, and includes Comprehensive Profit and Loss, Portfolio

Profit and Loss, Fee Income, Spread Profit and Loss, and Comprehensive

Profit and Loss Attribution. These measurements are intended to capture

the extent, scope, and type of profits and losses generated by trading

activities and provide important context for understanding how revenue

is generated by trading activities. Because permitted market making-

related activities seek to generate profits by providing customers with

intermediation and related services while maintaining, and to the

extent practicable, minimizing the risks associated with any asset or

risk inventory required to meet customer demands, these revenue

measurements would appear to provide helpful information to banking

entities and the CFTC regarding whether actual revenues are consistent

with these expectations. The CFTC notes that although banking entities

already routinely calculate and analyze the extent and source of

revenues derived from their trading activities, calculating the

proposed source of revenue measurements according to the specifications

described in proposed Appendix A may require banking entities to

implement new processes to calculate and furnish the required data.

The third set of measurements relates to realized risks and revenue

relative to realized risks, and includes Volatility of Profit and Loss,

Comprehensive Profit and Loss to Volatility Ratio and Portfolio Profit

and Loss to Volatility Ratio, Unprofitable Trading Days based on

Comprehensive Profit and Loss and Unprofitable Trading Days based on

Portfolio Profit and Loss, and Skewness of Portfolio Profit and Loss

and Kurtosis of Portfolio Profit and Loss. These measurements are

intended to provide banking entities and the Agencies with ex post,

data-based assessments of risk, as a supplement to internal, model-

based assessments of risk, and give further context around the

riskiness of underlying trading activities and the profitability of

these activities relative to the risks taken. Some of these

measurements, such as the skewness and kurtosis measurements, are

proposed in order to capture asymmetric, “fat tail” risks that (i)

are not well captured by simple volatility measures, (ii) may not be

well captured by internal risk measurement metrics, such as VaR, and

(iii) can be associated with proprietary trading strategies that seek

to earn short-term profits by taking exposures to these types of risks.

The CFTC expects that these realized-risk and revenue-relative-to-

realized-risk measurements would provide information useful in

assessing whether trading activities are producing revenues that are

consistent, in terms of the degree of risk that is being assumed, with

typical market making-related activities. Market making and related

activities seek to generate profitability primarily by generating fees,

commissions, spreads and other forms of customer revenue that are

relatively, though not completely, insensitive to market fluctuations

and generally result in a high level of revenue relative to risk over

an appropriate time frame. In contrast, proprietary trading strategies

seek to generate revenue primarily through favorable changes in asset

valuations. The CFTC notes that each of the proposed measurements

relating to realized risks and revenues relative to realized risks are

generally consistent with existing revenue, risk, and volatility data

routinely collected by banking entities with large trading operations

or are simple, standardized functions of such data.

The fourth set of quantitative measurements relates to customer-

facing activity measurements, and includes Inventory Risk Turnover,

Inventory Aging, and Customer-facing Trade Ratio. These measurements

are intended to provide banking entities and the CFTC with meaningful

information regarding the extent to which trading activities are

directed at servicing the demands of customers. Quantitative

measurements such as Inventory Risk Turnover and Inventory Aging assess

the extent to which size and volume of trading activity is aimed at

servicing customer needs, while the Customer-facing Trade Ratio

provides directionally useful information regarding the extent to which

trading transactions are conducted with customers. The CFTC expects

that these measurements will be useful in assessing whether permitted

market making-related activities are focused on servicing customer

demands. Although the CFTC understands that banking entities typically

measure inventory aging and turnover in the context of cash instruments

(e.g., equity and debt securities), they note that applying these

measurements, as well as the Customer-facing Trade Ratio generally,

would require banking entities to implement new processes to calculate

and furnish the related data.

The fifth set of quantitative measurements relates to the payment

of fees, commissions, and spreads, and includes the Pay-to-Receive

Spread Ratio. This measurement is intended to measure the extent to

which trading activities generate revenues for providing intermediation

services, rather than generate expenses paid to other intermediaries

for such services. Because market making-related activities ultimately

focus on servicing customer demands, they typically generate

substantially more fees,

[[Page 8374]]

spreads and other sources of customer revenue than must be paid to

other intermediaries to support customer transactions. Proprietary

trading activities, however, that generate almost no customer facing

revenue will typically pay a significant amount of fees, spreads and

commissions in the execution of trading strategies that are expected to

benefit from short-term price movements. Accordingly, the CFTC expects

that the proposed Pay-to-Receive Spread Ratio measurement will be

useful in assessing whether permitted market making-related activities

are primarily generating, rather than paying, fees, spreads and other

transactional revenues or expenses. A level of fees, commissions, and

spreads paid that is inconsistent with prior experience, the experience

of similarly situated trading units and management’s stated

expectations for such measures could indicate impermissible proprietary

trading.

For each individual quantitative measurement, proposed Appendix A

describes the measurement, provides general guidance regarding how the

measurement should be calculated (where needed) and specifies the

period over which each calculation should be made. The proposed

quantitative measurements attempt to incorporate, wherever possible,

measurements already used by banking entities to manage risks

associated with their trading activities. Of the measurements proposed,

the CFTC expects that a large majority of measurements proposed are

either (i) already routinely calculated by banking entities or (ii)

based solely on underlying data that are already routinely calculated

by banking entities. However, calculating these measurements according

to the specifications described in proposed Appendix A and at the

various levels of organization mandated may require banking entities to

implement new processes to calculate and furnish the required data.

The extent of the burden associated with calculating and reporting

quantitative measurements will likely vary depending on the particular

measurements and differences in the sophistication of management

information systems at different banking entities. As noted, the

proposal tailors these data collections to the size and type of

activity conducted by each banking entity in an effort to minimize the

burden in particular on firms that engage in few or no trading

activities subject to the proposed rule.

The CFTC also has attempted to provide, to the extent possible, a

standardized description and general method of calculating each

quantitative measurement that, while taking into account the potential

variation among trading practices and asset classes, would facilitate

reporting of sufficiently uniform information across different banking

entities so as to permit horizontal reviews and comparisons of the

quantitative profile of trading units across firms.

The CFTC requests comment on the proposed quantitative

measurements. In particular, the CFTC requests comment on the following

questions:

Question 168. Are the proposed quantitative measurements

appropriate in general? If not, what alternative(s) would be more

appropriate, and why? Should certain quantitative measurements be

eliminated, and if so, why? Should additional quantitative measurements

be added? If so, which measurements and why? How would those additional

measurements be described and calculated?

Question 168.1. Should the proposed CFTC Rule include all of the

required metrics? In particular, the Commission is interested in which

metrics are most relevant for swaps, futures, and their related hedges.

Please explain the rationale for including or excluding the provisions

in the proposed CFTC Rule.

Question 168.2. If the CFTC Rule reduces the number of required

metrics, should both sets of covered banking entities described in

sections III.A.(i) and III.A.(ii) of Appendix A be required to comply

with the reduced number of required metrics?

Question 169. How many of the proposed quantitative measurements do

banking entities currently utilize? What are the current benefits and

costs associated with calculating such quantitative measurements? Would

the reporting and recordkeeping requirements proposed in Appendix A for

such quantitative measurements impose any significant, additional

benefits or costs?

Question 170. Which of the proposed quantitative measurements do

banking entities currently not utilize? What are the potential benefits

and costs to calculating these quantitative measurements and complying

with the proposed reporting and recordkeeping requirements? Please

quantify your answers, to the extent feasible.

Question 171. Is the scope and frequency of required reporting

appropriate? If not, what alternatives would be more appropriate? What

burdens would be associated with reporting quantitative measurements on

that basis, and how could those burdens be reduced or eliminated in a

manner consistent with the purpose and language of the statute? Please

quantify your answers, to the extent feasible.

Question 172. For each of the categories of quantitative

measurements (e.g., quantitative measurements relating to risk

management), what factors should be considered in order to further

refine the proposed category of quantitative measurements to better

distinguish prohibited proprietary trading from permitted trading

activity? For example, should the timing of a calculation be considered

significant in certain contexts (e.g., should specific quantitative

measurements be calculated during the middle of a trading day instead

of the end of the day)? Please quantify your answers, to the extent

feasible.

Question 173. In light of the size, scope, complexity, and risk of

covered trading activities, do commenters anticipate the need to hire

new staff with particular expertise in order to calculate the required

quantitative measurements (e.g., collect data and make computations)?

Do commenters anticipate the need to develop additional infrastructure

to obtain and retain data necessary to compute the proposed

quantitative measurements? Please explain and quantify your answers, to

the extent feasible.

Question 174. For each individual quantitative measurement that is

proposed:

Is the use of the quantitative measurement to help

distinguish between permitted and prohibited trading activities

effective? If not, what alternative would be more effective? Does the

quantitative measurement provide any additional information of value

relative to other quantitative measurements proposed?

Is the use of the quantitative measurement to help

determine whether an otherwise-permitted trading activity is consistent

with the requirement that such activity must not result, directly or

indirectly, in a material exposure by the banking entity to high-risk

assets and high-risk trading strategies effective? If not, what

alternative would be more effective?

What factors should be considered in order to further

refine the proposed quantitative measurement to better distinguish

prohibited proprietary trading from permitted trading activity? For

example, should the timing of a calculation be considered significant

in certain contexts (e.g., should specific quantitative measurements be

calculated during the middle of a trading day instead of at the end of

the day)?

If the quantitative measurement is proposed to be applied

to a trading unit

[[Page 8375]]

that is engaged in activity pursuant to Sec. Sec. —-.4(a), —-.5,

or —-.6(a) of the proposed rule, is the quantitative measurement

calculable in relation to such activity? Is the quantitative

measurement useful for determining whether underwriting, risk-

mitigating hedging, or trading in certain government obligations is

resulting, directly or indirectly, in a material exposure by the

banking entity to high-risk assets or high-risk trading strategies?

Is the description of the quantitative measurement

sufficiently clear? What alternative would be more appropriate or

clearer? Is the description of the quantitative measurement

appropriate, or is it overly broad or narrow? If it is overly broad,

what additional clarification is needed? Should the CFTC provide this

additional clarification in the appendix’s description of the

quantitative measurement? If the description is overly narrow, how

should it be modified to appropriately describe the quantitative

measurement, and why?

Is the general calculation guidance effective and

sufficiently clear? If not, what alternative would be more effective or

clearer? Is more or less specific calculation guidance necessary? If

so, what level of specificity is needed to calculate the quantitative

measurement? What are the different calculation options and

methodologies that could be used to reach the desired level of

specificity? What are the costs and benefits of these different

options? If the proposed calculation guidance is not sufficiently

specific, how should the calculation guidance be modified to reach the

appropriate level of specificity? For example, rather than provide this

level of specificity in proposed Appendix A, should the CFTC instead

make each banking entity responsible for determining the best method of

calculating the quantitative measurement at this level of specificity,

based on the banking entity’s business and profile, which would then be

subject to supervision, review, or examination by the CFTC? If the

proposed calculation guidance is overly specific, why is it too

specific and how should the guidance be modified to reach the

appropriate level of specificity?

Is the general calculation guidance for the measurement

consistent with how banking entities currently calculate the

quantitative measurement, if they do so? If not, how does the proposed

guidance differ from methodology currently used by banking entities?

What is the purpose of the current calculation methodology used by

banking entities?

What operational or logistical challenges might be

associated with performing the calculation of the quantitative

measurement and obtaining any necessary informational inputs?

Is the quantitative measurement not calculable for any

specific type of trading unit? If so, what type of trading unit, and

why is the quantitative measurement not calculable for that type of

trading unit? Is there an alternative quantitative measurement that

would reflect the same trading activity but not pose the same

calculation difficulty? Are there particular challenges to documenting

that a specific quantitative measurement is not calculable?

Is the quantitative measurement substantially likely to

frequently produce false negatives or false positives that suggest that

prohibited proprietary trading is occurring when it is not, or vice

versa? If so, why? If so, what alternative quantitative measurement

would better help identify prohibited proprietary trading?

Should the quantitative measurement better account for

distinctions among trading activities, trading strategies, and asset

classes? If so, how? For example, should the quantitative measurements

better account for distinctions between trading activities in cash and

derivatives markets? If so, how? Are there any other distinctions for

which the quantitative measurements may need to account? If so, what

distinctions, and why?

Does the quantitative measurement provide useful

information as applied to all types of trading activities, or only a

certain subset of trading activities? If it only provides useful

information for a subset of trading activities, how should this issue

be addressed? How beneficial is the information that the quantitative

measurement provides for this subset of trading activities? Do any of

the other quantitative measurements provide the same level of

beneficial information for this subset of trading activities? Should

the quantitative measurement be required to be reported for all trading

activities, only a relevant subset of trading activities, or not at

all?

Does the quantitative measurement provide useful

information as applied to all asset classes, or only a certain subset

of asset classes? If it only provides useful information for a subset

of asset classes, how should this issue be addressed? How beneficial is

the information the quantitative measurement provides for this subset

of asset classes? Do any of the other quantitative measurements provide

the same level of beneficial information for this subset of asset

classes? Should the quantitative measurement be required to be reported

for all asset classes, only a relevant subset of asset classes, or not

at all?

Is the calculation period effective and sufficiently

clear? If not, what alternative would be more effective or clearer?

How burdensome and costly would it be to calculate the

measurement at the specified calculation frequency and calculation

period? Are there any difficulties or costs associated with calculating

the measurement for particular trading units? How significant are those

potential costs relative to the potential benefits of the measurement

in monitoring for impermissible proprietary trading? Are there

potential modifications that could be made to the measurement that

would reduce the burden or cost? If so, what are those modifications?

Please quantify your answers, to the extent feasible.

Question 175. In light of the size, scope, complexity, and risk of

covered trading activities, are there certain types of quantitative

measurements that will not be appropriate for some types of banking

entities, desks, or levels? If so, would it be appropriate to require

only certain quantitative measurements for such banking entities,

desks, or levels?

Question 176. How might the number of quantitative measurements

impact behavior of banking entities? Is there a cost of requiring more

quantitative measurements, such as the cost of increased uncertainty

regarding the combined results of such quantitative measurements? To

what extent and in what ways might uncertainty as to how the

quantitative measurements are applied and evaluated impact behavior?

Proposed Appendix B–Commentary Regarding Identification of Permitted

Market Making-Related Activities

Proposed Appendix B provides commentary that is intended to assist

a banking entity in distinguishing permitted market making-related

activities from trading activities that, even if conducted in the

context of a banking entity’s market making operations, would

constitute prohibited proprietary trading. As noted in Part I of

proposed Appendix B, the commentary applies to all banking entities

that are engaged in market making-related activities in reliance on

Sec. —-.4(b) of the proposed rule. Part II of proposed Appendix B

clarifies that all defined terms used in Appendix B have the meaning

given those terms in Sec. Sec. —-.2 and —-.3 of the proposed rule

and Appendix A.

[[Page 8376]]

The commentary regarding identification of permitted market making-

related activities, which is contained in Part III of proposed Appendix

B, includes three principal components. The first component provides an

overview of market making-related activities and describes, in detail,

typical practices in which market makers engage and typical

characteristics of market making-related activities, articulating the

general framework within which the CFTC views market making-related

activities.202 For example, the commentary provides that market

making-related activities, in the context of a banking entity acting as

principal, generally involve either (i) in the case of market making in

a security that is executed on an organized trading facility or

exchange, passively providing liquidity by submitting resting orders

that interact with the orders of others on an organized trading

facility or exchange and acting as a registered market maker, where

such exchange or organized trading facility provides the ability to

register as a market maker, or (ii) in other cases, providing an

intermediation service to its customers by assuming the role of a

counterparty that stands ready to buy or sell a position that the

customer wishes to sell or buy. The second component of the commentary

provides an overview of prohibited proprietary trading activities,

which describes the general framework within which the CFTC views

prohibited proprietary trading and contrasts that activity to the

practices and characteristics of market making-related activities.203

The third component describes certain challenges that arise in

distinguishing permitted market making-related activities and

prohibited proprietary trading, particularly in cases in which both of

these activities occur within the context of a market making

operation,204 and proposes guidance that the CFTC would apply in

distinguishing permitted market making-related activities from

prohibited proprietary trading. This guidance includes six factors that

would cause a banking entity to be considered, absent explanatory

circumstances, to be engaged in prohibited proprietary trading, and not

permitted market making-related activity. The six factors are:

—————————————————————————

202 See proposed rule Appendix B, Sec. III.A. The practices

and characteristics that are described generally reinforce and

augment the specific requirements that a banking entity must meet in

order to rely on the market-making exemption under Sec. —-.4(b)

of the proposed rule.

203 See proposed rule Appendix B, Sec. III.B.

204 See proposed rule Appendix B, Sec. III.C. Proposed

Appendix B notes, for example, that it may be difficult to

distinguish (i) inventory positions that appropriately support

market making-related activities from (ii) positions taken for

proprietary purposes. See id.

—————————————————————————

Trading activity in which a trading unit retains risk in

excess of the size and type required to provide intermediation services

to customers; 205

—————————————————————————

205 For simplicity and ease of reading, the CFTC has used the

term “customer” throughout the discussion of market making-related

activity. However, as discussed in proposed Appendix B, a market

maker’s “customers” generally vary depending on the asset class

and market in which the market maker is providing intermediation

services. In the context of market making in a security that is

executed on an organized trading facility or an exchange, a

“customer” is any person on behalf of whom a buy or sell order has

been submitted by a broker-dealer or any other market participant.

In the context of market making in a covered financial position in

an over-the-counter market, a “customer” generally would be a

market participant that makes use of the market maker’s

intermediation services, either by requesting such services or

entering into a continuing relationship with the market maker with

respect to such services. In certain cases, depending on the

conventions of the relevant market (e.g., the over-the-counter

derivatives market), such a “customer” may consider itself or

refer to itself more generally as a “counterparty.”

—————————————————————————

Trading activity in which a trading unit primarily

generates revenues from price movements of retained principal positions

and risks, rather than customer revenues;

Trading activity in which a trading unit: (i) Generates

only very small or very large amounts of revenue per unit of risk

taken; (ii) does not demonstrate consistent profitability; or (iii)

demonstrates high earnings volatility;

Trading activity in which a trading unit either (i) does

not transact through a trading system that interacts with orders of

others or primarily with customers of the banking entity’s market

making desk to provide liquidity services, or (ii) holds principal

positions in excess of reasonably expected near term customer demands;

Trading activity in which a trading unit routinely pays

rather than earns fees, commissions, or spreads; and

The use of compensation incentives for employees of a

particular trading activity that primarily reward proprietary risk-

taking.206

—————————————————————————

206 See proposed rule Appendix B, Sec. III.C.1-6. The CFTC

notes that each of these six criteria is directly related to the

overview of market making-related activities provided in section

III.A. of proposed Appendix B.

—————————————————————————

The proposed commentary makes clear that the enumerated factors are

subject to certain facts and circumstances that may explain why a

trading activity may meet one or more factors but does not involve

prohibited proprietary trading, and provides a range of examples of

such explanatory facts and circumstances.207 The CFTC emphasizes that

these examples are not meant to be exhaustive, as a variety of other

circumstances may exist to explain why a particular trading activity,

even if meeting one of the factors, may nonetheless be a permitted

market making-related activity.208

—————————————————————————

207 The proposed commentary does not contemplate explanatory

facts and circumstances for the compensation incentives factor,

given that the choice of compensation incentives provided to trading

personnel is under the full control of the banking entity.

208 The CFTC also notes that, although a particular trading

activity may not meet the requirements applicable to permitted

market making-related activities, it may still be exempt under

another available exemption.

—————————————————————————

In addition, for each of these six factors, the proposed rule

provides general guidance as to (i) the types of facts and

circumstances on which the CFTC may base any determination that a

banking entity’s trading activity met the relevant factor and (ii)

which quantitative measurements, if furnished by a banking entity

pursuant to Appendix A, the CFTC would use to help assess the extent to

which a banking entity’s activities met the relevant factor.

The CFTC requests comment on the proposed commentary regarding

identification of permitted market making-related activities. In

particular, the CFTC requests comment on the following questions:

Question 177. Is the overview of permitted market making-related

activities and prohibited proprietary trading proposed in Appendix B

accurate? If not, what alternative overview would be more accurate?

Does the overview appropriately account for differences in market

making-related activities across different asset classes? If not, which

type of market making-related activity does the overview not

sufficiently describe or account for?

Question 177.1. Should the proposed CFTC Rule include the entire

Appendix B (e.g., description of market-making in liquid exchange-

traded equity)? Please explain the rationale for including or excluding

certain provisions of Appendix B in the proposed CFTC Rule.

Question 178. Is the requirement that a market maker engaged in

market making that is executed on an exchange or an organized trading

facility must be a registered market maker, provided the relevant

exchange or organized trading facility provides the ability to

register, appropriate, or is it over- or under-inclusive? Please

discuss and provide detailed examples of any such markets where

registering as a market maker is not feasible or should not be required

for purposes of this rule, and

[[Page 8377]]

unregistered market makers provide similar services or perform similar

functions.

Question 179. With respect to market making that is executed on an

exchange or an organized trading facility, what potential impact or

unintended consequences might result from limiting the market making

exemption to registered market makers when the relevant exchange or

organized trading facility registers market makers? Would such a

requirement result in any potential decrease in the passive provision

of liquidity by the submission of resting orders? Do you anticipate

that any such decrease would be exacerbated in times of market stress?

If yes, please describe the impact on liquidity and the marketplace in

general. Please discuss whether and how any potential decrease in

liquidity could be mitigated. In addition, would such a requirement

result in additional costs that would be borne by market participants

purchasing and selling on an exchange or organized trading facility?

Please identify and discuss any other additional costs. Please discuss

whether and how any such consequences can be mitigated.

Question 180. In addition to benefits discussed in the

Supplementary Information, are there other benefits that would be

achieved by requiring that a market maker be registered with respect to

market making on an exchange or an organized trading facility? Is there

a way to amplify these benefits? Could these benefits be realized

through alternative means? If so, how?

Question 181. In addition to registered market makers on exchanges

or organized trading facilities, what other classes of liquidity

providers exist? Are their obligations and activities similar to, or

different than those of registered market makers? If so, how? Are the

compensated in a different manner?

Question 182. How much liquidity is provided by registered market

makers versus other liquidity providers by asset class (e.g., equities,

etc.) with respect to trading on an exchange or an organized trading

facility? The CFTC encourages commenters to provide data, or studies,

in support of comments.

Question 183. Is there any specific element of market making-

related activity that the overview does not take into account in its

description of market making? If so, how should the overview account

for this element? Are there any descriptions of market making-related

activity in the overview that should not be considered to be market

making-related activity? If so, why? Is there any specific element of

prohibited proprietary trading activity that the overview does not take

into account in its description of prohibited proprietary trading? If

so, how should the overview account for this element? Are there any

descriptions of prohibited proprietary trading activity in the overview

that should not be considered to be prohibited proprietary trading? If

so, why?

Question 184. Are each of the six factors specified for helping to

distinguish permitted market making-related activity from prohibited

proprietary trading appropriate? If not, how should they be changed,

and why? Should any factors be eliminated or added? If so, which ones

and why? Could any of the proposed factors occur as a result of the

banking entity engaging in one of the other permitted activities (e.g.,

underwriting, trading on behalf of customers)? If so, would the facts

and circumstances that the CFTC proposes to consider be sufficient to

determine and verify that the banking entity is not engaged in

prohibited proprietary trading? If not, how should this issue be

addressed?

Question 185. Are the facts and circumstances that would be used to

determine whether a banking entity’s activities satisfy a certain

factor appropriate? If not, how should they be changed, and why? Should

any be eliminated or added? If so, which ones, and why?

Question 186. Are the identified quantitative measurements that the

CFTC would use to help assess a particular factor appropriate? If not,

how should they be changed, and why? Should any be eliminated or added?

If so, which ones, and why?

e. Incorporation of Numerical Thresholds in the Commentary Regarding

Identification of Permitted Market Making-Related Activities

As noted above, the CFTC is currently requesting comment on whether

to incorporate, as part of the proposed rule, numerical thresholds for

certain quantitative measurements, and if so, how to do so. For

example, the proposed rule could include one or more numerical

thresholds that, if met by a banking entity, would require the banking

entity to review its trading activities for compliance and summarize

that review to the CFTC.

The primary purpose of using some form of threshold would be to

provide banking entities with a clear standard regarding trading

activity that presented a quantitative profile sufficiently

questionable to warrant further review and explanation to the CFTC.

Such clarity would appear to provide significant benefits both to

banking entities in conducting their trading activities in conformance

with the proposed rule and to the CFTC in monitoring trading activities

and obtaining additional, more detailed information in circumstances

warranting closer scrutiny. In addition to the benefits of

transparency, thresholds would also encourage consistent review by

banking entities and the CFTC of transactions, both within a banking

entity and across all banking entities. The purpose of such thresholds

would not be to serve as bounds of permitted conduct or as a

comprehensive, dispositive tool for determining whether prohibited

proprietary trading has occurred.

Numerical thresholds have not been included in the proposed rule

because the CFTC believes that public comment and further review is

warranted before numerical thresholds and specific numerical amounts

may be proposed. Instead, the CFTC requests comment on whether such

thresholds would be desirable and, if so, what particular form such

thresholds should take and what specific numerical thresholds would be

appropriate. To facilitate the comment process, this request for

comment includes a number of illustrative examples of numerical

thresholds on which specific comment is sought.

In particular, the CFTC requests comment on the following

questions:

Question 187. What are the potential benefits and costs of

incorporating into the proposed rule one or more numerical thresholds

for certain quantitative measurements that, if reported by a banking

entity, would require the banking entity to review its trading

activities for compliance and summarize that review to the CFTC? Would

such thresholds provide useful clarity to banking entities and/or

market participants regarding the types of trading activities that

merit additional scrutiny? Should numerical thresholds be used for any

purposes other than highlighting trading activities that should be

reviewed, the results of which would be reported to the CFTC? If so,

for what purpose, and how and why?

Question 188. For which of the relevant quantitative measurements

might it be appropriate and effective to include a numerical threshold

that would trigger banking entity review and explanation? How should a

numerical threshold be formulated, and why? Should a numerical

threshold for a single quantitative measurement be applied

individually, or should the threshold instead be triggered by exceeding

some combination of numerical thresholds for different

[[Page 8378]]

measurements? For any particular threshold, what numerical amount

should be used, and why? How would such numerical amount be consistent

with a level at which further review and explanation is warranted?

Should the amount vary by asset class or other characteristic? If so,

how?

Question 189. For each of the following illustrative examples of

potential thresholds, is the threshold formulated effectively? If not,

what alternative formulation would be more effective? Should the

threshold formulation vary by asset class or other characteristic? If

so, how and why? If the threshold was utilized, what actual numerical

amount should be specified, and why? How would such numerical amount be

consistent with a level at which further review and explanation is

warranted? Should the numerical amount vary by asset class or other

characteristic? If so, how and why?

“If a trading unit reports an increase in VaR, Stress

VaR, or Risk Factor Sensitivities greater than [—-] over a period of

[—-] months, or such other threshold as the CFTC may require, the

banking entity must (i) promptly review and investigate the trading

unit’s activities to verify whether the trading unit is operating in

compliance with the proprietary trading restrictions and (ii) report to

the CFTC a summary of such review, including any explanatory

circumstances.”

“If a trading unit reports an average Comprehensive

Profit and Loss that is less than [—-] times greater than the

Portfolio Profit and Loss, exclusive of Spread Profit and Loss, for [–

–] consecutive months, or such other threshold as the CFTC may

require, the banking entity must (i) promptly review and investigate

the trading unit’s activities to verify whether the trading unit is

operating in compliance with the proprietary trading restrictions and

(ii) report to the CFTC a summary of such review, including any

explanatory circumstances.”

“If a trading unit reports a Comprehensive Profit and

Loss to Volatility Ratio that is less than [—-] times greater than

that trading desk’s Portfolio Profit and Loss to Volatility Ratio over

a period of [—-] months, or such other threshold as the CFTC may

require, the banking entity must (i) promptly review and investigate

the trading unit’s activities to verify whether the trading unit is

operating in compliance with the proprietary trading restrictions and

(ii) report to the CFTC a summary of such review, including any

explanatory circumstances.”

“If a trading unit reports a number of Unprofitable

Trading Days Based on Portfolio Profit and Loss that is less than [—-

] times greater than the number of Unprofitable Trading Days Based on

Comprehensive Profit and Loss for [—-] consecutive months, or such

other threshold as [Agency] may require, the banking entity must (i)

promptly review and investigate the trading unit’s activities to verify

whether the trading unit is operating in compliance with the

proprietary trading restrictions and (ii) report to [Agency] a summary

of such review, including any explanatory circumstances.”

“If a trading unit reports a Pay-to-Receive Spread Ratio

that is less than [—-] over a period of [—-] months, or such other

threshold as [Agency] may require, the banking entity must (i) promptly

review and investigate the trading unit’s activities to verify whether

the trading unit is operating in compliance with the proprietary

trading restrictions and (ii) report to [Agency] a summary of such

review, including any explanatory circumstances.”

6. Section —-.8: Limitations on permitted trading activities

Section —-.8 of the proposed rule implements section 13(d)(2) of

the BHC Act, which places certain limitations on the permitted trading

activities (e.g., permitted market making-related activities, risk-

mitigating hedging, etc.) in which a banking entity may engage.209

Consistent with the statute, Sec. —-.8(a) of the proposed rule

provides that no transaction, class of transactions, or activity is

permissible under Sec. Sec. —-.4 through —-.6 of the proposed rule

if the transaction, class of transactions, or activity would:

—————————————————————————

209 See 12 U.S.C. 1851(d)(2).

—————————————————————————

Involve or result in a material conflict of interest

between the banking entity and its clients, customers, or

counterparties;

Result, directly or indirectly, in a material exposure by

the banking entity to a high-risk asset or a high-risk trading

strategy; or

Pose a threat to the safety and soundness of the banking

entity or U.S. financial stability.

The proposed rule further defines “material conflict of

interest,” “high-risk asset,” and “high-risk trading strategy” for

these purposes.

a. Scope of “Material Conflict of Interest”

Section —-.8(b) of the proposed rule defines the scope of

material conflicts of interest which, if arising in connection with a

permitted trading activity, are prohibited under the proposal.210

Conflicts of interest may arise in a variety of circumstances related

to permitted trading activities. For example, a banking entity may

acquire substantial amounts of nonpublic information about the

financial condition of a particular company or issuer through its

lending, underwriting, investment advisory or other activities which,

if improperly transmitted to and used in trading operations, would

permit the banking entity to use such information to its customers’,

clients’ or counterparties’ disadvantage. Similarly, a banking entity

may conduct a transaction that places the banking entity’s own

interests ahead of its obligations to its customers, clients or

counterparties, or it may seek to gain by treating one customer

involved in a transaction more favorably than another customer involved

in that transaction. Concerns regarding conflicts of interest are

likely to be elevated when a transaction is complex, highly structured

or opaque, involves illiquid or hard-to-value instruments or assets,

requires the coordination of multiple internal groups (such as multiple

trading desks or affiliated entities), or involves a significant

asymmetry of information or transactional data among participants.211

In all cases, the existence of a material conflict of interest depends

on the specific facts and circumstances.

—————————————————————————

210 Section —-.17(b) of the proposed rule defines the scope

of material conflicts of interest which, if arising in connection

with permitted covered fund activities, are prohibited.

211 See, e.g., U.S. Senate Permanent Subcommittee on

Investigations, Wall Street and the Financial Crisis: Anatomy of a

Financial Collapse (Apr. 13, 2011), available at http://hsgac.senate.gov/public/_files/Financial_Crisis/FinancialCrisisReport.pdf.

—————————————————————————

To address these types of material conflicts of interest, Sec. —

–.8(b) of the proposed rule specifies that a material conflict of

interest between a banking entity and its clients, customers, or

counterparties exists if the banking entity engages in any transaction,

class of transactions, or activity that would involve or result in the

banking entity’s interests being materially adverse to the interests of

its client, customer, or counterparty with respect to such transaction,

class of transactions, or activity, unless the banking entity has

appropriately addressed and mitigated the conflict of interest, where

possible, and subject to specific requirements provided in the

proposal, through either (i) timely and effective disclosure, or (ii)

informational barriers.212 Unless the conflict of interest is

addressed and mitigated in one of the two ways specified in the

proposal, the related transaction, class of transactions or

[[Page 8379]]

activity would be prohibited under the proposed rule, notwithstanding

the fact that it may be otherwise permitted under Sec. Sec. —-.4

through —-.6 of the proposed rule.213

—————————————————————————

212 See proposed rule Sec. —-.8(b)(1).

213 The CFTC notes that a banking entity subject to Appendix C

must implement a compliance program that includes, among other

things, policies and procedures that explain how the banking entity

monitors and prohibits conflicts of interest with clients,

customers, and counterparties. Further, as noted in the discussion

of the definition of “material conflict of interest” in Part

III.B.6 of this Supplemental Information, the discussion of that

definition is provided solely for purposes of the proposed rule’s

definition of material conflict of interest, and does not affect the

scope of that term in other contexts or a banking entity’s

obligation to comply with additional or different requirements with

respect to a conflict under applicable securities, banking, or other

laws (e.g., section 27B of the Securities Act, which governs

conflicts of interest relating to certain securitizations; section

206 of the Investment Advisers Act of 1940, which applies to

conflicts of interest between investment advisers and their clients;

or 12 CFR 9.12, which applies to conflicts of interest in the

context of a national bank’s fiduciary activities).

—————————————————————————

However, while these conflicts may be material for purposes of the

proposed rule, the mere fact that the buyer and seller are on opposite

sides of a transaction and have differing economic interests would not

be deemed a “material” conflict of interest with respect to

transactions related to bona fide underwriting, market making, risk-

mitigating hedging or other permitted activities, assuming the

activities are conducted in a manner that is consistent with the

proposed rule and securities and banking laws and regulations.

Section —-.8(b)(1) of the proposed rule describes the two

requirements that must be met in cases where a banking entity addresses

and mitigates a material conflict of interest through timely and

effective disclosure. First, Sec. —-.8(b)(1)(i) of the proposed rule

requires that the banking entity, prior to effecting the specific

transaction or class or type of transactions, or engaging in the

specific activity, for which a conflict may arise, make clear, timely,

and effective disclosure of the conflict or potential conflict of

interest, together with any other necessary information.214 This

would also require such disclosure to be provided in reasonable detail

and in a manner sufficient to permit a reasonable client, customer, or

counterparty to meaningfully understand the conflict of interest.215

Disclosure that is only general or generic, rather than specific to the

individual, class, or type of transaction or activity, or that omits

details or other information that would be necessary to a reasonable

client’s, customer’s, or counterparty’s understanding of the conflict

of interest, would not meet this standard. Second, Sec. —

–.8(b)(1)(ii) of the proposed rule requires that the disclosure be

made explicitly and effectively, and in a manner that provides the

client, customer, or counterparty the opportunity to negate, or

substantially mitigate, any materially adverse effect on the client,

customer, or counterparty that was created or would be created by the

conflict or potential conflict.216

—————————————————————————

214 See proposed rule Sec. —-.8(b)(1)(A).

215 See id.

216 See proposed rule Sec. —-.8(b)(1)(B).

—————————————————————————

The CFTC notes that, in order to provide the requisite opportunity

for the client, customer or counterparty to negate or substantially

mitigate the disadvantage created by the conflict, the disclosure would

need to be provided sufficiently close in time to the client’s,

customer’s, or counterparty’s decision to engage in the transaction or

activity to give the client, customer, or counterparty an opportunity

to meaningfully evaluate and, if necessary, take steps that would

negate or substantially mitigate the conflict. Disclosure provided far

in advance of the individual, class, or type of transaction, such that

the client, customer, or counterparty is unlikely to take that

disclosure into account when evaluating a transaction, would not

suffice. Conversely, disclosure provided without a sufficient period of

time for the client, customer, or counterparty to evaluate and act on

the information it receives, or disclosure provided after the fact,

would also not suffice under the proposal. The CFTC notes that the

proposed definition would not prevent or require disclosure with

respect to transactions or activities that align the interests of the

banking entity with its clients, customers, or counterparties or that

otherwise do not involve “material” conflicts of interest as

discussed above.

The proposed disclosure standard reflects the fact that some types

of conflicts may be appropriately resolved through the disclosure of

clear and meaningful information to the client, customer, or

counterparty that provides such party with an informed opportunity to

consider and negate or substantially mitigate the conflict. However, in

the case of a conflict in which a client, customer, or counterparty

does not have sufficient information and opportunity to negate or

mitigate the materially adverse effect on the client, customer, or

counterparty created by the conflict, the existence of that conflict of

interest would prevent the banking entity from availing itself of any

exemption (e.g., the underwriting or market-making exemptions) with

respect to the relevant transaction, class of transactions, or

activity. The CFTC notes that the proposed disclosure provisions are

provided solely for purposes of the proposed rule’s definition of

material conflict of interest, and do not affect a banking entity’s

obligation to comply with additional or different disclosure or other

requirements with respect to a conflict under applicable securities,

banking, or other laws (e.g., section 27B of the Securities Act, which

governs conflicts of interest relating to certain securitizations;

section 206 of the Investment Advisers Act of 1940, which governs

conflicts of interest between investment advisers and their clients; or

12 CFR 9.12, which applies to conflicts of interest in the context of a

national bank’s fiduciary activities).

Section —-.8(b)(2) of the proposed rule describes the

requirements that must be met in cases where a banking entity uses

information barriers that are reasonably designed to prevent a material

conflict of interest from having a materially adverse effect on a

client, customer or counterparty. Information barriers can be used to

restrict the dissemination of information within a complex organization

and to prevent material conflicts by limiting knowledge and

coordination of specific business activities among units of the entity.

Examples of information barriers include, but are not limited to,

restrictions on information sharing, limits on types of trading, and

greater separation between various functions of the firm. Information

barriers may also require that banking entity units or affiliates have

no common officers or employees. Such information barriers have been

recognized in Federal securities laws and rules as a means to address

or mitigate potential conflicts of interest or other inappropriate

activities.217

—————————————————————————

217 For example, information barriers have been used in

complying with the requirement in section 15(g) of the Exchange Act

that registered brokers and dealers establish, maintain and enforce

written policies and procedures reasonably designed, taking into

consideration the nature of such broker’s or dealer’s business, to

prevent the misuse of material, nonpublic information by such broker

or dealer or any person associated with such broker or dealer.

—————————————————————————

In order to address and mitigate a conflict of interest through the

use of the information barriers pursuant to Sec. —-.8(b)(2) of the

proposed rule, a banking entity would be required to establish,

maintain, and enforce information barriers that are memorialized in

written policies and procedures, including physical separation of

personnel, functions, or limitations on types of activity, that are

reasonably designed, taking into

[[Page 8380]]

consideration the nature of the banking entity’s business, to prevent

the conflict of interest from involving or resulting in a materially

adverse effect on a client, customer or counterparty.218 Importantly,

the proposed rule also provides that, notwithstanding a banking

entity’s establishment of such information barriers, if the banking

entity knows or should reasonably know that a material conflict of

interest arising out of a specific transaction, class or type of

transactions, or activity may involve or result in a materially adverse

effect on a client, customer, or counterparty, the banking entity may

not rely on those information barriers to address and mitigate any

conflict of interest. In such cases, the transaction or activity would

be prohibited, unless the banking entity otherwise complies with the

requirements of Sec. —-.8(b)(1).219 This aspect of the proposal is

intended to make clear that, in specific cases in which a banking

entity has established an information barrier but knows or should

reasonably know that it has failed or will fail to prevent a conflict

of interest arising from a specific transactions or activity that

disadvantages a client, customer, or counterparty, the information

barrier is insufficient to address that conflict and the transaction

would be prohibited, unless the banking entity is otherwise able to

address and mitigate the conflict through timely and effective

disclosure under the proposal.220

—————————————————————————

218 See proposed rule Sec. —-.8(b)(2). As part of

maintaining and enforcing information barriers, a banking entity

should have processes to review, test, and modify information

barriers on a continuing basis. In addition, banking entities should

have ongoing monitoring to maintain and to enforce information

barriers, for example by identifying whether such barriers have not

prevented unauthorized information sharing and addressing instances

in which the barriers were not effective. This may require both

remediating any identified breach as well as updating the

information barriers to prevent further breaches, as necessary.

Periodic assessment of the effectiveness of information barriers and

periodic review of the written policies and procedures are also

important to the maintenance and enforcement of effective

information barriers and reasonably designed policies and

procedures. Such assessments can be done either (i) internally by a

qualified employee or (ii) externally by a qualified independent

party.

219 See proposed rule Sec. —-.8(b)(2).

220 In addition, if a conflict occurs to the detriment of a

client, customer, or counterparty despite an information barrier,

the CFTC would also expect the banking entity to review the

effectiveness of its information barrier and make adjustments, as

necessary, to avoid future occurrences, or review whether such

information barrier is appropriate for that type of conflict.

—————————————————————————

The CFTC notes that the proposed definition of material conflict of

interest does not address instances in which a banking entity has made

a material misrepresentation to its client, customer, or counterparty

in connection with a transaction, class of transactions, or activity,

as such transactions or activity appears to involve fraud rather than a

conflict of interest. However, the CFTC notes that such

misrepresentations are generally illegal under a variety of Federal and

State regulatory schemes (e.g., the Federal securities laws). In

addition, the CFTC notes that any activity involving a material

misrepresentation to, or other fraudulent conduct with respect to, a

client, customer, or counterparty would not be permitted under the

proposed rule in the first instance. For example, a trading activity

involving a material misrepresentation to a client, customer, or

counterparty would fail, on its face, to satisfy the proposed terms of

the underwriting or market-making exemption.

b. Definition of “High-Risk Asset” and “High-Risk Trading Strategy”

Section —-.8(c) of the proposed rule defines “high-risk asset”

and “high-risk trading strategy” for proposes of Sec. —-.8’s

proposed limitations on permitted trading activities. Section —

–.8(c)(1) defines a “high-risk asset” as an asset or group of assets

that would, if held by the banking entity, significantly increase the

likelihood that the banking entity would incur a substantial financial

loss or would fail. Section —-.8(c)(2) defines a “high-risk trading

strategy” as a trading strategy that would, if engaged in by the

banking entity, significantly increase the likelihood that the banking

entity would incur a substantial financial loss or would fail.221

—————————————————————————

221 The CFTC notes that a banking entity subject to proposed

Appendix C must implement a compliance program that includes, among

other things, policies and procedures that explain how the banking

entity monitors and prohibits exposure to high-risk assets and high-

risk trading strategies, and identifies a variety of assets and

strategies (e.g., assets or strategies with significant embedded

leverage).

—————————————————————————

c. Request for Comment

The CFTC requests comment on the proposed limitations on permitted

trading activities. In particular, the CFTC requests comment on the

following questions:

Question 190. Is the manner in which the proposed rule implements

the limitations of section 13(d)(2) of the BHC Act effective and

sufficiently clear? If not, what alternative would be more effective

and/or clearer?

Question 191. Is the proposed rule’s definition of material

conflict of interest effective and sufficiently clear? If not, what

alternative would be more effective and/or clearer?

Question 192. Is the proposed definition of material conflict of

interest over- or under-inclusive? If so, how should the definition be

broader or narrower? Is there an alternative definition that would be

appropriate? If so, what definition? Why would that alternative

definition better define material conflict of interest for purposes of

implementing section 13 of the BHC Act?

Question 193. Would the proposed definition of material conflict of

interest have any unintended chilling effect on underwriting, market

making, risk-mitigating hedging or other permitted activities? If so,

what alternatives might limit such an effect?

Question 194. Would the proposed definition of material conflict of

interest lead to unintended consequences? If so, what unintended

consequences and why? Please suggest modifications to the proposed

definition that would mitigate those consequences.

Question 195. Is it likely that the proposed definition of material

conflict of interest would anticipate all future material conflicts of

interest, particularly as the financial markets evolve and change? If

not, what alternative definition would better anticipate future

material conflicts of interest?

Question 196. Does the proposed rule provide sufficient guidance

for determining when a material conflict of interest exists? If not,

what additional detail should be provided? Should the CFTC adopt an

approach similar to that under the securities laws, in which a material

conflict of interest is not specifically defined?

Question 197. Are there transactions, classes or types of

transactions, or activities inherent in underwriting, market-making,

risk-mitigating hedging or other permitted activities that should not

be prohibited but may be captured by the proposed definition of

material conflict of interest? If so, what transactions and activities?

Should they be permitted under the proposed rule? If so, why and under

what conditions, if any? Conversely, are there transactions or

activities that would be permitted under the proposed rule that should

be prohibited? If so, what transactions and activities? Why should they

be prohibited under the proposed rule?

Question 198. Please discuss the inherent conflicts of interest

that arise from bona fide underwriting, market making-related activity,

risk-mitigating hedging, or any other permitted activity, and provide

specific examples of such inherent conflicts. Do you believe that such

conflicts ever result in a materially

[[Page 8381]]

adverse interest between a banking entity and a client, customer, or

counterparty? How should the proposal address inherent conflicts that

result from otherwise-permitted activities?

Question 199. Is the manner in which the proposed rule permits the

use of disclosure in certain cases to address and mitigate conflicts of

interest appropriate? Why or why not? Should additional or alternative

requirements be placed on the use of disclosure to address and mitigate

conflicts? If so, what additional and alternative requirements, and

why? Is the level of detail and specificity required by the proposed

rule with respect to disclosure appropriate? If not, what alternative

level of detail and specificity would be more appropriate?

Question 200. Should the proposed rule require written disclosure

to a client, customer, or counterparty regarding a material conflict of

interest? If so, please explain why written disclosure should be

required. Are there certain circumstances where written disclosure

should be required, but others where oral disclosure should be

sufficient? For example, should oral disclosure be permitted for

transactions in certain fast-moving markets or transactions with

sophisticated clients, customers, or counterparties? If oral disclosure

is permitted under certain circumstances, should subsequent written

disclosure be required? Please explain.

Question 201. Should the proposed rule provide further detail

regarding the types of conflicts of interest that cannot be addressed

and mitigated through disclosure? If so, what type of additional detail

would be helpful, and why? Should the proposed rule enumerate an

exhaustive or non-exhaustive list of conflicts that cannot be addressed

and mitigated through disclosure? If so, what conflicts should that

list include, and why?

Question 202. Should the proposed rule provide further detail

regarding the frequency at which disclosure must be made? Should

general disclosure be permitted for certain types of transactions,

classes of transactions, or activities? For example, should a banking

entity be permitted to make a one-time, written disclosure to a client,

customer, or counterparty prior to engaging in a certain type of

transaction or activity? Should general disclosure be permitted for

certain types of clients, customers, or counterparties (e.g., highly

sophisticated parties)? Please explain why specific disclosure (i.e.,

prior to each transaction, class of transaction, or activity) would not

be necessary under the identified circumstances. Are there any clients,

customers, or counterparties that should be able to waive a material

conflict of interest under certain circumstances? If so, under what

circumstances would a waiver approach be appropriate and consistent

with the statute? Please explain.

Question 203. Should the proposed definition of material conflict

of interest deem certain potential conflicts of interest to not be

material conflicts of interest if a banking entity establishes,

maintains, and enforces policies and procedures (other than information

barriers) reasonably designed to prevent transactions, classes of

transactions, or activities that would involve or result in a material

conflict of interest? If so, for what types of potential conflicts?

What policies and procedures would be appropriate? How would this

approach be consistent with the purpose and language of the statute?

Should such policies and procedures only be considered effective if

they prevent the banking entity from receiving an advantage to the

disadvantage of the client, customer, or counterparty?

Question 204. Are there any particular types of clients, customers,

or counterparties for whom disclosure of a material conflict of

interest should not be required under the proposal, consistent with the

statute? Please identify the types of clients, customers, or

counterparties for whom disclosure might not be necessary and explain.

Why might disclosures be useful for some clients, customers, or

counterparties, but not others? Please explain. What characteristics

should a firm use in determining whether or not a client, customer, or

counterparty needs a particular disclosure?

Question 205. Are there additional steps that a banking entity that

seeks to manage conflicts of interest through the use of disclosure

should be required to take with regard to disclosure? If so, what

steps?

Question 206. Are there circumstances in which disclosure might be

impracticable or ineffective? If so, what circumstances, and why?

Question 207. Is the manner in which the proposed rule permits the

use of information barriers to address and mitigate conflicts of

interest appropriate? Why or why not? Should additional or alternative

requirements be placed on the use of information barriers to address

and mitigate conflicts? If so, what additional and alternative

requirements, and why?

Question 208. Should the proposed rule mandate the use of other

means of managing potential conflicts of interest? If so, what specific

means should be considered? How effective are any such methods as

currently used? Can such methods be circumvented? If so, in what ways?

Question 209. What burdens or costs might be associated with the

disclosure-related or information barrier-related requirements

contained in the proposed definition of material conflict of interest?

How might these burdens or costs be eliminated or reduced in a manner

consistent with the purpose and language of section 13 of the BHC Act?

Question 210. Are there specific transactions, classes of

transactions or activities that should be managed through consent? If

so, what transactions or activities, and why? What form of consent

should be required? What level of detail should any such consent

include? Should consent only apply to certain conflicts and not others?

If so, which conflicts? Are there circumstances in which obtaining

consent might be impracticable or ineffective? Should consent be

limited to certain types of clients, customers, or counterparties? If

so, which clients, customers, or counterparties? Are there certain

types of clients, customers, or counterparties for whom consent would

never be sufficient? Are there additional steps that a banking entity

that seeks to manage conflicts of interest through the use of consent

should be required to take? Please specify such steps.

Question 211. What is the potential relationship between, and

interplay of, the proposed rule and Section 621 of the Dodd-Frank Act

regarding conflicts of interest relating to certain securitizations

which contains a prohibition on material conflicts of interest?

Question 212. Should the proposed rule provide for specific types

of procedures that would be more effective in managing and mitigating

conflicts of interest than others? Do banking entities currently use

certain procedures that effectively manage and mitigate material

conflicts of interest? If so, please describe such procedures and

explain why such procedures are effective. Is the proposed rule

consistent with such procedures? Why or why not? What are the costs and

benefits of modifying your current procedures in response to the

proposed rule?

Question 213. Is the proposed rule’s definition of a high-risk

asset effective and sufficiently clear? If not, what alternative would

be more effective and/or clearer? Should the proposed rule specify

particular assets that are deemed high-risk per se? If so, what assets

and why?

[[Page 8382]]

Question 214. Is the proposed rule’s definition of a high-risk

trading strategy effective and sufficiently clear? If not, what

alternative would be more effective and/or clearer? Should the proposed

rule specify particular trading strategies that are deemed high-risk

per se? If so, what trading strategies and why?

C. Subpart C–Covered Fund Activities and Investments

As noted above, except as otherwise permitted, section 13(a)(1)(B)

of the BHC Act prohibits a banking entity from acquiring or retaining

any ownership in, or acting as sponsor to, a covered fund.222 Subpart

C of the proposed rule applies those portions of section 13 of the BHC

Act that operate as a prohibition or restriction on a banking entity’s

ability, as principal, directly or indirectly, to acquire or retain an

ownership interest in, act as sponsor to, or have certain relationships

with, a covered fund. Subpart C also implements the permitted activity

and investment authorities provided for under section 13(d)(1) of the

BHC Act related to covered fund activities and investments, as well as

the rule of construction related to the sale and securitization of

loans under section 13(g)(2) of that Act. Additionally, subpart C

contains a discussion of the internal controls, reporting and

recordkeeping requirements applicable to covered fund activities and

investments, and incorporates by reference the minimum compliance

standards for banking entities contained in subpart D of the proposed

rule, as well as Appendix C, to the extent applicable.

—————————————————————————

222 See 12 U.S.C. 1851(a)(1)(B).

—————————————————————————

1. Section —-.10: Prohibition of Acquisition or Retention of

Ownership Interests in, and Certain Relationships With, a Covered Fund

Section —-.10 of the proposed rule defines the scope of the

prohibition on acquisition or retention of ownership interests in, and

certain relationships with, a covered fund, as well as defines a number

of key terms related to such prohibition.

a. Prohibition Regarding Covered Fund Activities and Investments

Section —-.10(a) of the proposed rule implements section

13(a)(1)(B) of the BHC Act and prohibits a banking entity from, as

principal, directly or indirectly, acquiring or retaining an equity,

partnership, or other ownership interest in, or acting as sponsor to, a

covered fund, unless otherwise permitted under subpart C of the

proposed rule.223 This prohibition reflects the statute’s purpose and

effect of limiting a banking entity’s ability to invest in or have

exposure to a covered fund.

—————————————————————————

223 See proposed rule Sec. —-.10(a).

—————————————————————————

The CFTC notes that the general prohibition in Sec. —-.10(a) of

the proposed rule applies solely to a banking entity’s acquisition or

retention of an ownership interest in or acting as sponsor to a covered

fund “as principal, directly or indirectly.” 224 As such, the

proposed rule would not prohibit the acquisition or retention of an

ownership interest (including a general partner or membership interest)

in a covered fund: (i) By a banking entity in good faith in a fiduciary

capacity, except where such ownership interest is held under a trust

that constitutes a company as defined in section (2)(b) of the BHC Act;

(ii) by a banking entity in good faith in its capacity as a custodian,

broker, or agent for an unaffiliated third party; (iii) by a

“qualified plan,” as that term is defined in section 401 of the

Internal Revenue Code of 1956 (26 U.S.C. 401), if the ownership

interest would be attributed to a banking entity solely by operation of

section 2(g)(2) of the BHC Act; or (iv) by a director or employee of a

banking entity who acquires the interest in his or her personal

capacity and who is directly engaged in providing advisory or other

services to the covered fund, unless the banking entity, directly or

indirectly, extended credit for the purpose of enabling the director or

employee to acquire the ownership interest in the fund and the credit

was used to acquire such ownership interest in the fund.

—————————————————————————

224 The CFTC notes that this language is intended to prevent a

banking entity from evading the restrictions contained in section

13(a)(1)(B) of the BHC Act on acquiring or retaining an ownership

interest in a covered fund.

—————————————————————————

Among other things, Sec. —-.10(b) of the proposed rule defines

the term “covered fund.” 225 This definition explains the universe

of entities to which the prohibition contained in Sec. —-.10(a)

applies unless the activity is specifically permitted under an

available exemption contained in subpart C of the proposed rule. Other

related terms, including “ownership interest,” “prime brokerage

transaction,” “sponsor,” and “trustee,” are in turn defined in

Sec. Sec. —-.10(b)(2) through —-.10(b)(6) of the proposed rule.

—————————————————————————

225 See proposed rule Sec. —-.10(b)(1). The term banking

entity, which is discussed above in Part III.A.2 of this

Supplementary Information, is defined in Sec. —-.2(e).

—————————————————————————

b. “Covered Fund” and Related Definitions

i. Definition of “Covered Fund”

Section 13(h)(2) of the BHC Act defines the terms “hedge fund”

and “private equity fund” to mean “any issuer that would be an

investment company, as defined in the [Investment Company Act], but for

section 3(c)(1) or 3(c)(7) of that Act,” or such similar funds as the

Agencies may by rule determine.226 Given that the statute defines a

“hedge fund” and “private equity fund” synonymously, the proposed

rule implements this statutory definition by combining the terms into

the definition of a “covered fund.” 227

—————————————————————————

226 12 U.S.C. 1851(h)(2). Sections 3(c)(1) and 3(c)(7) of the

Investment Company Act, in relevant part, provide two exclusions

from the definition of “investment company” for, as appropriate,

(1) any issuer whose outstanding securities are beneficially owned

by not more than one hundred persons and which is not making and

does not presently propose to make a public offering of its

securities (other than short-term paper), or (2) any issuer, the

outstanding securities of which are owned exclusively by persons

who, at the time of acquisition of such securities, are qualified

purchasers, and which is not making and does not at that time

proposes to make a public offering of such securities. See 15 U.S.C.

80a-3(c)(1) and (c)(7).

227 See proposed rule Sec. —-.10(b)(1).

—————————————————————————

Sections 3(c)(1) and 3(c)(7) of the Investment Company Act are

exclusions from the definition of “investment company” in that Act

and are commonly relied on by a wide variety of entities that would

otherwise be covered by the broad definition of “investment company”

contained in that Act. As a result, the statutory definition in section

13(h)(2) of the BHC Act could potentially include within its scope many

entities and corporate structures that would not usually be thought of

as a “hedge fund” or “private equity fund.” For instance, joint

ventures, acquisition vehicles, certain wholly-owned subsidiaries, and

other widely-utilized corporate structures typically rely on the

exclusion contained in section 3(c)(1) or 3(c)(7) of the Investment

Company Act. These types of entities are generally not used to engage

in investment or trading activities. Additionally, as noted in Part

II.H of this Supplementary Information, certain securitization vehicles

may be included in this definition.

The proposed rule follows the scope of the statutory definition by

covering an issuer only if it would be an investment company, as

defined in the Investment Company Act, but for section 3(c)(1) or

3(c)(7) of that Act.228

[[Page 8383]]

Additionally, the proposed rule incorporates the statutory application

of the rule to “such similar funds as the Agencies may determine by

rule as provided in section 13(b)(2) of the BHC Act.” 229 The CFTC

has proposed to include as “similar funds” a commodity pool,230 as

well as the foreign equivalent of any entity identified as a “covered

fund.” 231 These entities have been included in the proposed rule as

“similar funds” given that they are generally managed and structured

similar to a covered fund, except that they are not generally subject

to the Federal securities laws due to the instruments in which they

invest or the fact that they are not organized in the United States or

one or more States.

—————————————————————————

228 See proposed rule Sec. —-.10(b)(1)(i). Under the

proposed rule, if an issuer (including an issuer of asset-backed

securities) may rely on another exclusion or exemption from the

definition of “investment company” under the Investment Company

Act other than the exclusions contained in section 3(c)(1) or

3(c)(7) of that Act, it would not be considered a covered fund, as

long as it can satisfy all of the conditions of an alternative

exclusion or exemption for which it is eligible.

229 12 U.S.C. 1851(b)(2).

230 “Commodity pool” is defined in the Commodity Exchange

Act to mean any investment trust, syndicate, or similar form of

enterprise operated for the purpose of trading in commodity

interests, including any: (i) Commodity for future delivery,

security futures product, or swap; (ii) agreement, contract, or

transaction described in section 2(c)(2)(C)(i) or 2(c)(2)(D)(i) of

the Commodity Exchange Act; (iii) commodity option authorized under

section 4c of the Commodity Exchange Act; or (iv) leverage

transaction authorized under section 23 of the Commodity Exchange

Act. See 7 U.S.C. 1a(10).

231 See proposed rule Sec. —-.10(b)(1)(iii). The proposed

rule makes clear that any issuer, as defined in section 2(a)(22) of

the Investment Company Act, (15 U.S.C. 80a-2(a)(22)), that is

organized or offered outside of the United States, would qualify as

a covered fund if, were it organized or offered under the laws, or

offered for sale or sold to a resident, of the United States or of

one or more States, it would be either: (i) An investment company,

as defined in the Investment Company Act, but for section 3(c)(1) or

3(c)(7) of that Act; (ii) a commodity pool; or (iii) any such

similar fund as the appropriate Federal banking agencies, the SEC,

and the CFTC may determine, by rule, as provided in section 13(b)(2)

of the BHC Act.

—————————————————————————

ii. Definition of “Ownership Interest”

The proposed rule defines “ownership interest” in order to make

clear the scope of section 13(a)(1)(B) of the BHC Act and Sec. —

–.10(a)’s prohibition on a banking entity acquiring or retaining any

equity, partnership, or other ownership interest in a covered fund. The

definition of ownership interest includes a description of what

interests constitute an ownership interest, as well as an exclusion

from the definition of ownership interest for carried interest.232

The proposed rule defines ownership interest to mean, with respect to a

covered fund, any equity, partnership, or other similar interest

(including, without limitation, a share, equity security, warrant,

option, general partnership interest, limited partnership interest,

membership interest, trust certificate, or other similar interest) in a

covered fund, whether voting or nonvoting, as well as any derivative of

such interest. This definition focuses on the attributes of the

interest and whether it provides a banking entity with economic

exposure to the profits and losses of the covered fund, rather than its

form. To the extent that a debt security or other interest of a covered

fund exhibits substantially the same characteristics as an equity or

other ownership interest (e.g., provides the holder with voting rights,

the right or ability to share in the covered fund’s profits or losses,

or the ability, directly or pursuant to a contract or synthetic

interest, to earn a return based on the performance of the fund’s

underlying holdings or investments), the Agencies could consider such

instrument an ownership interest as an “other similar instrument.”

—————————————————————————

232 See proposed rule Sec. —-.10(b)(3).

—————————————————————————

Many banking entities that serve as investment adviser or commodity

trading advisor to a covered fund are compensated for services they

provide to the fund through receipt of so-called “carried interest.”

In recognition of the manner in which such compensation is

traditionally provided, the proposed rule also clarifies that an

ownership interest with respect to a covered fund does not include an

interest held by a banking entity (or an affiliate, subsidiary or

employee thereof) in a covered fund for which the banking entity (or an

affiliate, subsidiary or employee thereof) serves as investment

manager, investment adviser or commodity trading advisor, so long as:

(i) The sole purpose and effect of the interest is to allow the banking

entity (or the affiliate, subsidiary or employee thereof) to share in

the profits of the covered fund as performance compensation for

services provided to the covered fund by the banking entity (or the

affiliate, subsidiary or employee thereof), provided that the banking

entity (or the affiliate, subsidiary or employee thereof) may be

obligated under the terms of such interest to return profits previously

received; (ii) all such profit, once allocated, is distributed to the

banking entity (or the affiliate, subsidiary or employee thereof)

promptly after being earned or, if not so distributed, the reinvested

profit of the banking entity (or the affiliate, subsidiary or employee

thereof) does not share in the subsequent profits and losses of the

covered fund; (iii) the banking entity (or the affiliate, subsidiary or

employee thereof) does not provide funds to the covered fund in

connection with acquiring or retaining this carried interest; and (iv)

the interest is not transferable by the banking entity (or the

affiliate, subsidiary or employee thereof) except to an affiliate or

subsidiary.233 The proposed rule therefore permits a banking entity

to receive an interest as performance compensation for services

provided by it or one of its affiliates, subsidiaries, or employees to

a covered fund, but only if the enumerated conditions are met.

—————————————————————————

233 See proposed rule Sec. —-.10(b)(3)(ii).

—————————————————————————

iii. Definition of “Prime Brokerage Transaction”

Section 13(f)(3) of the BHC Act permits a banking entity to enter

into a prime brokerage transaction with a covered fund in which a

covered fund managed, organized, or sponsored by such banking entity

(or an affiliate or subsidiary thereof) has taken an ownership

interest.234 However, section 13 of the BHC Act does not define what

qualifies as a prime brokerage transaction. In order to provide clarity

regarding the types of services and relationships that are permitted as

a prime brokerage transaction, the proposed rule defines a “prime

brokerage transaction” to mean one or more products or services

provided by a banking entity to a covered fund, such as custody,

clearance, securities borrowing or lending services, trade execution,

or financing, data, operational, and portfolio management support.235

—————————————————————————

234 See 12 U.S.C. 1851(f)(3).

235 See proposed rule Sec. —-.10(b)(4).

—————————————————————————

iv. Definition of “Sponsor” and “Trustee”

The proposed rule defines “sponsor” in the same manner as section

13(h)(5) of the BHC Act.236 Section —-.10(b)(5) of the proposed

rule defines the term “sponsor” as an entity that: (i) serves as a

general partner, managing member, trustee, or commodity pool operator

of a covered fund; (ii) in any manner selects or controls (or has

employees, officers, or directors, or agents who constitute) a majority

of the directors, trustees, or management of a covered fund; or (iii)

shares with a covered fund, for the corporate, marketing, promotional,

or other purposes, the same name or a variation of the same name.237

—————————————————————————

236 See 12 U.S.C. 1851(h)(5).

237 See proposed rule Sec. —-.10(b)(5).

—————————————————————————

The definition of “sponsor” contained in section 13(h)(5) of the

BHC Act focuses on the ability to control the decision-making and

operational

[[Page 8384]]

functions of the fund. In keeping with this focus, the proposed rule

defines the term “trustee” (which is a part of the definition of

“sponsor”) to exclude trustee that does not exercise investment

discretion with respect to a covered fund, including a directed

trustee, as that term is used in section 403(a)(1) of the Employee’s

Retirement Income Security Act (29 U.S.C. 1103(a)(1)). The proposed

rule provides that a “trustee” includes any banking entity that

directs a directed trustee, or any person who possesses authority and

discretion to manage and control the assets of the covered fund.238

—————————————————————————

238 See proposed rule Sec. —-.10(b)(6)(ii).

—————————————————————————

v. Request for Comment

The CFTC requests comment on the proposed rule’s approach to

defining the terms covered fund, ownership interest, and other related

terms. In particular, the CFTC requests comment on the following

questions:

Question 215. Is the proposed rule’s approach to applying section

13 of the BHC Act’s restrictions related to covered fund activities and

investments to those instances where a banking entity acts “as

principal or beneficial owner” effective? If not, why? What

alternative approach might be more effective in light of the language

and purpose of the statute?

Question 216. Does the proposed rule effectively address the

circumstances under which an investment by a director or employee of a

banking entity in a covered fund would be attributed to a banking

entity? If not, why? What alternative might be more effective?

Question 217. Does the proposed rule’s definition of “covered

fund” effectively implement the statute? What alternative definitions

might be more effective in light of the language and purpose of the

statute?

Question 218. Is specific inclusion of commodity pools within the

definition of “covered fund” effective and consistent with the

language and purpose of the statute? Why or why not?

Question 218.1. The proposed CFTC Rule defines a “covered fund”

to include a commodity pool, as defined in section 1a(10) of the

Commodity Exchange Act. Is the use of this definition of “commodity

pools” too broad? For example, will this definition potentially pull

in additional pools that may be outside the intent of the proposed

regulations?

Question 219. The proposed definition of “sponsor” focuses on

“the ability to control the decision-making and operational functions

of the fund.” In the securitization context, is this an appropriate

manner to determine the identity of the sponsor? If not, what factors

should be used to determine the identity of the sponsor in the

securitization context for purposes of the proposed rule and why? Is

the definition of “sponsor” set forth in the SEC’s Regulation AB

239 an appropriate party to treat as sponsor for purposes of the

proposed rule? Is additional guidance necessary with respect to how the

proposed definition of “sponsor” should be applied to a

securitization transaction?

—————————————————————————

239 See 17 CFR 229.1101(l).

—————————————————————————

Question 220. Should the application of the proposed definition of

“sponsor” mean that the servicer or investment manager in a

securitization transaction would be considered the sponsor for purposes

of the proposed rule? What impact would this interpretation of the

proposed definition have on existing securitizations?

Question 221. Should the definition of “covered fund” focus on

the characteristics of an entity rather than whether it would be an

investment company but for section 3(c)(1) or 3(c)(7) of the Investment

Company Act? If so, what characteristics should be considered and why?

Would a definition focusing on an entity’s characteristics rather than

its form be consistent with the language and purpose of the statute?

Question 222. Instead of adopting a unified definition of “covered

fund” for those entities included under section 13(h)(2) of the BHC

Act, should the Agencies consider having separate definitions for

“hedge fund” and “private equity fund”? If so, which definitions

and why?

Question 223. Should the CFTC consider using the authority provided

under section 13(d)(1)(J) of the BHC Act to exempt the acquisition or

retention of an ownership interest in a covered fund with certain

attributes or characteristics, including, for example: (i) A

performance fee or allocation to an investment manager’s equity account

calculated by taking into account income and realized and unrealized

gains; (ii) borrowing an amount in excess of one-half of its total

capital commitments or has gross notional exposure in excess of twice

its total capital commitments; (iii) sells securities or other assets

short; (iv) has restricted or limited investor redemption rights; (v)

invests in public and non-public companies through privately negotiated

transactions resulting in private ownership of the business; (vi)

acquires the unregistered equity or equity-like securities of such

companies that are illiquid as there is no public market and third

party valuations are not readily available; (vii) requires holding

those investments long-term; (viii) has a limited duration of ten years

or less; or (ix) returns on such investments are realized and the

proceeds of the investments are distributed to investors before the

anticipated expiration of the fund’s duration? Which, if any, of these

characteristics are appropriate to describe a hedge fund or private

equity fund that should be considered a covered fund for purposes of

this rule? Are there any other characteristics that would be more

appropriate to describe a covered fund? If so, which characteristics

and why?

Question 224. Is specific inclusion of certain non-U.S. entities as

a “covered fund” under Sec. —-.10(b)(1)(iii) of the proposed rule

necessary, or would such entities already be considered to be a

“covered fund” under Sec. —-.10(b)(1)(i) of the proposed rule? If

so, why? Does the proposed rule’s language on non-U.S. entities

correctly describe those non-U.S. entities, if any, that should be

included in the definition of “covered fund”? Why or why not? What

alternative language would be more effective? Should the CFTC define

non-U.S. funds by reference to the following structural

characteristics: whether they are limited in the number or type of

investors; whether they operate without regard to statutory or

regulatory requirements relating to the types of instruments in which

they may invest or the degree of leverage they may incur? Why or why

not?

Question 225. Are there any entities that are captured by the

proposed rule’s definition of “covered fund,” the inclusion of which

does not appear to be consistent with the language and purpose of the

statute? If so, which entities and why?

Question 226. Are there any entities that are not captured by the

proposed rule’s definition of “covered fund,” the exclusion of which

does not appear to be consistent with the language and purpose of the

statute? If so, which entities and why?

Question 227. Do the proposed rule’s definitions of “covered

fund” and/or “ownership interest” pose unique concerns or challenges

to issuers of asset-backed securities and/or securitization vehicles?

If so, why? Do certain types of securitization vehicles (trusts, LLCs,

etc.) typically issue asset-backed securities which would be included

in the proposed definition of ownership interest? What would be the

impact of the application of the proposed rules to these securitization

[[Page 8385]]

vehicles? Are certain asset classes (collateralized debt obligations,

future flows, corporate debt repackages, etc.) more likely to be

impacted by the proposed definition of “covered fund” because the

issuer cannot rely on an exemption other than 3(c)(1) or 3(c)(7) of the

Investment Company Act?

Question 227.1. Should the proposed CFTC Rule cover securitization

vehicles? Please explain the rationale for including or excluding

securitization vehicles in the proposed CFTC Rule.

Question 228. How many existing issuers of asset-backed securities

would be included in the proposed definition of “covered fund?” What

would be the legal and economic impact of the proposed rule on holders

of asset-backed securities issued by existing securitization vehicles

that would be included in the proposed definition of covered fund?

Question 229. Are there entities that issue asset-backed securities

(as defined in Section 3(a) of the Exchange Act) that should be

exempted from the requirements of the proposed rule? How would such an

exemption promote and protect the safety and soundness of the banking

entity and the financial stability of the United States as required by

section 13(d)(1)(J) of the BHC Act?

Question 230. Since certain existing asset-backed securities may

have a term that exceeds the conformance or extended transition periods

provided for under section 13(c) of the BHC Act, should the CFTC

consider using the authority contained in section 13(d)(1)(J) of that

Act to exclude those existing asset-backed securities from the proposed

definition of “ownership interest” and/or should the rule permit a

banking entity to acquire or retain an ownership interest in existing

asset-backed issuers? If so, how would either approach be consistent

with the language and purpose of the statute?

Question 231. Many issuers of asset-backed securities have features

and structures that resemble some of the features of hedge funds and

private equity funds (e.g., CDOs are managed by an investment adviser

that has the discretion to choose investments, including investments in

securities). If the proposed definition of “covered fund” were to

exempt any entity issuing asset-backed securities, would this allow for

interests in hedge funds or private equity funds to be structured as

asset-backed securities and circumvent the proposed rule? If this

approach is taken, how should the proposal address this concern?

Question 232. Are the structural similarities between an entity

that issues asset-backed securities and hedge funds and private equity

funds of sufficient concern that the CFTC should not exclude any entity

that issues asset-backed securities from the definition of covered

fund?

Question 233. Should entities that rely on a separate exclusion

from the definition of investment company other than sections 3(c)(1)

or 3(c)(7) of the Investment Company Act be included in the definition

of “covered fund”? Why or why not?

Question 234. Do the proposed rule’s definitions of “ownership

interest” and “carried interest” effectively implement the statute?

What alternative definitions might be more appropriate in light of the

language and purpose of the statute? Are there other types of

instruments that should be included or excluded from the definition of

“ownership interest”? Does the proposed definition of ownership

interest capture most interests that are typically viewed as ownership

interests? Is the proposed rule’s exemption of carried interest from

the definition of ownership interest with respect to a covered fund

appropriate? Does the exemption adequately address existing

compensation arrangements and the way in which a banking entity becomes

entitled to carried interest? Is it consistent with the current tax

treatment of these arrangements?

Question 235. In the context of asset-backed securities, the

distinction between debt and equity may be complicated (e.g., trust

certificates issued in a residential mortgage backed security

transaction) and the legal, accounting and tax treatment may differ for

the same instrument. Is guidance necessary with respect to the

application of the definition of ownership interest for asset-backed

securitization transactions?

Question 236. In many securitization transactions, the residual

interest represents the “equity” in the transaction. As this often

constitutes the portion of the securitization transaction with the most

risk, because it may absorb any losses experienced by the underlying

assets before any other interests issued by the securitization vehicle,

should the CFTC instead use their authority under section 13(d)(1)(J)

of the BHC Act to exempt the buying and selling of any ownership

interest in a securitization vehicle that is a covered fund other than

the residual interest?

Question 237. For purposes of limiting either an exclusion for

issuers of asset-backed securities from the proposed definition of

“covered fund” and/or an exclusion of asset-backed securities from

the proposed definition of “ownership interest,” what definition of

asset-backed security most effectively implements the language of

section 13 of the BHC Act? Section 3(a)(77) of the Exchange Act and the

SEC’s Regulation AB 240 provide two possible definitions. Is either

of these definitions sufficient, and if so why? If one of the

definitions is too narrow, what additional entities/securities should

be included and why? If one of the definitions is too broad, what

entities/securities should be excluded and why? Would some other

definition of asset-backed security be more consistent with the

language and purpose of section 13 of the BHC Act?

—————————————————————————

240 See 17 CFR 229.1101(c).

—————————————————————————

Question 238. Are there special concerns raised by not including as

an ownership interest the residual interests in a securitization

vehicle? Should the CFTC instead exempt the buying and selling of any

ownership interest in a securitization vehicle that is a covered fund

other than the residual interest?

Question 239. Should the legal form of a beneficial interest be a

determining factor for deciding whether a beneficial interest is an

“ownership interest”? For example, should pass-through trust

certificates issued as part of a securitization transaction be excluded

from the definition of “ownership interest”? Should the definition of

ownership interest explicitly include debt instruments with equity

features (e.g., voting rights, profit participations, etc.)?

Question 240. How should the proposed rule address those instances

in which both debt and equity interests are issued, and the debt

interests receive all of the economic benefits and all of the control

rights? Should the debt interests (other than the residual interest) be

counted as ownership interests even though they are not legally

ownership and do not receive any profit participation? Should the

equity interests be counted as ownership interests even though the

holder does not receive economic benefits or have any control rights?

Should the residual interest be considered the only “ownership

interest” for purposes of the proposed rule? Should mezzanine

interests that lack both control rights and profit participation be

considered an ownership interest? If the mezzanine interests obtain

control rights (because more senior classes have been repaid), should

they become “ownership interests” at that time for purposes of the

proposed rule? If both debt and equity interests are counted as

ownership interests, how should percentages of ownership interests be

calculated when the units of measurement do not match (e.g., a

[[Page 8386]]

single trust certificate, a single residual certificate with no face

value and multiple classes of currency-denominated notes)?

Question 241. Does the proposed rule’s definition of “prime

brokerage transaction” effectively implement the statute? What other

types of transactions or services, if any, should be included in the

definition? Should any types of transactions or services be excluded

from the definition? Would an alternative definition be more effective,

and if so, why?

Question 242. Do the proposed rule’s definitions of “sponsor” and

“trustee” effectively implement the statute? Is the exclusion of

“directed trustee” from the definition of “trustee” appropriate?

Question 243. Do the proposed rule’s other definitions in Sec. —

–.10(b) effectively implement the statute? What alternative

definitions might be more effective in light of the language and

purpose of the statute? Are additional definitions needed, and if so,

what definition(s)?

2. Section –.11: Permitted Organizing and Offering of a Covered Fund

Section —-.11 of the proposed rule implements section 13(d)(1)(G)

of the BHC Act and permits a banking entity to organize and offer a

covered fund, including acting as sponsor of the fund, if certain

criteria are met.241 This exemption is designed to permit a banking

entity to be able to engage in certain traditional asset management and

advisory businesses in compliance with section 13 of the BHC Act.242

—————————————————————————

241 See proposed rule Sec. —-.11.

242 156 Cong. Rec. S5889 (daily ed. July 15, 2010) (statement

of Sen. Hagan).

—————————————————————————

a. Required Criteria for Permitted Organizing and Offering of Covered

Funds

Section —-.11 of the proposed rule provides for and describes the

conditions that must be met in order to enable a banking entity to

qualify for the exemption to organize and offer a covered fund.243

These conditions include: (i) The banking entity must provide bona fide

trust, fiduciary, investment advisory, or commodity trading advisory

services;244 (ii) the covered fund must be organized and offered only

in connection with the provision of bona fide trust, fiduciary,

investment advisory, or commodity trading advisory services and only to

persons that are customers of such services of the banking entity;

(iii) the banking entity may not acquire or retain an ownership

interest in the covered fund except as permitted under subpart C of the

proposed rule; (iv) the banking entity must comply with the

restrictions governing relationships with covered funds under Sec. —

–.16 of the proposed rule; (v) the banking entity may not, directly or

indirectly, guarantee, assume, or otherwise insure the obligations or

performance of the covered fund or of any covered fund in which such

covered fund invests; (vi) the covered fund, for corporate, marketing,

promotional, or other purposes, (A) may not share the same name or a

variation of the same name with the banking entity (or an affiliate or

subsidiary thereof), and (B) may not use the word “bank” in its name;

(vii) no director or employee of the banking entity may take or retain

an ownership interest in the covered fund, except for any director or

employee of the banking entity who is directly engaged in providing

investment advisory or other services to the covered fund; and (viii)

the banking entity must (A) clearly and conspicuously disclose, in

writing, to any prospective and actual investor in the covered fund

(such as through disclosure in the covered fund’s offering documents)

the enumerated disclosures contained in Sec. —-.11(h) of the

proposed rule, and (B) comply with any additional rules of the CFTC or

other Agencies, designed to ensure that losses in such covered fund are

borne solely by investors in the covered fund and not by the banking

entity.245 These requirements are explained in detail below.

—————————————————————————

243 See proposed rule Sec. Sec. —-.11(a)–(h).

244 While section 13(d)(1)(G) of the BHC Act does not

explicitly mention “commodity trading advisory services,” the CFTC

has proposed to include commodity pools within the definition of

“covered fund” and commodity trading advisory services in the same

way as investment advisory services because commodity trading

advisory services are the functional equivalent of investment

advisory services to commodity pools.

245 See id. at Sec. —-.11(a)-(h). The CFTC is not proposing

any such additional rules at this time, although they may do so in

the future.

—————————————————————————

i. Bona Fide Services

Section —-.11(a) of the proposed rule requires that, in order to

qualify for the exemption related to organizing and offering a covered

fund, a banking entity provide bona fide trust, fiduciary, investment

advisory, or commodity trading advisory services.246 Banking entities

provide a wide range of customer-oriented services which may qualify as

bona fide trust, fiduciary, investment advisory, or commodity trading

advisory services.247 Additionally, depending on the type of banking

entity that conducts the activity or provides the service, variations

in the precise services involved may occur. For example, a national

bank and an SEC-registered investment adviser may provide substantially

similar investment advisory services to clients, but be subject to

different statutory and regulatory requirements. In recognition of

potential variations in services and functional regulation, the

proposed rule does not specify what services would qualify as “bona

fide trust, fiduciary, investment advisory, or commodity trading

advisory services” under Sec. —-.11(a) of the proposed rule.

Instead, the proposed rule largely mirrors the statutory language of

section 13(d)(1)(G)(i) of the BHC Act and reflects the intention that

so long as a banking entity provides trust, fiduciary, investment

advisory, or commodity trading advisory services in compliance with

relevant statutory and regulatory requirements, the requirement

contained in Sec. —-.11(a) of the proposed rule would generally be

deemed to be satisfied.

—————————————————————————

246 See 12 U.S.C. 1851(d)(1)(G)(i); proposed rule Sec. —

–.11(a).

247 See, e.g., 12 U.S.C. 1843(c)(4), (c)(8), (k),12 CFR

225.28(b)(5) and (6), 12 CFR 225.86, 12 CFR 225.125 (with respect to

a bank holding company); 12 U.S.C. 24 (Seventh), 92a, 12 CFR Part 9

(with respect to a national bank); 12 U.S.C. 1831a, 12 CFR Part 362

(with respect to a state nonmember bank).

—————————————————————————

ii. “Customers of Such Services” Requirement

Section 13(d)(1)(G)(ii) of the BHC Act requires that a banking

entity organize and offer a covered fund “only in connection with”

the provision of qualified services to persons that are customers of

such services of the banking entity.248 Section —-.11(b) of the

proposed rule implements the statute and reflects the statutory

requirement that there are two independent conditions contained in

section 13(d)(1)(G)(ii) of the BHC Act: (i) A covered fund must be

organized and offered in connection with bona fide trust, fiduciary,

investment advisory, or commodity trading advisory services, and (ii)

the banking entity providing those services may offer the covered fund

only to persons that are customers of those services of the banking

entity.249 Requiring a customer relationship in connection with

organizing and offering a covered fund helps to ensure that a banking

entity is engaging in the covered fund activity for others and not on

the banking entity’s own behalf.250

—————————————————————————

248 See 12 U.S.C. 1851(d)(1)(G)(ii).

249 See proposed rule Sec. —-.11(b).

250 See 156 Cong. Rec. at S5897 (daily ed. July 15, 2010)

(statement of Sen. Merkley).

—————————————————————————

Section 13(d)(1)(G)(ii) of the BHC Act does not explicitly require

that the customer relationship be pre-existing.

[[Page 8387]]

Accordingly, the proposed rule provides that it may be established

through or in connection with the banking entity’s organization and

offering of a covered fund, so long as that fund is a manifestation of

the provision by the banking entity of bona fide trust, fiduciary,

investment advisory or commodity trading advisory services to the

customer. This application of the customer requirements is consistent

with the manner in which trust, fiduciary, investment advisory, and

commodity trading advisory services are provided by banking entities.

Historically, banking entities have raised capital commitments for

covered funds from existing customers as well as individuals or

entities that have no pre-existing relationship with the banking

entity.

Banking entities commonly organize and offer funds to customers of

the banking entity’s trust, fiduciary, and investment advisory or

commodity trading advisory services as a way of ensuring the efficient

and consistent provision of these services. For example, a person often

obtains the investment advisory services of the banking entity by

acquiring an interest in a fund organized and offered by the banking

entity. This is distinguished from a fund organized and offered by a

banking entity for the purpose of itself investing as principal,

indirectly through its investment in the fund, in assets held by the

fund. Under the proposed rule, a banking entity could, consistent with

past practice, provide a covered fund to persons that are customers of

such services for purposes of the exemption so long as the fund is

organized and offered as a means of providing bona fide trust,

fiduciary, investment advisory, or commodity trading advisory services

to customers. The banking entity may not organize and offer a covered

fund as a means of itself investing in the fund or assets held in the

fund.251

—————————————————————————

251 The proposed rule does not change any requirement imposed

by separate statute, regulation, or other law, if applicable. For

instance, a banking entity that conducts a private placement of a

covered fund pursuant to the SEC’s Regulation D pertaining to

private offerings would still be expected to comply with the

relevant requirements related to such offering, including the

limitations related to the manner in which and types of persons to

whom it may offer or sell interests in such fund. See 12 CFR 230.501

et seq.

—————————————————————————

The CFTC notes that a banking entity could, through organizing and

offering a covered fund pursuant to the authority contained in Sec. —

–.11 of the proposed rule that itself makes investments or engages in

trading activity, seek to evade the restrictions contained in section

13 of the BHC Act and the proposed rule. In order to address these

concerns, the proposed rule provides that a banking entity relying on

the authority contained in Sec. —-.11 must organize and offer a

covered fund pursuant to a credible plan or similar documentation

outlining how the banking entity intends to provide advisory or similar

services to its customers through organizing and offering such fund.

iii. Compliance With Investment Limitations

Section 13(d)(1)(G)(iii) of the BHC Act limits the ability of a

banking entity that organizes and offers a covered fund to acquire or

retain an ownership interest in that covered fund.252 Separately,

other provisions of section 13 of the BHC Act provide independent

exemptions which permit a banking entity to acquire or retain an

ownership interest in a covered fund.253 Section —-.11(c) of the

proposed rule incorporates these statutory provisions by prohibiting a

banking entity from acquiring or retaining an ownership interest in a

covered fund that it organizes and offers except as permitted under

subpart C of the proposed rule.254 The limits on a banking entity’s

ability to invest in a covered fund that it organizes and offers are

described in Sec. —-.12 of the proposal.

—————————————————————————

252 See 12 U.S.C. 1851(d)(1)(G)(iii).

253 See, e.g., id. at 1851(d)(1)(C).

254 See proposed rule Sec. —-.11(c).

—————————————————————————

iv. Compliance With Section 13(f) of the BHC Act

Section —-.11(d) of the proposed rule requires that the banking

entity comply with the limitations on certain relationships with

covered funds.255 These limitations apply in several contexts, and

are contained in Sec. —-.16 of the proposed rule, discussed in

detail below. In general, Sec. —-.16 of the proposed rule prohibits

certain transactions or relationships that would be covered by section

23A of the FR Act, and provides that any permitted transaction is

subject to section 23B of the FR Act, in each instance as if such

banking entity were a member bank and such covered fund were an

affiliate thereof.256

—————————————————————————

255 12 U.S.C. 1851(d)(1)(G)(iv); proposed rule Sec. —

–.11(d).

256 See SUPPLEMENTARY INFORMATION, Part III.C.7.

—————————————————————————

v. No Guarantees or Insurance of Fund Performance

Section —-.11(e) of the proposed rule prohibits the banking

entity from, directly or indirectly, guaranteeing, assuming or

otherwise insuring the obligations or performance of the covered fund

or any covered fund in which such covered fund invests.257 This prong

implements section 13(d)(1)(G)(iv) of the BHC Act and is intended to

prevent a banking entity from engaging in bailouts of a covered fund in

which it has an interest.258

—————————————————————————

257 12 U.S.C. 1851(d)(1)(G)(v); proposed rule Sec. —

–.11(e).

258 See 156 Cong. Rec. S5897 (daily ed. July 15, 2010)

(statement of Sen. Merkley).

—————————————————————————

vi. Limitation on Name Sharing With a Covered Fund

Section —-.11(f) of the proposed rule prohibits the covered fund

from sharing the same name or a variation of the same name with the

banking entity, for corporate, marketing, promotional, or other

purposes.259 This section implements section 13(d)(1)(G)(v) of the

BHC Act and addresses the concern that name-sharing could undermine

market discipline and encourage a banking entity to bail out a covered

fund it organizes and offers in order to preserve the entity’s

reputation.260 Thus, under Sec. —-.11(f) of the proposed rule, a

covered fund would be prohibited from sharing the same name or

variation of the same name with a banking entity that organizes and

offers or serves as sponsor to that fund (or an affiliate or subsidiary

of such banking entity). A covered fund would also be prohibited under

the proposed rule from using the word “bank” in its name.261

—————————————————————————

259 12 U.S.C. 1851(d)(1)(G)(vi); proposed rule Sec. —

–.11(f).

260 156 Cong. Rec. S5897 (daily ed. July 15, 2010) (statement

of Sen. Merkley).

261 Similar restrictions on a fund sharing the same name, or

variation of the same name, with an insured depository institution

or company that controls an insured depository institution or having

the word “bank” in its name, have been used previously in order to

prevent customer confusion regarding the relationship between such

companies and a fund. See, e.g., Bank of Ireland, 82 Fed. Res. Bull.

1129 (1996).

—————————————————————————

vii. Limitation on Ownership by Directors and Employees

Section —-.11(g) of the proposed rule implements section

13(d)(1)(G)(vii) of the BHC Act. The provision prohibits any director

or employee of the banking entity from acquiring or retaining an

ownership interest in the covered fund, except for any director or

employee of the banking entity who is directly engaged in providing

investment advisory or other services to the covered fund.262 This

allows an individual acting as fund manager or adviser and employed by

a banking entity to acquire or retain an ownership interest in a

covered fund that aligns the manager or adviser’s incentives with those

of its

[[Page 8388]]

customers by allowing the individual to have “skin in the game” with

respect to a covered fund for which that individual provides management

or advisory services (which customers or clients often request).263

—————————————————————————

262 See 12 U.S.C. 1851(d)(1)(G)(vii); proposed rule Sec. —

–.11(g).

263 See 156 Cong. Rec. S5897 (daily ed. July 15, 2010)

(statement of Sen. Merkley).

—————————————————————————

The CFTC recognizes that director or employee investments in a

covered fund may provide an opportunity for a banking entity to evade

the limitations regarding the amount or value of ownership interests a

banking entity may acquire or retain in a covered fund or funds

contained in section 13(d)(4) of the BHC Act and Sec. —-.12 of the

proposed rule. In order to address this concern, the proposed rule

would generally attribute an ownership interest in a covered fund

acquired or retained by a director or employee to such person’s

employing banking entity, if the banking entity either extends credit

for the purpose of allowing the director or employee to acquire such

ownership interest, guarantees the director or employee’s purchase, or

guarantees the director or employee against loss on the investment.

viii. Disclosure Requirements

Section —-.11(h) of the proposed rule requires that, in

connection with organizing and offering a covered fund, the banking

entity (i) clearly and conspicuously disclose, in writing, to

prospective and actual investors in the covered fund (such as through

disclosure in the covered fund’s offering documents) that “any losses

in [such covered fund] will be borne solely by investors in [the

covered fund] and not by [the banking entity and its affiliates or

subsidiaries]; therefore, [the banking entity’s and its affiliates’ or

subsidiaries’] losses in [such covered fund] will be limited to losses

attributable to the ownership interests in the covered fund held by

[the banking entity and its affiliates or subsidiaries] in their

capacity as investors in [the covered fund],” and (ii) comply with any

additional rules of the CFTC as provided in section 13(b)(2) of the BHC

Act designed to ensure that losses in any such covered fund are borne

solely by the investors in the covered fund and not by the banking

entity.264 The proposed rule also provides, as an additional

disclosure requirement related to organizing and offering a covered

fund, that a banking entity clearly and conspicuously disclose, in

writing, to any prospective and actual investor (such as through

disclosure in the covered fund’s offering documents): (i) That such

investor should read the fund offering documents before investing in

the covered fund; (ii) that the “ownership interests in the covered

fund are not insured by the FDIC, and are not deposits, obligations of,

or endorsed or guaranteed in any way, by any banking entity” (unless

that happens to be the case); and (iii) the role of the banking entity

and its affiliates, subsidiaries, and employees in sponsoring or

providing any services to the covered fund. As noted above, the

proposed rule clarifies that a banking entity may satisfy the

requirements of this prong with respect to a covered fund by making the

required disclosures, in writing, in the covered fund’s offering

documents.265

—————————————————————————

264 12 U.S.C. 1851(d)(1)(G)(viii); proposed rule Sec. —

–.11(h).

265 As contemplated in Sec. —-.11(a)(8)(ii) of the proposed

rule, to the extent that any additional rules are issued to ensure

that losses in a covered fund are borne solely by the investors in

the covered fund and not by the banking entity, a banking entity

would be required to comply with those as well in order to satisfy

the requirements of section 13(d)(1)(G)(viii) of the BHC Act.

—————————————————————————

ix. Request for Comment

The CFTC requests comment on the proposed rule’s approach with

respect to implementing the exemption permitting banking entities to

organize and offer a covered fund. In particular, the CFTC requests

comment on the following questions:

Question 244. Is the proposed rule’s approach to implementing the

exemption for organizing and offering a covered fund effective? If not,

what alternative approach would be more effective and why?

Question 245. Should the approach include other elements? If so,

what elements and why? Should any of the proposed elements be revised

or eliminated? If so, why and how?

Question 246. Is the proposed rule’s approach to implementing the

scope of bona fide trust, fiduciary, investment advisory and commodity

trading advisory services consistent with the statute? If not, what

alternative approach would be more effective? Should the scope of such

services be broader or, in the alternative, more limited? Are there

specific services which should be included but which are not currently

under the proposed rule?

Question 247. Does the proposed rule effectively implement the

“customers of such services” requirement? If not, what alternative

approach would be more effective and why? Is the proposed rule’s

approach consistent with the statute? Why or why not? How do banking

entities currently sell or provide interests in covered funds? Do

banking entities rely on a concept of “customer” by reference to

other laws or regulations, and if so, what laws or regulations?

Question 248. Does the proposed rule effectively and clearly

recognize the manner in which banking entities provide trust,

fiduciary, investment advisory, or commodity trading advisory services

to customers? If not, how should the proposed rule be modified to be

more effective or clearer?

Question 249. Should the CFTC consider adopting a definition of

“customer of such services” for purposes of implementing the

exemption related to organizing and offering a covered fund? If so,

what criteria should be included in such definition? For example,

should the customer requirement specify that the relationship be pre-

existing? Should the CFTC consider adopting an existing definition

related to “customer” and if so, what definitions (for instance, the

SEC’s “pre-existing, substantive relationship” concept applicable to

private offerings under its Regulation D) would provide for effective

implementation of the customer requirement in section 13(d)(1)(G) of

the BHC Act? If so, why and how? How should the customer requirement be

applied in the context of non-U.S. covered funds? Is there an

equivalent concept used for such non-U.S. covered fund offerings?

Question 250. Should the CFTC distinguish between direct and

indirect customer relationships for purposes of implementing section

13(d)(1)(G) of the BHC Act? Should the rule differentiate between a

customer relationship established by a customer as opposed to a banking

entity? If so, why?

Question 251. Does the proposed rule effectively implement the

prohibition on a banking entity guaranteeing or insuring the

obligations or performance of certain covered funds? If not, what

alternative approach would be more effective, and why?

Question 252. Does the proposed rule effectively implement the

requirement that a banking entity comply with the limitation on certain

relationships with a covered fund contained in Sec. —-.16 of the

proposed rule? If not, what alternative approach would be more

effective, and why?

Question 253. Does the proposed rule effectively implement the

prohibition on a covered fund sharing the same name or variation of the

same name with a banking entity? If not, what alternative approach

would be more effective and why? Should the prohibition on a covered

fund sharing the same name be limited to specific

[[Page 8389]]

types of banking entities (e.g., insured depository institutions and

bank holding companies) or only to the banking entity that organizes

and offers the fund, and if so why?

Question 254. Does the proposed rule effectively implement the

limitation on director or employee investments in a covered fund

organized and offered by a banking entity? If not, what alternative

approach would be more effective and why? Should the agencies provide

additional guidance on what “other services” should be included for

purposes of satisfying Sec. —-.11(g)? Why or why not?

Question 255. Are the disclosure requirements related to organizing

and offering a covered fund appropriate? If not, what alternative

disclosure requirement(s) should the proposed rule include? Should the

CFTC consider adoption of a model disclosure form related to this

requirement? Does the timing of the proposed disclosure requirement

adequately address disclosure to secondary market purchasers?

3. Section —-.12: Permitted Investment in a Covered Fund

Section —-.12 of the proposed rule describes the limited

circumstances under which a banking entity may acquire or retain, as an

investment, an ownership interest in a covered fund that the banking

entity or one of its subsidiaries or affiliates organizes and offers.

This section implements section 13(d)(4) of the BHC Act and related

provisions, and describes the statutory limits on both (i) the amount

and value of an investment by a banking entity in a covered fund, and

(ii) the aggregate value of all investments in all covered funds made

by the banking entity.

As described below, a banking entity that makes or retains an

investment in a covered fund under Sec. —-.12 of the proposed rule

is generally subject to three principal limitations related to such

investment. First, the banking entity’s investment in a covered fund

may not represent more than 3 percent of the total outstanding

ownership interests of such fund (after the expiration of any seeding

period provided under the rule). Second, the banking entity’s

investment in a covered fund may not result in more than 3 percent of

the losses of the covered fund being allocable to the banking entity’s

investment. Third, a banking entity may invest no more than 3 percent

of its tier 1 capital in covered funds.266

—————————————————————————

266 See, e.g., proposed rule Sec. Sec. —-.12(b)(2), (c).

—————————————————————————

a. Authority and Limitations on Permitted Investments

Section 13(d)(4) of the BHC Act permits a banking entity to acquire

and retain an ownership interest in a covered fund that the banking

entity organizes and offers pursuant to section 13(d)(1)(G), for the

purposes of (i) establishing the covered fund and providing the fund

with sufficient initial equity for investment to permit the fund to

attract unaffiliated investors, or (ii) making a de minimis investment

in the covered fund in compliance with applicable requirements.267

Section —-.12 of the proposed rule implements this authority and

related limitations.

—————————————————————————

267 See 12 U.S.C. 1851(d)(4).

—————————————————————————

Consistent with this statutory provision, the proposed rule

requires a banking entity to (i) actively seek unaffiliated investors

to ensure that the banking entity’s investment conforms with the limits

of Sec. —-.12, and (ii) reduce through redemption, sale, dilution,

or other methods the aggregate amount and value of all ownership

interests of the banking entity in a single fund held under Sec. —

–.12 to an amount that does not exceed 3 percent of the total

outstanding ownership interests of the fund not later than 1 year after

the date of establishment of the fund (or such longer period as may be

provided by the Board) (the “per-fund limitation”). Additionally,

Sec. —-.12 of the proposed rule implements the statutory requirement

that the aggregate value of all ownership interests of the banking

entity in all covered funds held as an investment not exceed 3 percent

of the tier 1 capital of the banking entity (the “aggregate funds

limitation”).268

—————————————————————————

268 See proposed rule at Sec. —-.12(a)(2)(ii). The process

and manner in which a banking entity’s 3 percent tier 1 capital

limit is determined for purposes of the proposed rule is discussed

in detail below in Part III.C.3 of this SUPPLEMENTARY INFORMATION.

—————————————————————————

b. Permitted Investment in a Single Covered Fund

Section —-.12(b) of the proposed rule describes the limitations

and restrictions on a banking entity’s ability to make or retain an

investment in a single covered fund. This section implements the

requirements of section 13(d)(4) of the BHC Act.269

—————————————————————————

269 See 12 U.S.C. 1851(d)(4)(B).

—————————————————————————

Section —-.12 of the proposed rule describes the manner in which

the limitations on the amount and value of ownership interests in a

covered fund must be calculated, in recognition of the fact that a

covered fund may have multiple classes of ownership interests which

possess different characteristics or values that impact a person’s

ownership in that fund. A banking entity must apply the limits to both

the total value and amount of its investment in a covered fund. For

purposes of applying these limits, the banking entity must calculate

(without regard to committed funds not yet called for investment): (i)

The value of all investments or capital contributions made with respect

to any ownership interest by the banking entity in a covered fund,

divided by the value of all investments or capital contributions made

by all persons in that covered fund, and (ii) the total number of

ownership interests held as an investment by the banking entity in a

covered fund divided by the total number of ownership interests held by

all persons in that covered fund.270 Therefore, under the proposed

rule, such calculation would include as the numerator the amount or

value of a banking entity’s investment in a covered fund, and as the

denominator the amount or value (matched to the unit of measurement in

the numerator) of all classes of ownership interests held by all

persons in that covered fund. As noted above, the banking entity’s

investment in a covered fund also may not result in more than 3 percent

of the losses of the covered fund being allocable to the banking

entity’s investment.271

—————————————————————————

270 See proposed rule Sec. —-.12(b)(2).

271 Under the proposed rule, a banking entity’s investment in

a covered fund may not result in more than 3 percent of the losses

of the covered fund being allocable to the banking entity’s

investment since the banking entity’s permitted investment in a

covered fund may be no more than 3 percent of the value and amount

of such fund’s total ownership interests, and the banking entity may

not, directly or indirectly, guarantee, assume, or otherwise insure

the obligations or performance of the covered fund. See 12 U.S.C.

1851(d)(1)(G)(v); proposed rule Sec. —-.11(e).

—————————————————————————

In order to ensure that a banking entity calculates its investment

in a covered fund accurately and does not evade the per-fund investment

limitation, the proposed rule requires that the banking entity must

calculate its investment in the same manner and according to the same

standards utilized by the covered fund for determining the aggregate

value of the fund’s assets and ownership interests in the covered

fund.272

—————————————————————————

272 See proposed rule Sec. —-.12(b)(4).

—————————————————————————

Under the proposed rule, the amount and value of a banking entity’s

investment in any single covered fund is (i) the total amount or value

held by the banking entity directly and through any entity that is

controlled, directly or indirectly, by the banking entity,273 plus

(ii) the pro rata amount or value of any

[[Page 8390]]

covered fund held by any entity (other than certain operating entities

noted below) that is not controlled, directly or indirectly, by the

banking entity but in which the banking entity owns, controls, or holds

with the power to vote more than 5 percent of the voting shares.274

—————————————————————————

273 See proposed rule Sec. —-.12(b)(1)(A).

274 See proposed rule Sec. —-.12(b)(1)(B). As noted above,

whether or not an investment is controlled or noncontrolled will be

determined consistent with the BHC Act, as implemented by the Board.

See 12 U.S.C. 1841(a)(2); 12 CFR 225.2(e).

—————————————————————————

Additionally, the proposed rule provides that, to the extent that a

banking entity is contractually obligated to directly invest in, or is

found to be acting in concert through knowing participation in a joint

activity or parallel action toward a common goal of investing in, one

or more investments with a covered fund that is organized and offered

by the banking entity (whether or not pursuant to an express

agreement), such investment shall be included in the calculation of a

banking entity’s per-fund limitation.275 In this way, the proposed

rule prevents a banking entity from evading the limitations under Sec.

—-.12 of the proposed rule through committed co-investments.

—————————————————————————

275 See proposed rule Sec. —-.12(b)(2)(B).

—————————————————————————

Section —-.12(b)(3) of the proposed rule provides that the amount

and value of a banking entity’s investment in a covered fund may at no

time exceed the 3 percent limits contained in Sec. —-.12(b) of the

proposed rule after the conclusion of any conformance period, if

applicable.276 In cases where a fund calculates its value or stands

ready to issue or redeem interests frequently (e.g., daily), a banking

entity must calculate its per-fund limitation no less frequently than

the fund performs such calculation or issues or redeems interests. In

recognition of the fact that not every covered fund may calculate or

determine its valuation daily (for instance, if it does not allow

redemptions except infrequently or invests principally in illiquid

assets for which no market price is readily available), the proposed

rule would not require a daily calculation of value for such fund

(unless a daily calculation is determined by the fund).277 In such

cases, the calculation of the amount and value of a banking entity’s

per-fund limitation must be made no less frequently than at the end of

every quarter.278 Additionally, since a banking entity must organize

and offer any covered fund in which it invests, the CFTC expects that

such banking entity would closely and regularly monitor not only the

value of such fund’s interests, but also any changes in the fund’s

investors’ relative ownership percentages.279

—————————————————————————

276 See proposed rule Sec. —-.12(b)(3).

277 With respect to an issuer of asset-backed securities,

depending on the transaction structure, such calculation may need to

be made each time a payment is made to any holder of the issuer’s

asset-backed securities.

278 The CFTC notes that while calculation of a banking

entity’s ownership interest in a covered fund must be determined no

less frequently than at the end of every quarter, it is possible

that no change in a banking entity’s ownership interest (e.g., no

redemptions or other changes in investor composition) may occur

during every quarter.

279 For instance, where a banking entity acts as sponsor to a

covered fund, in connection with the organizing and offering of that

fund it may include a requirement (such as a “tag-along”

redemption right) in the fund’s organizational documents in order to

assist the banking entity in complying with the per-fund investment

limitation.

—————————————————————————

c. Aggregate Permitted Investments in All Covered Funds and Calculation

of a Banking Entity’s Tier 1 Capital

In addition to a limit on investments in a single covered fund,

section 13(d)(4) of the BHC Act requires the banking entity to comply

with the aggregate funds limitation on investments in all covered

funds.280 As required under section 13(d)(4)(B)(ii)(II) of the BHC

Act, the proposed rule provides that the aggregate of a banking

entity’s ownership interests in all covered funds that are held under

Sec. —-.12 of the proposed rule may not exceed 3 percent of the tier

1 capital of a banking entity.281 In order to maintain equality in

application of the aggregate funds limitation, the proposed rule

provides that, for purposes of determining compliance with Sec. —

–.12 of the proposed rule, the aggregate of all of a banking entity’s

investments in all covered funds under Sec. —-.12 of the proposed

rule must be valued pursuant to applicable accounting standards.282

This value calculation is separate and in addition to the required

calculation of the value of a banking entity’s investment in a covered

fund as part of determining compliance with the per-fund limitation.

—————————————————————————

280 As noted in the discussion regarding the per-fund

limitation, the proposed rule provides that, for purposes of

determining compliance with Sec. —-.12, the banking entity’s

permitted investment in a covered fund shall be calculated in the

same manner and according to the same standards utilized by the

covered fund for determining the aggregate value of the fund’s

assets and ownership interests. However, the value of a banking

entity’s aggregate permitted investments in all covered funds shall

be determined in accordance with applicable accounting standards.

See proposed rule Sec. —-.12(c)(1).

281 See 12 U.S.C. 1851(d)(4)(B)(ii)(II); proposed rule Sec.

—-.12(a)(2)(ii).

282 See proposed rule Sec. —-.12(c)(1).

—————————————————————————

Tier 1 capital is a banking law concept that, in the United States,

is calculated and reported by certain depository institutions and bank

holding companies in order to determine their compliance with

regulatory capital standards. Accordingly, the proposed rule clarifies

that for purposes of the aggregate funds limitation in Sec. —-.12, a

banking entity that is a bank, a bank holding company, a company that

controls an insured depository institution that reports tier 1 capital,

or uninsured trust company that reports tier 1 capital (each a

“reporting banking entity”) must apply the reporting banking entity’s

tier 1 capital as of the last day of the most recent calendar quarter

that has ended, as reported to the relevant Federal banking

agency.283

—————————————————————————

283 See proposed rule Sec. —-.12(c)(1)(A).

—————————————————————————

However, not all entities subject to section 13 of the BHC Act

calculate and report tier 1 capital. In order to provide a measure of

equality related to the aggregate funds limitation contained in section

13(d)(4)(B)(ii)(II) of the BHC Act and Sec. —-.12(c) of the proposed

rule, the proposed rule clarifies how the aggregate funds limitation

shall be calculated for entities that are not required to calculate and

report tier 1 capital in order to determine compliance with regulatory

capital standards. Under the proposed rule, with respect to any banking

entity that is not affiliated with a reporting banking entity and not

itself required to report capital in accordance with the risk-based

capital rules of a Federal banking agency, the banking entity’s tier 1

capital for purposes of the aggregate funds limitation shall be the

total amount of shareholders’ equity of the top-tier entity within such

organization as of the last day of the most recent calendar quarter

that has ended, as determined under applicable accounting

standards.284 For a banking entity that is not itself required to

report tier 1 capital but is a subsidiary of a reporting banking entity

that is a depository institution (e.g., a subsidiary of a national

bank), the aggregate funds limitation shall be the amount of tier 1

capital reported by such depository institution.285 For a banking

entity that is not itself required to report tier 1 capital but is a

subsidiary of a reporting banking entity that is not a depository

institution (e.g., a nonbank subsidiary of a bank holding company), the

aggregate funds limitation shall be the amount of tier 1 capital

reported by the top-tier affiliate of such banking entity that holds

and reports tier 1 capital.286 Thus,

[[Page 8391]]

for purposes of calculating the aggregate funds limitation under Sec.

—-.12(c)(2) of the proposed rule, the tier 1 capital for the

different types of banking entities would be as follows:

—————————————————————————

284 See proposed rule Sec. —-.12(c)(2)(ii)(B)(2).

285 See proposed rule Sec. —-.12(c)(2)(ii)(A).

286 See proposed rule Sec. —-.12(c)(1)(B).

————————————————————————

Tier 1 capital for purposes of

Type of banking entity Sec. —-.12

————————————————————————

Depository institution that is a Tier 1 capital of the

reporting banking entity (or a depository institution as of

subsidiary thereof). the last day of the most

recent calendar quarter that

has ended, as reported to the

relevant Federal banking

agency.

Bank holding company or a subsidiary Tier 1 capital of the bank

thereof (other than a reporting holding company as of the last

banking entity). day of the most recent

calendar quarter that has

ended, as reported to the

Board.

Company that controls an insured Tier 1 capital of the top tier

depository institution and that is a entity within such

reporting banking entity (or a organization as of the last

subsidiary thereof other than a day of the most recent

reporting banking entity). calendar quarter that has

ended, as reported to the

Board.

Other banking entity (including an Shareholders’ equity of the top-

industrial loan company holding tier entity within such

company, thrift holding company, or a organization as of the last

subsidiary thereof). day of the most recent

calendar quarter that has

ended, under applicable

accounting standards.

————————————————————————

Additionally, in the case of a depository institution that is itself a

reporting banking entity and is also a subsidiary or affiliate of a

reporting banking entity, the aggregate of all investments in all

covered funds held by the depository institution (including investments

by its subsidiaries) may not exceed 3 percent of either the tier 1

capital of the depository institution or of the top-tier reporting

banking entity that controls such depository institution.287

—————————————————————————

287 If the aggregate value of all investments in all covered

funds attributable to such a depository institution is less than 3

percent of its tier 1 capital, then that amount of capital which is

greater than the amount supporting the depository institution’s

investments (or those held by its subsidiaries) in a covered fund,

but less than 3 percent of the depository institution’s tier 1

capital, may be used to support an investment in a covered fund by

an affiliated banking entity that is not itself a depository

institution that holds and reports tier 1 capital or controlled,

directly or indirectly, by such a depository institution.

—————————————————————————

d. Deduction of an Investment in a Covered Fund From Tier 1 Capital

Section 12(d) of the proposed rule also implements the provision

contained in section 13(d)(4)(b)(iii) of the BHC Act regarding the

deduction of a banking entity’s aggregate investment in a covered fund

held under section 13(d)(4) of that Act from the assets and tangible

equity of the banking entity. The statute also provides that the amount

of the deduction must increase commensurate with the leverage of the

underlying fund.288

—————————————————————————

288 See 12 U.S.C. 1851(d)(4)(B)(iii).

—————————————————————————

Section —-.12(d) of the proposal requires a banking entity to

deduct the aggregate value of its investments in covered funds from

tier 1 capital. Since Sec. —-.12 of the proposed rule implements the

authorities contained in section 13(d)(4) of the BHC Act related to an

investment in a fund organized and offered by the banking entity (or an

affiliate or subsidiary thereof), the deduction contained in Sec. —

–.12(d) applies only to those ownership interests held as an

investment by a banking entity pursuant to Sec. —-.12 of the

proposed rule.289 For instance, a banking entity that acquires or

retains an ownership interest in a covered fund as a permitted risk-

mitigating hedge under Sec. —-.13(b) of the proposed rule, or that

acquires or retains an ownership interest in the course of collecting a

debt previously contracted in good faith, would not be required to

deduct the value of such ownership interest from its tier 1

capital.290 The deduction required under Sec. —-.12(d) of the

proposed rule must be calculated consistent with other like deductions

under the applicable risk-based capital rules.291

—————————————————————————

289 See proposed rule Sec. —-.12(d).

290 The CFTC notes that since this deduction from capital

implements Section 13(d)(4)(B)(iii) of the BHC Act, it is being

included in this proposed rule which deals with Section 13 of the

BHC Act. However, the CFTC may relocate this deduction as part of

any later revised capital rules if, in the future, it is determined

that inclusion in such rules is more appropriate.

291 See 12 CFR part 208, Appendices A, E, and F (for a state

member bank); 12 CFR part 225, Appendices A, E, and G (for a bank

holding company); 12 CFR part 3, Appendices A, B, and C (for a

national bank); 12 CFR part 325, Appendices A, C, and D (for a state

nonmember bank); and 12 CFR part 167, Appendix C (for a federal

thrift).

—————————————————————————

e. Extension of Time To Divest an Ownership Interest in a Single

Covered Fund

Section 13(d)(4)(C) of the BHC Act permits the Board, upon

application by a banking entity, to extend for up to 2 additional years

the period of time within which a banking entity must reduce its

attributable ownership interests in a covered fund to no more than 3

percent of such fund’s total ownership interests.292 The statute

provides the possibility of an extension only with respect to the per-

fund limitation, and not to the aggregate funds limitation.293

Section —-.12(e) of the proposed rule implements this provision of

the statute. In order to grant any extension, the Board must determine

that the extension would be consistent with safety and soundness and

would not be detrimental to the public interest.294

—————————————————————————

292 12 U.S.C. 1851(d)(4)(C).

293 See id.

294 As noted in Part III.C.2.a.ii of this SUPPLEMENTARY

INFORMATION, the CFTC recognizes the potential for evasion of the

restrictions contained in section 13 of the BHC Act through

organizing and offering a covered fund pursuant to the authority

contained in Sec. —-.11 of the proposed rule. Therefore, in

addition to taking action against a banking entity that does not

actively seek unaffiliated investors to reduce or dilute the

investment of the banking entity as provided under Sec. —

–.12(a)(2) of the proposed rule, the CFTC expects that if a banking

entity is habitually or routinely seeking an extension of the one-

year period provided under Sec. —-.12(a)(2)(i)(B), this could be

evidence of seeking to evade the restrictions contained in the

proposed rule and, as appropriate, the CFTC may take action against

such banking entity.

—————————————————————————

Section —-.12(e) of the proposed rule requires any banking entity

that seeks an extension of this conformance period to submit a written

request to the Board. Under the proposal, any such request must: (i) Be

submitted in writing to the Board at least 90 days prior to the

expiration of the applicable time period; (ii) provide the reasons why

the banking entity believes the extension should be granted; and (iii)

provide a detailed explanation of the banking entity’s plan for

reducing or conforming its investment(s).

In addition, the proposed rule provides that any extension request

by a banking entity must address each of the following matters (to the

extent they are relevant): (i) Whether the investment would–(A)

involve or result in material conflicts of interest between the banking

entity and its clients, customers or counterparties; (B) result,

directly or indirectly, in a material exposure by the

[[Page 8392]]

banking entity to high-risk assets or high-risk trading strategies; (C)

pose a threat to the safety and soundness of the banking entity; or (D)

pose a threat to the financial stability of the United States; (ii)

market conditions; (iii) the contractual terms governing the banking

entity’s interest in the covered fund; (iv) the date on which the

covered fund is expected to have attracted sufficient investments from

investors unaffiliated with the banking entity to enable the banking

entity to comply with the limitations in section 12(a)(2)(i)(B) of the

proposed rule; (v) the total exposure of the banking entity to the

investment and the risks that disposing of, or maintaining, the

investment in the covered fund may pose to the banking entity or the

financial stability of the United States; (vi) the cost to the banking

entity of divesting or disposing of the investment within the

applicable period; (vii) whether the divestiture or conformance of the

investment would involve or result in a material conflict of interest

between the banking entity and unaffiliated clients, customers or

counterparties to which it owes a duty; (viii) the banking entity’s

prior efforts to divest or sell interests in the covered fund,

including activities related to the marketing of interests in such

covered fund; and (ix) any other factor that the Board believes

appropriate.295 Under the proposed rule, the Board would consider

requests for an extension in light of all relevant facts and

circumstances, including the factors described above.

—————————————————————————

295 See proposed rule Sec. —-.12(e)(1)(ii).

—————————————————————————

Section —-.12(e) of the proposed rule also would allow the Board

to impose conditions on any extension granted under the proposed rule

if the Board determines conditions are necessary or appropriate to

protect the safety and soundness of banking entities or the financial

stability of the United States, address material conflicts of interest

or other unsound practices, or otherwise further the purposes of

section 13 of the BHC Act and the proposed rule.296 In cases where

the banking entity is primarily supervised by the CFTC, the Board would

consult with the CFTC both in connection with its review of the

application and, if applicable, prior to imposing conditions in

connection with the approval of any request by the banking entity for

an extension of the conformance period under the proposed rule.297

—————————————————————————

296 Nothing in section 13 of the BHC Act or the proposed rule

limits or otherwise affects the authority that the Board, the other

Federal banking agencies, the SEC, or the CFTC may have under other

provisions of law. In the case of the Board, these authorities

include, but are not limited to, section 8 of the Federal Deposit

Insurance Act and section 8 of the BHC Act. See 12 U.S.C. 1818,

1847.

297 See proposed rule Sec. Sec. —-.12(e)(iii) and (iv).

—————————————————————————

f. Request for Comment

The CFTC requests comment on the proposed rule’s approach to

implementing the exemption which allows a banking entity to make or

retain a permitted investment in a covered fund that it organizes and

offers. In particular, the CFTC requests comment on the following

questions:

Question 256. Is the proposed rule’s approach to implementing the

exemption that allows a banking entity to make or retain a permitted

investment in a covered fund effective? If not, what alternative

approach would be more effective and why?

Question 257. Should the approach include other elements? If so,

what elements and why? Should any of the proposed elements be revised

or eliminated? If so, why and how?

Question 258. Should the proposed rule specify at what point a

covered fund will be considered to have been “established” for

purposes of commencing the period in which a banking entity may own

more than 3 percent of the total outstanding ownership interests in

such fund? If so, why and how?

Question 259. Does the proposed rule effectively implement the

requirement that a banking entity comply with the limitations on an

investment in a single covered fund? If not, what alternative approach

would be more effective and why?

Question 260. Does the proposed rule effectively implement the

requirement that a banking entity comply with the limitations on the

aggregate of all investments in all covered funds? If not, what

alternative approach would be more effective and why?

Question 261. Is the proposed rule’s approach to calculating a

banking entity’s investment in a covered fund effective? Should the

per-fund calculation be based on committed capital, rather than

invested capital? Why or why not? Is the timing of the calculation of a

banking entity’s ownership interest in a single covered fund

appropriate? If not, why not, and what alternative approach would be

more effective and why? For example, should the per-fund calculation be

required on a less-frequent basis (e.g., monthly) for funds that

compute their value and allow purchases and redemptions on a daily

basis (e.g., daily)? Why or why not?

Question 262. Is the proposed rule’s approach to parallel

investments effective? Why or why not? Should this provision require a

contractual obligation and/or knowing participation? Why or why not?

How else could the proposed rule define parallel investments? What

characteristics would more closely achieve the scope and intended

purposes of section 13 of the BHC Act?

Question 263. Is the proposed rule’s treatment of investments in a

covered fund by employees and directors of a banking entity effective?

If not, what alternative approach would be more effective and why?

Question 264. Is the proposed rule’s approach to differentiating

between controlled and noncontrolled investments in a covered fund

unduly complex or burdensome? If so, what alternative approach, if any,

would be more effective and why?

Question 265. Is the proposed rule’s approach to valuing an

investment in a covered fund according to the same standards utilized

by the covered fund for determining the aggregate value of its assets

and ownership interests effective? If not, what alternative valuation

approach would be more effective and why? Should the rule specify one

methodology for valuing an investment in a covered fund?

Question 266. Is the proposed rule’s approach regarding when to

require the calculation of a banking entity’s aggregate investments in

all covered funds effective? What is the potential impact of

calculating a banking entity’s aggregate investment limit under the

proposed rule on a quarterly basis as opposed to solely at the time an

investment in a covered fund is made? Would calculation of the

aggregate investment limit solely at the time an investment in a

covered fund is made be consistent with the language and purpose of the

statute? Does the proposed rule provide sufficient guidance for an

issuer of asset-backed securities about how and when to make such

calculation? Why or why not?

Question 267. Is the proposed rule’s approach to determining and

calculating a banking entity’s relevant tier 1 capital limit effective?

If not, what alternative approach would be more effective and why? With

respect to applying the aggregate funds limitation to a banking entity

that is not affiliated with an entity that is required to hold and

report tier 1 capital, is total shareholder equity on a consolidated

basis as of the last day of the most recent calendar quarter that has

ended an effective proxy for tier 1 capital? If not, what alternative

approach would be more effective and why?

[[Page 8393]]

Question 268. Should the proposed rule be modified to permit a

banking entity to bring its investments in covered funds into

compliance with the proposed rule within a reasonable period of time

if, for example, the banking entity’s aggregate permitted investments

in covered funds exceeds 3 percent of its tier 1 capital for reasons

unrelated to additional investments (e.g., a banking entity’s tier 1

capital decreases)? Why or why not?

Question 269. Does the proposed rule effectively and appropriately

implement the deduction from capital for an investment in a covered

fund contained in section 13(d)(4)(B)(iii) of the BHC Act? If not, what

alternative approach would be more effective or appropriate, given the

statutory language of the BHC Act and overall structure of section

13(d)(4), and why? What effect, if any, should the CFTC give to the

cross-reference in section 13(d)(4) to section 13(d)(3) of the BHC Act,

which provides the CFTC with discretion to require additional capital,

if appropriate, to protect the safety and soundness of banking entities

engaged in activities permitted under section 13 of the BHC Act? How,

if at all, should a banking entity’s deduction of its investment in a

covered fund be increased commensurate with the leverage of the covered

fund? Should the amount of the deduction be proportionate to the

leverage of the covered fund? For example, instead of a dollar-for-

dollar deduction, should the deduction be set equal to the banking

entity’s investment in the covered fund times the difference between 1

and the covered fund’s equity-to-assets ratio?

Question 270. Does the proposed rule effectively implement the

Board’s statutory authority to grant an extension of the period of time

a banking entity may retain in excess of 3 percent of the ownership

interests in a single covered fund? Are the enumerated factors that the

Board may consider in connection with reviewing such an extension

appropriate (including factors related to the effect of an extension of

the covered fund), and if not, why not? Are there additional factors

that the Board should consider in reviewing such a request? Are there

specific additional conditions or limitations that the Board should, by

rule, impose in connection with granting such an extension? If so, what

conditions or limitations would be more effective?

Question 271. Given that the statute does not provide for an

extension of time for a banking entity to comply with the aggregate

funds limitation, within what period of time should a banking entity be

required to bring its investments into conformance with the aggregate

funds limit? Should the proposed rule expressly contain a grace period

for complying with these limits? Why or why not? If yes, what grace

period would be most effective and why?

Question 272. Does the proposed rule effectively implement the

prohibition on a banking entity guaranteeing or insuring the

obligations or performance of certain covered funds? If not, what

alternative approach would be more effective and why?

Question 273. In the context of securitization transactions,

control and ownership are often completely separated. Is additional

guidance necessary with respect to how control should be determined

with respect to issuers of asset-backed securities for purposes of

determining the calculation of the per-fund and aggregate ownership

limitations?

Question 274. In many securitization transactions, the voting

rights of investors are extremely limited and management may be

contractually delegated to a third party (because issuers of asset-

backed securities rarely have a board with any authority or any

employees). The servicer or manager has the “ability to control the

decision-making and operational functions of the fund.” When

calculating the per-fund and aggregate ownership limitations, to whom

should the proposed rule allocate “control” in this type of

situation? Which participants in a securitization transaction would

need to include the activities of an issuer of asset-backed securities

in their calculations of per-fund and aggregate ownership, and what is

the potential impact of such inclusion?

Question 275. For purposes of calculating the per-fund and

aggregate ownership limitations, how should the proposed rule address

those instances in which equity is issued, but the equity holder does

not receive economic benefits or have any control rights? For instance,

in order to enhance or achieve bankruptcy remoteness, a single purpose

trust without an owner (i.e., an orphan trust) may hold all of the

equity interests in a securitization vehicle. Such interests often do

not have any meaningful economic or control rights.

4. Section —-.13: Other Permitted Covered Fund Activities and

Investments

Section 13 of the proposed rule implements the statutory exemptions

described in sections 13(d)(1)(C), (E), and (I) of the BHC Act that

permit a banking entity: (i) To acquire an ownership interest in, or

act as sponsor to, one or more SBICs, a public welfare investment, or a

certain qualified rehabilitation expenditure; 298 (ii) to acquire or

retain an ownership interest in a covered fund as a risk-mitigating

hedging position; and (iii) in the case of a non-U.S. banking entity,

to acquire or retain an ownership interest in or sponsor a foreign

covered fund. Additionally, Sec. —-.13 of the proposed rule

implements in part the rule of construction related to the sale and

securitization of loans contained in section 13(g)(2) of the BHC Act.

Similar to Sec. —-.6 of the proposed rule (which implements certain

permitted proprietary trading activities), Sec. —-.13 contains only

the statutory exemptions contained in section 13(d)(1) of the BHC Act

that the CFTC has determined apply, either by plain language or by

implication, to investments in or relationships with a covered

fund.299

—————————————————————————

298 Section —-.13(a) of the proposed rule also implements a

proposed determination by the CFTC under section 13(d)(1)(J) of the

BHC Act that a banking entity may not only invest in such entities

as provided under section 13(d)(1)(E) of the BHC Act, but also may

sponsor an entity described in that paragraph and that such

activity, since it generally would facilitate investment in small

businesses and support the public welfare, would promote and protect

the safety and soundness of banking entities and the financial

stability of the United States.

299 In particular, Sec. —-.13 of the proposed rule does not

include: (i) The exemption in section 13(d)(1)(A) of the BHC Act for

trading in certain permitted government obligations; (ii) the

exemption in section 13(d)(1)(H) of the BHC Act for certain foreign

proprietary trading activities; and (iii) the exemption contained in

section 13(d)(1)(B) of the BHC Act related to underwriting and

market-making related activities. Each of these exemptions appear

relevant only to covered trading activities and not to covered fund

activities.

—————————————————————————

a. Permitted Investments in SBICs and Related Funds

Section —-.13(a) of the proposed rule implements sections

13(d)(1)(E) and (J) of the BHC Act 300 and permits a banking entity

to acquire or retain any ownership interest in, or act as sponsor to:

(i) One or more SBICs, as defined in section 102 of the Small Business

Investment Act of 1958 (12 U.S.C. 662); (ii) an investment that is

designed primarily to promote the public welfare, of the type permitted

under paragraph (11) of section 5136 of the Revised Statutes of the

United States (12 U.S.C. 24), including the welfare of low- and

moderate-income communities or families (such as providing housing,

[[Page 8394]]

services, or jobs); and (iii) an investment that is a qualified

rehabilitation expenditure with respect to a qualified rehabilitation

building or certified historic structure, as such terms are defined in

section 47 of the Internal Revenue Code of 1986 or a similar State

historic tax credit program.301 Since section 13(d)(1)(E) of the BHC

Act does not limit a banking entity’s investment to a limited

partnership or other non-controlling investment, Sec. —-.13(a) of

the proposed rule would permit a banking entity to be a shareholder,

general partner, managing member, or trustee of an SBIC without regard

to whether the interest is a controlling or noncontrolling

interest.302

—————————————————————————

300 Section 13(d)(1)(E) of the BHC Act permits a banking

entity to make investments in one or more SBICs, investments

designed primarily to promote the public welfare, investments of the

type permitted under 12 U.S.C. 24 (eleventh), and investments that

are qualified rehabilitation expenditures with respect to a

qualified rehabilitated building or certified historic structure.

See 12 U.S.C. 1851(d)(1)(E).

301 See proposed rule Sec. —-.13(a).

302 Pursuant to the exemption contained in Sec. —-.13(a) of

the proposed rule, a banking entity may acquire an ownership

interest in, or act as sponsor to, a low income housing credit fund,

if such fund qualifies as an SBIC, public welfare investment or

qualified rehabilitation expenditure.

—————————————————————————

In addition to the acquisition or retention of an ownership

interest, permitting a banking entity to act as sponsor to these types

of public interest investments will provide valuable expertise and

services to these types of entities, as well as help enable banking

entities to provide valuable funding and assistance to small business

and low- and moderate-income communities. Therefore, the Agencies

believe this exemption would be consistent with the safe and sound

operation of banking entities, and would also promote the financial

stability of the United States.

The CFTC requests comment on the proposed rule’s approach to

implementing the exemption for permitted investments in and

relationships with SBICs and certain related funds. In particular, the

CFTC requests comment on the following questions:

Question 276. Is the proposed rule’s approach to implementing the

SBIC, public welfare and qualified rehabilitation investment exemption

for acquiring or retaining an ownership interest in a covered fund

effective? If not, what alternative approach would be more effective?

Question 277. Should the approach include other elements? If so,

what elements and why? Should any of the proposed elements be revised

or eliminated? If so, why and how?

Question 278. Should the proposed rule permit a banking entity to

sponsor an SBIC and other identified public interest investments? Why

or why not? Does the CFTC’s determination under section 13(d)(1)(J) of

the BHC Act regarding sponsoring of an SBIC, public welfare or

qualified rehabilitation investment effectively promote and protect the

safety and soundness of banking entities and the financial stability of

the United States? If not, why not?

Question 279. What would the effect of the proposed rule be on a

banking entity’s ability to sponsor and syndicate funds supported by

public welfare investments or low income housing tax credits which are

utilized to assist banks and other insured depository institutions with

meeting their Community Reinvestment Act (“CRA”) obligations?

Question 280. Does the proposed rule unduly constrain a banking

entity’s ability to meet the convenience and needs of the community

through CRA or other public welfare investments or services? If so, why

and how could the proposed rule be revised to address this concern?

b. Permitted Risk-Mitigating Hedging Activities

Section —-.13(b) of the proposed rule permits a banking entity to

acquire and retain an ownership interest in a covered fund if the

transaction is made in connection with, and related to, certain

individual or aggregated positions, contracts, or other holdings of the

banking entity and is designed to reduce the specific risks to the

banking entity in connection with and related to such positions,

contracts, or other holdings. This section of the proposed rule

implements, in relevant part, section 13(d)(1)(C) of the BHC Act, which

provides an exemption from the prohibition on acquiring or retaining an

ownership interest in a covered fund for certain risk-mitigating

hedging activities.303

—————————————————————————

303 See 12 U.S.C. 1851(d)(1)(C).

—————————————————————————

Interests by a banking entity in a covered fund may not typically

be used as hedges for specific positions, contracts, or other holdings

of a banking entity. However, two situations where a banking entity may

potentially acquire or retain an ownership interest in a covered fund

as a hedge are (i) when acting as intermediary on behalf of a customer

that is not itself a banking entity to facilitate the exposure by the

customer to the profits and losses of the covered fund (similar to

acting as a “riskless principal”),304 and (ii) to cover a

compensation arrangement with an employee of the banking entity that

directly provides investment advisory or other services to that fund.

Section —-.13(b) of the proposed rule provides an exemption for

banking entity to acquire or retain an ownership interest in a covered

fund in these limited situations.305

—————————————————————————

304 In order to prevent evasion of the general limitation that

a banking entity may not acquire or retain more than 3 percent of

the ownership interests in any single covered fund that such banking

entity organizes and offers, the proposed rule limits a banking

entity’s ability to acquire or retain an ownership interest in a

covered fund as a permitted risk-mitigating hedge to those

situations where the customer of the banking entity is not itself a

banking entity. See proposed rule Sec. —-.13(b)(1)(i)(A).

305 See proposed rule Sec. —-.13(b).

—————————————————————————

i. Approach for Hedges Using an Ownership Interest in a Covered Fund

As noted above in the discussion of Sec. —-.5 of the proposed

rule, risk-mitigating hedging activities present certain implementation

challenges because of the potential that prohibited activities or

investments could be conducted in the context of, or mischaracterized

as, hedging transactions. In light of these complexities, the Agencies

have proposed a multi-faceted approach to implementation, which is

discussed in detail above in reference to Sec. —-.5 of the proposed

rule.306 As with the hedging exemption provided under Sec. —-.5,

this multi-faceted approach is intended to clearly articulate the

CFTC’s expectation regarding the scope of permitted hedging activities

under Sec. —-.13(b) in a manner that limits potential abuse of the

hedging exemption while not unduly constraining the important risk

management function that is served by a banking entity’s hedging

activities. However, because of the possibility that using an ownership

interest in a covered fund as a hedging instrument may mask an intent

to evade the limitations on the amount and value of ownership interests

in a covered fund or funds under Sec. —-.12, the proposed rule

contains several additional requirements related to a banking entity’s

ability to use an ownership interest in a covered fund as a hedging

instrument.

—————————————————————————

306 See SUPPLEMENTARY INFORMATION, Part III.B.3.

—————————————————————————

ii. Required Criteria for Permitted Risk-Mitigating Hedging Activities

Involving a Covered Fund

Section —-.13(b) of the proposed rule describes the criteria that

a banking entity must meet in order to rely on the hedging exemption

with respect to ownership interests of a covered fund. The majority of

these requirements are substantially similar to those discussed in

detail above in connection with the risk-mitigating hedging exemption

contained in Sec. —-.5 of the proposed rule, and include the

requirements that:

[[Page 8395]]

(i) The hedge is made in connection with and related to individual or

aggregated obligations or liabilities of the banking entity that are:

(A) taken by the banking entity when acting as intermediary on behalf

of a customer that is not itself a banking entity to facilitate the

exposure by the customer to the profits and losses of the covered fund,

or (B) directly connected to a compensation arrangement with an

employee that directly provides investment advisory or other services

to the covered fund; (ii) the banking entity has established the

internal compliance program required by subpart D designed to ensure

the banking entity’s compliance with the requirements of this

paragraph, including reasonably designed written policies and

procedures regarding the instruments, techniques and strategies that

may be used for hedging, internal controls and monitoring procedures,

and independent testing; (iii) the transaction is designed to reduce

the specific risks to the banking entity in connection with and related

to such obligations or liabilities; (iv) the acquisition or retention

of an ownership interest in a covered fund: (A) Is made in accordance

with the written policies, procedures and internal controls established

by the banking entity pursuant to subpart D; (B) hedges or otherwise

mitigates an exposure to a covered fund through a substantially similar

offsetting exposure to the same covered fund and in the same amount of

ownership interest in that covered fund that arises out of a

transaction conducted solely to accommodate a specific customer request

with respect to, or directly connected to its compensation arrangement

with an employee that directly provides investment advisory or other

services to, that covered fund; (C) does not give rise, at the

inception of the hedge, to significant exposures that were not already

present in individual or aggregated positions, contracts, or other

holdings of a banking entity and are not hedged contemporaneously; and

(D) is subject to continuing review, monitoring and management by the

banking entity that: (1) Is consistent with its written hedging

policies and procedures; (2) maintains a substantially similar

offsetting exposure to the same amount and type of ownership interest,

based upon the facts and circumstances of the underlying and hedging

positions and the risks and liquidity of those positions, to the risk

or risks the purchase or sale is intended to hedge or otherwise

mitigate; and (3) mitigates any significant exposure arising out of the

hedge after inception; and (v) the compensation arrangements of persons

performing the risk-mitigating hedging activities are designed not to

reward proprietary risk-taking.307

—————————————————————————

307 See proposed rule Sec. —-.13(b).

—————————————————————————

These requirements, while substantially similar to those contained

in Sec. —-.5 above, are different in several material aspects.

First, Sec. —-.13(b)(1)(i) of the proposed rule provides that any

banking entity relying on this exemption may only hedge or otherwise

mitigate one or more specific risks arising in connection with and

related to the two situations enumerated in that section. These are

risks taken by the banking entity when acting as intermediary on behalf

of a customer that is not itself a banking entity to facilitate the

exposure by the customer to the profits and losses of the covered fund,

or directly connected to its compensation arrangement with an employee

that directly provides investment advisory or other services to the

covered fund.308 Second, Sec. —-.13(b)(2)(ii)(B) of the proposed

rule requires that the acquisition or retention of an ownership

interest in a covered fund hedge or otherwise mitigate a substantially

similar offsetting exposure to the same covered fund and in the same

amount of ownership interest in that covered fund, which requires

greater equivalency between the reference asset and hedging instrument

than the correlation required under Sec. —-.5. Third, Sec. —

–.13(b)(3) of the proposed rule imposes a documentation requirement on

all types of hedging transactions where the banking entity uses

ownership interests in a covered fund as the hedging instrument. This

requirement is broader than that contained in Sec. —-.5 and is

reflective of the limited scope of positions or exposures for which a

banking entity may acquire or retain an ownership interest in a covered

fund as a hedge. Specifically, for any transaction that a banking

entity acquires or retains an ownership interest in a covered fund in

reliance of the hedging exemption, the banking entity must document the

risk-mitigating purposes of the transaction and identify the risks of

the individual or aggregated positions, contracts, or other holding of

the banking entity that the transaction is designed to reduce. Such

documentation must be established at the time the hedging transaction

is effected, not after the fact. This documentation requirement

establishes a contemporaneous record that will assist the CFTC in

assessing the actual reasons for which the position was established.

—————————————————————————

308 See proposed rule Sec. —-.13(b)(1)(i).

—————————————————————————

iii. Request for Comment

In addition to those questions raised in connection with the

proposed implementation of the risk-mitigating hedging exemption under

Sec. —-.5 of the proposed rule, the CFTC requests comment on the

proposed implementation of that same exemption with respect to covered

fund activities. In particular, the CFTC requests comment on the

following questions:

Question 281. Is the proposed rule’s approach to implementing the

hedging exemption for acquiring or retaining an ownership interest in a

covered fund effective? If not, what alternative approach would be more

effective?

Question 282. Should the approach include other elements? If so,

what elements and why? Should any of the proposed elements be revised

or eliminated? If so, why and how?

Question 283. What burden will the proposed approach to

implementing the hedging exemption have on banking entities? How can

any burden be minimized or eliminated in a manner consistent with the

language and purpose of the statute?

Question 284. Are the criteria included in Sec. —-.13(b)’s

hedging exemption effective? Is the application of each criterion to

potential transactions sufficiently clear? Should any of the criteria

be changed or eliminated? Should other requirements be added?

Question 285. Is the requirement that an ownership interest in a

covered fund may only be used as a hedge (i) by the banking entity when

acting as intermediary on behalf of a customer that is not itself a

banking entity to facilitate the exposure by the customer to the

profits and losses of the covered fund, or (ii) to cover compensation

arrangements with an employee of the banking entity that directly

provides investment advisory or other services to that fund effective?

If not, what other requirements would be more effective?

Question 286. Does the proposed rule sufficiently articulate the

types of risks and positions that a banking entity typically would

utilize an ownership interest in a covered fund to hedge? If not, how

should the proposal be changed?

Question 287. Is the requirement that the hedging transaction

involve a substantially similar offsetting exposure to the same covered

fund and in the same amount of ownership interest to the risk or risks

the transaction is intended to hedge or otherwise mitigate effective?

If not, how should the

[[Page 8396]]

requirement be changed? Should some other level of correlation be

required? Should the proposal specify in greater detail how correlation

should be measured? If not, how could it better do so?

Question 288. Is the requirement that the transaction not give

rise, at the inception of the hedge, to material risks that are not

themselves hedged in a contemporaneous transaction effective? Is the

proposed materiality qualifier appropriate and sufficiently clear? If

not, what alternative would be effective and/or clearer?

Question 289. Is the requirement that any transaction conducted in

reliance on the hedging exemption be subject to continuing review,

monitoring and management after the transaction is established

effective? If not, what alternative would be more effective?

Question 290. Is the proposed documentation requirement effective?

If not, what alternative would be more effective? What burden would the

proposed documentation requirement place on covered banking entities?

How might such burden be reduced or eliminated in a manner consistent

with the language and purpose of the statute?

c. Permitted Covered Fund Activities and Investments Outside of the

United States

Section —-.13(c) of the proposed rule, which implements section

13(d)(1)(I) of the BHC Act,309 permits certain foreign banking

entities to acquire or retain an ownership interest in, or to act as

sponsor to, a covered fund so long as such activity occurs solely

outside of the United States and the entity meets the requirements of

sections 4(c)(9) or 4(c)(13) of the BHC Act. The purpose of this

statutory exemption appears to be to limit the extraterritorial

application of the statutory restrictions on covered fund activities to

foreign firms that, in the course of operating outside of the United

States, engage outside the United States in activities permitted under

relevant foreign law, while preserving national treatment and

competitive equality among U.S. and foreign firms within the United

States.310 Consistent with this purpose, the proposed rule defines

both the type of foreign banking entities that are eligible for the

exemption and the circumstances in which covered fund activities or

investments by such an entity will be considered to have occurred

solely outside of the United States (including clarifying when an

ownership interest will be deemed to have been offered for sale or sold

to a resident of the United States).

—————————————————————————

309 Section 13(d)(1)(I) of the BHC Act permits a banking

entity to acquire or retain an ownership interest in, or have

certain relationships with, a covered fund notwithstanding the

prohibition on proprietary trading and restrictions on investments

in, and relationships with, a covered fund, if: (i) such activity or

investment is conducted by a banking entity pursuant to paragraph

(9) or (13) of section 4(c) of the BHC Act; (ii) the activity occurs

solely outside of the United States; (iii) no ownership interest in

such fund is offered for sale or sold to a resident of the United

States; and (iv) the banking entity is not directly or indirectly

controlled by a banking entity that is organized under the laws of

the United States or of one or more States. See 12 U.S.C.

1851(d)(1)(I).

310 See 156 Cong. Rec. S5897 (daily ed. July 15, 2010)

(statement of Sen. Merkley).

—————————————————————————

i. Foreign Banking Entities Eligible for the Exemption

Section —-.13(c)(1)(i) of the proposed rule incorporates the

statutory requirement that the banking entity not be, directly or

indirectly, controlled by a banking entity that is organized under the

laws of the United States or of one or more States. Consistent with the

statutory language, banking entities organized under the laws of the

United States or of one or more States, or the subsidiaries or branches

thereof (wherever organized or licensed), may not rely on the

exemption. Similarly, the U.S. subsidiaries or U.S. branches of foreign

banking entities would not qualify for the exemption.

Section —-.13(c)(2) clarifies when a banking entity would be

considered to have met the statutory requirement that the banking

entity conduct the activity pursuant to paragraphs 4(c)(9) or 4(c)(13)

of the BHC Act 311 Section 4(c)(9) of the BHC Act generally provides

that the restrictions on nonbanking activities contained in section

4(a) of that statute do not apply to the ownership of shares held or

activities conducted by any company organized under the laws of a

foreign country the greater part of whose business is conducted outside

the United States, if the Board by regulation or order determines that,

under the circumstances and subject to the conditions set forth in the

regulation or order, the exemption would not be substantially at

variance with the purposes of this Act and would be in the public

interest.312 The CFTC notes that the Board has, in part, implemented

section 4(c)(9) through subpart B of the Board’s Regulation K, which

specifies a number of conditions and requirements that a foreign

banking organization must meet in order to use such authority. Such

conditions and requirements include, for example, a qualifying foreign

banking organization test that requires the foreign banking

organization to demonstrate that more than half of its worldwide

business is banking and that more than half of its banking business is

outside the United States.

—————————————————————————

311 Section —-.13(c)(2) of the proposed rule only addresses

when a transaction or activity will be considered to have been

conducted pursuant to section 4(c)(9) of the BHC Act; although the

statute also references section 4(c)(13) of the BHC Act, the CFTC

notes that the Board has applied the authority contained in that

section only to include certain foreign activities of U.S. banking

organizations. The express language of section 13(d)(1)(I) of the

BHC Act limits its availability to foreign banking entities that are

not controlled by a banking entity organized under the laws of the

United States or of one or more States. A foreign banking entity may

not rely on the exemptive authority of section 4(c)(13) and, so,

that section is not addressed in the proposed rule.

312 See 12 U.S.C. 1843(c)(9).

—————————————————————————

The proposed rule makes clear that a banking entity will qualify

for the foreign fund exemption if the entity is a foreign banking

organization subject to subpart B of the Board’s Regulation K and the

transaction occurs solely outside the United States. Section 13 of the

BHC Act also applies to foreign companies that are banking entities

covered by Section 13 but are not currently subject either to the BHC

Act generally or the Board’s Regulation K, for example, because the

foreign company controls a savings association or an FDIC-insured

industrial loan company but not a bank or branch in the United States.

Accordingly, the proposed rule clarifies when such a foreign banking

entity would be considered to have conducted a transaction or activity

“pursuant to section 4(c)(9)” for purposes of the exemption at Sec.

—-.13(c) of the proposed rule.313 In particular, the proposed rule

proposes that to qualify for the foreign banking entity exemption, such

firms must meet at least two of three requirements that evaluate the

extent to which the foreign entity’s business is conducted outside the

United States, as measured by assets, revenues, and income. This test

largely mirrors the qualifying foreign banking organization test that

is made applicable under section 4(c)(9) and Sec. 211.23(a) of the

Board’s Regulation K, except that the relevant test under Sec. —

–.13(c)(2)(ii) of the proposed rule does not require such a foreign

entity to demonstrate that more than half of its

[[Page 8397]]

business is banking conducted outside the United States.314

—————————————————————————

313 The CFTC notes that the Board emphasizes that this

clarification would be applicable solely in the context of sections

13(d)(1)(H) and (I) of the BHC Act. The application of section

4(c)(9) to such foreign companies in other contexts is likely to

involve different legal and policy issues and may therefore merit

different approaches.

314 See 12 U.S.C. 1843(c)(9); 12 CFR 211.23(a); proposed rule

Sec. —-.13(c)(2). This difference reflects the fact that foreign

entities subject to section 13 of the BHC Act but not the BHC Act

are, in many cases, predominantly commercial firms. A requirement

that a firm also demonstrate that more than half of its banking

business is outside the United States would likely make the

exemption unavailable to many such firms and subject their global

activities to the prohibition on acquiring or retaining an ownership

interest in, or acting as sponsor to, a covered fund, a result that

the statute does not appear to have intended.

—————————————————————————

ii. Transactions and Activities Solely Outside of the United States

Section —-.13(c) of the proposed rule also clarifies when a

transaction or activity will be considered to have occurred solely

outside of the United States for purposes of the exemption. In

interpreting this aspect of the statutory language, the proposal

focuses on the extent to which material elements of the transaction

occur within, or are effected by personnel within, the United States.

This aspect of the proposal reflects the apparent intent of the foreign

funds exemption to avoid extraterritorial application of the

restrictions on covered funds activities and investments outside the

United States while preserving competitive parity within U.S. market.

The proposed rule does not evaluate solely whether the risk of the

transaction or activity, or management or decision-making with respect

to such transaction or activity, rests outside the United States.

Rather, the proposal also provides that foreign banking entities may

not structure a transaction or activity so as to be “outside of the

United States” for risk and booking purposes while simultaneously

engaging in transactions within U.S. markets that are prohibited for

U.S. banking entities.

In particular, Sec. —-.13(c)(3) of the proposed rule provides

that a transaction or activity will be considered to have occurred

solely outside of the United States only if all of the following three

conditions are satisfied:

The transaction or activity is conducted by a banking

entity that is not organized under the laws of the United States or of

one or more States;

No subsidiary, affiliate, or employee of the banking

entity that is involved in the offer or sale of an ownership interest

in the covered fund is incorporated or physically located in the United

States; and

No ownership interest in such covered fund is offered for

sale or sold to a resident of the United States.

These three criteria reflect statutory constraints and are intended to

ensure that a transaction or activity conducted in reliance on the

exemption does not involve either investors that are residents of the

United States or a relevant U.S. employee of the banking entity, as

such involvement would appear to constitute a sufficient locus of

activity in the U.S. marketplace so as to preclude the availability of

the exemption.

A resident of the United States is defined in Sec. —-.2(t) of

the proposed rule, and is described in detail in Part III.B.4.d of this

SUPPLEMENTARY INFORMATION. The proposed rule applies this definition in

the context of the foreign covered funds exemption because it would

appear to appropriately capture the scope of counterparties (including

investors that are residents of the United States) or relevant U.S.

personnel of the banking entity, that, if involved in the transaction

or activity, would preclude such transaction or activity from being

considered to have occurred solely outside the United States. Under the

proposed rule, an employee or entity engaged in the offer or sale of an

ownership interest (or booking such transaction) must be outside of the

United States; however, an employee or entity with no customer

relationship and involved solely in providing administrative services

or so-called “back office” functions to the fund as incident to the

activity permitted under Sec. —-.13(c) of the proposed rule (such as

clearing and settlement or maintaining and preserving records of the

fund with respect to a transaction where no ownership interest is

offered for sale or sold to a resident of the United States) would not

be subject to this requirement.

iii. Request for Comment

The CFTC requests comment on the proposed rule’s approach to

implementing the foreign covered funds activity and investment

exemption. In particular, the CFTC request comment on the following

questions:

Question 291. Is the proposed rule’s implementation of the

“foreign funds” exemption effective? If not, what alternative would

be more effective and/or clearer?

Question 292. Are the proposed rule’s provisions regarding when an

activity will be considered to be conducted pursuant to section 4(c)(9)

of the BHC Act effective and sufficiently clear? If not, what

alternative would be more effective and/or clearer? Does it effectively

address application of the foreign funds exemption to foreign banking

entities not subject to the BHC Act generally? If not, how could it

better address application of the exemption?

Question 293. Are the proposed rule’s provisions regarding when a

transaction or activity will be considered to have occurred solely

outside the United States effective and sufficiently clear? If not,

what alternative would be more effective and/or clearer? Should

additional requirements be added? If so, what requirements and why?

Should additional requirements be modified or removed? If so, what

requirements and why or how?

Question 294. Is the proposed exemption consistent with the purpose

of the statute? Is the proposed exemption consistent with respect to

national treatment for foreign banking organizations? Is the proposed

exemption consistent with the concept of competitive equity?

Question 295. Does the proposed rule effectively define a resident

of the United States for these purposes? If not, how should the

definition be altered? What definitions of resident of the United

States are currently used by banking entities? Would using any one of

these definitions reduce the burden of complying with section 13 of the

BHC Act? Why or why not?

d. Sale and Securitization of Loans

Section —-.13(d) of the proposed rule permits a banking entity to

acquire and retain an ownership interest in a covered fund that is an

issuer of asset-backed securities, the assets or holdings of which are

solely comprised of: (i) Loans; (ii) contractual rights or assets

directly arising from those loans supporting the asset-backed

securities; and (iii) interest rate or foreign exchange derivatives

that (A) materially relate to the terms of such loans or contractual

rights or assets and (B) are used for hedging purposes with respect to

the securitization structure.315 The authority contained in this

section of the proposed rule would therefore allow a banking entity to

engage in the sale and securitization of loans by acquiring and

retaining an ownership interest in certain securitization vehicles

(which could qualify as a covered fund for purposes of section 13(h)(2)

of the BHC Act and the proposed rule) that the banking entity organizes

and offers, or acts as sponsor to, in excess of and

[[Page 8398]]

without being subject to the limitations contained in Sec. —-.12 of

the proposed rule. Proposed Sec. —-.13(d) is designed to assist in

implementing section 13(g)(2) of the BHC Act, which provides that

nothing in section 13 of the BHC Act 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.316

—————————————————————————

315 See proposed rule Sec. —-.13(d). The types of

derivatives permitted under Sec. —-.13(d)(3) of the proposed rule

are not meant to include a synthetic securitization or a

securitization of derivatives, but rather to include those

derivatives that are used to hedge foreign exchange or interest rate

risk resulting from loans held by the issuer of asset-backed

securities.

316 See 12 U.S.C. 1851(g)(2).

—————————————————————————

The CFTC notes that the phrase “materially relate to terms of such

loans” is intended to quantitatively limit the derivatives permitted

in a “securitization of loans” under Sec. —-.13(d) of the proposed

rule to include only those derivatives where the notional amount of the

derivative is tied to the outstanding principal balance of the loans

supporting the asset-backed securities of such issuer, either

individually or in the aggregate. Additionally, such derivatives must

be used solely to hedge risks that result from a mismatch between the

loans and the related asset-backed securities (e.g., fixed rate loans

with floating rate asset-backed securities, loans tied to the Prime

Rate with LIBOR asset-backed securities, or Euro-denominated loans with

Dollar-denominated asset-backed securities). Therefore, Sec. —

–.13(d)(3) of the proposed rule would not allow the use of a credit

default swap by an issuer of asset-backed securities.

The CFTC requests comment on the proposed rule’s approach to

implementing the rule of construction related to the sale and

securitization of loans. In particular, the CFTC requests comment on

the following questions:

Question 296. Is the proposed rule’s implementation of the

statute’s “sale and securitization of loans” rule of construction

effective? If not, what alternative would be more effective and/or

clearer?

Question 296.1. Should the proposed CFTC Rule include the

securitization exemption in Sec. —-.13(d)? Please explain the

rationale for including or excluding the securitization exemption in

the proposed CFTC Rule.

Question 297. Are there other entities or activities that should be

included in the proposed rule’s implementation of the rule of

construction related to the sale and securitization of loans? If so,

what entity or activity and why?

Question 298. Is the proposed rule’s application of the rule of

construction contained in section 13(g)(2) of the BHC Act appropriate?

Question 299. Are the proposed rule and this SUPPLEMENTARY

INFORMATION sufficiently clear regarding which derivatives would be

allowed in a “securitization of loans” under Sec. —-.13(d)(3) of

the proposed rule? Is additional guidance necessary with respect to the

types of derivatives that would be included in or excluded from a

securitization of loans for purposes of interpreting the rule of

construction contained in section 13(g)(2) of the BHC Act? If so, what

topics should the additional guidance discuss and why?

Question 300. Should derivatives other than interest rate or

foreign exchange derivatives be allowed in a “securitization of

loans” for purposes of interpreting the rule of construction contained

in section 13(g)(2) of the BHC Act? Why or why not? What would be the

legal and economic impact of not allowing the use of derivatives other

than interest rate or foreign exchange derivatives in a

“securitization of loans” under Sec. —-.13(d)(3) of the proposed

rule for existing issuers of asset-backed securities and for future

issuers of asset-backed securities?

Question 301. Should the CFTC consider providing additional

guidance for when a transaction with intermediate steps constitutes one

or more securitization transactions that each would be subject to the

rule? For example, both auto lease securitizations and asset-backed

commercial paper conduits typically involve intermediate

securitizations. The asset-backed securities issued to investors in

such covered funds are technically supported by the intermediate asset-

backed securities. Should these kinds of securitizations be viewed as a

single transaction and included within a securitization of loans for

purposes of the proposed rule? Should each step be viewed as a separate

securitization?

5. Section —-.14: Covered Fund Activities and Investments Determined

To Be Permissible

Section —-.14 of the proposed rule, which implements section

13(d)(1)(J) of the BHC Act,317 permits a banking entity to engage in

any covered funds activity that the CFTC determines promotes and

protects the safety and soundness of a banking entity and the financial

stability of the United States.318 Any activity authorized under

Sec. —-.14 of the proposed rule must still comply with the

prohibition and limitations governing relationships with covered funds

contained in section 13(f) of the BHC Act, as implemented by Sec. —

–.16 of this proposal.319 Additionally, like other activities

permissible under section 13(d)(1) of the BHC Act and as implemented by

subpart C of the proposed rule, activities found permissible under

Sec. —-.14 of the proposed rule and section 13(d)(1)(J) remain

subject to other provisions of section 13 of the BHC Act, including the

sections limiting conflicts of interest and high-risk assets or trading

strategies, as well as the section designed to prevent evasion of

section 13 of the BHC Act.320

—————————————————————————

317 Section 13(d)(1)(J) of the BHC Act provides the CFTC

discretion to determine that other activities not specifically

identified by sections 13(d)(1)(A)-(I) of the BHC Act are exempted

from the general prohibitions contained in section 13(a) of that

Act, and are thus permitted activities. In order to make such a

determination, the CFTC must find that such activity or activities

promote and protect the safety and soundness of a banking entity, as

well as promote and protect the financial stability of the United

States. See 12 U.S.C. 1851(d)(1)(J).

318 See 12 U.S.C. 1851(d)(1)(J).

319 Section 13(d)(1)(J) of the BHC Act only provides the CFTC

with the ability to provide additional exemptions from the

prohibitions contained in section 13(a)(1) of the BHC Act. Section

13(f) of the BHC Act, which deals with relationships and

transactions with a fund that is, directly or indirectly, organized

and offered or sponsored by a banking entity, operates as an

independent prohibition and set of limitations on the activities of

banking entities. As such, Sec. —-.14 of the proposed rule cannot

and does not provide any exemptions from the prohibition on

relationships or transaction with a covered fund contained in

section 13(f) of the BHC Act or Sec. —-.16 of the proposed rule.

320 See 12 U.S.C. 1851(d)(2), (e)(1).

—————————————————————————

The CFTC has proposed to permit three activities at this time under

this authority. These activities involve acquiring or retaining an

ownership interest in and sponsoring of (i) certain BOLI separate

accounts; (ii) certain entities that, although within the definition of

covered fund are, in fact, common corporate organizational vehicles;

and (iii) a covered fund in the ordinary course of collecting a debt

previously contracted in good faith or pursuant to and in compliance

with the conformance or extended transition period provided for under

the Board’s rules issued under section 13(c)(6) of the BHC Act.

a. Investments in Certain Bank Owned Life Insurance Separate Accounts

Banking entities have for many years invested in life insurance

policies that cover key employees, in accordance with supervisory

policies established by the Federal banking agencies.321 These BOLI

investments are typically structured as investments in separate

accounts that are excluded from the definition of “investment

company” under the Investment Company Act by virtue of section 3(c)(1)

or 3(c)(7) of that

[[Page 8399]]

Act. By virtue of reliance on these exclusions, these BOLI accounts

would be covered by the definition of “hedge fund” or “private

equity fund” in section 13 of the BHC Act.322

—————————————————————————

321 See, e.g., Bank Owned Life Insurance, Interagency

Statement on the Purchase and Risk Management of Life Insurance

(“Interagency BOLI Guidance”) (Dec. 7, 2004).

322 See 12 U.S.C. 1851(h)(2).

—————————————————————————

However, when made in the normal course, these investments do not

involve the speculative risks intended to be addressed by section 13 of

the BHC Act. Moreover, applying the prohibitions in section 13 to these

investments would eliminate an investment that helps banking entities

to reduce their costs of providing employee benefits as well as other

costs.

Section —-.14(a)(1) of the proposed rule permits a banking entity

to acquire and retain these BOLI investments, as well as act as sponsor

to a BOLI separate account.323 The proposal includes a number of

conditions designed to ensure that BOLI investments are not conducted

in a manner that raises the concerns that section 13 of the BHC Act is

intended to address. In particular, in order for a banking entity to

invest in or sponsor a BOLI separate account, the banking entity that

purchases the insurance policy: (i) May not control the investment

decisions regarding the underlying assets or holdings of the separate

account; and (ii) must hold its ownership interests in the separate

account in compliance with applicable supervisory guidance provided by

the appropriate Federal regulatory agency regarding BOLI.324

—————————————————————————

323 The proposed rule defines “separate account” as “an

account established and maintained by an insurance company subject

to regulation by a State insurance regulatory or a foreign insurance

regulator under which income, gains, and losses, whether or not

realized, from assets allocated to such account, are, in accordance

with the applicable contract, credited to or charged against such

account without regard to other income, gains, or losses of the

insurance company.” See proposed rule Sec. —-.2(z).

324 See proposed rule Sec. —-.14(a)(1)(i)-(ii). While other

guidance or requirements may be imposed by the CFTC or other

Agencies for a specific banking entity for which it serves as the

primary financial regulator, the CFTC notes that, at a minimum,

investments under authority of this section must comply with the

Interagency BOLI Guidance. This guidance requires, among other

things, that a banking entity generally: (i) Not control the

investment decisions regarding the underlying assets or holdings of

the separate account; (ii) demonstrate to the satisfaction of the

CFTC that the potential returns from the investments in such

separate account are appropriately matched to the banking entity’s

employee compensation or benefit plan obligations; and (iii) not use

such separate account to take speculative positions or to support

the general operations of the banking entity.

—————————————————————————

The CFTC has structured this exemption in the proposed rule so as

to allow a banking entity to continue to manage and structure its risks

and obligations related to its employee compensation or benefit plan

obligations in a manner that promotes and protects the safety and

soundness of banking entities, which on an industry-wide level has the

concomitant effect of promoting and protecting the financial stability

of the United States.

b. Investments in Certain Other Covered Funds

As noted above, the definition of “covered fund” as contained in

Sec. —-.10(b)(1) of the proposed rule potentially includes within

its scope many entities and corporate structures that would not usually

be thought of as a “hedge fund” or “private equity fund.”

Additionally, the Dodd-Frank Act contains other provisions that permit

or require a banking entity to acquire or retain an ownership interest

in or act as sponsor to a covered fund in a manner not specifically

described under section 13 of the BHC Act.

Section —-.14(a)(2) of the proposed rule permits a banking entity

to own certain specified entities that are often part of corporate

structures and that, by themselves and without other extenuating

circumstances or factors, do not raise the type of concerns which

section 13 of the BHC Act was intended to address but which

nevertheless may be captured by the definition of “hedge fund” or

“private equity fund” in section 13(h)(2) of the BHC Act.

Specifically, Sec. —-.14(a)(2) of the proposed rule permits a

banking entity to acquire or retain an ownership interest in or act as

sponsor to (i) a joint venture between the banking entity and any other

person, provided that the joint venture is an operating company and

does not engage in any activity or any investment not permitted under

the proposed rule; (ii) an acquisition vehicle, provided that the sole

purpose and effect of such entity is to effectuate a transaction

involving the acquisition or merger of one entity with or into the

banking entity or one of its affiliates; and (iii) a wholly-owned

subsidiary of the banking entity that is (A) engaged principally in

providing bona fide liquidity management services described under Sec.

—-.3(b)(2)(iii)(C) of the proposed rule, and (B) carried on the

balance sheet of the banking entity.325

—————————————————————————

325 See proposed rule Sec. —-.14(a)(2).

—————————————————————————

The CFTC notes that these types of entities may meet the definition

of covered fund contained in Sec. —-.10(b)(1) of the proposed rule

(and as contained in section 13(h)(2) of the BHC Act), to the extent

these entities rely solely on section 3(c)(1) or 3(c)(7) of the

Investment Company Act. However, these types of entities do not engage

in the type and scope of activities to which Congress intended section

13 of the BHC Act to apply.326 Additionally, without this exemption,

many entities would be forced to alter their corporate structure

without achieving any reduction in risk. Permitting such investments in

these entities would thus appear to promote and protect the safety and

soundness of banking entities and promote and protect the financial

stability of the United States.

—————————————————————————

326 See 156 Cong. Rec. H5226 (daily ed. June 30, 2010)

(statement of Reps. Hymes and Frank).

—————————————————————————

Section —-.14(a)(2) of the proposed rule also permits a banking

entity to comply with section 15G of the Exchange Act (15 U.S.C. 78o-

11), added by section 941 of the Dodd-Frank Act, which requires a

banking entity to maintain a certain minimum interest in certain

sponsored or originated asset-backed securities.327 In order to give

effect to this separate requirement under the Dodd-Frank Act, Sec. —

–.14(a)(2)(iii) of the proposed rule permits a banking entity to

acquire or retain an ownership interest in or act as sponsor to an

issuer of asset-backed securities, but only with respect to that amount

or value of economic interest in a portion of the credit risk for an

asset-backed security that is retained by a banking entity that is a

“securitizer” or “originator” in compliance with the minimum

requirements of section 15G of the Exchange Act (15 U.S.C. 78o-11) and

any implementing regulations issued thereunder.328 The Agencies have

structured this exemption to recognize that Congress imposed other

requirements on firms that are banking entities under section 13 of the

BHC Act. Additionally, permitting a banking entity to retain the

minimum level of economic interest will incent banking entities to

engage in more careful and prudent underwriting and evaluation of the

risks and obligations that may accompany asset-backed securitizations,

which would promote and protect the safety and soundness of banking

entities and the financial stability of the United States.

—————————————————————————

327 The SEC and certain banking agencies issued a proposed

rule to implement the requirements of section 15G of the Exchange

Act, as required under section 941 of the Dodd-Frank Act. See Credit

Risk Retention, 76 FR 24090 (Apr. 29, 2011).

328 See proposed rule Sec. —-.14(a)(2)(iii).

—————————————————————————

Section 14(a)(2) of the proposed rule permits a banking entity to

acquire and retain an ownership interest in a covered fund that is an

issuer of asset-backed securities described in Sec. 13(d) of the

proposed rule, the assets or holdings of which are solely comprised of:

(i) Loans; (ii) contractual rights or assets directly arising from

those loans

[[Page 8400]]

supporting the asset-backed securities; and (iii) interest rate or

foreign exchange derivatives that (A) materially relate to the terms of

such loans or contractual rights or assets and (B) are used for hedging

purposes with respect to the securitization structure. This exemption

augments the authority regarding the sale and securitization of loans

available under Sec. —-.13(d) of the proposed rule (which partially

implements the rule of construction under section 13(g)(2) of the BHC

Act) and permits a banking entity to engage in the purchase, and not

only the sale and securitization, of loans through authorizing the

acquisition or retention of an ownership interest in such

securitization vehicles that the banking entity does not organize and

offer, or for which it does not act as sponsor, provided that the

assets or holdings of such vehicles are solely comprised of the

instruments or obligations referenced above.329

—————————————————————————

329 See id. at Sec. —-.14(a)(2)(v).

—————————————————————————

Permitting banking entities to acquire or retain an ownership

interest in these loan securitizations will provide a deeper and richer

pool of potential participants and a more liquid market for the sale of

such securitizations, which in turn should result in increased

availability of funds to individuals and small businesses, as well as

provide greater efficiency and diversification of risk. The CFTC

believes this exemption would promote and protect the safety and

soundness of a banking entity, and would also promote and protect the

financial stability of the United States.330

—————————————————————————

330 The CFTC notes that proposed exemption applies only to the

covered fund-related provisions of the proposed rule, and not to its

prohibition on proprietary trading.

—————————————————————————

c. Acquiring or Retaining an Ownership Interest in or Acting a Sponsor

to a Covered Fund Under Certain Specified Authorities

Section —-.14(b) of the proposed rule permits a banking entity to

acquire or retain an ownership interest in or act as sponsor to a

covered fund in those instances where the ownership interest is

acquired or retained by a banking entity (i) in the ordinary course of

collecting a debt previously contracted in good faith, if the banking

entity divests the ownership interest within applicable time periods

provided for by the CFTC, or (ii) pursuant to and in compliance with

the Conformance or Extended Transition Period authorities provided for

under the proposed rule.331

—————————————————————————

331 See proposed rule Sec. —-.14(b). The Conformance or

Extended Transition period authorities are substantially similar to

those proposed by the Board in its February 2011 final rule

governing such conformance periods under section 13 of the BHC Act.

—————————————————————————

Allowing banking entities to rely on these authorities for

acquiring or retaining an ownership interest in or acting as sponsor to

a covered fund will enable banking entities to manage their risks and

structure their business in a manner consistent with their chosen

corporate form and in a manner that otherwise complies with applicable

laws. Thus, permitting such activities would promote and protect the

safety and soundness of a banking entity, and would also promote and

protect the financial stability of the United States.

d. Request for Comment

The CFTC requests comment on the proposed rule’s approach to

implementing the exemption related to activities specifically

determined to be permissible under section 13(d)(1)(J) of the BHC Act.

In particular, the CFTC requests comment on the following questions:

Question 302. Is the proposed rule’s implementation of exemptions

for covered fund activities and investments pursuant to section

13(d)(1)(J) of the BHC Act effective? If not, what alternative would be

more effective and/or clearer?

Question 302.1. Should the proposed CFTC Rule include the

additional exemptions listed in section 13(d)(1)(J) of the BHC Act in

Section —-.14 (e.g., BOLI, certain acquisition vehicles)? Please

explain the rationale for including or excluding the exemptions in the

proposed CFTC Rule.

Question 303. Is the proposed rule’s approach to utilizing section

13(d)(1)(J) of the BHC Act to permit a banking entity to acquire or

retain an ownership interest in, or act as sponsor to, certain entities

that would fall into the definition of covered fund effective? Why or

why not? If not, what alternative would be more effective and why? What

legal authority under the statute would permit such an alternative?

Question 304. Are the proposed rule’s provisions regarding when a

covered fund activity will be deemed to be permitted under authority of

section 13(d)(1)(J) of the BHC Act effective and sufficiently clear? If

not, what alternative would be more effective and/or clearer?

Question 305. Do the exemptions provided for in Sec. —-.14 of

the proposed rule effectively promote and protect the safety and

soundness of banking entities and the financial stability of the United

States? If not, why not?

Question 306. Are the proposed rule’s provisions regarding what

qualifications must be satisfied in order to qualify for an exemption

under Sec. —-.14 of the proposed rule effective and sufficiently

clear? If not, what alternative would be more effective and/or clearer?

Should additional requirements be added? If so, what requirements and

why? Should additional requirements be modified or removed? If so, what

requirements and why or how?

Question 307. Does the proposed rule effectively cover the scope of

covered funds activities which the Agencies should specifically

determine to be permissible under section 13(d)(1)(J) of the BHC Act?

If not, what activity or activities should be permitted? For additional

activities that should be permitted, on what grounds would these

activities promote and protect the safety and soundness of banking

entities and the financial stability of the United States?

Question 308. Does the proposed rule effectively address the

interplay between the restrictions on covered fund activities and

investments in section 13 of the BHC Act and the requirements imposed

on certain banking entities under section 15G of the Exchange Act? Why

or why not?

Question 309. Rather than permitting the acquisition or retentions

of an ownership interest in, or acting as sponsor to, specific covered

funds under section 13(d)(1)(J) of the BHC Act, should the CFTC use the

authority provided under section 13(d)(1)(J) to permit investments in a

covered fund that display certain characteristics? If so, what

characteristics should the Agencies consider? How would investments

with such characteristics promote and protect the safety and soundness

of the banking entity and promote the financial stability of the United

States?

Question 310. Should venture capital funds be excluded from the

definition of “covered fund”? Why or why not? If so, should the

definition contained in rule 203(l)-1 under the Advisers Act be used?

Should any modification to that definition of venture capital fund be

made? How would permitting a banking entity to invest in such a fund

meet the standards contained in section 13(d)(1)(J) of the BHC Act?

Question 311. Should non-U.S. funds or entities be included in the

definition of “covered fund”? Should any non-U.S. funds or entities

be excluded from this definition? Why or why not? How would permitting

a banking entity to invest in such a fund meet the standards contained

in section 13(d)(1)(J) of the BHC Act?

[[Page 8401]]

Question 312. Should so-called “loan funds” that invest

principally in loans and not equity be excluded from the definition of

“covered fund”? Why or why not? What characteristics would be most

effective in determining whether a fund invests principally in loans

and not equity? How would permitting a banking entity to invest in such

a fund meet the standards contained in section 13(d)(1)(J) of the BHC

Act?

Question 313. Are the proposed rule’s proposed determinations that

the specified covered funds activities or investments promote and

protect the safety and soundness of banking entities and the financial

stability of the United States appropriate? If not, how should the

determinations be amended or altered?

6. Section —-.15: Internal Controls, Reporting and Recordkeeping

Requirements Applicable to Covered Fund Activities and Investments

Section —-.15 of the proposed rule, which implements section

13(e)(1) of the BHC Act,332 requires a banking entity engaged in

covered fund activities and investments to comply with (i) the internal

controls, reporting, and recordkeeping requirements required under

Sec. —-.20 and Appendix C of the proposed rule, as applicable and

(ii) such other reporting and recordkeeping requirements as the CFTC

may deem necessary to appropriately evaluate the banking entity’s

compliance with this subpart C.333 These requirements are discussed

in detail in Part III.D of this SUPPLEMENTARY INFORMATION.

—————————————————————————

332 Section 13(e)(1) of the BHC Act requires the Agencies to

issue regulations regarding internal controls and recordkeeping to

ensure compliance with section 13. See 12 U.S.C. 1851(e)(1).

333 See proposed rule Sec. —-.15.

—————————————————————————

7. Section —-.16: Limitations on Relationships With a Covered Fund

Section 13(f) of the BHC Act generally prohibits a banking entity

from entering into certain transactions with a covered fund that would

be a covered transaction as defined in section 23A of the FR Act.334

Section —-.16 of the proposed rule implements this provision. Section

—-.16(a)(2) of the proposed rule clarifies that, for reasons

explained in detail below, certain transactions between a banking

entity and a covered fund remain permissible. Section —-.16(b) of the

proposed rule implements the statute’s requirement that any transaction

permitted under section 13(f) of the BHC Act (including a prime

brokerage transaction) between the banking entity and covered fund is

subject to section 23B of the FR Act,335 which, in general, requires

that the transaction be on market terms or on terms at least as

favorable to the banking entity as a comparable transaction by the

banking entity with an unaffiliated third party.

—————————————————————————

334 12 U.S.C. 371c.

335 12 U.S.C. 371c-1.

—————————————————————————

a. General Prohibition on Certain Transactions and Relationships

Section 13(f)(1) of the BHC Act generally prohibits a banking

entity that, directly or indirectly, serves as investment manager,

investment adviser, commodity trading adviser, or sponsor to a covered

fund (or that organizes and offers a covered fund pursuant to section

13(d)(1)(G) of the BHC Act) from engaging in any transaction with the

covered fund, or with any covered fund that is controlled by such fund,

if the transaction would be a “covered transaction” as defined in

section 23A of the FR Act, as if the banking entity and any affiliate

thereof were a member bank and the covered fund were an affiliate

thereof.336 Section —-.16(a)(1) of the proposed rule includes this

prohibition.

—————————————————————————

336 As noted above, the proposed rule implements the

definition of “banking entity” in a manner that does not include

covered funds for which a banking entity acts as sponsor or

organizes and offers pursuant to section 13(d)(1)(G) of the BHC Act,

or any covered fund in which such related covered fund invests.

Accordingly, these covered funds (and any covered fund in which such

covered fund acquired or retains a controlling investment) are not

generally subject to the prohibitions contained in Sec. —-.16 of

the proposed rule.

—————————————————————————

Consistent with the requirements of section 13(f)(1) of the BHC

Act, Sec. —-.16(a)(1) of the proposed rule is more restrictive than

section 23A of the FR Act because Sec. —-.16(a)(1) generally

prohibits a banking entity and any of its affiliates from entering into

any such transaction, while section 23A permits covered transactions

with affiliates so long as the transactions meet specified quantitative

and qualitative requirements.337

—————————————————————————

337 Section 23A of the FR Act limits the aggregate amount of

covered transactions by a member bank to no more than (i) 10 per

centum of the capital stock and surplus of the member bank in the

case of any affiliate, and (ii) 20 per centum of the capital stock

and surplus of the member bank in the case of all affiliates. See 12

U.S.C. 371c(a). Conversely, section 13(f) of the BHC Act operates as

a general prohibition on such transactions without providing any

similar amount of permitted transactions.

—————————————————————————

b. Transactions That Would Be a “Covered Transaction”

Section 13(f) of the BHC Act applies to covered transactions as

defined in section 23A of the FR Act without incorporating any of the

provisions in section 23A that provide exemptions from the prohibitions

in that section for certain types of covered transactions.338 Section

—-.16 of the proposed rule adopts the same language as the statute.

The definition of “covered transaction” contained in section 23A of

the FR Act itself includes an explicit exemption from the definition of

“covered transaction” for “such purchase of real and personal

property as may be specifically exempted by the Board by order or

regulation.” 339 Since these transactions are, by definition,

excluded from the definition of “covered transaction,” any

transaction that is specifically exempted by the Board pursuant to this

specific authority would not be deemed to be a covered transaction as

defined in section 23A of the FR Act.

—————————————————————————

338 The term “covered transaction” is defined in section 23A

of the FR Act to mean, with respect to an affiliate of a member

bank: (i) a loan or extension of credit to the affiliate, including

a purchase of assets subject to an agreement to repurchase; (ii) a

purchase of or an investment in securities issued by the affiliate;

(iii) a purchase of assets from the affiliate, except such purchase

of real and personal property as may be specifically exempted by the

Board by order or regulation; (iv) the acceptance of securities or

other debt obligations issued by the affiliate as collateral

security for a loan or extension of credit to any person or company;

(v) the issuance of a guarantee, acceptance, or letter of credit,

including an endorsement or standby letter of credit, on behalf of

an affiliate; (vi) a transaction with an affiliate that involves the

borrowing or lending of securities, to the extent that the

transaction causes a member bank or subsidiary to have credit

exposure to the affiliate; or (vii) a derivative transaction, as

defined in paragraph (3) of section 5200(b) of the Revised Statutes

of the United States (12 U.S.C. 84(b)), with an affiliate, to the

extent that the transaction causes a member bank or a subsidiary to

have credit exposure to the affiliate. See 12 U.S.C. 371c(b)(7), as

amended by section 608 of the Dodd-Frank Act.

339 Id. at 371c(b)(7)(C).

—————————————————————————

c. Certain Transactions and Relationships Permitted

While section 13(f)(1) of the BHC Act operates as a general

prohibition on a banking entity’s ability to enter into a transaction

with a related covered fund that would be a covered transaction as

defined under section 23A of the FR Act, other specific portions of the

statute expressly provide for, or make reference to, a banking entity’s

ability to engage in certain transactions or relationships with such

funds.340 Section —-.16(a)(2) of the proposed rule implements and

clarifies these authorities.

—————————————————————————

340 See, e.g.,12 U.S.C. 1851(d)(1)(G), (d)(4), and (f)(3).

—————————————————————————

i. Permitted Investments and Ownerships Interests

Section—-.16(a)(2) of the proposed rule clarifies that a banking

entity may acquire or retain an ownership interest in a covered fund in

accordance with the requirements of subpart C of the

[[Page 8402]]

proposed rule.341 This clarification is proposed in order to remove

any ambiguity regarding whether the section prohibits a banking entity

from acquiring or retaining an interest in securities issued by a

related covered fund in accordance with the other provisions of the

rule, since the purchase of securities of a related covered fund would

be a covered transaction as defined by section 23A of the FR Act. There

is no evidence that Congress intended section 13(f)(1) of the BHC Act

to override the other provisions of section 13 with regard to the

acquisition or retention of ownership interests specifically permitted

by the section. Moreover, a contrary reading would make these more

specific sections that permit covered transactions between a banking

entity and a covered fund mere surplusage.

—————————————————————————

341 See proposed rule Sec. —-.16(a)(2)(i).

—————————————————————————

ii. Prime Brokerage Transactions Also Permitted

Section —-.16(a)(2)(ii) of the proposed rule implements section

13(f)(3)(A) of the BHC Act, which provides that a banking entity may

enter into any prime brokerage transaction with a covered fund in which

a covered fund managed, sponsored, or advised by such banking entity

has taken an ownership interest, so long as certain enumerated

conditions are satisfied.342 The proposed rule defines “prime

brokerage transaction” to mean one or more products or services

provided by the banking entity to a covered fund, such as custody,

clearance, securities borrowing or lending services, trade execution,

or financing, and data, operational, and portfolio management

support.343 To engage in a prime brokerage transaction with a covered

fund pursuant to Sec. —-.16(a)(2)(ii) of the proposed rule, a

banking entity must be in compliance with the limitations set forth in

Sec. —-.11 of the proposed rule with respect to a covered fund

organized and offered by such banking entity. In addition, as required

by statute, the chief executive officer (or equivalent officer) of the

banking entity must certify in writing annually that the banking entity

does not, directly or indirectly, guarantee, assume, or otherwise

insure the obligations or performance of the covered fund or of any

covered fund in which such covered fund invests. Finally, the Board

must not have determined that such transaction is inconsistent with the

safe and sound operation and condition of the banking entity.

—————————————————————————

342 See proposed rule Sec. —-.16(a)(2)(ii).

343 See proposed rule Sec. —-.10(b)(4).

—————————————————————————

d. Restrictions on Transactions With Any Permitted Covered Fund

Section —-.16(b) of the proposed rule implements sections

13(f)(2) and 13(f)(3)(B) of the BHC Act and applies section 23B of the

FR Act 344 to certain transactions and investments between a banking

entity and a covered fund as if such banking entity were a member bank

and such covered fund were an affiliate thereof.345 Section 23B

provides that transactions between a member bank and an affiliate must

be on terms and under circumstances, including credit standards, that

are substantially the same or at least as favorable to such banking

entity as those prevailing at the time for comparable transactions with

or involving other unaffiliated companies or, in the absence of

comparable transactions, on terms and under circumstances, including

credit standards, that in good faith would be offered to, or would

apply to, nonaffiliated companies.346

—————————————————————————

344 12 U.S.C. 371c-1.

345 See proposed rule Sec. —-.16(b).

346 12 U.S.C. 371c-1(a); 12 CFR 223.51.

—————————————————————————

Section —-.16(b) applies this requirement to transactions between

a banking entity that serves as investment manager, investment adviser,

commodity trading adviser, or sponsor to a covered fund and that fund

and any other fund controlled by that fund. It also applies this

condition to a permissible prime brokerage transaction in which a

banking entity may engage pursuant to Sec. —-.16(a)(2)(ii) of the

proposed rule.347

—————————————————————————

347 See 12 U.S.C. 1851(f)(2), (f)(3)(B); proposed rule Sec.

—-.16(b).

—————————————————————————

e. Request for Comment

The CFTC requests comment on the proposed rule’s approach to

implementing the limitations on certain relationships with covered

funds and, in particular, the manner in which the CFTC has proposed to

apply a banking entity’s ability to make explicitly permitted

investments for these purposes, as described above. In particular, the

CFTC requests comment on the following questions:

Question 314. Is the proposed rule’s approach to implementing the

limitations on certain transactions with a covered fund effective? If

not, what alternative approach would be more effective and why?

Question 315. Should the approach include other elements? If so,

what elements and why? Should any of the proposed elements be revised

or eliminated? If so, why and how?

Question 316. What types of transactions or relationships that

currently exist between banking entities and a covered fund (or another

covered fund in which such covered fund makes a controlling investment)

would be prohibited under the proposed rule? What would be the effect

of the proposed rule on banking entities’ ability to continue to meet

the needs and demands of their clients? Are there other transactions

between a banking entity and such covered funds that are not already

covered but that should be prohibited or limited under the proposed

rule?

Question 317. Should the CFTC provide a different definition of

“prime brokerage transaction” under the proposed rule? If so, what

definition would be appropriate? Are there any transactions that should

be included in the definition of “prime brokerage transaction”? Are

there transactions or practices provided by banking entities that

should be excluded in order to mitigate the burdens of complying with

section 13 of the BHC Act?

Question 318. With respect to the CEO (or equivalent officer)

certification required under section 13(f)(3)(A) (ii) of the BHC Act

and Sec. —-.16(a)(2)(ii)(B) of the proposed rule, what would be the

most useful, efficient method of certification (e.g., a new stand-alone

certification, a certification incorporated into an existing form or

filing, Web site certification, or certification filed directly with

the CFTC)?

8. Section —-.17: Other Limitations on Permitted Covered Funds

Activities

Section —-.17 of the proposed rule implements section 13(d)(2) of

the BHC Act, which places certain limitations on the permitted covered

fund activities and investments in which a banking entity may engage.

Consistent with the statute and Sec. —-.8 of the proposed rule,

Sec. —-.17 provides that no transaction, class of transactions, or

activity is permissible under Sec. Sec. —-.11 through —-.16 of the

proposed rule if the transaction, class of transactions, or activity

would:

Involve or result in a material conflict of interest

between the banking entity and its clients, customers, or

counterparties;

Result, directly or indirectly, in a material exposure by

the banking entity to a high-risk asset or a high-risk trading

strategy; or

Pose a threat to the safety and soundness of the banking

entity or the financial stability of the United States.

Section —-.17 of the proposed rule further defines “material

conflict of interest,” “high-risk assets,” and “high-

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risk trading strategies for these purposes, which are identical to the

definitions of the same terms for purposes of Sec. —-.8 of the

proposed rule related to proprietary trading, and are described in

detail in Part III.B.6 of this SUPPLEMENTARY INFORMATION.348

—————————————————————————

348 As noted in the discussion of the definition of “material

conflict of interest in Part III.B.6 of this Supplementary

Information, the proposed disclosure provisions of that definition

are provided solely for purposes of the proposed rule’s definition

of material conflict of interest, and do not affect a banking

entity’s obligation to comply with additional or different

disclosure or other requirements with respect to a conflict under

applicable securities, banking, or other laws (e.g., section 27B of

the Securities Act, which governs conflicts of interest relating to

certain securitizations; section 206 of the Investment Advisers Act

of 1940, which applies to conflicts of interest between investment

advisers and their clients; or 12 CFR 9.12, which applies to

conflicts of interest in the context of a national bank’s fiduciary

activities).

—————————————————————————

The CFTC requests comment on the proposed limitations on permitted

covered fund activities and investments, including with respect to the

questions in Part III.B.6 of the Supplemental Information as they

pertain to covered fund activities and investments in particular.

D. Subpart D (Compliance Program Requirement) and Appendix C (Minimum

Standards for Programmatic Compliance)

Subpart D of the proposed rule, which implements section 13(e)(1)

of the BHC Act,349 requires certain banking entities to develop and

provide for the continued administration of a program reasonably

designed to ensure and monitor compliance with the prohibitions and

restrictions on covered trading activities and covered fund activities

and investments set forth in section 13 of the BHC Act and the proposed

rule.350 This compliance program requirement forms a key part of the

proposal’s multi-faceted approach to implementing section 13 of the BHC

Act, and is intended to ensure that banking entities establish,

maintain and enforce compliance procedures and controls to prevent

violation or evasion of the prohibitions and restrictions on covered

trading activities and covered fund activities and investments.

—————————————————————————

349 See 12 U.S.C. 1851(e)(1).

350 See proposed rule Sec. —-.20.

—————————————————————————

1. Section —-.20: Compliance Program Mandate

The proposed rule adopts a tiered approach to implementing the

compliance program mandate, requiring a banking entity engaged in

covered trading activities or covered fund activities and investments

to establish a compliance program that contains specific elements and,

if the banking entity’s activities are significant, meet a number of

minimum standards. If a banking entity does not engage in covered

trading activities and covered fund activities and investments, it must

ensure that its existing compliance policies and procedures include

measures that are designed to prevent the banking entity from becoming

engaged in such activities and making such investments and must develop

and provide for the required compliance program under proposed Sec. —

–.20(a) of the proposed rule prior to engaging in such activities or

making such investments, but is not otherwise required to meet the

requirements of subpart D of the proposed rule.351

—————————————————————————

351 See proposed rule Sec. —-.20(d).

—————————————————————————

Section —-.20(a) of the proposed rule contains the core

requirement that each banking entity engaged in covered trading

activities or covered fund activities and investments must establish,

maintain and enforce a program reasonably designed to ensure and

monitor compliance with the prohibitions and restrictions on

proprietary trading activities and covered fund activities and

investments set forth in section 13 of the BHC Act and the proposed

rule and that such program must be suitable for the size, scope, and

complexity of activities and business structure of the banking entity.

Section —-.20(b) of the proposed rule specifies the following six

elements that each compliance program established under subpart D must

provide for, at a minimum:

Internal written policies and procedures reasonably

designed to document, describe, and monitor the covered trading

activities and covered fund activities and investments of the banking

entity to ensure that such activities and investments comply with

section 13 of the BHC Act and the proposed rule;

A system of internal controls reasonably designed to

monitor and identify potential areas of noncompliance with section 13

of the BHC Act and the proposed rule in the banking entity’s covered

trading activities and covered fund activities and investments and to

prevent the occurrence of activities that are prohibited by section 13

of the BHC Act and the proposed rule;

A management framework that clearly delineates

responsibility and accountability for compliance with section 13 of the

BHC Act and the proposed rule;

Independent testing for the effectiveness of the

compliance program, conducted by qualified banking entity personnel or

a qualified outside party;

Training for trading personnel and managers, as well as

other appropriate personnel, to effectively implement and enforce the

compliance program; and

Making and keeping records sufficient to demonstrate

compliance with section 13 of the BHC Act and the proposed rule, which

a banking entity must promptly provide to the CFTC upon request and

retain for a period of no less than 5 years.

In addition, for a banking entity with significant covered trading

activities or covered fund activities and investments, Sec. —-.20(c)

requires the compliance program established under subpart D to meet a

number of minimum standards, which are specified in Appendix C of the

proposed rule. In particular, a banking entity must comply with the

minimum standards specified in Appendix C of the proposed rule if:

With respect to its covered trading activities, it engages

in any covered trading activities and has, together with its affiliates

and subsidiaries, trading assets and liabilities the average gross sum

of which (on a worldwide consolidated basis), as measured as of the

last day of each of the four prior calendar quarters, (i) is equal to

or greater than $1 billion or (ii) equals 10 percent or more of its

total assets; and

With respect to its covered fund activities and

investments, it engages in any covered fund activities and investments

and either (i) has, together with its affiliates and subsidiaries,

aggregate investments in one or more covered funds the average value of

which is, as measured as of the last day of each of the four prior

calendar quarters, equal to or greater than $1 billion or (ii) sponsors

or advises, together with its affiliates and subsidiaries, one or more

covered funds the average total assets of which are, as measured as of

the last day of each of the four prior calendar quarters, equal to or

greater than $1 billion.

The application of detailed minimum standards to these types of

banking entities is intended to reflect the heightened compliance risks

of large covered trading and large covered fund activities and

investments and provide guidance to such banking entities regarding the

minimum compliance measures that would be required under the proposed

rule.

If a banking entity does not meet the thresholds specified in Sec.

—-.20(c)(2), it need not comply with each of the minimum standards

specified in Appendix C. However, the proposed rule would require such

a banking

[[Page 8404]]

entity to establish a compliance program that effectively implements

the six elements specified in Sec. —-.20(b). Banking entities

engaged in a relatively small amount of covered fund activities are

encouraged to look to the minimum standards of Appendix C for guidance.

Generally, the CFTC would expect that the closer a banking entity is to

the thresholds specified in Sec. —-.20(c)(2), the more its

compliance program should generally include the specific requirements

described in Appendix C. Within the bounds of subpart D and Appendix C,

a banking entity has discretion to structure and manage its program for

compliance with section 13 of the BHC Act and the proposed rule in a

manner that best reflects the unique organization and operation of the

banking entity and its affiliates and subsidiaries, and is suitable

taking account of the size, scope, and complexity of activities in

which the banking entity and its affiliates and subsidiaries engage.

As described above, Sec. —-.20(d) of the proposed rule clarifies

that, if a banking entity does not engage in covered trading activities

and/or covered fund activities or investments, it will have satisfied

the requirements of this section if its existing compliance policies

and procedures include measures that are designed to prevent the

banking entity from becoming engaged in such activities or making such

investments and which require the banking entity to develop and provide

for the compliance program required under paragraph (a) of this section

prior to engaging in such activities or making such investments.

2. Appendix C–Minimum Standards for Programmatic Compliance

Appendix C of the proposed rule specifies a variety of minimum

standards applicable to the compliance program of a banking entity with

significant covered trading activities or covered fund activities and

investments.352 Section I.A of proposed Appendix C sets forth the

purpose of the required compliance program, which is to ensure that

each banking entity establishes, maintains, and enforces an effective

compliance program, consisting of written policies and procedures,

internal controls, a management framework, independent testing,

training, and recordkeeping, that:

—————————————————————————

352 The CFTC has proposed to include these minimum standards

as part of the regulation itself, rather than as accompanying

guidance, reflecting the compliance program’s importance within the

general implementation framework.

—————————————————————————

Is designed to clearly document, describe, and monitor the

covered trading activities and covered fund activities or investments

and the risks of the banking entity related to such activities or

investments, identify potential areas of noncompliance, and prevent

activities or investments prohibited by, or that do not comply with,

section 13 of the BHC Act and the proposed rule;

Specifically addresses the varying nature of activities or

investments conducted by different units of the banking entity’s

organization, including the size, scope, complexity, and risks of the

individual activity or investment;

Subjects the effectiveness of the compliance program to

independent review and testing;

Makes senior management and intermediate managers

accountable for the effective implementation of the compliance program,

and ensures that the board of directors or chief executive office

(“CEO”) review the effectiveness of the compliance program; and

Facilitate supervision of the banking entity’s covered

trading activities and covered fund activities or investments by the

CFTC.

A banking entity’s compliance program should not be developed

through a generic, one-size-fits-all approach, but rather should

carefully take into account and reflect the unique manner in which a

banking entity operates, as well as the particular compliance risks and

challenges that its businesses present. In light of the complexities

presented in differentiating prohibited proprietary trading from

permitted market making-related activities in particular, the CFTC

expects that such a dynamic, carefully-tailored approach to internal

compliance will play an important role in ensuring that banking

entities comply with section 13’s prohibitions and restrictions. In

addition, although this statement of purpose appears within the text of

proposed Appendix C, the CFTC notes the statement equally describes the

general purpose of any compliance program required under subpart D of

the proposed rule, regardless of whether proposed Appendix C

specifically applies.

Section I.B of proposed Appendix C provides for several definitions

used throughout the appendix, including the definition of “trading

unit” and “asset management unit” to which the minimum standards

apply. The term “trading unit” is defined in the same way as in

Appendix A, as described in Part II.B.5 of the Supplementary

Information, and is intended to identify multiple layers of a banking

entity’s organizational structure because any effective compliance

program will need to manage, limit and monitor covered trading activity

at each such level of organization in order to effectively support

compliance with the prohibition on proprietary trading. The term

“asset management unit” is defined as any unit of organization of a

banking entity that makes an investment in, acts as sponsor to, or has

relationships with, a covered fund that the banking entity sponsors,

organizes and offers, or in which a covered fund sponsored or advised

by a banking entity invests.

Section I.C of proposed Appendix C incorporates by reference the

six elements that must be included in the compliance program under

Sec. —-.20 of the proposed rule, and section I.D describes the

structure of a compliance program meeting the minimum standards. In

particular, section I.D permits a banking entity to establish a

compliance program on an enterprise-wide basis to satisfy the

requirements of Sec. —-.20 of the proposed rule and the appendix,

which program could cover the banking entity and all of its affiliates

and subsidiaries collectively. In order to do so, the program must (i)

be clearly applicable, both by its terms and in operation, to all such

affiliates and subsidiaries, (ii) specifically address the requirements

set forth in proposed Appendix C, (iii) take into account and address

the consolidated organization’s business structure, size, and

complexity, as well as the particular activities, risks, and applicable

legal requirements of each subsidiary and affiliate, and (iv) be

determined through periodic independent testing to be effective for the

banking entity and its affiliates and subsidiaries. In addition, the

enterprise-wide program would be subject to supervisory review and

examination by any Agency vested with rulewriting authority under

section 13 of the BHC Act with respect to the compliance program and

the activities of any banking entity for which the Agency has such

authority. Further, such Agency would have access to all records

related to the enterprise-wide compliance program pertaining to any

banking entity that is supervised by the Agency vested with such

rulewriting authority.

a. Internal Policies and Procedures

Section II of proposed Appendix C articulates minimum standards for

the first element of the compliance program, internal policies and

procedures, for both covered trading activities and covered fund

activities and investments. With respect to covered trading activities,

the proposal would require

[[Page 8405]]

that internal policies and procedures: (i) Specify how the banking

entity identifies its trading accounts; (ii) identify the trading

activity in which the banking entity is engaged and how that activity

is organized; (iii) thoroughly articulate the mission, strategy, risks,

and compliance controls for each trading unit; (iv) include for each

trader a mandate that describes the scope of his or her trading

activity; (v) clearly articulate and document a comprehensive

description of the risks associated with the trading unit’s activities;

(vi) document a comprehensive explanation of how the mission and

strategy of the trading unit, and its related risk levels, comply with

the proposed rule; and (vii) require the banking entity to promptly

address and remedy any violation of section 13 of the BHC Act and the

proposed rule. These internal policies and procedures would require

banking entities to have the data and standards to prevent prohibited

proprietary trading and to identify abnormalities and discrepancies

that may be indicative of prohibited proprietary trading. The internal

policies and procedures should also provide the Agencies with a clear,

comprehensive picture of a banking entity’s covered trading activities

that can be effectively reviewed. With respect to covered fund

activities and investments, the proposal would require that internal

policies and procedures describe all covered fund activities in which

the banking entity engages and the procedures used by the banking

entity to ensure that it complies with the restrictions of section 13

of the BHC Act and the proposed rule.

The CFTC expects that these internal policies and procedures will

be regularly reviewed and updated to reflect changes in business

practices, strategies, or laws and regulations, though frequent,

unexplained changes to policies and procedures or other aspects of the

compliance program–particularly changes to reduce their stringency–

would warrant additional scrutiny from banking entity management,

independent testing personnel, and CFTC examiners.

b. Internal Controls

Section III of proposed Appendix C articulates minimum standards

for the second element of the compliance program, internal controls.

With respect to covered trading activities, the proposal would require

internal controls that: (i) Are reasonably designed to ensure that the

covered trading activity is conducted in conformance with a trading

unit’s authorized risks, instruments and products, as documented in the

banking entity’s written policies and procedures; (ii) establish and

enforce risk limits for each trading unit; and (iii) perform robust

analysis and quantitative measurement of covered trading activity for

conformance with section 13 of the BHC Act and the proposed rule. In

particular, the banking entity must perform analysis and quantitative

measurement that is reasonably designed to: (i) Ensure that the

activity of each trading unit is appropriate to the mission, strategy,

and risk of each trading unit, as documented in the banking entity’s

internal written policies and procedures; (ii) monitor and assist in

the identification of potential and actual prohibited trading activity;

and (iii) prevent the occurrence of prohibited proprietary trading.

This analysis and measurement should incorporate the quantitative

measurements calculated and reported under Appendix A of the proposed

rule, but should also include other analysis and measurements developed

by the banking entity that are specifically tailored to the business,

risks, practices, and strategies of its trading units. The Agencies

expect that the thoughtful use of these types of quantitative tools to

monitor the extent to which the activities of a trading unit are

consistent with its stated mission, strategy, and risk profile may help

identify, for banking entities and the CFTC, abnormalities or

discrepancies in permitted trading activity that may be indicative of

prohibited proprietary trading. In addition, these internal controls

must provide for regular monitoring of the effectiveness of the banking

entity’s compliance program and require the banking entity to take

prompt action to address and remedy any deficiencies identified and to

provide timely notification to the CFTC of any investigation and

remedial action taken.

With respect to covered fund activities and investments, the

internal controls required under section III of proposed Appendix C

generally focus on ensuring that a banking entity has effective

controls in place to monitor its investments in, and relationships

with, covered funds to ensure its compliance with the covered fund

activity and investments restrictions, including controls that relate

to implementing remedies in the event of a violation of the

requirements of section 13 of the BHC Act and the proposed rule.

c. Responsibility and Accountability

Section IV of proposed Appendix C articulates minimum standards for

the third element of the compliance program, responsibility and

accountability. These standards focus on four key constituencies–the

board of directors, the CEO, senior management, and managers at each

trading unit and asset management unit level. Section IV makes clear

that the board of directors, or similar corporate body, and the CEO are

responsible for creating an appropriate “tone at the top” by setting

an appropriate culture of compliance and establishing clear policies

regarding the management of covered trading activities and covered fund

activities and investments. Senior management must be made responsible

for communicating and reinforcing the culture of compliance established

by the board of directors and the CEO, for the actual implementation

and enforcement of the approved compliance program, and for taking

effective corrective action, where appropriate. Managers with

responsibility for one or more trading units or asset management units

of the banking entity that are engaged in covered trading activity or

covered fund activity and investments are accountable for effective

implementation and enforcement of the compliance program for the

applicable trading unit or asset management unit.

d. Independent Testing

Section V of proposed Appendix C articulates minimum standards for

the fourth element of the compliance program, independent testing. A

banking entity subject to the appendix must ensure that its independent

testing is conducted by a qualified independent party, such as the

banking entity’s internal audit department, outside auditors,

consultants or other qualified independent parties. The independent

testing must examine both the banking entity’s compliance program and

its actual compliance with the proposed rule. Such testing must include

not only the general adequacy and effectiveness of the compliance

program and compliance efforts, but also the effectiveness of each

element of the compliance program and the banking entity’s compliance

with each provision of the proposed rule. This requirement is intended

to ensure that a banking entity continually reviews and assesses, in an

objective manner, the strength of its compliance efforts and promptly

identifies and remedies any weaknesses or matters requiring attention

within the compliance framework.

e. Training

Section VI of proposed Appendix C articulates minimum standards for

the fifth element of the compliance program, training. It proposes to

require that a banking entity provide adequate

[[Page 8406]]

training to its trading personnel and managers, as well as other

appropriate personnel, in order to effectively implement and enforce

the compliance program. In particular, personnel engaged in covered

trading activities or covered fund activities and investments should be

educated with respect to applicable prohibitions and restrictions,

exemptions, and compliance program elements to an extent sufficient to

permit them to make informed, day-to-day decisions that support the

banking entity’s compliance with the proposed rule and section 13 of

the BHC Act. In particular, any personnel with discretionary authority

to trade, in any amount, should be appropriately trained regarding the

differentiation of prohibited proprietary trading and permitted trading

activities and given detailed guidance regarding what types of trading

activities are prohibited. Similarly, personnel providing investment

management or advisory services, or acting as general partner, managing

member, or trustee of a covered fund, should be appropriately trained

regarding what covered fund activities and investments are permitted

and prohibited.

f. Recordkeeping

Section VII of proposed Appendix C articulates minimum standards

for the sixth element of the compliance program, recordkeeping.

Generally, a banking entity must create records sufficient to

demonstrate compliance and support the operation and effectiveness of

its compliance program (i.e., records demonstrating the banking

entity’s compliance with the requirements of section 13 of the BHC Act

and the proposed rule, any scrutiny or investigation by compliance

personnel or risk managers, and any remedies taken in the event of a

violation or non-compliance), and retain these records for no less than

five years in a form that allows the banking entity to promptly produce

these records to the CFTC upon request. Records created and retained

under the compliance program shall include trading records of the

trading units, including trades and positions of each such unit.

g. Request for Comment

The CFTC requests comment on the compliance program requirement

contained in Sec. —-.20 of the proposed rule and the minimum

standards specified in proposed Appendix C. In particular, the CFTC

requests comment on the following questions:

Question 319. Is the proposed rule’s inclusion of a compliance

program requirement effective in light of the purpose and language of

the statute? If not, what alternative would be more effective?

Question 320. Is the proposed application of Sec. —-.20’s

compliance program requirement to all banking entities engaged in

covered trading activity or covered trading investments and activities

and the minimum standards of proposed Appendix C to only banking

entities with significant covered trading or covered fund activities,

effective? If not, what alternative would be more effective? Should

proposed Appendix C apply to all banking entities? If so, why? Are the

thresholds proposed for determining whether a banking entity must

comply with proposed Appendix C appropriate? If not, what alternative

would be more effective?

Question 321. What implementation, operational, or other burdens or

expenses might be associated with the compliance program requirement?

How could those burdens or expenses be reduced or eliminated in a

manner consistent with the purpose and language of the statute?

Question 322. Do the proposed compliance program requirement and

minimum standards provide sufficient guidance and clarity regarding how

compliance programs should be structured? If not, what additional

guidance or clarity is needed? Do the proposed compliance program

requirement and minimum standards provide sufficient discretion to

banking entities to structure a compliance program that appropriately

reflects the unique nature of their businesses? If not, how could

additional discretion be provided in a manner consistent with the

purpose and language of the statute?

Question 323. Are the six proposed elements of a required

compliance program effective? If not, what alternative would be more

effective? Should elements be added or removed? If so, which ones and

why?

Question 324. For each of the six proposed elements of a required

compliance program for which minimum standards are provided in proposed

Appendix C, are the proposed minimum standards effective? If not, what

alternative would be more effective? Should minimum standards be added

or removed? If so, which ones and why?

Question 325. Does the requirement that a banking entity provide

timely notification to the relevant Agency provide sufficient guidance

as to what activities must be reported and how and when such reporting

should be made? Should more specific standards be provided (e.g.,

regarding the timing of reporting and the types of activities that must

be reported)? If so, what additional criteria should be implemented?

Should the notification requirement be applied explicitly to banking

entities that are not required to comply with the minimum standards

specified in Appendix C because they are below the thresholds specified

in Sec. —-.20(c)(2)? Why or why not?

Question 326. Are there specific records that banking entities

should be required to make and keep to document compliance with section

13 of the BHC Act and the proposed rule? Please explain.

Question 327. What process should the Agencies use in determining

whether to require a banking entity that, based on its size, would not

be subject to Appendix C to comply with all or portions of the appendix

under section I.E of the proposed appendix? What considerations should

the CFTC take into account in making such a determination? Should this

requirement be implemented by a CFTC order, by authority delegated to

the CFTC staff, or a different method? Please explain.

Question 328. Should the proposed rule permit banking entities to

comply with Appendix C of the proposed rule on an enterprise-wide

basis? If so, why? What are the advantages and disadvantages of an

enterprise-wide compliance program? Should the proposed appendix

provide additional clarity or discretion regarding how such an

enterprise-wide program should be structured? If so, how? Please

include a discussion relating to the infrastructure of an enterprise-

wide compliance program and its management. If enterprise-wide

compliance or similar programs are used in other contexts, please

describe your experience with such programs and how those experiences

influence your judgment concerning whether or not you would choose an

enterprise-wide compliance program in this context.

Question 329. Should the proposed rule permit banking entities to

comply with Sec. —-.20(b) of the proposed rule on an enterprise-wide

basis? If so, why? What are the advantages and disadvantages of an

enterprise-wide compliance program for smaller banking entities that

are not subject to Appendix C? Please include a discussion relating to

the infrastructure of an enterprise-wide compliance program and its

management in the context of smaller banking entities. If enterprise-

wide compliance or similar programs are used in other contexts, please

describe your experience with such programs and how those experiences

influence your judgment concerning whether or

[[Page 8407]]

not you would choose an enterprise-wide compliance program in this

context. Are there particular reasons why a enterprise-wide compliance

program should be permitted for larger banking entities subject to the

requirements of Appendix C, but not those that are subject to Sec. —

–.20(b) of the proposed rule?

Question 330. What are the particular challenges that should be

considered in connection with establishing a compliance program on an

enterprise-wide basis? How will such challenges be addressed? Can an

enterprise-wide compliance program be appropriately tailored to each of

the subsidiaries and affiliates of a banking entity?

Question 331. Are there efficiencies that can be gained through an

enterprise-wide compliance program? If so, how and what efficiencies?

Question 332. Would the complexities of various types of covered

trading activity be adequately reflected in an enterprise-wide

compliance program?

Question 333. Should only outside parties be permitted to conduct

independent testing for the effectiveness of the proposed compliance

program to satisfy certain minimum standards? If so, why? Under the

proposal, the independent testing requirement may be satisfied by

testing conducted by an internal audit department or a third party.

Should the rule specify the minimum standards for “independence” as

applied to internal and/or external parties testing the effectiveness

of the compliance program? For example, would an internal audit be

deemed to be independent if none of the persons involved in the testing

are involved with, or report to persons that are involved with,

activities implicated by section 13 of the BHC Act? Why or why not?

Question 334. Do you anticipate that banking entities that do not

meet the thresholds specified in Sec. —-.20(c) would voluntarily

comply with the proposed minimum standards in Appendix C in order to

effectively implement the six elements specified in Sec. —-.20(b)?

Are there specific minimum standards that would not be practical or

would be unattainable for a banking entity that does not meet the Sec.

——.20(c) thresholds? Please identify the minimum standard(s) and

explain.

Question 335. In light of the size, scope, complexity, and risk of

covered trading activities, do commenters anticipate the need to hire

new staff with particular expertise in order to establish, maintain,

and enforce the proposed compliance program requirement concerning

covered trading activities or any subset of covered trading activities?

Question 336. With respect to the proposed requirement that

training should occur with a frequency appropriate to the size and risk

profile of the banking entity’s covered trading activities and covered

fund activities, should there be a minimum requirement that such

training shall be conducted no less than once every twelve (12) months?

If so, why?

Question 337. Should proposed rule’s Appendix C be revised to

require a banking entity’s CEO to annually certify that the banking

entity has in place processes to establish, maintain, enforce, review,

test and modify the compliance program established pursuant to Appendix

C in a manner that is reasonably designed to achieve compliance with

section 13 of the BHC Act and this proposal? If so, why? If so, what

would be the most useful, efficient method of certification (e.g., a

new stand-alone certification, a certification incorporated into an

existing form or filing, Web site certification, or certification filed

directly with the CFTC)? Would a central data repository with a CEO

attestation to the CFTC be a preferable approach?

Question 338. Do the proposed rule requirements relating to

establishment and implementation of a compliance program pose unique

concerns or challenges to issuers of asset-backed securities that are

banking entities, and if so, why? Are certain asset classes

particularly impacted by the proposed rule requirements, and if so,

how?

Question 339. How would existing issuers of asset-backed securities

that are banking entities pay for establishing and implementing a

compliance program? Should existing issuers of asset-backed securities

that cannot comply with the compliance program requirements be excluded

from the proposed definition of “banking entity”? Should such

exclusion be limited, and if so, based on what factors? Are the

proposed thresholds specified in Sec. —-.20(c) of the proposed rule

and/or the allowance of an enterprise-wide compliance program as set

forth in Appendix C of the proposed rule sufficient to minimize these

concerns for issuers of asset-backed securities?

Question 340. With respect to future securitizations, what would be

the impact of the establishment and implementation of the compliance

program related to the provisions of the proposed rule as required by

Sec. —-.20 of the proposed rule (including Appendix C, where

applicable)? Are the proposed thresholds specified in Sec. —-.20(c)

of the proposed rule and/or the allowance of an enterprise-wide

compliance program as set forth in Appendix C of the proposed rule

sufficient to minimize these concerns for issuers of asset-backed

securities?

Question 341. Would existing issuers of asset-backed securities

that are banking entities be able to establish and implement a

compliance program related to the provisions of the proposed rule as

required by Sec. —-.20 of the proposed rule (including Appendix C,

where applicable)? If amendments to transactional documents are

necessary, are there any obstacles that would make such amendments

difficult to execute? If existing issuers of asset-backed securities

cannot establish and implement a compliance program, what would be the

impact on such existing issuers of asset-backed securities and the

holders of securities issued by a non-compliant issuer of asset-backed

securities? Is the allowance of an enterprise-wide compliance program

as set forth in Appendix C of the proposed rule sufficient to minimize

these concerns for issuers of asset-backed securities?

Question 342. To rely on the exemptions for permitted underwriting,

market making-related, and risk-mitigating hedging activities, the

proposed rule requires banking entities to establish the internal

compliance program under Sec. —-.20 and, where applicable, Appendix

C, designed to ensure compliance with the requirements of the

applicable exemption (e.g., policies and procedures, internal controls

and monitoring procedures, etc.). Do these requirements in the proposed

rule impose undue cumulative burdens, such that the marginal benefit of

a given requirement is not justified by the cost that the requirement

imposes? If so, why does the proposed rule impose cumulative burdens

and what are the costs of those burdens? Please explain the

circumstances under which these burdens may arise. Is there a way to

reduce or eliminate such burdens or requirements in a manner consistent

with the language and purpose of the statute? For any requirements that

impose undue burdens, are there other requirements that could be

substituted that would more efficiently ensure compliance with the

statute? Are there any requirements that the proposed rule imposes that

are particularly effective, and if so, how can the Agencies make better

use of these requirements?

Question 343. Are the six elements of the proposed compliance

program requirement mutually reinforcing and

[[Page 8408]]

cost effective, or are there redundancies in the six elements? Please

explain any redundant requirements in the policies and procedures,

internal controls, management framework, independent testing, training,

and recordkeeping requirements in Sec. —-.20(b) of the proposed rule

or proposed Appendix C. Why are such requirements redundant, and how

should the redundancy be addressed and remedied in the rule?

Question 344. A banking entity that meets the $1 billion or greater

trading assets and liabilities threshold would be required under the

proposed rule to comply with both the reporting and recordkeeping

requirements in Appendix A with respect to quantitative measurements

and the compliance program requirement in Appendix C. Are the

requirements in these appendices mutually reinforcing and cost

effective, or do the appendices impose redundant requirements on

banking entities that meet the $1 billion threshold? Please explain any

redundant requirements in the appendices and how such redundancy should

be addressed and remedied in the rule.

Question 345. Proposed Appendix C incorporates the quantitative

measurements provided in proposed Appendix A in the internal controls

requirement for banking entities that are engaged in covered trading

activity and meet the $1 billion or greater trading assets and

liabilities threshold. Do the requirements in proposed Appendix A and

Appendix C impose undue cumulative burdens with respect to any elements

(e.g., quantitative measurements), such that the marginal benefit of a

given requirement is not justified by the cost that the requirement

imposes? Please explain why the proposed appendices impose cumulative

burdens, the costs of those burdens, and the circumstances under which

these burdens may arise. Is there a way to reduce or eliminate such

burdens or requirements in a manner consistent with the language and

purpose of the statute? For any requirements in the appendices that

impose undue burdens, are there other requirements that could be

substituted that would more efficiently ensure compliance with the

statute? Are there any requirements that the proposed appendices impose

that are particularly effective, and if so, how can the CFTC make

better use of these requirements?

Question 346. Should the CFTC prescribe any specific method by

which the board of directors or similar corporate body reviews and

approves the compliance program? For example, should the CFTC require

that: (i) A chief compliance officer or similar officer present an

annual compliance report including, as appropriate, recommended actions

to be taken by the banking entity to improve compliance or correct any

compliance deficiencies; (ii) the board review any such recommendations

and determine whether to approve them; and (iii) the banking entity

notify the CFTC if the board declines to approve such recommendations,

or approves different actions than those recommended in the compliance

report? What are the advantages and disadvantages of such an approach?

3. Section —-.21: Termination of Activities or Investments; Penalties

for Violations

Section —-.21 of the proposed rule implements section 13(e)(2) of

the BHC Act, which requires the termination of activities or

investments that violate or function as an evasion of section 13 of the

Act.353 In particular, Sec. —-.21(a) of the proposed rule requires

any banking entity that engages in an activity or makes an investment

in violation of section 13 of the BHC Act or the proposed rule or in a

manner that functions as an evasion of the requirements of section 13

of the BHC Act or the proposed rule, including through an abuse of any

activity or investment permitted under subparts B or C, or otherwise

violates the restrictions and requirements of section 13 of the BHC Act

or the proposed rule, to terminate the activity and, as relevant,

dispose of the investment.354 Section —-.21(b) of the proposed rule

provides that if a relevant Agency finds reasonable cause to believe

any banking entity has engaged in an activity or made an investment

described in paragraph (a), the CFTC may, after due notice and an

opportunity for hearing, by order, direct the banking entity to

restrict, limit, or terminate the activity and, as relevant, dispose of

the investment.355

—————————————————————————

353 See 12 U.S.C. 1851(e)(2).

354 See proposed rule Sec. —-,21(a). The CFTC has proposed

to include Sec. —-.21(a), in addition to the provisions of Sec.

—-.21(b) of the proposed rule, to make clear that the requirement

to terminate an activity or, as relevant, dispose of an investment

would be triggered where a banking entity discovers a violation or

evasion, regardless of whether an Agency order has been issued.

355 See proposed rule Sec. —-,21(b).

—————————————————————————

IV. Request for Comments

The CFTC is interested in receiving comments on all aspects of the

proposed rule.

V. The Economic Impact of the Proposed Rule Under Section 13 of the BHC

Act–Request for Comment

Section 13 of the BHC Act imposes on all banking entities

prohibitions and restrictions on proprietary trading and certain

interests in, and relationships with, a covered fund,356 which apply

to banking entities whether or not the CFTC adopts implementing rules.

In formulating the proposed rule to implement these provisions, which

is required by statute, the CFTC has chosen a multi-faceted approach to

establish a regulatory framework that provides for clear, robust, and

effective implementation of the statute’s provisions in a consistent

manner, while also not unduly constraining the ability of banking

entities to engage in permitted activities and investments.357 The

CFTC has proposed this approach after considering the Council’s

findings and recommendations regarding how to implement section 13 of

the BHC Act and a variety of alternatives described throughout this

Supplemental Information.358 The CFTC seeks comment, in particular,

on the potential costs and benefits of those aspects of the proposed

rule that involve choices made, or the exercise of discretion, by the

CFTC in implementing section 13 of the BHC Act.359

—————————————————————————

356 As noted above in connection with the conformance and

extended transition periods, the proposed rule would not require an

immediate application of these restrictions for any activity or

investment entered into prior to the effective date of section 13 of

the BHC Act (July 21, 2012). However, any activity or investment

entered into after the effective date would be required to comply

with section 13 of the BHC Act and the proposed rule, if adopted.

See Supplemental Information Part III.E.

357 See Supplemental Information Part II.A.

358 See 12 U.S.C. 1851(b)(2)(A); see also Financial Stability

Oversight Council, Study & Recommendations on Prohibitions on

Proprietary Trading & Certain Relationships with Hedge Funds &

Private Equity Funds (Jan. 2011), available at http://www.treasury.gov/initiatives/Documents/Volcker%20sec%20%20619%20study%20final%201%2018%2011%20rg.pdf.

359 This CFTC Rule is being promulgated exclusively under

section 13 of the BHC. Therefore, the Commission will not be

conducting a cost-benefit consideration under Section 15(a) of the

Commodity Exchange Act. However, the Commission will consider the

responses to the questions posed in this section when finalizing

this rulemaking.

—————————————————————————

The CFTC recognizes that there are economic impacts that may arise

from the proposed rule and its implementation of section 13 of the BHC

Act and invite comment on the manner in which the proposed rule

implements section 13 of the BHC Act, including commenters’ views on

the potential economic impacts discussed in this Part of the

Supplemental

[[Page 8409]]

Information. In addition, the CFTC seeks comment on whether the

proposed rule represents a balanced and effective approach to

implementing section 13 of the BHC Act or whether alternative

approaches to implementing section 13 of the BHC Act exist that would

provide greater benefits or involve fewer costs, consistent with the

statutory purpose. We also request comment on the potential competitive

effects of the manner in which the proposed rule implements the

statute.360

—————————————————————————

360 For example, implementation of section 13(d)(1)(H) of the

BHC Act may result in a competitive advantage for foreign-controlled

banking entities over U.S.-controlled banking entities with respect

to activities that occur solely outside of the United States.

—————————————————————————

In addition to the questions posed throughout Part II of the

Supplemental Information with respect to the potential costs and

benefits of particular aspects of the statute and proposed rule, in

order to assist in the analysis of the economic impacts associated with

the final rule and any alternatives the CFTC may evaluate, the CFTC

encourages commenters to provide quantitative information about the

rule’s impact on banking entities, their clients, customers, and

counterparties, specific markets or asset classes, and any other

entities potentially affected by the proposed rule with respect to:

1. The direct and indirect costs and benefits of compliance with

section 13 of the BHC Act, as proposed to be implemented;

2. The effect of section 13 of the BHC Act, as proposed to be

implemented, on competition; and

3. Any other economic impacts of the proposal.

In addition, to assist with potential estimates of the proposed

rule’s quantitative impacts, we request specific comment on: (i) The

extent to which banking entities currently engage in proprietary

trading activity or covered funds activities or investments that are

prohibited or restricted by the statute, or have otherwise divested or

conformed such activities; and (ii) the potential costs and benefits or

other quantitative impacts of various aspects of the proposed rule,

such as the compliance program requirement, the required reporting of

quantitative measurements, and the conditions and requirements for

relying on the proposed exemptions.

To further facilitate public comment on the economic effects of the

manner in which the proposed rule implements the statute, the CFTC has

identified below a number of significant aspects of the proposed rule

and potential economic impacts that may result from section 13 of the

BHC Act’s requirements, as proposed to be implemented. We seek

commenters’ views on the likelihood of the potential economic impacts

identified in this Part and whether there are additional costs,

benefits, or other impacts that may arise from the proposed rule. To

the extent that such costs, benefits, or other impacts are

quantifiable, commenters are encouraged to identify, discuss, analyze,

and supply relevant data, information, or statistics related to such

costs, benefits, and other impacts and the quantification of such

costs, benefits, and other impacts. In addition, commenters are asked

to identify or estimate start-up, or non-recurring, costs separately

from costs or effects they believe would be ongoing.

A. Proprietary Trading Provisions

1. Definition of Trading Account

Section —-.3 of the proposed rule, which implements the statutory

definition of “trading account,” provides a multi-pronged definition

of that term that is intended to ensure that banking entities do not

engage in “hidden” proprietary trading by characterizing trading

activity as being conducted outside a trading account. In addition to

positions taken principally for the purpose of short-term resale,

benefitting from short-term price movements, realizing short-term

arbitrage profits, or hedging another trading account position, the

proposed definition also includes: (i) With respect to a banking entity

subject to the Federal banking agencies’ Market Risk Capital Rules, all

positions in financial instruments subject to the prohibition on

proprietary trading that are treated as “covered positions” under

those capital rules, other than certain foreign exchange and

commodities positions; and (ii) all positions acquired or taken by

certain registered securities and derivatives dealers (or, in the case

of financial institutions that are government securities dealers, that

have filed notice with an appropriate regulatory agency) in connection

with their activities that require such registration or notice.

Although these prongs of the definition are proposed to prevent evasion

of the statutory requirements, we seek comment on the extent to which

either of these two prongs may create a competitive disadvantage for

certain banking entities vis-[agrave]-vis competitors that are either

not subject to section 13 of the BHC Act and/or competitors subject to

different prongs of the proposed definition.

2. Exemption for Underwriting Activities

Section 13(d)(1)(B) of the BHC Act provides an exemption from the

prohibition on proprietary trading for purchases and sales in

connection with underwriting activities, to the extent that such

activities are designed not to exceed the reasonably expected near term

demands of clients, customers, or counterparties. In implementing this

exemption in Sec. —-.4(a) of the proposed rule, the CFTC has

endeavored to establish a regime that clearly sets forth the

requirements for relying on the underwriting exemption established in

the statute to facilitate banking entities’ compliance with the

statutory requirements. In considering potential requirements for the

underwriting exemption, and assessing the potential economic impacts of

each such requirement, the CFTC strived to propose an appropriate

balance between considerations related to: (i) The potential for

evasion of the statutory prohibition on proprietary trading through

misuse of the underwriting exemption; and (ii) the potential costs that

may arise from constraints on legitimate underwriting activities.

The CFTC has proposed to use, wherever practicable, common terms

from existing laws and regulations in the context of underwriting to

facilitate market participants’ understanding and use of the exemption

and to promote consistency across laws and regulations. Specifically,

the proposed definitions of “distribution” and “underwriter”

established in the proposed rule largely mirror the definitions

provided for these terms in the SEC’s Regulation M. Because the

proposed rule uses a modified version of the Regulation M definition of

“underwriter” to include selling group members, the proposed

definition would permit the current market practice of members of the

underwriting syndicate entering into an agreement with other selling

group members to collectively distribute the securities, rather than

requiring all members of a distribution to join the underwriting

syndicate.

In addition, the definition of “distribution” from Regulation M

that the CFTC has proposed in Sec. —-.4(a) of the proposed rule is

intended to ensure that the underwriting exemption does not unduly

constrain banking entities from providing underwriting services, while

at the same time preventing banking entities from relying on the

underwriting exemption to evade the proposed rule and the statutory

prohibition on proprietary trading. The CFTC anticipates that the

proposed

[[Page 8410]]

approach to implementing the underwriting exemption should permit

legitimate forms of underwriting in which market participants currently

engage and, thus, should not unduly burden capital formation. In

addition, the proposed rule would permit underwriters to continue to

employ existing practices to stabilize a distribution of securities,

which stabilization promotes confidence among issuers, selling security

holders, and investors and further supports capital formation.

Under the proposed rule, the underwriting activities of a banking

entity must be designed to generate revenues primarily from fees,

commissions, underwriting spreads or other income, not from

appreciation in value of covered financial positions that the banking

entity holds related to such activities or the hedging of such covered

financial positions. This proposed requirement should promote investor

confidence by ensuring that the activities conducted in reliance on the

underwriting exemption are designed to benefit the interests of clients

seeking to bring their securities to market, not the interests of the

underwriters themselves. The proposed requirement should also help

prevent evasion of the statutory prohibition on proprietary trading, as

trading activity designed to generate revenues from appreciation in the

value of positions held by the banking entity would be indicative of

prohibited proprietary trading, not underwriting activity. We seek

comment on whether this approach of identifying underwriting activity

by reference to revenue source could also make underwriting less

profitable to the extent that it precludes or discourages certain types

of profitability for bona fide underwriting services.

In addition to commenters’ views on the potential economic impacts

identified above, we request comment on whether the proposed rule may

cause some banking entities to choose to decrease the supply of

underwriting services in response to potential costs of the proposed

rule and whether this result would adversely affect competition among

underwriters or have a harmful impact on capital formation. In

addition, if banking entities were to pass the increased costs of

complying with the proposed exemption on to issuers, selling security

holders, or their customers, we seek comment on whether the effect

would be to increase the cost of raising capital and whether this would

harm capital formation to the extent that such cost increases were

sufficient to preclude issuers from accessing the capital markets. As

described above, the CFTC has designed the proposal to balance such

potential costs with provisions intended to permit banking entities’

legitimate underwriting activities to continue as provided by the

statute, while also establishing sufficient requirements to prevent

evasion of the statutory goals through misuse of the underwriting

exemption.

3. Exemption for Market Making-Related Activities

Section 13(d)(1)(B) of the BHC Act provides an exemption from the

prohibition on proprietary trading for purchases and sales in

connection with market making-related activities, to the extent that

such activities are designed not to exceed the reasonably expected near

term demands of clients, customers, or counterparties. In setting forth

the requirements for eligibility for this exemption in Sec. —-.4(b)

of the proposed rule, the CFTC has endeavored to establish a regime

that clearly sets forth the requirements for relying on the exemption

for market making-related activity established in the statute to

facilitate banking entities’ compliance with the statutory

requirements. In considering potential requirements for the market-

making exemption, and assessing the potential economic impacts of each

such requirement, the CFTC tried to strike an appropriate balance

between considerations related to: (i) The potential for evasion of the

statutory prohibition on proprietary trading through misuse of the

exemption for market making-related activity; (ii) the potential

difficulties related to distinguishing market making-related activity

from prohibited proprietary trading; and (iii) potential costs that may

arise from constraints on legitimate market making-related activities.

The CFTC has proposed to use, where practicable, terms and concepts

used in current laws and regulations in the context of market making to

promote clarity and consistency. Recognizing that there are differences

in market making activities between different types of asset classes

(e.g., liquid and illiquid instruments) and market structures (e.g.,

organized trading facilities and the over-the-counter markets), the

CFTC has proposed to implement the market-making exemption in a manner

that accounts for these distinctions and permits market making

activities in different asset classes and market structures. Permitting

legitimate market making in its different forms should promote market

liquidity and efficiency by allowing banking entities to continue to

provide customer intermediation and liquidity services in both liquid

and illiquid instruments. The CFTC also recognizes, however, that

market making-related activities in the over-the-counter markets or

activities involving less liquid instruments are sometimes less

transparent than similar activities on organized trading facilities or

in liquid markets. We seek comment on whether, in order to comply with

the statutory prohibition on proprietary trading, some banking entities

may be inclined to abstain from some market-making activities in an

effort to reduce the risk of noncompliance. We also request comment on

whether, if banking entities did so, this could result in reduced

liquidity for certain types of trades or for certain less liquid

instruments.

In addition, the proposed exemption permits anticipatory market

making, block positioning, and hedging of market making positions under

certain circumstances, which should further facilitate customer

intermediation and market liquidity and efficiency. However, certain

conditions are placed on such market making-related activities in the

proposal in an effort to ensure that such activities are, in fact,

market making-related activities, and are not hidden proprietary

trading activities subject to the statutory prohibition.

The proposal requires that the market making-related activities be

designed to generate revenues primarily from fees, commissions, bid/ask

spreads or other income not attributable to appreciation in the value

of covered financial positions a banking entity holds in trading

accounts or the hedging of such positions. This proposed requirement

should promote investor confidence by helping to ensure that market

making serves customer needs. The proposed requirement should also help

prevent evasion of the statutory prohibition on proprietary trading, as

trading activity designed to generate revenues from appreciation in the

value of positions held by the banking entity would be indicative of

prohibited proprietary trading, not market making-related activity. The

CFTC requests comment on whether this approach of identifying market

making activity by reference to a market making trading unit’s revenue

source would also make market making activity less profitable and

whether it would preclude or discourage certain types of profitability

for bona fide market making services. Commenters should also address

whether this requirement would reduce the willingness of some banking

entities to continue to provide market making-related services and

whether this could

[[Page 8411]]

reduce liquidity, harm capital formation, or make market making-related

services more expensive. The CFTC notes that, in order to balance the

potential for such effects with the statutory purpose, the proposed

rule does not expressly prohibit all types of non-client income, and

recognizes that the precise type and source of revenues generated by

bona fide market making services can and will vary depending on the

relevant market, asset, and facts and circumstances.

4. Exemption for Risk-Mitigating Hedging Activities

Section 13(d)(1)(C) provides an exemption from the prohibition on

proprietary trading for risk-mitigating hedging activities in

connection with and related to individual or aggregated positions,

contracts, or other holdings of a banking entity that are designed to

reduce the specific risks to the banking entity in connection with and

related to such positions, contracts, or other holdings. The proposed

exemption requires that the hedging transaction be reasonably

correlated to these risks that the transaction is intended to hedge or

otherwise mitigate. This proposed requirement is intended to address

the potential for misuse of the exemption where a transaction is not

closely tied to risk mitigation, while also providing some flexibility

in the degree of correlation that is required in order to promote

consistency with the statutory goals and requirements.

In addition, the proposed exemption requires that the hedging

transaction: (i) Not give rise, at the inception of the hedge, to

significant exposures that are not themselves hedged in a

contemporaneous transaction; and (ii) be subject to continuing review,

monitoring, and management. Together, these proposed requirements are

designed to ensure that a banking entity does not use the hedging

exemption to conduct prohibited proprietary trading in the guise of

hedging activity and to prevent evasion of the proprietary trading

prohibition contained in section 13 of the BHC Act and the proposed

rule. These proposed requirements are intended to ensure that an exempt

hedging transaction will mitigate, not amplify, risk. Moreover, such

requirements should further the goals of compliance with the statutory

requirements and reducing banking entities’ risks.

We seek comment on whether the proposed requirements for relying on

the hedging exemption are more restrictive than necessary to implement

the statutory language and purpose, and to prevent evasion of the

statutory provisions, and whether a banking entity’s hedging activities

could be unduly constrained by the proposed rule. Further, commenters

should address the extent to which a banking entity may be unable or

unwilling to execute certain hedges and whether, as a result, a banking

entity could be limited in its means to reduce its risk. In addition,

would banking entities be dissuaded from engaging in other permitted

activities or activities outside the scope of the statute (e.g., long-

term investments) if the requirements of the proposed hedging exemption

unduly limits or prevents them from mitigating the risks associated

with such activities? We request comment on whether a reduction in

efficiency could result from a reduced ability of covered banking

entities to transfer risks to those more willing to bear them.

Commenters should also address whether the proposed rule would reduce a

banking entity’s willingness to engage in permitted risk-mitigating

hedging activities in order to avoid costs related to ensuring

compliance with the exemption’s requirements and whether this would

increase the banking entity’s risk exposure. In order to balance the

potential for such effects with the statutory purpose, the proposed

rule attempts to implement the risk-mitigating hedging exemption in a

manner that recognizes that the precise nature and execution of risk

mitigation through hedging transactions can and will vary depending on

the relevant market, asset, and facts and circumstances, while also

establishing requirements designed to ensure that transactions relying

on the hedging exemption are, in fact, hedges and not hidden

proprietary trading prohibited by the statute.

The proposed exemption would require documentation with respect to

hedges established at a different level of organization than that

responsible for the underlying positions or risks that are being

hedged. This proposed documentation requirement is intended to

facilitate review by banking entities and Agency supervisors and

examiners in assessing whether the hedge position was established to

hedge or otherwise mitigate another unit’s risks. Without such

documentation, there could be an increased risk of evasion of the

statute’s prohibition on proprietary trading, as it would be difficult

to assess whether a purported hedging transaction was established to

mitigate another level of organization’s risk or solely to profit from

price appreciation of the position established by the purported hedge.

We seek comment on the costs of the proposed documentation requirement

for certain hedging transactions, such as the costs related to systems

changes and maintenance, employee resources and time, and

recordkeeping.361 The CFTC also requests comment on the extent to

which the proposed documentation requirement would reduce the speed in

which a banking entity could execute a hedge at a different level

within the entity and whether this could reduce efficiency or result in

a banking entity being exposed to a greater amount of risk. Further, we

seek commenters’ views on whether potentially slower execution times

could also reduce profitability associated with the position as it

remains unhedged (or, alternatively, increase profitability, depending

on whether the value of the unhedged position is increasing or

decreasing in the market). To balance the potential for such

consequences with the statutory purpose, the CFTC has proposed to apply

the documentation requirement to only a subset of hedging transactions

that pose the greatest compliance risk (i.e., hedges that are

established at a different level of organization than that establishing

or responsible for the underlying positions or risks that are being

hedged). In addition, the CFTC expects that the preparation of required

documentation would become less burdensome and more efficient over time

as systems are developed and personnel become more accustomed to the

proposed requirement.

—————————————————————————

361 The Agencies note that, for some costs of the proposed

rule, hour burden estimates are provided in Part [internal cite to

PRA] of this SUPPLEMENTARY INFORMATION for purposes of the Agencies’

compliance with the Paperwork Reduction Act.

—————————————————————————

5. Compensation Related to Permitted Activities

The proposed rule would require that the compensation arrangements

of persons performing underwriting, market making-related, and risk-

mitigating hedging activities be designed not to reward proprietary

risk-taking. These proposed requirements are intended to reduce

incentives for personnel of the banking entity to violate the statutory

prohibition on proprietary trading and expose the banking entity to

risks arising from prohibited proprietary trading. We request comment

on whether the proposed rule’s requirements regarding compensation

arrangements would reduce the banking entity’s ability to attract

talented and experienced trading personnel or would harm the banking

entity’s ability to compete with entities that are not subject to

section 13 of the BHC Act and the proposed rule. In order

[[Page 8412]]

to balance the potential for such effects with the statutory goals, the

proposed rule does not expressly prescribe how a banking entity must

compensate its personnel or prohibit all types of compensation

incentives related to non-client income, but instead proposes an

approach that leaves banking entities with a degree of flexibility to

compensate their personnel as they deem appropriate.

6. Exemption for Trading on Behalf of Customers

Section —-.6(b) of the proposed rule implements section

13(d)(1)(D) of the BHC Act, which permits a banking entity,

notwithstanding the prohibition on proprietary trading, to purchase or

sell a covered financial position on behalf of customers. Because the

statute does not define when a transaction would be conducted on behalf

of customers, the proposed rule identifies three categories of

transactions that would qualify under this exemption. By providing that

only transactions meeting the terms of the three categories would be

considered to be on behalf of customers for purposes of the exemption,

the proposed rule addresses the potential for evasion of the statutory

prohibition. At the same time, the proposed rule also would not permit

banking entities to rely on the exemption with respect to other,

unanticipated transactions that banking entities may undertake on

behalf of customers. The CFTC seeks comment on whether banking entities

currently engage in principal transactions on behalf of customers that

are not covered by the proposed exemption or other permitted activities

and whether the lack of an exemption in the proposed rule for such

activities would impact beneficial customer facilitation, market

liquidity, efficiency, or capital formation.

7. Exemption for Trading Outside of the United States

Section —-.6(d) of the proposed rule implements section

13(d)(1)(H) of the BHC Act, which permits certain foreign banking

entities to engage in proprietary trading that occurs “solely outside

of the United States.” The proposed exemption provides a number of

specific criteria for determining when trading will be considered to

have occurred solely outside of the United States to help prevent

evasion of the statutory restriction. The proposed exemption also

provides a definition of “resident of the United States” that is

similar to the SEC’s definition of “U.S. person” in Regulation S,

which should promote consistency and understanding among market

participants that have experience with the concept from the SEC’s

Regulation S. In addition, the proposed exemption clarifies when a

foreign banking entity will be considered to engage in such trading

pursuant to sections 4(c)(9) and 4(c)(13) of the BHC Act, as required

by the statute, including with respect to a foreign banking entity that

is not a “foreign banking organization” under the Board’s Regulation

K. This implementation of section 13(d)(1)(H) of the BHC Act would

permit certain foreign banking entities that are not “qualifying

foreign banking organizations” under the Board’s Regulation K to also

rely on the exemption, notwithstanding the fact such foreign banking

entities are not currently subject to the BHC Act generally or the

Board’s Regulation K. As a result, such foreign banking entities should

encounter fewer costs related to complying with the proprietary trading

prohibitions than if they were unable to rely on the exemption in

section 13(d)(1)(H) of the BHC Act.

Despite the reference to section 4(c)(13) of the BHC Act, the

statute provides that the exemption for trading outside of the United

States is only available to banking entities that are not directly or

indirectly controlled by U.S. banking entities (i.e., not any U.S.

banking entities or their foreign subsidiaries and affiliates). Under

the statute, the prohibition on proprietary trading applies to the

consolidated, worldwide operations of U.S. firms. As required by

statute, the proposal prohibits U.S. banking entities from engaging in

proprietary trading unless the requirements of one or more relevant

exemptions (other than the exemption for trading by foreign banking

entities) are satisfied. As a result, the statute creates a competitive

difference between the foreign activities of U.S. banking entities,

which must monitor and limit their foreign activities in accordance

with the requirements of section 13 of the BHC Act, relative to the

foreign activities of foreign-based banking entities, which may not be

subject to restrictions similar to those in section 13 of BHC Act. The

CFTC seeks commenters’ views on whether the proposed rule’s

implementation of section 13(d)(1)(H) of the BHC Act imposes additional

competitive differences, beyond those recognized above, and the

potential economic impact of such competitive differences.

8. Quantitative Measurements

Section —-.7 of the proposed rule, which implements in part

section 13(e)(1) of the BHC Act,362 requires certain banking entities

to comply with the reporting and recordkeeping requirements specified

in Appendix A of the proposed rule. Proposed Appendix A requires a

banking entity with significant trading activities to furnish periodic

reports to the relevant Agency regarding various quantitative

measurements of its trading activities and create and retain records

documenting the preparation and content of these reports. The proposed

measurements would vary depending on the scope, type, and size of

trading activities. In addition, proposed Appendix B contains a

detailed commentary regarding the characteristics of permitted market

making-related activities and how such activities may be distinguished

from trading activities that, even if conducted in the context of

banking entity’s market making operations, would constitute prohibited

proprietary trading. These proposed requirements are intended, in

particular, to address some of the difficulties associated with (i)

identifying permitted market making-related activities and

distinguishing such activities from prohibited proprietary trading and

(ii) identifying certain trading activities resulting in material

exposure to high-risk assets or high-risk strategies. In combination,

Sec. —-.7 and Appendix A of the proposed rule provide a quantitative

overlay designed to help banking entities and the CFTC identify trading

activities that warrant further analysis or review in a variety of

levels and contexts.

—————————————————————————

362 Section 13(e)(1) of the BHC Act requires the CFTC to issue

regulations regarding internal controls and recordkeeping to ensure

compliance with section 13. See 12 U.S.C. 1851(e)(1). Section —

–.20 and Appendix C of the proposed rule also implement section

13(e)(1) of the BHC Act.

—————————————————————————

The various quantitative measurements that would be required to be

reported focus on assessing banking entities’ risk management, sources

of revenue, revenues in relation to risk, customer servicing, and fee

generation. Aberrant patterns among the measurements with respect to

these areas would warrant further review to determine whether trading

activities have occurred that are proprietary in nature and whether

such activities may be exposing banking entities to disproportionate

risk. For example, quantitative measurements should provide banking

entities with a useful starting point for assessing whether their

trading activities are consistent with the proposed rule and whether

traders are exposing the entity to disproportionate risks. In addition,

[[Page 8413]]

proposed Appendix A applies a standardized description and general

method of calculating each quantitative measurement that, while taking

into account the potential variation among trading practices and asset

classes, is intended to facilitate reporting of sufficiently uniform

information across different banking entities so as to permit

horizontal reviews and comparisons of the quantitative profile of

trading units across firms. This proposed approach, which recognizes

that quantitative measurements must be applied with respect to

differences within a banking entity’s structure, business lines, and

trading desks, should facilitate efficient application within firms and

efficient examination across firms. The proposed use of a suite of

quantitative measurements for these purposes may also limit erroneous

indications of potential violations or erroneous indications of

compliance (i.e., false positives and false negatives), thus allowing

banking entities and examiners and supervisors to focus upon the

measurements that may be most relevant in identifying prohibited

conduct. The uniformity of the proposed measurements across different

types of banking entities is also intended to ensure that banking

entities are calculating comparable measurements consistently and that

comparable measurements are being evaluated consistently by the CFTC.

The CFTC expects that as the implementation of quantitative

measurements and the internal compliance and external oversight

processes become more efficient over time, banking entities will find

compliance efforts less burdensome.

The CFTC seeks comment on the extent to which banking entities will

incur costs associated with implementing, monitoring, and attributing

financial and personnel resources for purposes of complying with the

requirements of proposed Appendix A. Specifically, please discuss the

extent to which banking entities are unlikely to currently calculate

certain quantitative measurements in the manner required under the

proposal (e.g., Spread Profit and Loss or Customer-facing Trade Ratio)

and whether this may result in significant start-up costs associated

with developing these measurements. Under the proposal, banking

entities would also need to dedicate personnel and supervisory staff to

review for potential aberrant patterns of activity that warrant further

review, as well as maintain appropriate records of that review. In

order to limit these calculation and surveillance costs to the greatest

extent practicable, the CFTC has proposed measurements that, in many

cases, are already calculated by many banking entities to measure and

manage trading risks and activities. The costs to banking entities

associated with calculating the proposed quantitative metrics should

also be mitigated by the tiered application of Appendix A, which would

require banking entities with the most extensive trading activities to

report the largest number of quantitative measurements, while imposing

fewer or no reporting requirements on banking entities with smaller

trading activities. By limiting the application of aspects of Appendix

A to firms with greater than $1 billion in trading assets and

liabilities, and all aspects of the appendix only to entities with

greater than $5 billion in trading assets and liabilities, the costs

imposed should be proportional to the market reach and complexity of a

banking entity’s trading activities.

B. Covered Fund Activities

Subpart C implements the statutory provisions of section

13(a)(1)(B) of the BHC Act, which prohibit banking entities from

acquiring or retaining any equity, partnership, or other ownership

interest in, or sponsoring, a covered fund, and other provisions of

section 13 of the BHC Act which provide exemptions from, or otherwise

relate to, that prohibition. In implementing the covered funds

provisions of section 13 of the BHC Act, the CFTC has proposed to

define and interpret several terms used in implementing these

provisions and the goals of section 13. We seek comment on whether the

proposed rule represents a balanced and effective approach to

implementing the covered fund provisions of the statute.

1. General Scope

For banking entities that invest in, sponsor or have relationships

with one or more covered funds, the economic impact of complying with

the statute and the implementing rule will vary, depending on the size,

scope and complexity of their respective business, operations and

relationships with clients, customers and counterparties. Moreover, the

types of covered funds advised or sponsored by an adviser, the types of

business and other relationships that an adviser may conduct with such

funds and the adviser’s other business activities, including

relationships with other third party advised covered funds, will affect

whether a covered fund activity would be subject to the statutory

prohibition, eligible for a particular exemption or subject to

particular internal control requirements as specified by the proposed

rule.

For example, with respect to a banking entity that does not

“sponsor,” invest in, or otherwise provide “prime brokerage

transactions” to, a “covered fund,” the statute, as implemented by

the proposed rule, would not substantively restrict the banking

entity’s activity; instead, the proposed rule would only require the

minimum internal controls reasonably designed to prevent the entity

from engaging in the prohibited activities. As a result, we do not

expect that the proposed rule would have a significant effect on most

banking entities, such as investment advisers, that are primarily

engaged in providing bona fide trust, fiduciary, or advisory services

to unrelated parties. Although such advisers may incur some incremental

costs to develop and implement a compliance program reasonably designed

to ensure that they do not engage in otherwise prohibited activities,

there should be no significant costs associated with modifying existing

business practices and procedures. We request comment on the extent to

which such banking entities would be required to modify their existing

business practices and procedures to comply with the proposed rule. For

instance, would a registered investment adviser that only advises

registered investment companies and that does not trade for its own

account incur costs, benefits or other impacts in addition to costs to

implement the minimum internal controls reasonably designed to prevent

it from engaging in prohibited activities? Would an adviser that trades

on behalf of itself incur, with respect to such trading activities,

additional costs, benefits or other impacts described above relating to

the proposed restrictions on proprietary trading?

In contrast, a banking entity that seeks to invest in a covered

fund could only do so in reliance on an exemption specified in the

statute or the proposed rule, such as the exemption for organizing and

offering certain covered funds provided in section 13(d)(1)(G), as

implemented in Sec. —-.11 of the proposed rule. Similarly, a banking

entity that seeks to enter into “prime brokerage transactions” with a

covered fund could only do so by meeting certain requirements under the

proposed rule. Accordingly, the economic impact of the proposed rule

will depend on whether an adviser’s activities fall within the scope of

the terms as proposed such that the banking entity would be subject to

the limitations on covered fund activities. To the extent that these

terms or

[[Page 8414]]

exemptions would result in more, or fewer, activities being captured by

the proposed rule, what are the attendant costs and benefits that a

covered banking may incur? We request commenters provide empirical

data, or studies, where possible.

Definition of Covered Fund. The proposed rule’s definition of

“covered fund” includes hedge funds and private equity funds as

defined by statute, but also identifies two types of similar funds–

commodity pools and certain non-U.S. funds–that are subject to the

covered fund restrictions and prohibitions of section 13 of the BHC

Act, as implemented by the proposed rule. The CFTC has proposed to

include these funds since they are generally managed and structured

similar to a covered fund, but are not generally subject to the Federal

securities laws due to the instruments in which they invest or the fact

that they are not organized in the United States or one or more States.

We request comment on whether applying the definition of covered fund

in this way as proposed would increase the number of investment

vehicles or similar entities that would be subject to the limitations

under the proposed rule. Would this approach increase compliance costs

for banking entities that sponsor, invest in, or have certain

relationships with these types of funds?

The proposed rule also excludes certain types of investments in

covered funds, pursuant to section 13(d)(1)(J) of the BHC Act, which

authorizes the CFTC to exclude from the general covered fund activity

prohibition those activities that would promote the safety and

soundness of a banking entity. Section —-.14 of the proposed rule

would exclude from the prohibition, among other things, a banking

entity’s investments in covered funds related to bank owned life

insurance, certain joint ventures and interests in securitization

vehicles retained in compliance with the minimum credit risk retention

requirements of section 15G of the Exchange Act. We request comment on

the potential economic impact of the proposal to exclude these types of

investments from the general prohibition. For banking entities whose

only covered fund activities are those described in Sec. —-.14, what

economic impact would be attributed to complying with this provision of

the proposed rule? Would these costs and benefits differ from those of

banking entities that conduct covered fund activities as well as engage

in activities described in Sec. —-.14? As described in the

Supplementary Information, a banking entity that generally does not

engage in any prohibited activities is only required to adopt and

implement a compliance program reasonably designed to ensure that the

entity does not engage in prohibited activities. To what extent will

the proposed provisions in Sec. —-.14 increase or mitigate any

costs, benefits or other impacts associated with the foregoing minimum

internal controls requirement?

Definition of Sponsor. Under the proposed rule, the term

“sponsor” is defined by incorporating the definition set forth in

section 13(h)(5) of the BHC Act, but the CFTC has proposed to clarify

that the term trustee, as used in the definition of sponsor, does not

include a trustee that does not provide discretionary investment

services to a covered fund. This exception distinguishes a trustee

providing non-discretionary advisory services from trustees providing

services similar to those associated with entities serving as general

partner, managing member, commodity pool operator or investment adviser

of a covered fund. We request comment on the economic impact associated

with the proposed definition of “sponsor.” Will the economic impact

differ depending on the scope of a banking entity’s covered fund

activities? For example, a banking entity whose only relationship with

a covered fund involves the provision of non-discretionary investment

services would not be a sponsor under the proposed rule. We request

comment on whether such a banking entity would benefit from this

exception. We also request comment on whether a covered fund’s

investors and counterparties would bear any costs associated with a

banking entity’s modification of its business practices or its

relationship to the covered fund.

Other Definitions. The covered fund provisions also define, among

other things, “director” and “prime brokerage transaction.” What

are the costs, benefits or other impacts associated with the way the

proposed rule defines these terms? For example, would the proposed

definition of “prime brokerage transaction” enable a banking entity

to provide services to a covered fund that would not ordinarily be

understood to be prime brokerage as long as it met certain conditions?

What costs, or benefits, for banking entities, clients, customers or

counterparties may be associated with this approach to defining prime

brokerage transaction?

2. Exemptions

In implementing the covered funds provisions of section 13 of the

BHC Act, the CFTC also has interpreted or defined terms contained in

the three principal exemptions related to covered fund activities by a

banking entity: (i) The exemption for organizing and offering covered

funds; (ii) the exemption for investment in a covered fund in the case

of risk-mitigating hedging; and (iii) the exemption for covered fund

activities outside of the United States. We request comment generally

on the potential impact of these statutory exemptions, as implemented

by the proposed rule. The CFTC notes that there are multiple factors

that could affect the impact of the statute and the proposed rule on a

banking entity’s covered fund activities, including other conditions

set forth in the statute or the proposed rule that could mitigate costs

or enhance benefits associated with a particular element or condition

of an exemption.

Organize and Offer Exemption. Section —-.11 of the proposed rule

implements the exemption set forth in section 13(d)(1)(G) of the BHC

Act and generally incorporates all of the conditions specified in the

statute. As required by the statute, the exemption for organizing and

offering covered funds is available only to banking entities that

provide bona fide trust, fiduciary, commodity trading or investment

advisory services, which must meet certain requirements. As a result,

the exemption should not preclude banking entities, such as registered

advisers, registered operators, or other advisers, from providing trust

or advisory services to their clients. We request comment on whether

the proposed requirements of the exemption would result in a banking

entity modifying its business practices or bearing higher costs to

comply with the limitations and requirements applicable to this

statutory exemption, as implemented by the proposed rule. These costs

may include, for example, developing a credible plan that documents how

advisory services would be provided to banking entity customers through

organizing and offering covered funds and making the specified

disclosures required by the exemption. We also request comment on

whether the banking entity will pass these costs on to covered fund

investors and counterparties.

In implementing this statutory exemption, the CFTC has defined or

clarified several key terms or requirements, including (i) the

definition of ownership interest and (ii) the method for calculating

the 3% ownership interest limit. The proposed definition of ownership

interest is designed to describe the typical types of relationships

through which an investor has exposure to the profits and losses of

[[Page 8415]]

a covered fund. Consistent with this approach, carried interest is not

included within the proposed definition of ownership interest. As

discussed in the Supplementary Information above, carried interest

generally entitles service providers, such as banking entities that

provide advisory services, to receive compensation for such services

determined as a share of a covered fund’s profits. As a result, the

proposed rule does not treat carried interest as an ownership interest,

which could have costs and benefits. To help discern these costs and

benefits, we request comment on whether this is consistent with how

providers of advisory services view the receipt of such “carried

interest” (i.e., as compensation for services rather than as an

“ownership interest” equivalent to an investor’s interest that shares

in a fund’s profits and losses). The proposed definition of carried

interest has limitations designed to prevent a banking entity from

circumscribing the proposed rule’s limitations on ownership. For

instance, among other things, the proposed definition requires that the

“sole purpose and effect of the interest is to allow banking entity *

* * to share in the profits of the covered fund. 363 For banking

entities receiving compensation that would satisfy all of the elements

of the proposed definition, there should be no burden associated with

modifying existing business practices. For other banking entities,

however, the conditions specified in the proposed definition could

result in more banking entities being deemed to hold “ownership

interests” and hence subject to the limitations under the statute and

the proposed rule, including the limitations on material conflicts of

interest, high-risk trading activities and exposure to high-risk

assets. We request comment on whether these banking entities would need

to modify their existing practices and develop alternatives, and, if

so, whether these modifications will impose costs and benefits. For

example, costs associated with modifying business practices could

include developing and implementing a compliance program in accordance

with the proposed rule; benefits that may arise as a result of

modifying business practices could include limiting the extent to which

material conflicts of interest may arise between clients, customer and

counterparties of banking entities. We also request comment on whether

such costs, if any, are likely to be passed on to fund investors,

clients and counterparties.

—————————————————————————

363 Proposed rule Sec. —-.10(b)(3)(i).

—————————————————————————

As required by statute, a banking entity that seeks to invest in a

covered fund under the exemption for organizing and offering covered

funds could not, after the expiration of an initial one-year period

(plus any applicable extensions), hold more than 3% of the total

outstanding ownership interests of such fund. The proposed rule would

require that a banking entity calculate the per-fund limit whenever the

covered fund calculates its value or permits investor investments or

redemptions, but in no case less frequently than quarterly. We request

comment on whether this approach will limit any additional burden

associated with calculating the per-fund limit for banking entities

that invest in covered funds that determine their value on at least a

quarterly basis. We also request comment on whether such banking

entities will incur any additional significant costs in determining

their compliance with the 3% ownership limitation.

Risk-mitigating Hedging Exemption. The proposed rule specifies an

exemption from the general prohibition on covered fund activities in

the case of risk-mitigating hedging. Similar to the hedging exemption

in the case of proprietary trading (discussed above), the hedging

exemption for covered fund activities specifies a number of conditions

that are identical except for two conditions. In the case of the

hedging exemption for covered fund activities, the hedging must

generally “offset” the exposure of the banking entity to the

liabilities associated with (i) the facilitation of customer

transactions or (ii) compensation arrangements for certain employees.

Consistent with the statute, the proposed exemption would enable a

banking entity to invest in a covered fund without limit if the

investment is for risk-mitigating hedging purposes.

We request comment on whether the proposed requirements will have

benefits of furthering the goals of compliance with the statute and

reducing banking entities’ risks. We also request comment on whether

the proposed requirements are more restrictive than necessary to

implement the statute and whether they could unnecessarily limit a

banking entity’s hedging activities and ability to reduce risk.

Commenters should also address whether the proposed requirements will

dissuade banking entities from engaging in other permitted activities

(e.g., organizing and offering covered funds) or those activities

outside the scope of the statute to the extent that the exemption

prevents them from mitigating the risks associated with such

activities. We request comment on whether a reduction in efficiency

could result from a reduced ability of covered banking entities to

transfer risks to those more willing to bear them. Commentators should

also address whether the proposed rule could reduce a banking entity’s

willingness to engage in permitted risk-mitigating hedging activities

in order to avoid costs related to ensuring compliance with the

exemption’s requirements, and whether this would increase the banking

entity’s risk exposure.

Exemption for Covered Fund Activities Outside of the United States.

Section —-.13(c) of the proposed rule implements section 13(d)(1)(I)

of the BHC Act, which permits certain foreign banking entities to

sponsor or invest in covered funds “solely outside of the United

States,” so long as the covered fund is not offered or sold to a

resident of the United States. The proposed exemption provides a number

of specific criteria for determining when a banking entity will be

considered to have invested or sponsored a covered fund solely outside

of the United States. The proposed exemption provides a definition of

“resident of the United States” that is similar, but not identical,

to the SEC’s definition of “U.S. person” in Regulation S, which

should promote consistency and understanding among market participants

that have experience with the concept from the SEC’s Regulation S. In

addition, the proposed exemption clarifies when a foreign banking

entity will be considered to engage in such trading pursuant to

sections 4(c)(9) and 4(c)(13) of the BHC Act, as required by the

statute, including with respect to a foreign banking entity that is not

a “foreign banking organization” under the Board’s Regulation K. This

implementation of section 13(d)(1)(I) of the BHC Act would permit

certain foreign banking entities that are not “qualifying foreign

banking organizations” under the Board’s Regulation K to also rely on

the exemption, notwithstanding the fact such foreign banking entities

are not currently subject to the BHC Act generally or the Board’s

Regulation K. As a result, such foreign banking entities should

encounter fewer costs related to complying with the covered fund

activity prohibitions than if they were unable to rely on the exemption

in section 13(d)(1)(I) of the BHC Act.

Despite the reference to section 4(c)(13) of the BHC Act, the

statute provides that the exemption for covered fund activities outside

of the United States is only available to banking entities that are not

directly or indirectly controlled by U.S. banking entities (i.e., not

any U.S. banking

[[Page 8416]]

entities or their foreign subsidiaries and affiliates). Under the

statute, the prohibition and restrictions on covered fund activities

apply to the consolidated, worldwide operations of U.S. firms. As

required by statute, the proposal prohibits U.S. banking entities from

investing in or sponsoring covered funds unless the requirements of one

or more relevant exemptions (other than the exemption for trading by

foreign banking entities) are satisfied. As a result, the statute

creates a competitive difference between the foreign activities of U.S.

banking entities, which must monitor and limit their foreign activities

in accordance with the requirements of section 13 of the BHC Act,

relative to the foreign activities of foreign-based banking entities,

which may not be subject to restrictions similar to those in section 13

of the BHC Act. The CFTC seeks commenters’ views on whether the

proposed rule’s implementation of section 13(d)(1)(I) of the BHC Act

imposes additional competitive differences, beyond those discussed

above, and the potential economic impact of such competitive

differences.

3. Securitizations

The CFTC recognizes that by defining “covered fund” and “banking

entity” broadly, securitization vehicles may be affected by the

restrictions and requirements of the proposed rule, and this may give

rise to various economic effects. The CFTC preliminarily believes that

the proposed rule should mitigate the impact of securitization market

participants and investors in some non-loan asset classes (including,

for example, banking entities that are participants in a securitization

that may acquire or retain ownership interests in a securitization

vehicle that falls within the definition of covered fund) by excluding

loan securitizations from the restrictions on sponsoring or acquiring

and retaining ownership interests in covered funds.

Costs may be incurred to establish internal compliance programs to

track compliance for any securitization vehicle that falls within the

definition of banking entity. These costs may be minimized for future

securitization vehicles, however, because such securitizations may be

able both to incorporate any internal compliance program requirements

into their documentation prior to execution and to minimize (or

eliminate) any activities that may trigger greater compliance costs.

The proposed rule should further minimize the costs of the internal

compliance programs by (i) allowing for enterprise-wide compliance

programs and minimal requirements for banking entities that do not

engage in covered trading activities and/or covered fund activities or

investments (each as described below), and (ii) allowing for reduced

compliance program requirements by establishing financial thresholds

for “significant” covered trading activities or covered fund

activities or investments (as described below).

There could be initial costs both for banking entities that have an

ownership interest in a securitization vehicle and for other

securitization participants to determine if a particular vehicle falls

within the definition of covered fund. Additional costs could be

incurred to the extent that banking entities divest their ownership

interests in any securitization vehicle that is a covered fund and is

not otherwise eligible for one of the exceptions allowed under the

proposed rule. This divestment could result in selling pressure that

may have a negative impact on the market prices for the vehicles that

fall within the definition of covered fund, which in turn could impact

all investors in those securitization vehicles. Additionally, under the

proposed rule, banking entities would no longer be allowed to acquire

and retain such ownership interests, which may result in fewer

potential investors and reduced liquidity in the market for ownership

interests in these covered funds.

For example, the proposed rule could lead to significant potential

market impacts if, with respect to an issuance of asset-backed

securities secured by assets which are not loans, the market requires

credit risk retention in excess of the minimum requirements to be

adopted pursuant to Section 941 of the Dodd-Frank Act (i.e., the market

believes that 5% credit risk retention is insufficient to address

potential misalignment of incentives in a particular transaction). In

such circumstances, the proposed rule could reduce potential investors’

demand for such securitizations and could make such securitizations

more expensive.

C. Limitations on Permitted Activities for Material Conflicts of

Interest and High-Risk Assets and High-Risk Trading Strategies

Section 13(d)(2)(A)(i) of the BHC Act provides that an otherwise-

permitted activity would not qualify for a statutory exemption if it

would involve or result in a material conflict of interest. The

proposed rule’s definition of material conflict of interest, as

discussed in more detail in Part II of the Supplemental Information,

would provide flexibility to banking entities and their clients,

customers, and counterparties with respect to how transactions are

structured, while also establishing a structure to prevent banking

entities from engaging in transactions and activities in reliance on a

statutory exemption when the transaction or activity would have a

materially adverse effect on the clients, customers, or counterparties

of the banking entity. Specifically, the proposed definition would

permit the use of timely and effective disclosure and/or information

barriers in certain circumstances to address and mitigate conflicts of

interest, while prohibiting transactions or activities where such a

conflict of interest cannot be addressed or mitigated in the specified

manner. The CFTC has endeavored to establish a workable definition that

sets forth when a banking entity may not rely on an exemption because

it would involve or result in a material conflict of interest,

consistent with the statutory goals, to facilitate banking entities’

compliance with the statutory requirements. We seek comment on whether

the statutory prohibition, as implemented by the proposal, may impose

costs on banking entities or their clients, customers, or

counterparties. For instance, by permitting a client, customer or

counterparty the option of negating or mitigating the conflict after

the banking entity has disclosed the conflict, would the banking entity

incur certain costs related to terminating the transaction, providing

compensation or other means of mitigating the conflict, or

administrative costs associated with negotiating the extent of any such

compensation or other means of mitigating the conflict, depending on

the actions of the client, customer, or counterparty in response to the

disclosure?

In addition, section 13(d)(2)(A)(ii) of the BHC Act provides that

an otherwise-permitted activity would not qualify for a statutory

exemption if it would result, directly or indirectly, in a material

exposure by the banking entity to high-risk assets or high-risk trading

strategies. This statutory limitation, as implemented in the proposed

rule, would prevent a banking entity from engaging in certain high-risk

activity. The CFTC requests comment on whether the proposed definitions

of high-risk asset and high-risk trading strategy would potentially

reduce liquidity or create a reduction in efficiency for assets or

markets related to that high-risk activity.

D. Compliance Program

Under Sec. —-.20 of the proposed rule, all covered banking

entities that are engaged in covered trading activities or

[[Page 8417]]

covered fund activities or investments would be required to have a

compliance program that provides for the following six elements, at a

minimum: (i) Internal written policies and procedures; (ii) internal

controls; (iii) a management framework; (iv) independent testing; (v)

training; and (vi) recordkeeping. For those banking entities with

significant covered trading activities or covered fund activities or

investments under Sec. —-.20(c) of the proposed rule, additional

standards in proposed Appendix C must be met with respect to these six

elements.364 Collectively, the six proposed requirements would

facilitate a banking entity’s review and assessment of its compliance

with section 13 of the BHC Act and the proposed rule, including

identifying potential areas of deficiency in a banking entity’s

compliance program and providing the banking entity the opportunity to

take appropriate corrective or disciplinary action, where warranted.

The proposed compliance program would also facilitate Agency

examination and supervision for compliance with the requirements of the

statute and the proposed rule. By requiring that a banking entity have

in place specific, documented elements (e.g., written policies and

procedures and internal controls, recordkeeping requirements), the

proposed rule would ensure that Agency examiners and supervisors can

effectively review a banking entity’s activities and investments to

assess compliance and, where a banking entity is not in compliance with

the proposed rule, take appropriate action.

—————————————————————————

364 Proposed rule Sec. —-.20 and Appendix C implement

section 13(e) of the BHC Act, which requires the Agencies to issue

regulations regarding internal controls and recordkeeping to ensure

compliance with section 13.

—————————————————————————

Beyond the benefits recognized above, the individual elements of

the proposed compliance program should also provide certain benefits.

For example, the proposed management framework requirement is designed

to give management a greater incentive to comply with the proposed rule

and to ascertain that the employees they are responsible for overseeing

are also complying with the proposed rule. Further, by establishing a

management framework for compliance, the banking entity would be

required to set a strong compliance tone at the top of the banking

entity’s organization and signal to its employees that management is

serious about compliance, which should foster a strong culture of

compliance throughout the banking entity. Similarly, the proposed

independent testing requirement would provide a third-party assessment

of a banking entity’s compliance with the proposed rule, which should

provide assurances to the banking entity, its clients, customers, and

counterparties, and current or prospective investors that the banking

entity is in compliance with the proposed rule. In addition, the

proposed training requirement should help the various employees of a

banking entity that have responsibilities and obligations under the

proposed rule (e.g., complying with the requirements for permitted

market making-related activity) understand such responsibilities and

obligations and facilitate the banking entity’s compliance with the

proposed rule. This proposed requirement may also promote market

confidence by assuring that trading personnel, and other appropriate

personnel of the banking entity, are familiar with their regulatory

responsibilities and are complying with the applicable laws and

regulations in their interactions with clients, customers, and

counterparties.

Because the six elements would be required to be established by all

banking entities, other than those that are not engaged in covered

trading activities or covered fund activities or investments, the

proposed compliance program requirement should promote consistency

across banking entities. However, the proposed elements are also

intended to give a banking entity a degree of flexibility in

establishing and maintaining its compliance program in order to address

the varying nature of activities or investments conducted by different

units of the banking entity’s organization, including the size, scope,

complexity, and risks of the activity or investment.

We seek comment on whether developing and providing for the

continued administration of a compliance program under Sec. —-.20 of

the proposed rule is likely to impose material costs on banking

entities. Costs related to the proposed compliance program requirement

are likely to be higher for those banking entities that are engaged in

significant covered trading or covered fund activities or investments

and, as a result, are required to comply with the more detailed,

specific requirements of proposed Appendix C. Potential costs related

to implementation of a compliance program under the proposal include

those associated with: Hiring additional personnel or other personnel

modifications, new or additional systems (including computer hardware

or software), developing exception reports, and consultation with

outside experts (e.g., attorneys, accountants). The proposed compliance

program requirement would also impose ongoing costs related to

maintenance and enforcement of the compliance program elements, which

may include those associated with: Ongoing system maintenance,

surveillance (e.g., reviewing and monitoring exception reports),

recordkeeping, independent testing, and training. For example, the

independent testing requirement in the proposal may necessitate that

additional resources be provided to the internal audit department of

the covered banking entity that is a registered broker-dealer or

security-based swap dealer, if such testing is conducted by a qualified

internal tester. Alternatively, if an outside party is used to conduct

the independent testing, the covered banking entity would incur costs

associated with paying the qualified outside partys for its services.

The CFTC does not anticipate significant costs related to the proposed

management framework requirement, as banking entities should already

have relevant management structures in place.

The tiered approach with which the proposal applies the proposed

compliance program requirement to banking entities of varying size

should reduce the costs associated with developing and providing for

the continued administration of a compliance program. In setting forth

the proposed compliance program requirement in Sec. —-.20 of the

proposed rule and Appendix C, the CFTC has taken into consideration the

size, scope, and complexity of a banking entity’s covered trading

activities and covered fund activities and investments in developing

requirements targeted to the compliance risks of large and small

banking entities. Specifically, banking entities that do not meet the

thresholds established in Sec. —-.20(c) of the proposed rule would

not be required to comply with the more detailed and burdensome

requirements set forth in Appendix C. In addition, banking entities

that do not engage in covered trading activities and covered fund

activities and investments would not be required to establish a

compliance program under the proposed rule, and therefore should incur

only minimal costs associated with adding measures to their existing

compliance policies and procedures to prevent the banking entity from

becoming engaged in such activities or making such investments.

Together, these provisions have been proposed in order to permit a

banking entity to tailor its compliance program to its activities and

investments and,

[[Page 8418]]

where possible, leverage its existing compliance structures, all of

which should minimize the incremental costs associated with

establishing a compliance program under the proposed rule. However,

banking entities that are engaged in significant covered trading and

covered fund activities and investments and thereby present a

heightened compliance risk due to the size and nature of their

activities and investments would be required to comply with the

additional standards set forth in proposed Appendix C.

Costs associated with the requirements of proposed Appendix C

should also be reduced by aspects of the proposed rule that would

permit a banking entity to establish an enterprise-wide compliance

program under certain circumstances. An enterprise-wide compliance

program would generally permit one compliance program to be established

for a banking entity and all of its affiliates and subsidiaries

collectively, rather than each legal entity being required to establish

its own separate compliance program. The CFTC expects that an

enterprise-wide compliance program should promote efficiencies and

economies of scale, and reduce costs, associated with establishing

separate compliance programs.

E. Additional Request for Comment

In addition to the requests for comment discussed above, we seek

commenters’ views on the following additional questions related to the

potential economic impacts of the proposed framework for implementing

section 13 of the BHC Act:

Question 348. What are the expected costs and benefits of complying

with the requirements of the proposed rule? We seek commenters’

estimates of the aggregate cost or benefit that would be incurred or

received by banking entities subject to section 13 of the BHC Act to

comply. We also ask commenters to break out the costs or benefits of

compliance to banking entities with each individual aspect of the

proposed rule. Please provide an explanation of how cost or benefit

estimates were derived. Please also identify any costs or benefits that

would occur on a one time basis and costs that would recur. Would

particular costs or benefits decrease or increase over time? If certain

costs or benefits cannot be estimated, please discuss why such costs or

benefits cannot be estimated.

Question 348.1 The CFTC seeks comment on the proposed rule’s

effects on market-making and liquidity, the costs of borrowing by

businesses and consumers, the prices of financial assets, and the

competitiveness of the United States financial services sector. The

Commission also solicits comment on the benefits that will result from

the proposed regulations and how these benefits compare to the costs of

complying with the proposed regulations. The Commission also solicits

comment on the CFTC’s assessments of the costs and benefits of the

regulations proposed herein.

Question 349. Please identify any costs or benefits that would

occur on a one-time basis and costs or benefits that would recur (e.g.,

training and compliance monitoring). Please identify any costs or

benefits that you believe would decrease over time. Please identify any

costs or benefits that you believe may increase over time or remain

static.

Question 350. Are there circumstances in which registered dealers,

security-based swap dealers, and/or swap dealers (i) hold accounts

other than trading accounts or (ii) hold investment positions for

activities for which they are required to be registered? If so, would

including all such dealer positions within the trading account

definition create competitive burdens as well as additional burdens on

the operations of such dealers that may not be consistent with the

language and purpose of the statute? Please describe how this may

occur, and to what extent it may occur.

Question 351. Please identify the ways, if any, that banking

entities might alter the ways they currently conduct business as a

result of the costs that could be incurred to comply with the

requirements of the proposed rule. Do you anticipate that banking

entities will terminate any services or products currently offered to

clients, customers, or counterparties due to the proposed rule, if

adopted? Please explain.

Question 352. How would trading systems and practices used in

today’s marketplace be impacted by the proposed rule? What would be the

costs and/or benefits of such changes in trading practices and systems?

Question 353. Would the proposed rule create any additional

implementation or operational costs or benefits associated with systems

(including computer hardware and software), surveillance, procedural,

recordkeeping, or personnel modifications, beyond those discussed in

the above analysis? Would smaller banking entities be

disproportionately impacted by any of these additional implementation

or operational costs?

Question 354. We seek specific comments on the costs and benefits

associated with systems changes on banking entities with respect to the

proposed rule, including the type of systems changes necessary and

quantification of costs associated with changing the systems, including

both start-up and maintenance costs. We request comments on the types

of jobs and staff that would be affected by systems modifications and

training with respect to the proposed rule, the number of labor hours

that would be required to accomplish these matters, and the

compensation rates of these staff members.

Question 355. Please discuss any human resources costs associated

with the proposed rule, along with any associated overhead costs.

Question 356. What are the benefits and costs associated with the

requirements for relying on the underwriting exemption? What impact

will these requirements have on capital formation, efficiency,

competition, liquidity, price efficiency, if any? Please estimate any

resulting benefits and costs or discuss why such benefits and costs

cannot be estimated. What alternatives, if any, may be more cost-

effective while still being consistent with the purpose and language of

the statute?

Question 357. What are the benefits and costs associated with the

requirements for relying on the exemption for market-making-related

activity, including the requirement that such activity be consistent

with the commentary in Appendix B? What impact will these requirements

have on liquidity, price efficiency, capital formation, efficiency, and

competition, if any? Please estimate any resulting benefits and costs

or discuss why such benefits and costs cannot be estimated. What

alternatives, if any, may be more cost-effective while still being

consistent with the purpose and language of the statute?

Question 358. What are the benefits and costs associated with the

requirements for relying on the exemption for risk-mitigating hedging

activity, including the requirement that certain hedge transactions be

documented? What impact will these requirements have on liquidity,

price efficiency, capital formation, efficiency, and competition, if

any? Please estimate any resulting benefits and costs or discuss why

such benefits and costs cannot be estimated. What alternatives, if any,

may be more cost-effective while still being consistent with the

purpose and language of the statute?

Question 359. Are there traditional risk management activities of

banking entities that are not covered by the liquidity management and

risk-

[[Page 8419]]

mitigating hedging exemptions as currently proposed? What risks do

banking entities face that go beyond market, counterparty/credit,

currency/foreign exchange, interest rate, and basis risk? Could the

proposed construction of the liquidity management and risk-mitigating

hedging exemptions increase the costs of management or impede the

ability of banking entities to effectively manage risk?

Question 360. To rely on the exemptions from the proposed rule for

permitted underwriting, market-making-related activity, and risk-

mitigating hedging, banking entities must establish, maintain, and

enforce a compliance program, including written policies and procedures

and internal controls. Please discuss how the costs incurred, or

benefits received, by banking entities related to initial

implementation and ongoing maintenance of the compliance program would

impact their customers and their businesses with respect to

underwriting, market making, and hedging activity.

Question 361. Please discuss benefits and costs related to the

limitations on permitted activities for material conflicts of interest,

high-risk assets and trading strategies, and threats to the safety and

soundness of banking entities or to the financial stability of the U.S.

in the proposed rule. Are there particular benefits and costs related

to the proposed definitions of material conflict of interest, high-risk

asset, and high-risk trading strategy in the proposed rule? Would these

definitions have any unintended costs, such as creating undue burdens

and limitations on permitted underwriting, market making-related, or

hedging activity? Please explain. What alternatives, if any, may be

more cost-effective while still being consistent with the purpose and

language of the statute?

Question 362. Please discuss the benefits and costs related to the

definition of derivative in the proposed rule and the application of

the restrictions on proprietary trading to transactions in the

different types of derivatives covered by the definition. What

alternatives, if any, may be more cost-effective while still being

consistent with the purpose and language of the statute?

Question 363. What costs and benefits would be associated with

calculating, reviewing, and analyzing the proposed quantitative

measurements? What costs and benefits would be associated with

reporting the proposed quantitative measurements to an Agency? Please

identify any of the proposed quantitative measurements that are already

reported to an Agency and discuss whether the current reporting regime

would mitigate costs associated with the proposed rule. With respect to

any quantitative measurement that is not already reported to an Agency,

what are the costs and benefits of beginning to report the measurement?

Would banking entities have to create or purchase new systems or

implement changes to existing systems in order to report these

quantitative measurements? Please discuss the costs and benefits

associated with such systems changes.

Question 364. How much of the data necessary to calculate the

quantitative measurements in Appendix A is currently captured,

retained, and utilized by banking entities? If the applicable data is

not currently used by banking entities, is it readily available? Is it

possible to collect all of the data that is necessary for calculating

the required measurements? Please identify any data that banking

entities do not currently utilize that would need to be captured and

retained for purposes of proposed Appendix A and discuss the costs and

benefits of capturing and retaining such data.

Question 365. Do the costs and benefits of calculating, analyzing,

and reporting certain or all quantitative measurements differ between

trading units and their trading activities, including trading

strategies, asset classes, market structure, experience and market

share, and market competitiveness? Are any quantitative measurements

particularly costly to calculate or analyze for specific trading

activities or, alternatively, particularly beneficial? If so, which

quantitative measurement, what type of trading activity, and what

factor(s) of that trading activity make the quantitative measurement

particularly costly or beneficial? Please discuss how these costs, if

any, could be mitigated or benefits, if any, could be enhanced.

Question 366. The proposed definition of trading unit would require

a tiered approach to calculating and reporting quantitative

measurements, such that the measurements would be calculated and

reported for different levels within the banking entity, with higher

levels encompassing smaller units (e.g., trading desks, business lines,

and all trading operations). What are the costs and benefits of

calculating the quantitative measurements for each level within the

definition of trading unit? Can the higher level calculations

incorporate the lower level calculations such that the higher level

calculations result in small, incremental costs? Why or why not? Are

there particular costs or benefits associated with calculating,

analyzing, and reporting a quantitative measurement at one of the

levels within the definition of trading unit that would not be

experienced at the other levels? Please explain. What are the costs, if

any, of “noise,” “false positives,” or “false negatives” with

respect to the quantitative measurements and calculations at different

levels? Can these costs be mitigated and, if so, how? What

alternatives, if any, may be more cost-effective while still being

consistent with the purpose and language of the statute?

Question 367. We seek comment on whether the requirement that

banking entities employ a suite of quantitative measurements may lead

to redundancies and/or inefficiencies in the application of the

measurements for some types of trading units within some banking

entities. Despite the flexibility of Appendix A via recognition that

quantitative measurements will be applied with respect to differences

within a banking entity’s structure, business lines, and trading desks,

we seek comment on whether the requirement of a mandatory suite of

quantitative measurements may prove burdensome. For instance, is the

application of certain quantitative measurements not efficient,

appropriate, or calculable for certain asset classes or trading units

or would the benefits of applying such quantitative measurements be

negligible in relation to the costs of applying such measurements? In

addition, would the overlay divert a banking entity from allocating

resources toward quantitative–or other–measurements that might prove

more useful and better tailored to its specific and unique trading

practices?

Question 368. What are the benefits and costs of the recordkeeping

requirement in proposed Appendix A? Please explain and quantify, to the

extent possible. To what extent would the proposed recordkeeping

requirement impose new or additional costs and benefits beyond the

current recordkeeping obligations of different types of banking

entities (e.g., affiliated broker-dealers, affiliated investment

advisers, insured depository institutions, etc.)? What alternatives, if

any, may be more cost-effective while still being consistent with the

purpose and language of the statute?

Question 369. Please identify any cost savings that would be

achieved through the use of an enterprise-wide compliance program.

Alternatively, would you expect certain costs to increase when using an

enterprise-wide compliance program? Please explain. Please identify any

benefits that might

[[Page 8420]]

be amplified or reduced when using an enterprise-wide compliance

program.

Question 370. Are there tools or elements in the contents of the

compliance program set forth in Sec. —-.20(b) for which the costs

may be negligible because banking entities use the same or similar

elements for other purposes (e.g., satisfying other regulatory

requirements, risk management, etc.) and could utilize existing

infrastructure for purposes of the proposed rule? For example, could

existing trader mandates or an existing training program be expanded to

meet the requirements of the proposed rule, rather than developing an

entirely new infrastructure? Alternatively, would the proposed rule

require redundancies or duplications within a banking entity’s

infrastructure (e.g., the trader mandates currently used for one

purpose do not conform to the requirements of the proposed rule, so a

banking entity would have to utilize both in different circumstances)?

Please identify and explain any such redundancies and how the rule

could be modified to reduce or eliminate such redundancies, if

possible.

Question 371. How would the proposed rule affect compliance costs

(e.g., personnel or system changes) or benefits for each category of

banking entity: small, medium, and large? Please discuss any

differences between the costs and benefits of the compliance program

required under Sec. —-.20(b) for smaller banking entities and the

compliance program requirements of Appendix C for larger banking

entities. Are the differences between these benefits and costs

justified due to the differences in size and complexity of smaller and

larger banking entities?

Question 372. The definition of trading unit in proposed Appendix C

covers different levels of a banking entity and, as a result, requires

a tiered approach to establishing, maintaining, and enforcing the

compliance program requirements with respect to covered trading

activities. What are the costs and benefits of applying the compliance

program requirements at several levels within the banking entity? To

what extent does the ability to incorporate written policies and

procedures of lower-level units by reference, rather than establishing

separate written policies and procedures, mitigate the costs of the

proposed requirements? Are there other ways that the proposed

requirements could be made more cost-effective for the different levels

within the banking entity?

Question 373. How will the proposed definition of “covered fund”

affect a banking entity’s investment advisory activities, in particular

activities and relationships with investment funds that would be

treated as “covered funds”? Please estimate any resulting costs or

benefits or discuss why such costs or benefits cannot be estimated.

Question 374. How have banking entities traditionally organized and

offered covered funds? What are the benefits and costs associated with

the proposed requirements for relying on the exception for organizing

and offering covered funds? Please estimate any resulting costs or

benefits or discuss why such costs or benefits cannot be estimated.

Question 375. What are the costs and benefits associated with the

way the proposed rule implements the “customers of such services”

requirement in the exception for organizing and offering covered funds?

What alternative, if any, may be more cost-effective while still being

consistent with the language and purpose of the statute?

Question 376. Is it common for a banking entity to share a name

with the covered funds that it invests in or sponsors? If yes, what

entity in the banking structure typically shares a name with such

covered funds? What costs and benefits will result from the proposed

rule’s implementation of the name sharing requirement in exception for

organizing and offering a covered fund? What alternatives, if any, may

be more cost-effective while still being consistent with the purpose of

the statute?

Question 377. Under what circumstances do directors and employees

of a banking entity invest in covered funds? What are the benefits and

costs associated with the proposed provisions regarding director and

employee investments in covered funds? What alternatives, if any, may

be more cost-effective while still being consistent with the purpose of

the statute?

Question 378. Do banking entities currently invest in or sponsor

SBICs and public welfare and qualified rehabilitation investments? If

yes, to what extent? What are the benefits and costs associated with

the proposed rule’s implementation of the exception for investment in

SBICs and public welfare and qualified rehabilitation investments?

Question 379. Do banking entities currently invest in or sponsor

each of the vehicles that the proposed rule permits banking entities to

continue to invest in and sponsor under section 12(d)(1)(J) of the BHC

Act? If yes, to what extent? What are the benefits and costs associated

with the proposed rule’s implementation of these exceptions?

Question 380. For banking entities that are affiliated investment

advisers, are there additional costs or benefits to complying with

section 13 of the BHC Act and the proposed rule? For example, do

affiliated investment advisers typically maintain records that would

enable them to demonstrate compliance with the 3% ownership limits or

restrictions on transactions that would be subject to sections 23A and

23B of the FR Act?

Question 381. Would complying with section 13 of the BHC Act and

the proposed rule affect an affiliated investment adviser’s other

business activities (benefit or burden) that are not subject to

restrictions on proprietary trading or other covered fund activities?

For example, would advisers incur additional burdens to distinguish

covered fund activities from non-covered fund activities?

Question 382. For banking entities that are affiliated investment

advisers, are there particular costs or benefits to complying with the

portions of Appendix C that are applicable to each asset management

unit of the adviser? Do these costs and benefits differ depending on

whether the adviser complies with Appendix C individually or on an

enterprise basis? Does the rule provide sufficient clarify for how

Appendix C applies to unregistered affiliates of an affiliated

investment adviser?

Question 383. To the extent applicable, please address each of the

questions above with respect to securitization vehicles that would be

included in the proposed definition of covered fund.

VI. Administrative Law Matters

A. Paperwork Reduction Act Analysis; Request for Comment on Proposed

Information Collection

In accordance with section 3512 of the Paperwork Reduction Act of

1995 (44 U.S.C. 3501-3521) (“PRA”), the CFTC may not conduct or

sponsor, and a respondent is not required to respond to, an information

collection unless it displays a currently valid Office of Management

and Budget (“OMB”) control number. In conjunction with the Joint

Release, the OCC, FDIC, and the Board obtained OMB control numbers. The

information collection requirements contained in the Joint Release, to

the extent they apply to banking entities that are not under a holding

company, were submitted by the OCC and FDIC to OMB for review and

approval under section 3506 of the PRA and section

[[Page 8421]]

1320.11 of OMB’s implementing regulations (5 C.F.R. Sec. 1320).365

Under the Joint Release, the Board will submit to OMB once the final

rule is published and the submission will include burden for Federal

Reserve-supervised institutions, as well as burden for OCC-, FDIC-,

SEC-, and CFTC-supervised institutions under a holding company.366

Under the Joint Release, the OCC or the FDIC will take burden for

banking entities that are not under a holding company.367

—————————————————————————

365 See 76 FR 68936.

366 See id.

367 See id.

—————————————————————————

In this CFTC Rule, the CFTC is proposing a separate rulemaking

under which the CFTC would adopt the same substantive requirements as

proposed in the Joint Release. Accordingly, the burden for CFTC-

supervised institutions under the CFTC Rule would be the same as the

burdens set forth and assumed by the Board and the OCC in the Joint

Release.368

—————————————————————————

368 See id.

—————————————————————————

In the Joint Release, the proposed collection of information is

titled “Reporting, Recordkeeping, and Disclosure Requirements

Associated with Restrictions on Proprietary Trading and Certain

Relationships with Hedge Funds and Private Equity Funds.” The

collection of information request submitted to OMB by the FDIC is

titled “Prohibitions and Restrictions on Proprietary Trading and

Certain Interests In, and Relationships with, Hedge Funds and Private

Equity Funds.”

In the Joint Release, the Board stated that it would take burden

for all institutions under a holding company, including, among other

things, banking entities for which the CFTC is the primary financial

regulatory agency, as defined in section 2(12)(C) of the Dodd-Frank

Act.369

—————————————————————————

369 See id.

—————————————————————————

In the Joint Release, the OCC stated that it will take the burden

with respect to registered investment advisers and commodity trading

advisers and commodity pool operators that are subsidiaries of national

banks, federal savings associations, and federal savings banks not

under a bank holding company.

The CFTC seeks comment on whether there are any banking entities

supervised by the FDIC or are subsidiaries or affiliates of an FDIC-

supervised banking entity (“FDIC supervised-entities) for which the

CFTC will be the primary financial regulatory agency under section

2(12)(C) of the Dodd-Frank Act. The Joint Release does not identify any

such entities.

The CFTC will request, pursuant to 44 U.S.C. 3509, that the

director of the OMB designate the Board or the OCC as the respective

collection agency for PRA purposes for the banking entities for which

the CFTC is the primary financial regulatory agency under section

2(12)(C). This does not affect the CFTC’s obligation and authority to

receive and review the relevant information (as set forth in the PRA

section of the Joint Release for all banking entities) for those

entities.370

—————————————————————————

370 See 76 FR 68936-38.

—————————————————————————

B. Initial Regulatory Flexibility Act Analysis

The Regulatory Flexibility Act (“RFA”), 5 U.S.C. 601 et seq.,

requires an agency to consider whether the rules it proposes will have

a significant economic impact on a substantial number of small

entities.371 If so, the agency must prepare an initial and final

regulatory flexibility analysis respecting the significant economic

impact. Pursuant to section 605(b) of the RFA, the regulatory

flexibility analysis otherwise required under sections 603 and 604 of

the RFA is not required if an agency certifies that the rule will not

have a significant economic impact on a substantial number of small

entities. The Agencies have considered the potential impact of the

proposed rule on small entities in accordance with the RFA. The

proposed rule would not appear to have a significant economic impact on

small entities for several reasons.

—————————————————————————

371 A banking organization is generally considered to be a

small banking entity for the purposes of the RFA if it has assets

less than or equal to $175 million. See also 13 CFR 121.1302(a)(6)

(noting factors that the Small Business Administration considers in

determining whether an entity qualifies as a small business,

including receipts, employees, and other measures of its domestic

and foreign affiliates).

—————————————————————————

First, while the proposed rule will affect all banking

organizations, including those that have been defined to be “small

businesses” under the RFA, only certain limited requirements would be

imposed on entities that engage in little or no covered trading

activities or covered fund activities and investments. Significantly,

the reporting and recordkeeping requirements of Sec. —-.7 and

Appendix A of the proposed rule apply only to banking entities with

average trading assets and liabilities on a consolidated, worldwide

basis equal to or greater than $1 billion for the preceding year. This

is a threshold that a small banking entity typically would not meet.

Second, the scope and size of the compliance program requirements

set forth in subpart D and Appendix C of the proposed rule would vary

based on the size and activities of each covered banking entity. Only

banking entities with average trading assets and liabilities on a

worldwide consolidated basis equal to or greater than $1 billion or 10

percent or more of their total assets, or that have aggregate

investments in, or sponsor or advise, covered funds with aggregate

total assets of more than $1 billion must establish, maintain and

enforce a full compliance program under the proposed rule. Banking

entities that engage in trading activities or covered fund activities

and investments under these thresholds must adopt, at a minimum, only

the six core compliance requirements set forth in Sec. —-.20 of the

proposed rule. Banking entities that do not engage in any covered

trading or fund activities, typical of small banking entities, must

ensure only that their compliance programs include measures designed to

prevent the entities from becoming engaged in covered activities unless

they first adopt a compliance program. These compliance requirements

would not appear to have a significant economic impact on a substantial

number of small entities.

For the reasons stated above, the head of the CFTC certifies, for

the covered banking entities subject to the CFTC’s jurisdiction, that

the proposed rule would not result in a significant economic impact on

a substantial number of small entities. The CFTC encourages written

comments regarding this certification, and request that commenters

describe the nature of any impact on small entities and provide

empirical data, or studies, to illustrate and support the extent of the

impact.

VII. CFTC: Additional Matters

A. Commodity Pool Operators and Commodity Trading Advisors

As discussed above, under the proposed rule, a covered banking

entity as defined in Sec. —-.2(j) would generally be subject to the

substantive requirements contained in the CFTC Rule. These substantive

requirements implement the provisions on proprietary trading and

covered fund activities under section 13 of the BHC Act. Thus for

example, a covered banking entity that is a registered swap dealer

would be required to comply with subparts A through D of the CFTC Rule,

including Appendices A, B and C, where applicable. With respect to

covered fund activities, investments, or relationships set forth in

subpart C and

[[Page 8422]]

Sec. —-.20 of subpart D (“covered fund restrictions”), however,

the CFTC’s proposed rule would require that a covered banking entity

that is a covered banking entity because it is a commodity pool

operator or commodity trading advisor for which the CFTC is the primary

financial regulatory agency under sections 2(12)(C)(ii) and

2(12)(C)(iii) of the Dodd-Frank Act comply with the covered fund

restrictions issued by the appropriate Federal banking agency that

regulates the banking entity specified in Sec. —-.2(e)(1), (2) and

(3) with which the commodity pool operator or commodity trading advisor

is affiliated.372 Under this approach, a commodity pool operator or

commodity trading advisor would be required to comply with the rules

and related guidance issued by the appropriate Federal banking agency.

The CFTC would, however, retain enforcement authority over all

activities of commodity pool operators or commodity trading advisors

(i.e., both proprietary trading and covered fund restrictions).

—————————————————————————

372 A commodity pool operator or commodity trading advisor

would, however, be required to comply with the provisions that

implement the proprietary trading restrictions set forth in subparts

A, B and Sec. —-.20 of subpart D of the proposed rule as

promulgated by the CFTC, including Appendix C, where applicable.

—————————————————————————

The covered fund restrictions of section 13 of the BHC Act and the

proposed implementing rules make reference to or incorporate a number

of banking law and supervision concepts that traditionally appear in

Federal banking law and are interpreted and applied by the Federal

banking agencies. For example, as discussed in greater detail in the

Supplementary Information, the limitations on ownership interests in a

covered fund set forth in the statute and the proposed rule generally

reference the tier 1 capital of the affiliated insured depository

institution or the affiliated holding company. Similarly, capital

deductions under the proposed rule refer to the tier 1 capital of the

affiliated insured depository institution or the affiliated holding

company. In addition, the covered fund restrictions of the statute and

the proposed rule incorporate by reference sections 23A and 23B of the

FR Act and are administered by the Federal banking agencies. These

sections of the FR Act restrict and limit transactions between certain

banking organizations and their affiliates, some of which are based on

a percentage of bank capital. Further, other covered fund restrictions,

including for example exemptions for investments involving the public

welfare and bank-owned life insurance and the extension of time to

divest of investments after the seeding period, reference other banking

laws or regulations that are administered by the Federal banking

agencies.

In light of these considerations, the proposed CFTC Rule would

require a commodity pool operator or commodity trading advisor to

comply with the covered fund restrictions contained in subpart C and

Sec. .—-20 of subpart D of rules implementing section 13 of the BHC

that are issued by the appropriate Federal banking agency that

regulates the banking entity with which the commodity pool operator or

commodity trading advisor is affiliated. Under the proposed approach, a

commodity pool operator or commodity trading advisor complying with the

CFTC Rule would do so by complying with the rule issued by the

appropriate Federal banking agency, including any related

interpretations or guidance regarding such requirements. Similarly,

under the proposed approach, the foregoing determinations regarding

capital or other banking law requirements that may be applicable to a

commodity pool operator or commodity trading advisor would be made by

the appropriate Federal banking agency that regulates the banking

entity with which the commodity pool operator or commodity trading

advisor is affiliated. This approach would mitigate the burdens of

complying with the covered fund restrictions for commodity pool

operators or commodity trading advisors and would avoid creating

incentives for covered fund activities to be moved from a commodity

pool operator or commodity trading advisor to a bank.

The proposed CFTC Rule specifies that a commodity operator or

commodity trading advisor must comply with the covered fund

restrictions contained in subpart C and Sec. —-.20 of subpart D that

are issued by the appropriate Federal banking agency that regulates the

banking entity with which the commodity pool operator or commodity

trading advisor is affiliated. Subpart C, which uses terms defined in

subpart A, specifies the covered fund restrictions. Subpart D Sec. —

–.20 requires the establishment of a compliance program when engaging

in covered fund activities. A commodity pool operator or commodity

trading advisor complying with subpart C and Sec. —-.20 of subpart

D, as issued by the appropriate Federal banking agency, would also rely

on interpretative guidance issued by the appropriate Federal banking

agency with respect to those subparts of the proposed rule. Because

Sec. —-.20 of subpart D relates to both the prohibitions and

restrictions on proprietary trading activity as well as the

prohibitions and restrictions on covered fund activities and

investments, a commodity pool operator or commodity trading advisor

would be required to comply with the relevant covered fund provisions

issued by the appropriate Federal banking agency. A commodity pool

operator or commodity trading advisor, however, would be subject to the

provisions set forth in subpart D of the proposed CFTC Rule, including

Sec. —-.20, that relate to covered trading activities.

Nothing set forth in the discussion above, or in Sec. —

–.10(a)(2) of the proposed CFTC Rule, however, is intended, or shall

be deemed, to limit the CFTC’s authority under any other provision of

law, including pursuant to section 13 of the BHC Act.

The CFTC requests comment on the its proposed approach to

implementing section 13 of the BHC Act as it applies to commodity pool

operators or commodity trading advisors with respect to the covered

fund restrictions. In particular, the CFTC requests comment on the

following:

Question CFTC-5. Should the CFTC instead require commodity pool

operators or commodity pool advisors to comply with the covered fund

restrictions proposed by the CFTC, instead of those issued the

appropriate Federal banking agency? If so, could this create incentives

to move the advisory business between the commodity pool operator or

commodity trading advisor and its affiliated bank? Are there benefits

to this alternate approach? If so, please explain.

Question CFTC-6. Are there other alternative approaches to the

proposed rule that would be more effective? If yes, what alternatives

and why?

Question CFTC-7. Would commodity pool operators or commodity

trading advisors affiliated with insured depository institutions

benefit from the proposed approach? Why or why not?

Question CFTC-8. Would a commodity pool operator or commodity

trading advisor that is affiliated with insured depository institutions

that are regulated by multiple Federal banking agencies encounter

additional burdens in implementing the proposed approach? With respect

to these commodity pool operators or commodity trading advisors, which

Federal banking agency’s rules should be applicable to the commodity

pool operator or commodity trading advisor? For example, should the

commodity pool operator or commodity trading advisor be subject to the

rules applicable to the commodity pool operator or commodity trading

advisor’s

[[Page 8423]]

immediate parent that is an insured depository institution?

Question CFTC-9. Is the proposed requirement that commodity pool

operators or commodity trading advisors comply with the covered fund

restrictions in Sec. —-.20 issued by the Federal banking agency that

regulates the banking entity specified in Sec. —-.2(e)(1), (2) and

(3) of the proposed rule with which the commodity pool operator or

commodity trading advisor is affiliated sufficiently clear? Are there

particular compliance program requirements in Sec. —-.20 with

respect to the covered fund restrictions that overlap with the

proprietary trading restrictions, such that it would be difficult to

identify which requirements are related to the covered fund

restrictions and which requirements are related to the proprietary

trading restrictions? If so, which requirements and how should this

overlap be addressed? Should commodity pool operators or commodity

trading advisors be required to comply with Sec. —-.20 of the CFTC

Rule in its entirety? Why or why not?

Question CFTC-10. Will the CFTC’s proposed approach limit the

potential for inconsistent application of the proposed rules with

respect to affiliates of entities specified in Sec. —-.2(e)(1), (2)

and (3)? Why or why not?

Question CFTC-11. Will the CFTC’s proposed approach be effective in

avoiding the creation of incentives for covered fund activities to move

from a commodity pool operator or commodity trading advisor to a bank?

Why or why not?

Text of the Proposed Common Rules 373 (applicable to the

OCC, Board, FDIC, and SEC under the Joint Release)

—————————————————————————

373 The text of the Proposed Common Rules section of the CFTC

Rule is identical to the text of the Proposed Common Rules adopted

in the Joint Release. See 76 FR 68944-68967.

—————————————————————————

The text of the proposed common rules appears below:

PART [ ]–PROPRIETARY TRADING AND CERTAIN INTERESTS IN AND

RELATIONSHIPS WITH COVERED FUNDS.

Subpart A–Authority and Definitions

Sec.

—-.1 Authority, purpose, scope, and relationship to other

authorities [Reserved].

—-.2 Definitions.

Subpart B–Proprietary Trading

—-.3 Prohibition on proprietary trading.

—-.4 Permitted underwriting and market making-related activities.

—-.5 Permitted risk-mitigating hedging activities.

—-.6 Other permitted proprietary trading activities.

—-.7 Reporting and recordkeeping requirements applicable to

trading activities.

—-.8 Limitations on permitted proprietary trading activities.

—-.9 [Reserved]

Subpart C–Covered Fund Activities and Investments

—-.10 Prohibition on acquiring or retaining an ownership interest

in and having certain relationships with a covered fund.

—-.11 Permitted organizing and offering of a covered fund.

—-.12 Permitted investment in a covered fund.

—-.13 Other permitted covered fund activities and investments.

—-.14 Covered fund activities and investments determined to be

permissible.

—-.15 Internal controls, reporting and recordkeeping requirements

applicable to covered fund activities and investments.

—-.16 Limitations on relationships with a covered fund.

—-.17 Other limitations on permitted covered fund activities and

investments.

—-.18 [Reserved]

—-.19 [Reserved]

Subpart D–Compliance Program Requirement; Violations

—-.20 Program for monitoring compliance; enforcement.

—-.21 Termination of activities or investments; penalties for

violations.

Appendix A to Part [ ]–Reporting and Recordkeeping Requirements for

Covered Trading Activities

Appendix B to Part [ ]–Commentary Regarding Identification of

Permitted Market Making-Related Activities

Appendix C to Part [ ]–Minimum Standards for Programmatic Compliance

Subpart A–Authority and Definitions

Sec. —-.1 Authority, purpose, scope, and relationship to other

authorities. [Reserved]

Sec. —-.2 Definitions.

Unless otherwise specified, for purposes of this part:

(a) Affiliate has the same meaning as in section 2(k) of the BHC

Act (12 U.S.C. 1841(k)).

(b) Applicable accounting standards means U.S. generally accepted

accounting principles or such other accounting standards applicable to

a covered banking entity that the [Agency] determines are appropriate,

that the covered banking entity uses in the ordinary course of its

business in preparing its consolidated financial statements.

(c) BHC Act means the Bank Holding Company Act of 1956 (12 U.S.C.

1841 et seq.).

(d) Bank holding company has the same meaning as in section 2 of

the BHC Act (12 U.S.C. 1841).

(e) Banking entity means:

(1) Any insured depository institution;

(2) Any company that controls an insured depository institution;

(3) Any company that is treated as a bank holding company for

purposes of section 8 of the International Banking Act of 1978 (12

U.S.C. 3106); and

(4) Any affiliate or subsidiary of any entity described in

paragraphs (e)(1), (2), or (3) of this section, other than an affiliate

or subsidiary that is:

(i) A covered fund that is organized, offered and held by a banking

entity pursuant to Sec. —-.11 and in accordance with the provisions

of subpart C of this part, including the provisions governing

relationships between a covered fund and a banking entity; or

(ii) An entity that is controlled by a covered fund described in

paragraph (e)(4)(i) of this section.

(f) Board means the Board of Governors of the Federal Reserve

System.

(g) Buy and purchase each include any contract to buy, purchase, or

otherwise acquire. For security futures products, such terms include

any contract, agreement, or transaction for future delivery. With

respect to a commodity future, such terms include any contract,

agreement, or transaction for future delivery. With respect to a

derivative, such terms include the execution, termination (prior to its

scheduled maturity date), assignment, exchange, or similar transfer or

conveyance of, or extinguishing of rights or obligations under, a

derivative, as the context may require.

(h) CFTC means the Commodity Futures Trading Commission.

(i) Commodity Exchange Act means the Commodity Exchange Act (7

U.S.C. 1 et seq.).

(j) [Reserved]

(k) Depository institution has the same meaning as in section 3(c)

of the Federal Deposit Insurance Act (12 U.S.C. 1813(c)).

(l) (i) Derivative means:

(A) Any swap, as that term is defined in section 1a(47) of the

Commodity Exchange Act (7 U.S.C. 1a(47)), or security-based swap, as

that term is defined in section 3(a)(68) of the Exchange Act (15 U.S.C.

78c(a)(68)), and as those terms are further jointly defined by the CFTC

and SEC by joint regulation, interpretation, guidance, or other action,

in consultation with the

[[Page 8424]]

Board pursuant to section 712(d) of the Dodd-Frank Wall Street Reform

and Consumer Protection Act (15 U.S.C. 8302(d));

(B) Any purchase or sale of a nonfinancial commodity for deferred

shipment or delivery that is intended to be physically settled;

(C) Any foreign exchange forward (as that term is defined in

section 1a(24) of the Commodity Exchange Act (7 U.S.C. 1a(24)) or

foreign exchange swap (as that term is defined in section 1a(25) of the

Commodity Exchange Act (7 U.S.C. 1a(25));

(D) Any agreement, contract, or transaction in foreign currency

described in section 2(c)(2)(C)(i) of the Commodity Exchange Act (7

U.S.C. 2(c)(2)(C)(i));

(E) Any agreement, contract, or transactions in a commodity other

than foreign currency described in section 2(c)(2)(D)(i) of the

Commodity Exchange Act (7 U.S.C. 2(c)(2)(D)(i)); and

(F) Any transaction authorized under section 19 of the Commodity

Exchange Act (7 U.S.C. 23(a) or (b));

(ii) A derivative does not include:

(A) Any consumer, commercial, or other agreement, contract, or

transaction that the CFTC and SEC have further defined by joint

regulation, interpretation, guidance, or other action as not within the

definition of swap, as that term is defined in section 1a(47) of the

Commodity Exchange Act (7 U.S.C. 1a(47)), or security-based swap, as

that term is defined in section 3(a)(68) of the Exchange Act (15 U.S.C.

78c(a)(68));

(B) Any identified banking product, as defined in section 402(b) of

the Legal Certainty for Bank Products Act of 2000 (7 U.S.C. 27(b)),

that is subject to section 403(a) of that Act (7 U.S.C. 27a(a)).

(m) Exchange Act means the Securities Exchange Act of 1934 (15

U.S.C. 78a et seq.).

(n) Federal banking agencies means the Board, the Office of the

Comptroller of the Currency, and the Federal Deposit Insurance

Corporation.

(o) Foreign banking organization has the same meaning as in section

211.21(o) of the Board’s Regulation K (12 CFR 211.21(o)).

(p) Insured depository institution has the same meaning as in

section 3(c) of the Federal Deposit Insurance Act (12 U.S.C. 1813(c)),

but does not include any insured depository institution that is

described in section 2(c)(2)(D) of the BHC Act (12 U.S.C.

1841(c)(2)(D)).

(q) Loan means any loan, lease, extension of credit, or secured or

unsecured receivable.

(r) Nonbank financial company supervised by the Board has the

meaning specified in section 102 of the Financial Stability Act of 2010

(12 U.S.C. 5311).

(s) Qualifying foreign banking organization means a foreign banking

organization that qualifies as such under section 211.23(a) of the

Board’s Regulation K (12 CFR 211.23(a)).

(t) Resident of the United States means:

(1) Any natural person resident in the United States;

(2) Any partnership, corporation or other business entity organized

or incorporated under the laws of the United States or any State;

(3) Any estate of which any executor or administrator is a resident

of the United States;

(4) Any trust of which any trustee, beneficiary or, if the trust is

revocable, any settlor is a resident of the United States;

(5) Any agency or branch of a foreign entity located in the United

States;

(6) Any discretionary or non-discretionary account or similar

account (other than an estate or trust) held by a dealer or fiduciary

for the benefit or account of a resident of the United States;

(7) Any discretionary account or similar account (other than an

estate or trust) held by a dealer or fiduciary organized or

incorporated in the United States, or (if an individual) a resident of

the United States; or

(8) Any person organized or incorporated under the laws of any

foreign jurisdiction formed by or for a resident of the United States

principally for the purpose of engaging in one or more transactions

described in Sec. —-.6(d)(1) or Sec. —-.13(c)(1).

(u) SEC means the Securities and Exchange Commission.

(v) Sale and sell each include any contract to sell or otherwise

dispose of. For security futures products, such terms include any

contract, agreement, or transaction for future delivery. With respect

to a commodity future, such terms include any contract, agreement, or

transaction for future delivery. With respect to a derivative, such

terms include the execution, termination (prior to its scheduled

maturity date), assignment, exchange, or similar transfer or conveyance

of, or extinguishing of rights or obligations under, a derivative, as

the context may require.

(w) Security has the meaning specified in section 3(a)(10) of the

Exchange Act (15 U.S.C. 78c(a)(10)).

(x) Security future has the meaning specified in section 3(a)(55)

of the Exchange Act (15 U.S.C. 78c(a)(55)).

(y) Securities Act means the Securities Act of 1933 (15 U.S.C. 77a

et seq.).

(z) Separate account means an account established and maintained by

an insurance company subject to regulation by a State insurance

regulator or a foreign insurance regulator under which income, gains,

and losses, whether or not realized, from assets allocated to such

account, are, in accordance with the applicable contract, credited to

or charged against such account without regard to other income, gains,

or losses of the insurance company.

(aa) State means any State, territory or possession of the United

States, and the District of Columbia.

(bb) Subsidiary has the same meaning as in section 2(d) of the BHC

Act (12 U.S.C. 1841(d)).

Subpart B–Proprietary Trading

Sec. —-.3 Prohibition on proprietary trading.

(a) Prohibition. Except as otherwise provided in this subpart, a

covered banking entity may not engage in proprietary trading.

(b) Definition of “proprietary trading” and related terms. For

purposes of this subpart:

(1) Proprietary trading means engaging as principal for the trading

account of the covered banking entity in any purchase or sale of one or

more covered financial positions. Proprietary trading does not include

acting solely as agent, broker, or custodian for an unaffiliated third

party.

(2) Trading account.

(i) Trading account means any account that is used by a covered

banking entity to:

(A) Acquire or take one or more covered financial positions

principally for the purpose of:

(1) Short-term resale;

(2) Benefitting from actual or expected short-term price movements;

(3) Realizing short-term arbitrage profits; or

(4) Hedging one or more positions described in paragraphs

(b)(2)(i)(A)(1), (2), or (3) of this section;

(B) Acquire or take one or more covered financial positions, other

than positions that are foreign exchange derivatives, commodity

derivatives, or contracts of sale of a commodity for future delivery,

that are market risk capital rule covered positions, if the covered

banking entity, or any affiliate of the covered banking entity that is

a bank holding company, calculates risk-based capital ratios under the

market risk capital rule; or

(C) Acquire or take one or more covered financial position for any

purpose, if the covered banking entity is:

[[Page 8425]]

(1) A dealer or municipal securities dealer that is registered with

the SEC under the Exchange Act, to the extent the position is acquired

or taken in connection with the activities of the dealer or municipal

securities dealer that require it to be registered under that Act;

(2) A government securities dealer that is registered, or that has

filed notice, with an appropriate regulatory agency (as that term is

defined in section 3(a)(34) of the Exchange Act (15 U.S.C. 78c(a)(34)),

to the extent the position is acquired or taken in connection with the

activities of the government securities dealer that require it to be

registered, or to file notice, under that Act;

(3) A swap dealer that is registered with the CFTC under the

Commodity Exchange Act, to the extent the position is acquired or taken

in connection with the activities of the swap dealer that require it to

be registered under that Act;

(4) A security-based swap dealer that is registered with the SEC

under the Exchange Act, to the extent the position is acquired or taken

in connection with the activities of the security-based swap dealer

that require it to be registered under that Act; or

(5) Engaged in the business of a dealer, swap dealer, or security-

based swap dealer outside of the United States to the extent the

position is acquired or taken in connection with the activities of such

business.

(ii) Rebuttable presumption for certain positions. An account shall

be presumed to be a trading account if it is used to acquire or take a

covered financial position, other than a covered financial position

described in paragraph (b)(2)(i)(B) or (C) of this section, that the

covered banking entity holds for a period of sixty days or less, unless

the covered banking entity can demonstrate, based on all the facts and

circumstances, that the covered financial position, either individually

or as a category, was not acquired or taken principally for any of the

purposes described in paragraph (b)(2)(i)(A) of this section.

(iii) An account shall not be deemed a trading account for purposes

of paragraph (b)(2)(i) of this section to the extent that such account

is used to acquire or take a position in one or more covered financial

positions:

(A) That arise under a repurchase or reverse repurchase agreement

pursuant to which the covered banking entity has simultaneously agreed,

in writing, to both purchase and sell a stated asset, at stated prices,

and on stated dates or on demand with the same counterparty;

(B) That arise under a transaction in which the covered banking

entity lends or borrows a security temporarily to or from another party

pursuant to a written securities lending agreement under which the

lender retains the economic interests of an owner of such security, and

has the right to terminate the transaction and to recall the loaned

security on terms agreed by the parties;

(C) For the bona fide purpose of liquidity management and in

accordance with a documented liquidity management plan of the covered

banking entity that:

(1) Specifically contemplates and authorizes the particular

instrument to be used for liquidity management purposes, its profile

with respect to market, credit and other risks, and the liquidity

circumstances in which the particular instrument may or must be used;

(2) Requires that any transaction contemplated and authorized by

the plan be principally for the purpose of managing the liquidity of

the covered banking entity, and not for the purpose of short-term

resale, benefitting from actual or expected short-term price movements,

realizing short-term arbitrage profits, or hedging a position taken for

such short-term purposes;

(3) Requires that any position taken for liquidity management

purposes be highly liquid and limited to financial instruments the

market, credit and other risks of which the covered banking entity does

not expect to give rise to appreciable profits or losses as a result of

short-term price movements;

(4) Limits any position taken for liquidity management purposes,

together with any other positions taken for such purposes, to an amount

that is consistent with the banking entity’s near-term funding needs,

including deviations from normal operations, as estimated and

documented pursuant to methods specified in the plan; and

(5) Is consistent with [Agency]’s supervisory requirements,

guidance and expectations regarding liquidity management; or

(D) That are acquired or taken by a covered banking entity that is

a derivatives clearing organization registered under section 5b of the

Commodity Exchange Act (7 U.S.C. 7a-1) or a clearing agency registered

with the SEC under section 17A of the Exchange Act (15 U.S.C. 78q-1) in

connection with clearing derivatives or securities transactions.

(3) Covered financial position.

(i) Covered financial position means any position, including any

long, short, synthetic or other position, in:

(A) A security, including an option on a security;

(B) A derivative, including an option on a derivative; or

(C) A contract of sale of a commodity for future delivery, or

option on a contract of sale of a commodity for future delivery.

(ii) A covered financial position does not include any position

that is:

(A) A loan;

(B) A commodity; or

(C) Foreign exchange or currency.

(c) Definition of other terms related to proprietary trading. For

purposes of this subpart:

(1) Commodity has the same meaning as in section 1a(9) of the

Commodity Exchange Act (7 U.S.C. 1a(9)), except that a commodity does

not include any security;

(2) Contract of sale of a commodity for future delivery means a

contract of sale (as that term is defined in section 1a(13) of the

Commodity Exchange Act (7 U.S.C. 1a(13)) for future delivery (as that

term is defined in section 1a(27) of the Commodity Exchange Act (7

U.S.C. 1a(27)).

(3) Exempted security has the same meaning as in section

3(a)(12)(A) of the Exchange Act (15 U.S.C. 78c(a)(12)(A)).

(4) Foreign insurance regulator means the insurance commission, or

a similar official or agency, of one or more countries other than the

United States that is engaged in the supervision of insurance companies

under foreign insurance law.

(5) General account means, with respect to an insurance company,

all of the assets of the insurance company that are not legally

segregated and allocated to separate accounts under applicable State or

foreign law.

(6) Government securities has the same meaning as in section

3(a)(42) of the Exchange Act (15 U.S.C. 78c(a)(42)).

(7) Market risk capital rule covered position means a covered

position as that term is defined for purposes of:

(i) In the case of a covered banking entity that is a bank holding

company or insured depository institution, the market risk capital rule

that is applicable to the covered banking entity; and

(ii) In the case of a covered banking entity that is affiliated

with a bank holding company, other than a covered banking entity to

which a market risk capital rule is applicable, the market risk capital

rule that is applicable to the affiliated bank holding company.

(8) Market risk capital rule means 12 CFR 3, Appendix B, 12 CFR

208, Appendix E, 12 CFR 225, Appendix E, and 12 CFR 325, Appendix C, as

applicable.

[[Page 8426]]

(9) Municipal securities has the same meaning as in section

3(a)(29) of the Exchange Act (15 U.S.C. 78c(a)(29)).

(10) Security-based swap has the meaning specified in section

3(a)(68) of the Exchange Act (15 U.S.C. 78c(a)(68)).

(11) Swap has the meaning specified in section 1a(47) of the

Commodity Exchange Act (7 U.S.C. 1a(47)).

(12) State insurance regulator means the insurance commission, or a

similar official or agency, of a State that is engaged in the

supervision of insurance companies under State insurance law.

Sec. —-.4 Permitted underwriting and market making-related

activities.

(a) Underwriting activities.

(1) Permitted underwriting activities. The prohibition on

proprietary trading contained in Sec. —-.3(a) does not apply to the

purchase or sale of a covered financial position by a covered banking

entity that is made in connection with the covered banking entity’s

underwriting activities.

(2) Requirements. For purposes of paragraph (a)(1) of this section,

a purchase or sale of a covered financial position shall be deemed to

be made in connection with a covered banking entity’s underwriting

activities only if:

(i) The covered banking entity has established the internal

compliance program required by subpart D of this part that is designed

to ensure the covered banking entity’s compliance with the requirements

of paragraph (a)(2) of this section, including reasonably designed

written policies and procedures, internal controls, and independent

testing;

(ii) The covered financial position is a security;

(iii) The purchase or sale is effected solely in connection with a

distribution of securities for which the covered banking entity is

acting as underwriter;

(iv) The covered banking entity is:

(A) With respect to a purchase or sale effected in connection with

a distribution of one or more covered financial positions that are

securities, other than exempted securities, security-based swaps,

commercial paper, bankers’ acceptances, or commercial bills:

(1) A dealer that is registered with the SEC under section 15 of

the Exchange Act (15 U.S.C. 78o), or a person that is exempt from

registration or excluded from regulation as a dealer thereunder; or

(2) Engaged in the business of a dealer outside of the United

States and subject to substantive regulation of such business in the

jurisdiction where the business is located;

(B) With respect to a purchase or sale effected as part of a

distribution of one or more covered financial positions that are

municipal securities, a municipal securities dealer that is registered

under section 15B of the Exchange Act (15 U.S.C. 78o-4) or exempt from

registration thereunder; or

(C) With respect to a purchase or sale effected as part of a

distribution of one or more covered financial positions that are

government securities, a government securities dealer that is

registered, or that has filed notice, under section 15C of the Exchange

Act (15 U.S.C. 78o-5) or exempt from registration thereunder;

(v) The underwriting activities of the covered banking entity with

respect to the covered financial position are designed not to exceed

the reasonably expected near term demands of clients, customers, or

counterparties;

(vi) The underwriting activities of the covered banking entity are

designed to generate revenues primarily from fees, commissions,

underwriting spreads or other income not attributable to:

(A) Appreciation in the value of covered financial positions

related to such activities; or

(B) The hedging of covered financial positions related to such

activities; and

(vii) The compensation arrangements of persons performing

underwriting activities are designed not to reward proprietary risk-

taking.

(3) Definition of distribution. For purposes of paragraph (a) of

this section, a distribution of securities means an offering of

securities, whether or not subject to registration under the Securities

Act, that is distinguished from ordinary trading transactions by the

magnitude of the offering and the presence of special selling efforts

and selling methods.

(4) Definition of underwriter. For purposes of paragraph (a) of

this section, underwriter means:

(i) A person who has agreed with an issuer of securities or selling

security holder:

(A) To purchase securities for distribution;

(B) To engage in a distribution of securities for or on behalf of

such issuer or selling security holder; or

(C) To manage a distribution of securities for or on behalf of such

issuer or selling security holder; and

(ii) A person who has an agreement with another person described in

paragraph (a)(4)(i) of this section to engage in a distribution of such

securities for or on behalf of the issuer or selling security holder.

(b) Market making-related activities.

(1) Permitted market making-related activities. The prohibition on

proprietary trading contained in Sec. —-.3(a) does not apply to the

purchase or sale of a covered financial position by a covered banking

entity that is made in connection with the covered banking entity’s

market making-related activities.

(2) Requirements. For purposes of paragraph (b)(1) of this section,

a purchase or sale of a covered financial position shall be deemed to

be made in connection with a covered banking entity’s market making-

related activities only if:

(i) The covered banking entity has established the internal

compliance program required by subpart D that is designed to ensure the

covered banking entity’s compliance with the requirements of paragraph

(b)(2) of this section, including reasonably designed written policies

and procedures, internal controls, and independent testing;

(ii) The trading desk or other organizational unit that conducts

the purchase or sale holds itself out as being willing to buy and sell,

including through entering into long and short positions in, the

covered financial position for its own account on a regular or

continuous basis;

(iii) The market making-related activities of the trading desk or

other organizational unit that conducts the purchase or sale are, with

respect to the covered financial position, designed not to exceed the

reasonably expected near term demands of clients, customers, or

counterparties;

(iv) The covered banking entity is:

(A) With respect to a purchase or sale of one or more covered

financial positions that are securities, other than exempted

securities, security-based swaps, commercial paper, bankers’

acceptances, or commercial bills:

(1) A dealer that is registered with the SEC under section 15 of

the Exchange Act (15 U.S.C. 78o), or a person that is exempt from

registration or excluded from regulation as a dealer thereunder; or

(2) Engaged in the business of a dealer outside of the United

States and subject to substantive regulation of such business in the

jurisdiction where the business is located;

(B) With respect to a purchase or sale of one or more covered

financial positions that are swaps:

(1) A swap dealer that is registered with the CFTC under the

Commodity Exchange Act (7 U.S.C. 1a) or a person that is exempt from

registration thereunder; or

(2) Engaged in the business of a swap dealer outside the United

States and subject to substantive regulation of such business in the

jurisdiction where the business is located;

[[Page 8427]]

(C) With respect to a purchase or sale of one or more covered

financial positions that are security-based swaps:

(1) A security-based swap dealer that is registered with the SEC

under section 15F of the Exchange Act (15 U.S.C. 78o-10) or a person

that is exempt from registration thereunder; or

(2) Engaged in the business of a security-based swap dealer outside

of the United States and subject to substantive regulation of such

business in the jurisdiction where the business is located;

(D) With respect to a purchase or sale of one or more covered

financial positions that are municipal securities, a municipal

securities dealer that is registered under section 15B of the Exchange

Act (15 U.S.C. 78o-4) or a person that is exempt from registration

thereunder; or

(E) With respect to a purchase or sale of one or more covered

financial positions that are government securities, a government

securities dealer that is registered, or that has filed notice, under

section 15C of the Exchange Act (15 U.S.C. 78o-5) or a person that is

exempt from registration thereunder;

(v) The market making-related activities of the trading desk or

other organizational unit that conducts the purchase or sale are

designed to generate revenues primarily from fees, commissions, bid/ask

spreads or other income not attributable to:

(A) Appreciation in the value of covered financial positions it

holds in trading accounts; or

(B) The hedging of covered financial positions it holds in trading

accounts;

(vi) The market making-related activities of the trading desk or

other organizational unit that conducts the purchase or sale are

consistent with the commentary provided in appendix B to this part; and

(vii) The compensation arrangements of persons performing the

market making-related activities are designed not to reward proprietary

risk-taking.

(3) Market making-related hedging. For purposes of paragraph (b)(1)

of this section, a purchase or sale of a covered financial position

shall also be deemed to be made in connection with a covered banking

entity’s market making-related activities if:

(i) The covered financial position is purchased or sold to reduce

the specific risks to the covered banking entity in connection with and

related to individual or aggregated positions, contracts, or other

holdings acquired pursuant to paragraph (b) of this section; and

(ii) The purchase or sale meets all of the requirements described

in Sec. —-.5(b) and, if applicable, Sec. —-.5(c).

Sec. —-.5 Permitted risk-mitigating hedging activities.

(a) Permitted risk-mitigating hedging activities. The prohibition

on proprietary trading contained in Sec. —-.3(a) does not apply to

the purchase or sale of a covered financial position by a covered

banking entity that is made in connection with and related to

individual or aggregated positions, contracts, or other holdings of a

covered banking entity and is designed to reduce the specific risks to

the covered banking entity in connection with and related to such

positions, contracts, or other holdings.

(b) Requirements. For purposes of paragraph (a) of this section, a

purchase or sale of a covered financial position shall be deemed to be

in connection with and related to individual or aggregated positions,

contracts, or other holdings of a covered banking entity and designed

to reduce the specific risks to the covered banking entity in

connection with and related to such positions, contracts, or other

holdings only if:

(1) The covered banking entity has established the internal

compliance program required by subpart D of this part designed to

ensure the covered banking entity’s compliance with the requirements of

paragraph (b) of this section, including reasonably designed written

policies and procedures regarding the instruments, techniques and

strategies that may be used for hedging, internal controls and

monitoring procedures, and independent testing;

(2) The purchase or sale:

(i) Is made in accordance with the written policies, procedures and

internal controls established by the covered banking entity pursuant to

subpart D of this part;

(ii) Hedges or otherwise mitigates one or more specific risks,

including market risk, counterparty or other credit risk, currency or

foreign exchange risk, interest rate risk, basis risk, or similar

risks, arising in connection with and related to individual or

aggregated positions, contracts, or other holdings of a covered banking

entity;

(iii) Is reasonably correlated, based upon the facts and

circumstances of the underlying and hedging positions and the risks and

liquidity of those positions, to the risk or risks the purchase or sale

is intended to hedge or otherwise mitigate;

(iv) Does not give rise, at the inception of the hedge, to

significant exposures that were not already present in the individual

or aggregated positions, contracts, or other holdings of a covered

banking entity and that are not hedged contemporaneously;

(v) Is subject to continuing review, monitoring and management by

the covered banking entity that:

(A) Is consistent with the written hedging policies and procedures

required under paragraph (b)(1) of this section; and

(B) Maintains a reasonable level of correlation, based upon the

facts and circumstances of the underlying and hedging positions and the

risks and liquidity of those positions, to the risk or risks the

purchase or sale is intended to hedge or otherwise mitigate; and

(C) Mitigates any significant exposure arising out of the hedge

after inception; and

(vi) The compensation arrangements of persons performing the risk-

mitigating hedging activities are designed not to reward proprietary

risk-taking.

(c) Documentation. With respect to any purchase, sale, or series of

purchases or sales conducted by a covered banking entity pursuant to

this Sec. —-.5 for risk-mitigating hedging purposes that is

established at a level of organization that is different than the level

of organization establishing or responsible for the positions,

contracts, or other holdings the risks of which the purchase, sale, or

series of purchases or sales are designed to reduce, the covered

banking entity must, at a minimum, document, at the time the purchase,

sale, or series of purchases or sales are conducted:

(1) The risk-mitigating purpose of the purchase, sale, or series of

purchases or sales;

(2) The risks of the individual or aggregated positions, contracts,

or other holdings of a covered banking entity that the purchase, sale,

or series of purchases or sales are designed to reduce; and

(3) The level of organization that is establishing the hedge.

Sec. —-.6 Other permitted proprietary trading activities.

(a) Permitted trading in government obligations.

(1) The prohibition on proprietary trading contained in Sec. —

–.3(a) does not apply to the purchase or sale by a covered banking

entity of a covered financial position that is:

(i) An obligation of the United States or any agency thereof;

(ii) An obligation, participation, or other instrument of or issued

by the Government National Mortgage

[[Page 8428]]

Association, the Federal National Mortgage Association, the Federal

Home Loan Mortgage Corporation, a Federal Home Loan Bank, the Federal

Agricultural Mortgage Corporation or a Farm Credit System institution

chartered under and subject to the provisions of the Farm Credit Act of

1971 (12 U.S.C. 2001 et seq.); or

(iii) An obligation of any State or any political subdivision

thereof.

(2) An obligation or other instrument described in paragraphs

(a)(1)(i), (ii) or (iii) of this section shall include both general

obligations and limited obligations, such as revenue bonds.

(b) Permitted trading on behalf of customers. (1) The prohibition

on proprietary trading contained in Sec. —-.3(a) does not apply to

the purchase or sale of a covered financial position by a covered

banking entity on behalf of customers.

(2) For purposes of paragraph (b)(1) of this section, a purchase or

sale of a covered financial position by a covered banking entity shall

be considered to be on behalf of customers if:

(i) The purchase or sale:

(A) Is conducted by a covered banking entity acting as investment

adviser, commodity trading advisor, trustee, or in a similar fiduciary

capacity for a customer;

(B) Is conducted for the account of the customer; and

(C) Involves solely covered financial positions of which the

customer, and not the covered banking entity or any subsidiary or

affiliate of the covered banking entity, is beneficial owner (including

as a result of having long or short exposure under the relevant covered

financial position);

(ii) The covered banking entity is acting as riskless principal in

a transaction in which the covered banking entity, after receiving an

order to purchase (or sell) a covered financial position from a

customer, purchases (or sells) the covered financial position for its

own account to offset a contemporaneous sale to (or purchase from) the

customer; or

(iii) The covered banking entity is an insurance company that

purchases or sells a covered financial position for a separate account,

if:

(A) The insurance company is directly engaged in the business of

insurance and subject to regulation by a State insurance regulator or

foreign insurance regulator;

(B) The insurance company purchases or sells the covered financial

position solely for a separate account established by the insurance

company in connection with one or more insurance policies issued by

that insurance company;

(C) All profits and losses arising from the purchase or sale of a

covered financial position are allocated to the separate account and

inure to the benefit or detriment of the owners of the insurance

policies supported by the separate account, and not the insurance

company; and

(D) The purchase or sale is conducted in compliance with, and

subject to, the insurance company investment and other laws,

regulations, and written guidance of the State or jurisdiction in which

such insurance company is domiciled.

(c) Permitted trading by a regulated insurance company. The

prohibition on proprietary trading contained in Sec. —-.3(a) does

not apply to the purchase or sale of a covered financial position by an

insurance company or any affiliate of an insurance company if:

(1) The insurance company is directly engaged in the business of

insurance and subject to regulation by a State insurance regulator or

foreign insurance regulator;

(2) The insurance company or its affiliate purchases or sells the

covered financial position solely for the general account of the

insurance company;

(3) The purchase or sale is conducted in compliance with, and

subject to, the insurance company investment laws, regulations, and

written guidance of the State or jurisdiction in which such insurance

company is domiciled; and

(4) The appropriate Federal banking agencies, after consultation

with the Financial Stability Oversight Council and the relevant

insurance commissioners of the States, have not jointly determined,

after notice and comment, that a particular law, regulation, or written

guidance described in paragraph (c)(3) of this section is insufficient

to protect the safety and soundness of the covered banking entity, or

of the financial stability of the United States.

(d) Permitted trading outside of the United States.

(1) The prohibition on proprietary trading contained in Sec. —

–.3(a) does not apply to the purchase or sale of a covered financial

position by a covered banking entity if:

(i) The covered banking entity is not directly or indirectly

controlled by a banking entity that is organized under the laws of the

United States or of one or more States;

(ii) The purchase or sale is conducted pursuant to paragraph (9) or

(13) of section 4(c) of the BHC Act; and

(iii) The purchase or sale occurs solely outside of the United

States.

(2) A purchase or sale shall be deemed to be conducted pursuant to

paragraph (9) or (13) of section 4(c) of the BHC Act only if:

(i) With respect to a covered banking entity that is a foreign

banking organization, the banking entity is a qualifying foreign

banking organization and is conducting the purchase or sale in

compliance with subpart B of the Board’s Regulation K (12 CFR 211.20

through 211.30); or

(ii) With respect to a covered banking entity that is not a foreign

banking organization, the covered banking entity meets at least two of

the following requirements:

(A) Total assets of the covered banking entity held outside of the

United States exceed total assets of the covered banking entity held in

the United States;

(B) Total revenues derived from the business of the covered banking

entity outside of the United States exceed total revenues derived from

the business of the covered banking entity in the United States; or

(C) Total net income derived from the business of the covered

banking entity outside of the United States exceeds total net income

derived from the business of the covered banking entity in the United

States.

(3) A purchase or sale shall be deemed to have occurred solely

outside of the United States only if:

(i) The covered banking entity conducting the purchase or sale is

not organized under the laws of the United States or of one or more

States;

(ii) No party to the purchase or sale is a resident of the United

States;

(iii) No personnel of the covered banking entity who is directly

involved in the purchase or sale is physically located in the United

States; and

(iv) The purchase or sale is executed wholly outside of the United

States.

Sec. —-.7 Reporting and recordkeeping requirements applicable to

trading activities.

A covered banking entity engaged in any proprietary trading

activity permitted under Sec. Sec. —-.4 through —-.6 shall comply

with:

(a) The reporting and recordkeeping requirements described in

appendix A to this part, if the covered banking entity has, together

with its affiliates and subsidiaries, trading assets and liabilities

the average gross sum of which (on a worldwide consolidated basis) is,

as measured as of the last day of each of the four prior calendar

quarters, equal to or greater than $1 billion;

[[Page 8429]]

(b) The recordkeeping requirements required under Sec. —-.20 and

appendix C to this part, as applicable; and

(c) Such other reporting and recordkeeping requirements as [Agency]

may impose to evaluate the covered banking entity’s compliance with

this subpart.

Sec. —-.8 Limitations on permitted proprietary trading activities.

(a) No transaction, class of transactions, or activity may be

deemed permissible under Sec. Sec. —-.4 through —-.6 if the

transaction, class of transactions, or activity would:

(1) Involve or result in a material conflict of interest between

the covered banking entity and its clients, customers, or

counterparties;

(2) Result, directly or indirectly, in a material exposure by the

covered banking entity to a high-risk asset or a high-risk trading

strategy; or

(3) Pose a threat to the safety and soundness of the covered

banking entity or to the financial stability of the United States.

(b) Definition of material conflict of interest. For purposes of

this section, a material conflict of interest between a covered banking

entity and its clients, customers, or counterparties exists if the

covered banking entity engages in any transaction, class of

transactions, or activity that would involve or result in the covered

banking entity’s interests being materially adverse to the interests of

its client, customer, or counterparty with respect to such transaction,

class of transactions, or activity, unless:

(1) Timely and effective disclosure and opportunity to negate or

substantially mitigate. Prior to effecting the specific transaction or

class or type of transactions, or engaging in the specific activity,

for which a conflict of interest may arise, the covered banking entity:

(i) Makes clear, timely, and effective disclosure of the conflict

of interest, together with other necessary information, in reasonable

detail and in a manner sufficient to permit a reasonable client,

customer, or counterparty to meaningfully understand the conflict of

interest; and

(ii) Makes such disclosure explicitly and effectively, and in a

manner that provides the client, customer, or counterparty the

opportunity to negate, or substantially mitigate, any materially

adverse effect on the client, customer, or counterparty created by the

conflict of interest; or

(2) Information barriers. The covered banking entity has

established, maintained, and enforced information barriers that are

memorialized in written policies and procedures, such as physical

separation of personnel, or functions, or limitations on types of

activity, that are reasonably designed, taking into consideration the

nature of the covered banking entity’s business, to prevent the

conflict of interest from involving or resulting in a materially

adverse effect on a client, customer, or counterparty. A covered

banking entity may not rely on such information barriers if, in the

case of any specific transaction, class or type of transactions or

activity, the banking entity knows or should reasonably know that,

notwithstanding the covered banking entity’s establishment of

information barriers, the conflict of interest may involve or result in

a materially adverse effect on a client, customer, or counterparty.

(c) Definition of high-risk asset and high-risk trading strategy.

For purposes of this section:

(1) High-risk asset means an asset or group of related assets that

would, if held by a covered banking entity, significantly increase the

likelihood that the covered banking entity would incur a substantial

financial loss or would fail.

(2) High-risk trading strategy means a trading strategy that would,

if engaged in by a covered banking entity, significantly increase the

likelihood that the covered banking entity would incur a substantial

financial loss or would fail.

Subpart C–Covered Funds Activities and Investments

Sec. —-.10 Prohibition on acquiring or retaining an ownership

interest in and having certain relationships with a covered fund.

(a) Prohibition. Except as otherwise provided in this subpart, a

covered banking entity may not, as principal, directly or indirectly,

acquire or retain any ownership interest in or sponsor a covered fund.

(b) Definitions. For purposes of this part:

(1) Covered fund means:

(i) 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 (15 U.S.C. 80a-3(c)(1) or (7));

(ii) A commodity pool, as defined in section 1a(10) of the

Commodity Exchange Act (7 U.S.C. 1a(10));

(iii) Any issuer, as defined in section 2(a)(22) of the Investment

Company Act of 1940 (15 U.S.C. 80a-2(a)(22)), that is organized or

offered outside of the United States that would be a covered fund as

defined in paragraphs (b)(1)(i), (ii), or (iv) of this section, were it

organized or offered under the laws, or offered to one or more

residents, of the United States or of one or more States; and

(iv) Any such similar fund as the appropriate Federal banking

agencies, the SEC, and the CFTC may determine, by rule, as provided in

section 13(b)(2) of the BHC Act.

(2) Director has the same meaning as provided in Sec. 215.2(d)(1)

of the Board’s Regulation O (12 CFR 215.2(d)(1)).

(3) Ownership interest.

(i) Ownership interest means any equity, partnership, or other

similar interest (including, without limitation, a share, equity

security, warrant, option, general partnership interest, limited

partnership interest, membership interest, trust certificate, or other

similar instrument) in a covered fund, whether voting or nonvoting, or

any derivative of such interest.

(ii) Ownership interest does not include, with respect to a covered

fund:

(A) Carried interest. An interest held by a covered banking entity

(or an affiliate, subsidiary or employee thereof) in a covered fund for

which the covered banking entity (or an affiliate, subsidiary or

employee thereof) serves as investment manager, investment adviser or

commodity trading adviser, so long as:

(1) The sole purpose and effect of the interest is to allow the

covered banking entity (or the affiliate, subsidiary or employee

thereof) to share in the profits of the covered fund as performance

compensation for services provided to the covered fund by the covered

banking entity (or the affiliate, subsidiary or employee thereof),

provided that the covered banking entity (or the affiliate, subsidiary

or employee thereof) may be obligated under the terms of such interest

to return profits previously received;

(2) All such profit, once allocated, is distributed to the covered

banking entity (or the affiliate, subsidiary or employee thereof)

promptly after being earned or, if not so distributed, the reinvested

profit of the covered banking entity (or the affiliate, subsidiary or

employee thereof) does not share in the subsequent profits and losses

of the covered fund;

(3) The covered banking entity (or the affiliate, subsidiary or

employee thereof) does not provide funds to the covered fund in

connection with acquiring or retaining this interest; and

(4) The interest is not transferable by the covered banking entity

(or the affiliate, subsidiary or employee thereof) except to another

affiliate or subsidiary thereof.

[[Page 8430]]

(4) Prime brokerage transaction means one or more products or

services provided by a covered banking entity to a covered fund, such

as custody, clearance, securities borrowing or lending services, trade

execution, or financing, data, operational, and portfolio management

support.

(5) Sponsor, with respect to a covered fund, means:

(i) To serve as a general partner, managing member, trustee, or

commodity pool operator of a covered fund;

(ii) In any manner to select or to control (or to have employees,

officers, or directors, or agents who constitute) a majority of the

directors, trustees, or management of a covered fund; or

(iii) To share with a covered fund, for corporate, marketing,

promotional, or other purposes, the same name or a variation of the

same name.

(6) Trustee. (i) For purposes of this subpart, a trustee does not

include a trustee that does not exercise investment discretion with

respect to a covered fund, including a directed trustee, as that term

is used in section 403(a)(1) of the Employee’s Retirement Income

Security Act (29 U.S.C. 1103(a)(1)).

(ii) Any covered banking entity that directs a person identified in

paragraph (b)(6)(i) of this section, or that possesses authority and

discretion to manage and control the assets of a covered fund for which

such person identified in paragraph (b)(6)(i) of this section serves as

trustee, shall be considered a trustee of such covered fund.

Sec. —-.11 Permitted organizing and offering of a covered fund.

Section —-.10(a) does not prohibit a covered banking entity from,

directly or indirectly, organizing and offering a covered fund,

including serving as a general partner, managing member, trustee, or

commodity pool operator of the covered fund and in any manner selecting

or controlling (or having employees, officers, directors, or agents who

constitute) a majority of the directors, trustees, or management of the

covered fund, including any necessary expenses for the foregoing, only

if:

(a) The covered banking entity provides bona fide trust, fiduciary,

investment advisory, or commodity trading advisory services;

(b) The covered fund is organized and offered only in connection

with the provision of bona fide trust, fiduciary, investment advisory,

or commodity trading advisory services and only to persons that are

customers of such services of the covered banking entity, pursuant to a

credible plan or similar documentation outlining how the covered

banking entity intends to provide advisory or similar services to its

customers through organizing and offering such fund;

(c) The covered banking entity does not acquire or retain an

ownership interest in the covered fund except as permitted under this

subpart;

(d) The covered banking entity complies with the restrictions under

Sec. —-.16 of this subpart;

(e) The covered banking entity does not, directly or indirectly,

guarantee, assume, or otherwise insure the obligations or performance

of the covered fund or of any covered fund in which such covered fund

invests;

(f) The covered fund, for corporate, marketing, promotional, or

other purposes:

(1) Does not share the same name or a variation of the same name

with the covered banking entity (or an affiliate or subsidiary

thereof); and

(2) Does not use the word “bank” in its name;

(g) No director or employee of the covered banking entity takes or

retains an ownership interest in the covered fund, except for any

director or employee of the covered banking entity who is directly

engaged in providing investment advisory or other services to the

covered fund; and

(h) The covered banking entity:

(1) Clearly and conspicuously discloses, in writing, to any

prospective and actual investor in the covered fund (such as through

disclosure in the covered fund’s offering documents):

(i) That “any losses in [such covered fund] will be borne solely

by investors in [the covered fund] and not by [the covered banking

entity and its affiliates or subsidiaries]; therefore, [the covered

banking entity’s and its affiliates’ or subsidiaries’] losses in [such

covered fund] will be limited to losses attributable to the ownership

interests in the covered fund held by the [covered banking entity and

its affiliates or subsidiaries] in their capacity as investors in the

[covered fund]”;

(ii) That such investor should read the fund offering documents

before investing in the covered fund;

(iii) That the “ownership interests in the covered fund are not

insured by the FDIC, and are not deposits, obligations of, or endorsed

or guaranteed in any way, by any banking entity” (unless that happens

to be the case);

(iv) The role of the covered banking entity and its affiliates,

subsidiaries and employees in sponsoring or providing any services to

the covered fund; and

(2) Complies with any additional rules of the appropriate Federal

banking agencies, the SEC, or the CFTC, as provided in section 13(b)(2)

of the BHC Act, designed to ensure that losses in such covered fund are

borne solely by investors in the covered fund and not by the covered

banking entity and its affiliates or subsidiaries.

Sec. —-.12 Permitted investment in a covered fund.

(a) Authority and limitations on permitted investments in covered

funds. (1) The prohibition contained in Sec. —-.10(a) does not apply

with respect to a covered banking entity acquiring and retaining any

ownership interest in a covered fund that the covered banking entity or

an affiliate or subsidiary thereof organizes and offers, for the

purposes of:

(i) Establishment. Establishing the covered fund and providing the

fund with sufficient initial equity for investment to permit the fund

to attract unaffiliated investors as required by paragraph (a)(2)(i) of

this section; or

(ii) De minimis investment. Making and retaining an investment in

the covered fund that does not exceed 3 percent of the total

outstanding ownership interests in the fund.

(2) Ownership limits.

(i) With respect to an investment in any covered fund pursuant to

paragraph (a)(1)(i) of this section, the covered banking entity:

(A) Must actively seek unaffiliated investors to reduce through

redemption, sale, dilution, or other methods the aggregate amount of

all ownership interests of the covered banking entity in any covered

fund under Sec. —-.12 to the amount permitted in paragraph

(a)(2)(i)(B) of this section; and

(B) May not exceed 3 percent of the total amount or value of

outstanding ownership interests of the fund not later than 1 year after

the date of establishment of the fund (or such longer period as may be

provided by the Board pursuant to paragraph (e) of this section); and

(ii) The aggregate value of all ownership interests of the covered

banking entity in all covered funds under Sec. —-.12 may not exceed

3 percent of the tier 1 capital of the covered banking entity, as

provided under paragraph (c) of this section.

(b) Limitations on investments in a single covered fund. For

purposes of determining whether a covered banking entity is in

compliance with the limitations and restrictions on permitted

investments in covered funds contained in paragraph (a) of this

section, a covered banking entity shall calculate its amount and value

of a permitted

[[Page 8431]]

investment in a single covered fund as follows:

(1) Attribution of ownership interests to a covered banking entity.

The amount and value of a banking entity’s permitted investment in any

single covered fund shall include:

(i) Controlled investments. Any ownership interest held under Sec.

—-.12 by any entity that is controlled, directly or indirectly, by

the covered banking entity for purposes of this part; and

(ii) Noncontrolled investments. The pro rata share of any ownership

interest held under Sec. —-.12 by any covered fund that is not

controlled by the covered banking entity but in which the covered

banking entity owns, controls, or holds with the power to vote more

than 5 percent of the voting shares.

(2) Calculation of amount of ownership interests in a single

covered fund. For purposes of determining whether an investment in a

single covered fund does not exceed 3 percent of the total outstanding

ownership interests of the fund under paragraph (a)(2)(i)(B) of this

section:

(i) The aggregate amount of all ownership interests of the covered

banking entity shall be the greater of (without regard to committed

funds not yet called for investment):

(A) The value of any investment or capital contribution made with

respect to all ownership interests held under Sec. —-.12 by the

covered banking entity in the covered fund, divided by the value of all

investments or capital contributions, respectively, made by all persons

in that covered fund; or

(B) The total number of ownership interests held under Sec. —

–.12 by the covered banking entity in a covered fund divided by the

total number of ownership interests held by all persons in that covered

fund.

(ii) Inclusion of certain parallel investments. To the extent that

a covered banking entity is contractually obligated to directly invest

in, or is found to be acting in concert through knowing participation

in a joint activity or parallel action toward a common goal of

investing in, one or more investments with a covered fund that is

organized and offered by the covered banking entity, whether or not

pursuant to an express agreement, such investments shall be included in

any calculation required under paragraph (a)(2) of this section.

(3) Timing of single covered fund investment calculation. The

aggregate amount of all ownership interests of a covered banking entity

in a single covered fund may at no time exceed the limits in this

paragraph after the conclusion of the period provided in paragraph

(a)(2)(i)(B) of this section.

(4) Methodology and standards for calculation. For purposes of

determining the amount or value of its investment in a covered fund

under this paragraph (b), a covered banking entity must calculate its

investment in the same manner and according to the same standards

utilized by the covered fund for determining the aggregate value of the

fund’s assets and ownership interests.

(c) Aggregate permitted investments in all covered funds. (1) For

purposes of determining the aggregate value of all permitted

investments in all covered funds by a covered banking entity under

paragraph (a)(2)(ii) of this section, the aggregate value of all

ownership interests held by that covered banking entity shall be the

sum of the value of each investment in a covered fund held under Sec.

—-.12, as determined in accordance with applicable accounting

standards.

(2) Calculation of tier 1 capital. For purposes of determining

compliance with paragraph (a)(2)(ii) of this section:

(i) Entities that are required to hold and report tier 1 capital.

If a covered banking entity is required to calculate and report tier 1

capital, the covered banking entity’s tier 1 capital shall be equal to

the amount of tier 1 capital calculated by that covered banking entity

as of the last day of the most recent calendar quarter that has ended,

as reported to its primary financial regulatory agency, as defined in

section 2(12) of the Dodd-Frank Wall Street Reform and Consumer

Protection Act; and

(ii) If a covered banking entity is not required to calculate and

report tier 1 capital, the covered banking entity’s tier 1 capital

shall be determined to be equal to:

(A) In the case of a covered banking entity that is controlled,

directly or indirectly, by a depository institution that calculates and

reports tier 1 capital, the amount of tier 1 capital reported by such

controlling depository institution pursuant to paragraph (c)(2)(i) of

this section;

(B) In the case of a covered banking entity that is not controlled,

directly or indirectly, by a depository institution that calculates and

reports tier 1 capital:

(1) Bank holding company subsidiaries. If the covered banking

entity is a subsidiary of a bank holding company or company that is

treated as a bank holding company, the amount of tier 1 capital

reported by the top-tier affiliate of such covered banking entity that

calculates and reports tier 1 capital, pursuant to paragraph (c)(2)(i)

of this section; and

(2) Other holding companies and any subsidiary or affiliate

thereof. If the covered banking entity is not a subsidiary of a bank

holding company or a company that is treated as a bank holding company,

the total amount of shareholders’ equity of the top-tier affiliate

within such organization as of the last day of the most recent calendar

quarter that has ended, as determined under applicable accounting

standards.

(3) A covered banking entity’s aggregate permitted investment in

all covered funds shall be calculated as of the last day of each

calendar quarter.

(d) Capital treatment for a permitted investment in a covered fund.

For purposes of calculating capital pursuant to the applicable capital

rules, a covered banking entity shall deduct the aggregate value of all

permitted investments in all covered funds made or retained by a

covered banking entity pursuant to this section (as determined under

paragraph (c)(1) of this section) from the banking entity’s tier 1

capital (as determined under paragraph (c)(2) of this section).

(e) Extension of time to divest an ownership interest. (1) Upon

application by a covered banking entity, the Board may extend the

period of time to meet the requirements under paragraphs (a)(2)(i)(A)

and (B) of this section for up to 2 additional years, if the Board

finds that an extension would be consistent with safety and soundness

and not detrimental to the public interest. An application for

extension must:

(i) Be submitted to the Board at least 90 days prior to the

expiration of the applicable time period;

(ii) Provide the reasons for application, including information

that addresses the factors in paragraph (e)(2) of this section; and

(iii) Explain the covered banking entity’s plan for reducing the

permitted investment in a covered fund through redemption, sale,

dilution or other methods as required in paragraph (a)(2)(i) of this

section.

(2) Factors governing Board determinations. In reviewing any

application under paragraph (e)(1) of this section, the Board may

consider all the facts and circumstances related to the permitted

investment in a covered fund, including:

(i) Whether the investment would:

(A) Involve or result in material conflicts of interest between the

covered banking entity and its clients, customers or counterparties;

(B) Result, directly or indirectly, in a material exposure by the

covered

[[Page 8432]]

banking entity to high-risk assets or high-risk trading strategies;

(C) Pose a threat to the safety and soundness of the covered

banking entity; or

(D) Pose a threat to the financial stability of the United States;

(ii) Market conditions;

(iii) The contractual terms governing the covered banking entity’s

interest in the covered fund;

(iv) The date on which the covered fund is expected to have

attracted sufficient investments from investors unaffiliated with the

covered banking entity to enable the covered banking entity to comply

with the limitations in paragraph (a)(2)(i) of this section;

(iv) The total exposure of the covered banking entity to the

investment and the risks that disposing of, or maintaining, the

investment in the covered fund may pose to the covered banking entity

and the financial stability of the United States;

(v) The cost to the covered banking entity of divesting or

disposing of the investment within the applicable period;

(vi) Whether the divestiture or conformance of the investment would

involve or result in a material conflict of interest between the

covered banking entity and unaffiliated clients, customers or

counterparties to which it owes a duty;

(vii) The covered banking entity’s prior efforts to reduce through

redemption, sale, dilution, or other methods its ownership interests in

the covered fund, including activities related to the marketing of

interests in such covered fund; and

(viii) Any other factor that the Board believes appropriate.

(3) Consultation. In the case of a covered banking entity that is

primarily regulated by another Federal banking agency, the SEC, or the

CFTC, the Board will consult with such agency prior to approval of an

application by the covered banking entity for an extension under

paragraph (e)(1) of this section.

(4) Authority to impose restrictions on activities or investment

during any extension period. (i) The Board may impose such conditions

on any extension approved under paragraph (e)(1) of this section as the

Board determines are necessary or appropriate to protect the safety and

soundness of the covered banking entity or the financial stability of

the United States, address material conflicts of interest or other

unsound banking practices, or otherwise further the purposes of section

13 of the BHC Act (12 U.S.C. 1851) and this part.

(ii) Consultation. In the case of a covered banking entity that is

primarily regulated by another Federal banking agency, the SEC, or the

CFTC, the Board will consult with such agency prior to imposing

conditions on the approval of a request by the covered banking entity

for an extension under paragraph (e)(1) of this section.

Sec. —-.13 Other permitted covered fund activities and investments.

(a) Permitted investments in SBICs and related investments. The

prohibition contained in Sec. —-.10(a) does not apply with respect

to acquiring or retaining an ownership interest in, or acting as

sponsor to, a covered fund by a covered banking entity or an affiliate

or subsidiary thereof:

(1) In one or more small business investment companies, as defined

in section 102 of the Small Business Investment Act of 1958 (15 U.S.C.

662);

(2) That is designed primarily to promote the public welfare, of

the type permitted under paragraph (11) of section 5136 of the Revised

Statutes of the United States (12 U.S.C. 24), including the welfare of

low- and moderate-income communities or families (such as providing

housing, services, or jobs); or

(3) That is a qualified rehabilitation expenditure with respect to

a qualified rehabilitation building or certified historic structure, as

such terms are defined in section 47 of the Internal Revenue Code of

1986 or a similar State historic tax credit program.

(b) Permitted Risk-Mitigating Hedging Activities.

(1) The prohibition contained in Sec. —-.10(a) does not apply

with respect to an ownership interest in a covered fund by a covered

banking entity, provided that the acquisition or retention of the

ownership interest is:

(i) Made in connection with and related to individual or aggregated

obligations or liabilities of the covered banking entity that are:

(A) Taken by the covered banking entity when acting as intermediary

on behalf of a customer that is not itself a banking entity to

facilitate the exposure by the customer to the profits and losses of

the covered fund, or

(B) Directly connected to a compensation arrangement with an

employee that directly provides investment advisory or other services

to the covered fund; and

(ii) Designed to reduce the specific risks to the covered banking

entity in connection with and related to such obligations or

liabilities.

(2) Requirements. For purposes of paragraph (b)(1) of this section,

acquiring or retaining an ownership interest in a covered fund by a

covered banking entity shall be a permissible risk-mitigating hedging

activity under this section only if:

(i) The covered banking entity has established the internal

compliance program required by subpart D designed to ensure the covered

banking entity’s compliance with the requirements of this paragraph

(b)(2) of this section including reasonably designed written policies

and procedures regarding the instruments, techniques and strategies

that may be used for hedging, internal controls and monitoring

procedures, and independent testing;

(ii) The acquisition or retention of an ownership interest in a

covered fund:

(A) Is made in accordance with the written policies, procedures and

internal controls established by the covered banking entity pursuant to

subpart D of this part;

(B) Hedges or otherwise mitigates an exposure to a covered fund

through an offsetting exposure to the same covered fund and in the same

amount of ownership interest in that covered fund that:

(1) Arises out of a transaction conducted solely to accommodate a

specific customer request with respect to, or

(2) Is directly connected to its compensation arrangement with an

employee that directly provides investment advisory or other services

to, that covered fund;

(C) Does not give rise, at the inception of the hedge, to

significant exposures that were not already present in individual or

aggregated positions, contracts, or other holdings of a covered banking

entity and that are not hedged contemporaneously; and

(D) Is subject to continuing review, monitoring and management by

the covered banking entity that:

(1) Is consistent with its written hedging policies and procedures;

(2) Maintains a substantially similar offsetting exposure to the

same amount and type of ownership interest, based upon the facts and

circumstances of the underlying and hedging positions and the risks and

liquidity of those positions, to the risk or risks the purchase or sale

is intended to hedge or otherwise mitigate; and

(3) Mitigates any significant exposure arising out of the hedge

after inception; and

(iii) The compensation arrangements of persons performing the risk-

mitigating hedging activities are designed not to reward proprietary

risk-taking.

[[Page 8433]]

(3) Documentation. With respect to any acquisition or retention of

an ownership interest in a covered fund by a covered banking entity

pursuant to this paragraph (b), the covered banking entity must

document, at the time the transaction is conducted:

(i) The risk-mitigating purpose of the acquisition or retention of

an ownership interest in a covered fund;

(ii) The risks of the individual or aggregated obligation or

liability of a covered banking entity that the acquisition or retention

of an ownership interest in a covered fund is designed to reduce; and

(iii) The level of organization that is establishing the hedge.

(c) Certain permitted covered fund activities and investments

outside of the United States.

(1) The prohibition contained in Sec. —-.10(a) does not apply to

the acquisition or retention of any ownership interest in, or the

sponsorship of, a covered fund by a covered banking entity if:

(i) The covered banking entity is not directly or indirectly

controlled by a banking entity that is organized under the laws of the

United States or of one or more States;

(ii) The activity is conducted pursuant to paragraph (9) or (13) of

section 4(c) of the BHC Act;

(iii) No ownership interest in such covered fund is offered for

sale or sold to a resident of the United States; and

(iv) The activity occurs solely outside of the United States.

(2) An activity shall be considered to be conducted pursuant to

paragraph (9) or (13) of section 4(c) of the BHC Act only if:

(i) With respect to a covered banking entity that is a foreign

banking organization, the covered banking entity is a qualifying

foreign banking organization and is conducting the activity in

compliance with subpart B of the Board’s Regulation K (12 CFR 211.20

through 211.30); or

(ii) With respect to a covered banking entity that is not a foreign

banking organization, the covered banking entity meets at least two of

the following requirements:

(A) Total assets of the covered banking entity held outside of the

United States exceed total assets of the covered banking entity held in

the United States;

(B) Total revenues derived from the business of the covered banking

entity outside of the United States exceed total revenues derived from

the business of the covered banking entity in the United States; or

(C) Total net income derived from the business of the covered

banking entity outside of the United States exceeds total net income

derived from the business of the covered banking entity in the United

States.

(3) An activity shall be considered to have occurred solely outside

of the United States only if:

(i) The covered banking entity engaging in the activity is not

organized under the laws of the United States or of one or more States;

(ii) No subsidiary, affiliate, or employee of the covered banking

entity that is involved in the offer or sale of an ownership interest

in the covered fund is incorporated or physically located in the United

States or in one or more States; and

(iii) No ownership interest in such covered fund is offered for

sale or sold to a resident of the United States.

(d) Loan securitizations. The prohibition contained in Sec. —

–.10(a) does not apply with respect to the acquisition or retention by

a covered banking entity of any ownership interest in, or acting as

sponsor to, a covered fund that is an issuer of asset-backed

securities, the assets or holdings of which are solely comprised of:

(1) Loans;

(2) Contractual rights or assets directly arising from those loans

supporting the asset-backed securities; and

(3) Interest rate or foreign exchange derivatives that:

(i) Materially relate to the terms of such loans or contractual

rights or assets; and

(ii) Are used for hedging purposes with respect to the

securitization structure.

Sec. —-.14 Covered fund activities determined to be permissible.

(a) The prohibition contained in Sec. —-.10(a) does not apply to

the acquisition or retention by a covered banking entity of any

ownership interest in or acting as sponsor to:

(1) Bank owned life insurance. A separate account which is used

solely for the purpose of allowing a covered banking entity to purchase

an insurance policy for which the covered banking entity is the

beneficiary, provided that the covered banking entity that purchases

the insurance policy:

(i) Does not control the investment decisions regarding the

underlying assets or holdings of the separate account; and

(ii) Holds its ownership interest in the separate account in

compliance with applicable supervisory guidance regarding bank owned

life insurance.

(2) Certain other covered funds. Any of the following entities that

would otherwise qualify as a covered fund:

(i) A joint venture between the covered banking entity or one of

its affiliates and any other person, provided that the joint venture:

(A) Is an operating company; and

(B) Does not engage in any activity or make any investment that is

prohibited under this part;

(ii) An acquisition vehicle, provided that the sole purpose and

effect of such entity is to effectuate a transaction involving the

acquisition or merger of one entity with or into the covered banking

entity or one of its affiliates;

(iii) An issuer of an asset-backed security, but only with respect

to that amount or value of economic interest in a portion of the credit

risk for an asset-backed security that is retained by a covered banking

entity that is a “securitizer” or “originator” in compliance with

the minimum requirements of section 15G of the Exchange Act (15 U.S.C.

78o-11) and any implementing regulations issued thereunder;

(iv) A wholly-owned subsidiary of the covered banking entity that

is:

(A) Engaged principally in performing bona fide liquidity

management activities described in Sec. —-.3(b)(2)(iii)(C), and

(B) Carried on the balance sheet of the covered banking entity; and

(v) A covered fund that is an issuer of asset-backed securities

described in Sec. —-.13(d), the assets or holdings of which are

solely comprised of:

(A) Loans;

(B) Contractual rights or assets directly arising from those loans

supporting the asset-backed securities; and

(C) Interest rate or foreign exchange derivatives that:

(1) Materially relate to the terms of such loans or contractual

rights or assets, and

(2) Are used for hedging purposes with respect to the

securitization structure.

(b) The prohibition contained in Sec. —-.10(a) does not apply to

the acquisition or retention by a covered banking entity of any

ownership interest in, or acting as sponsor to, a covered fund, but

only if such ownership interest is acquired or retained by a covered

banking entity (or an affiliate or subsidiary thereof):

(1) In the ordinary course of collecting a debt previously

contracted in good faith, if the covered banking entity divests the

ownership interest within applicable time periods provided for by the

[Agency]; or

[[Page 8434]]

(2) Pursuant to and in compliance with the conformance or extended

transition period authorities provided for in subpart E of the Board’s

rules implementing section 13 of the BHC Act (12 CFR 248.30 through

248.35).

Sec. —-.15 Internal controls, reporting and recordkeeping

requirements applicable to covered fund activities and investments.

A covered banking entity engaged in any covered fund activity or

making or holding any investment permitted under this subpart shall

comply with:

(a) The internal controls, reporting, and recordkeeping

requirements required under Sec. —-.20 and appendix C to this part,

as applicable; and

(b) Such other reporting and recordkeeping requirements as the

[Agency] may deem necessary to appropriately evaluate the covered

banking entity’s compliance with this subpart.

Sec. —-.16 Limitations on relationships with a covered fund.

(a) Relationships with a covered fund.

(1) Except as provided for in paragraph (a)(2) of this section, no

covered banking entity that serves, directly or indirectly, as the

investment manager, investment adviser, commodity trading advisor, or

sponsor to a covered fund, or that organizes and offers a covered fund

pursuant to Sec. —-.11, and no affiliate of such entity, may enter

into a transaction with the covered fund, or with any other covered

fund that is controlled by such covered fund, that would be a covered

transaction as defined in section 23A of the Federal Reserve Act (12

U.S.C. 371c), as if such covered banking entity and the affiliate

thereof were a member bank and the covered fund were an affiliate

thereof.

(2) Notwithstanding paragraph (a)(1) of this section, a covered

banking entity may:

(i) Acquire and retain any ownership interest in a covered fund in

accordance with the requirements of this subpart; and

(ii) Enter into any prime brokerage transaction with any covered

fund in which a covered fund managed, sponsored, or advised by such

covered banking entity (or an affiliate or subsidiary thereof) has

taken an ownership interest, if:

(A) The covered banking entity is in compliance with each of the

limitations set forth in Sec. —-.11 with respect to a covered fund

organized and offered by such covered banking entity (or an affiliate

or subsidiary thereof);

(B) The chief executive officer (or equivalent officer) of the top-

tier affiliate of the covered banking entity certifies in writing

annually (with a duty to update the certification if the information in

the certification materially changes) that the covered banking entity

does not, directly or indirectly, guarantee, assume, or otherwise

insure the obligations or performance of the covered fund or of any

covered fund in which such covered fund invests; and

(C) The Board has not determined that such transaction is

inconsistent with the safe and sound operation and condition of the

covered banking entity.

(b) Restrictions on transactions with covered funds. A covered

banking entity that serves, directly or indirectly, as the investment

manager, investment adviser, commodity trading advisor, or sponsor to a

covered fund, or that organizes and offers a covered fund pursuant to

Sec. —-.11, shall be subject to section 23B of the Federal Reserve

Act (12 U.S.C. 371c-1), as if such covered banking entity were a member

bank and such covered fund were an affiliate thereof.

(c) Restrictions on prime brokerage transactions. A prime brokerage

transaction permitted under paragraph (a)(2)(ii) of this section shall

be subject to section 23B of the Federal Reserve Act (12 U.S.C. 371c-1)

as if the counterparty were an affiliate of the covered banking entity.

Sec. —-.17 Other limitations on permitted covered fund activities.

(a) No transaction, class of transactions, or activity may be

deemed permissible under Sec. Sec. —-.11 through —-.14 and Sec.

—-.16 if the transaction, class of transactions, or activity would:

(1) Involve or result in a material conflict of interest between

the covered banking entity and its clients, customers, or

counterparties;

(2) Result, directly or indirectly, in a material exposure by the

covered banking entity to a high-risk asset or a high-risk trading

strategy; or

(3) Pose a threat to the safety and soundness of the covered

banking entity or the financial stability of the United States.

(b) Definition of material conflict of interest. For purposes of

this section, a material conflict of interest between a covered banking

entity and its clients, customers, or counterparties exists if the

covered banking entity engages in any transaction, class of

transactions, or activity that would involve or result in the covered

banking entity’s interests being materially adverse to the interests of

its client, customer, or counterparty with respect to such transaction,

class of transactions, or activity, unless:

(1) Timely and effective disclosure and opportunity to negate or

substantially mitigate. Prior to effecting the specific transaction or

class or type of transactions, or engaging in the specific activity,

for which a conflict of interest may arise, the covered banking entity:

(i) Makes clear, timely, and effective disclosure of the conflict

of interest, together with other necessary information, in reasonable

detail and in a manner sufficient to permit a reasonable client,

customer, or counterparty to meaningfully understand the conflict of

interest; and

(ii) Makes such disclosure explicitly and effectively, and in a

manner that provides the client, customer, or counterparty the

opportunity to negate, or substantially mitigate, any materially

adverse effect on the client, customer, or counterparty created by the

conflict of interest; or

(2) Information barriers. The covered banking entity has

established, maintained, and enforced information barriers that are

memorialized in written policies and procedures, such as physical

separation of personnel, or functions, or limitations on types of

activity, that are reasonably designed, taking into consideration the

nature of the covered banking entity’s business, to prevent the

conflict of interest from involving or resulting in a materially

adverse effect on a client, customer, or counterparty. A covered

banking entity may not rely on such information barriers if, in the

case of any specific transaction, class or type of transactions or

activity, the banking entity knows or should reasonably know that,

notwithstanding the covered banking entity’s establishment of

information barriers, the conflict of interest may involve or result in

a materially adverse effect on a client, customer, or counterparty.

(c) Definition of high-risk asset and high-risk trading strategy.

For purposes of this section:

(1) High-risk asset means an asset or group of related assets that

would, if held by a covered banking entity, significantly increase the

likelihood that the covered banking entity would incur a substantial

financial loss or would fail.

(2) High-risk trading strategy means a trading strategy that would,

if engaged in by a covered banking entity, significantly increase the

likelihood that the covered banking entity would incur a substantial

financial loss or would fail.

[[Page 8435]]

Sec. —-.18 [Reserved]

Sec. —-.19 [Reserved]

Subpart D–Compliance Program Requirement; Violations

Sec. —-.20 Program for monitoring compliance; enforcement.

(a) Program requirement. Except as provided in paragraph (d) of

this section, each covered banking entity shall develop and provide for

the continued administration of a program reasonably designed to ensure

and monitor compliance with the prohibitions and restrictions on

proprietary trading and covered fund activities and investments set

forth in section 13 of the BHC Act and this part, and such program

shall be appropriate for the size, scope and complexity of activities

and business structure of the covered banking entity.

(b) Contents of compliance program. The compliance program required

by paragraph (a) of this section, at a minimum, shall include:

(1) Internal written policies and procedures reasonably designed to

document, describe, and monitor trading activities subject to subpart B

and activities and investments with respect to a covered fund subject

to subpart C (including those permitted under Sec. Sec. —-.4 through

—-.6 or Sec. Sec. —-.11 through —-.16) to ensure that such

activities and investments comply with section 13 of the BHC Act and

this part;

(2) A system of internal controls reasonably designed to monitor

and identify potential areas of noncompliance with section 13 of the

BHC Act and this part in the covered banking entity’s trading

activities subject to subpart B and activities and investments with

respect to a covered fund subject to subpart C (including those

permitted under Sec. Sec. —-.4 through —-.6 or Sec. Sec. —-.11

through —-.16) and to prevent the occurrence of activities or

investments that are prohibited by section 13 of the BHC Act and this

part;

(3) A management framework that clearly delineates responsibility

and accountability for compliance with section 13 of the BHC Act and

this part;

(4) Independent testing for the effectiveness of the compliance

program conducted by qualified personnel of the covered banking entity

or by a qualified outside party;

(5) Training for trading personnel and managers, as well as other

appropriate personnel, to effectively implement and enforce the

compliance program; and

(6) Making and keeping records sufficient to demonstrate compliance

with section 13 of the BHC Act and this part, which a covered banking

entity must promptly provide to [Agency] upon request and retain for a

period of no less than 5 years.

(c) Additional Standards. (1) In the case of any covered banking

entity described in paragraph (c)(2) of this section, the compliance

program required by paragraph (a) of this section shall also satisfy

the requirements and other standards contained in appendix C to this

part.

(2) A covered banking entity is subject to paragraph (c)(1) of this

section if:

(i) The covered banking entity engages in proprietary trading and

has, together with its affiliates and subsidiaries, trading assets and

liabilities the average gross sum of which (on a worldwide consolidated

basis), as measured as of the last day of each of the four prior

calendar quarters:

(A) Is equal to or greater than $1 billion; or

(B) Equals 10 percent or more of its total assets;

(ii) The covered banking entity invests in, or has relationships

with, a covered fund and:

(A) The covered banking entity has, together with its affiliates

and subsidiaries, aggregate investments in one or more covered funds,

the average value of which is, as measured as of the last day of each

of the four prior calendar quarters, equal to or greater than $1

billion; or

(B) Sponsors or advises, together with its affiliates and

subsidiaries, one or more covered funds, the average total assets of

which are, as measured as of the last day of each of the four prior

calendar quarters, equal to or greater than $1 billion; or

(iii) [Agency] deems it appropriate.

(d) No program required for certain banking entities. To the extent

that a covered banking entity does not engage in activities or

investments prohibited or restricted by subpart B or subpart C of this

part, a covered banking entity will have satisfied the requirements of

this section if its existing compliance policies and procedures include

measures that are designed to prevent the covered banking entity from

becoming engaged in such activities or making such investments and

which require the covered banking entity to develop and provide for the

compliance program required under paragraph (a) of this section prior

to engaging in such activities or making such investments.

Sec. —-.21 Termination of activities or investments; penalties for

violations.

(a) Any covered banking entity that engages in an activity or makes

an investment in violation of section 13 of the BHC Act or this part or

in a manner that functions as an evasion of the requirements of section

13 of the BHC Act or this part, including through an abuse of any

activity or investment permitted under subparts B or C of this part, or

otherwise violates the restrictions and requirements of section 13 of

the BHC Act or this part, shall terminate the activity and, as

relevant, dispose of the investment.

(b) After due notice and an opportunity for hearing, if the

[Agency] finds reasonable cause to believe any covered banking entity

has engaged in an activity or made an investment described in paragraph

(a) of this section, the [Agency] may, by order, direct the banking

entity to restrict, limit, or terminate the activity and, as relevant,

dispose of the investment.

(c) [Reserved]

Appendix A to Part [ ]–Reporting and Recordkeeping Requirements for

Covered Trading Activities

I. Purpose

This appendix sets forth reporting and recordkeeping

requirements that certain covered banking entities must satisfy in

connection with the restrictions on proprietary trading set forth in

subpart B (“proprietary trading restrictions”). Pursuant to Sec.

—-.7, this appendix generally applies to a covered banking entity

that has, together with its affiliates and subsidiaries, trading

assets and liabilities the average gross sum of which (on a

worldwide consolidated basis) is, as measured as of the last day of

each of the four prior calendar quarters, equal to or greater than

$1 billion. These entities are required to (i) furnish periodic

reports to [Agency] regarding a variety of quantitative measurements

of their covered trading activities, which vary depending on the

scope and size of covered trading activities, and (ii) create and

maintain records documenting the preparation and content of these

reports. The requirements of this appendix should be incorporated

into the covered banking entity’s internal compliance program under

Sec. —-.20 and Appendix C.

The purpose of this appendix is to assist covered banking

entities and [Agency] in:

(i) Better understanding and evaluating the scope, type, and

profile of the covered banking entity’s trading activities;

(ii) Monitoring the covered banking entity’s trading activities;

(iii) Identifying trading activities that warrant further review

or examination by the covered banking entity to verify compliance

with the proprietary trading restrictions;

(iv) Evaluating whether the trading activities of trading units

engaged in market making-related activities subject to Sec. —

–.4(b) are consistent with the requirements governing permitted

market making-related activities;

(v) Evaluating whether the covered trading activities of trading

units that are engaged in permitted trading activity subject to

[[Page 8436]]

Sec. Sec. —-.4, —-.5, or —-.6(a) (i.e., underwriting and

market making-related activity, risk-mitigating hedging, or trading

in certain government obligations) are consistent with the

requirement that such activity not result, directly or indirectly,

in a material exposure to high-risk assets or high-risk trading

strategies;

(vi) Identifying the profile of particular trading activities of

the covered banking entity, and the individual trading units of the

banking entity, to help establish the appropriate frequency and

scope of examination by [Agency] of such activities; and

(vii) Assessing and addressing the risks associated with the

covered banking entity’s covered trading activities.

The quantitative measurements that must be furnished pursuant to

this appendix are not intended to serve as a dispositive tool for

the identification of permissible or impermissible activities.

In addition to the quantitative measurements required in this

appendix, a covered banking entity may need to develop and implement

other quantitative measurements in order to effectively monitor its

covered trading activities for compliance with section 13 of the BHC

Act and this part and to have an effective compliance program, as

required by Sec. —-.20 and appendix C to this part. The

effectiveness of particular quantitative measurements may differ

based on the profile of the banking entity’s businesses in general

and, more specifically, of the particular trading unit, including

types of instruments traded, trading activities and strategies, and

history and experience (e.g., whether the trading desk is an

established, successful market maker or a new entrant to a

competitive market). In all cases, covered banking entities must

ensure that they have robust measures in place to identify and

monitor the risks taken in their trading activities, to ensure that

the activities are within risk tolerances established by the covered

banking entity, and to monitor and examine for compliance with the

proprietary trading restrictions in this part.

On an ongoing basis, covered banking entities should carefully

monitor, review, and evaluate all furnished quantitative

measurements, as well as any others that they choose to utilize in

order to maintain compliance with section 13 of the BHC Act and this

part. All measurement results that indicate a heightened risk of

impermissible proprietary trading, including with respect to

otherwise-permitted activities under Sec. Sec. —-.4 through —

–.6 that result in a material exposure to high-risk assets or high-

risk trading strategies, should be escalated within the banking

entity for review, further analysis, explanation to [Agency], and

remediation, where appropriate. Many of the quantitative

measurements discussed in this appendix will also be helpful to

covered banking entities in identifying and managing the risks

related to their covered trading activities.

II. Definitions

The terms used in this appendix have the same meanings as set

forth in Sec. Sec. —-.2 and —-.3. In addition, for purposes of

this appendix, the following definitions apply:

Covered trading activity means proprietary trading, as defined

in paragraph (b)(1) of Sec. —-.3.

Trading unit means each of the following units of organization

of a covered banking entity:

(i) Each discrete unit that is engaged in the coordinated

implementation of a revenue-generation strategy and that

participates in the execution of any covered trading activity; 1

—————————————————————————

1 [Agency] expects that this will generally be the smallest

unit of organization used by the covered banking entity to structure

and control its risk-taking activities and employees, and will

include each unit generally understood to be a single “trading

desk.”

—————————————————————————

(ii) Each organizational unit that is used to structure and

control the aggregate risk-taking activities and employees of one or

more trading units described in paragraph (i); 2

—————————————————————————

2 [Agency] expects that this will generally include management

or reporting divisions, groups, sub-groups, or other intermediate

units of organization used by the covered banking entity to manage

one or more discrete trading units (e.g., “North American Credit

Trading,” “Global Credit Trading,” etc.).

—————————————————————————

(iii) All trading operations, collectively; and

(iv) Any other unit of organization specified by the [Agency]

with respect to a particular banking entity.

Calculation period means the period of time for which a

particular quantitative measurement must be calculated.

III. Reporting and Recordkeeping of Quantitative Measurements

A. Scope of Required Reporting

General scope. The quantitative measurements that must be

furnished by a covered banking entity depend on the aggregate size

of the covered banking entity’s trading activities and the

activities in which its trading units engage, as follows:

(i) With respect to any covered banking entity that is engaged

in any covered trading activity, and has trading assets and

liabilities the average gross sum of which (on a worldwide

consolidated basis) is, as measured as of the last day of each of

the four prior calendar quarters, equal to or greater than $5

billion:

(a) Each trading unit of the covered banking entity that is

engaged in market making-related activities subject to Sec. —

–.4(b) must furnish the following quantitative measurements,

calculated in accordance with this appendix:

Value-at-Risk and Stress VaR;

VaR Exceedance;

Risk Factor Sensitivities;

Risk and Position Limits;

Comprehensive Profit and Loss;

Portfolio Profit and Loss;

Fee Income and Expense;

Spread Profit and Loss;

Comprehensive Profit and Loss Attribution;

Pay-to-Receive Spread Ratio;

Unprofitable Trading Days Based on Comprehensive Profit

and Loss and Unprofitable Trading Days Based on Portfolio Profit and

Loss;

Skewness of Portfolio Profit and Loss and Kurtosis of

Portfolio Profit and Loss;

Volatility of Comprehensive Profit and Loss and

Volatility of Portfolio Profit and Loss;

Comprehensive Profit and Loss to Volatility Ratio and

Portfolio Profit and Loss to Volatility Ratio;

Inventory Risk Turnover;

Inventory Aging; and

Customer-facing Trade Ratio; and

(b) Each trading unit of the covered banking entity that is

engaged in permitted trading activity subject to Sec. Sec. —

–.4(a), —-.5, or —-.6(a) must furnish the following

quantitative measurements, calculated in accordance with this

appendix:

Value-at-Risk and Stress VaR;

Risk Factor Sensitivities;

Risk and Position Limits;

Comprehensive Profit and Loss; and

Comprehensive Profit and Loss Attribution; and

(ii) With respect to any covered banking entity that is engaged

in any covered trading activity, and has trading assets and

liabilities the average gross sum of which (on a worldwide

consolidated basis) is, as measured as of the last day of each of

the four prior calendar quarters, equal to or greater than $1

billion and less than $5 billion, each trading unit of the covered

banking entity that is engaged in market making-related activities

under Sec. —-.4(b) must furnish the following quantitative

measurement, calculated in accordance with this appendix:

Comprehensive Profit and Loss;

Portfolio Profit and Loss;

Fee Income and Expense;

Spread Profit and Loss;

Value-at-Risk;

Comprehensive Profit and Loss Attribution;

Volatility of Comprehensive Profit and Loss and

Volatility of Portfolio Profit and Loss; and

Comprehensive Profit and Loss to Volatility Ratio and

Portfolio Profit and Loss to Volatility Ratio.

B. Frequency of Required Calculation and Reporting

A covered banking entity must calculate any applicable

quantitative measurement for each trading day. A covered banking

entity must report each applicable quantitative measurement to

[Agency] on a monthly basis, or on any other reporting schedule

requested by [Agency]. All quantitative measurements for any

calendar month must be reported to [Agency] no later than 30 days

after the end of that calendar month or on any other time basis

requested by [Agency].3

—————————————————————————

3 For example, under section IV.B.1 of this appendix, a

banking entity is required to report to [Agency] the Comprehensive

Profit and Loss quantitative measurement, as calculated for all

trading days in June of any year, no later than July 30 of that

year.

—————————————————————————

C. Recordkeeping

A covered banking entity must, for any quantitative measurement

furnished to [Agency] pursuant to this appendix and Sec. —-.7,

create and maintain records documenting the preparation and content

of

[[Page 8437]]

these reports, as well as such information as is necessary to permit

[Agency] to verify the accuracy of such reports, for a period of 5

years.

IV. Quantitative Measurements

A. Risk-Management Measurements

1. Value-at-Risk and Stress Value-at-Risk

Description: For purposes of this appendix, Value-at-Risk

(“VaR”) is the commonly used percentile measurement of the risk of

future financial loss in the value of a given portfolio over a

specified period of time, based on current market conditions. For

purposes of this appendix, Stress Value-at-Risk (“Stress VaR”) is

the percentile measurement of the risk of future financial loss in

the value of a given portfolio over a specified period of time,

based on market conditions during a period of significant financial

stress.

General Calculation Guidance: Banking entities should compute

and report VaR and Stress VaR by employing generally accepted

standards and methods of calculation. VaR should reflect a loss in a

trading unit that is expected to be exceeded less than one percent

of the time over a one-day period. For those banking entities that

are subject to regulatory capital requirements imposed by a Federal

banking agency, VaR and Stress VaR should be computed and reported

in a manner that is consistent with such regulatory capital

requirements. In cases where a trading unit does not have a

standalone VaR or Stress VaR calculation but is part of a larger

portfolio for which a VaR or Stress VaR calculation is performed, a

VaR or Stress VaR calculation that includes only the trading unit’s

holdings should be performed consistent with the VaR or Stress VaR

model and methodology used by the larger portfolio.

Calculation Period: One trading day.

2. VaR Exceedance

Description: For purposes of this appendix, VaR Exceedance is

the difference between VaR and Portfolio Profit and Loss, exclusive

of Spread Profit and Loss, for a trading unit for any given

calculation period.

Calculation Period: One trading day.

3. Risk Factor Sensitivities

Description: For purposes of this appendix, Risk Factor

Sensitivities are changes in a trading unit’s Portfolio Profit and

Loss, exclusive of Spread Profit and Loss, that are expected to

occur in the event of a change in a trading unit’s “risk factors”

(i.e., one or more underlying market variables that are significant

sources of the trading unit’s profitability and risk).

General Calculation Guidance: A covered banking entity should

report the Risk Factor Sensitivities that are monitored and managed

as part of the trading unit’s overall risk management policy. The

underlying data and methods used to compute a trading unit’s Risk

Factor Sensitivities should depend on the specific function of the

trading unit and the internal risk management models employed. The

number and type of Risk Factor Sensitivities that are monitored and

managed by a trading unit, and furnished to [Agency], should depend

on the explicit risks assumed by the trading unit. In general,

however, reported Risk Factor Sensitivities should be sufficient to

account for a preponderance of the price variation in the trading

unit’s holdings.

Trading units should take into account any relevant factors in

calculating Risk Factor Sensitivities, including, for example, the

following with respect to particular asset classes:

Commodity derivative positions: sensitivities with

respect to the related commodity type (e.g., precious metals, oil

and petroleum or agricultural products), the maturity of the

positions, volatility and/or correlation sensitivities (expressed in

a manner that demonstrates any significant non-linearities), and the

maturity profile of the positions;

Credit positions: sensitivities with respect to credit

spread factors that are sufficiently granular to account for

specific credit sectors and market segments, the maturity profile of

the positions, and sensitivities to interest rates at all relevant

maturities;

Credit-related derivative positions: credit positions

sensitivities and volatility and/or correlation sensitivities

(expressed in a manner that demonstrates any significant non-

linearities), and the maturity profile of the positions;

Equity positions: sensitivity to equity prices and

sensitivities that differentiate between important equity market

sectors and segments, such as a small capitalization equities and

international equities;

Equity derivative positions: equity position

sensitivities and volatility and/or correlation sensitivities

(expressed in a manner that demonstrates any significant non-

linearities), and the maturity profile of the positions;

Foreign exchange derivative positions: sensitivities

with respect to major currency pairs and maturities, sensitivity to

interest rates at relevant maturities, and volatility and/or

correlation sensitivities (expressed in a manner that demonstrates

any significant non-linearities), as well as the maturity profile of

the positions; and

Interest rate positions, including interest rate

derivative positions: sensitivities with respect to major interest

rate categories and maturities and volatility and/or correlation

sensitivities (expressed in a manner that demonstrates any

significant non-linearities), as well as the maturity profile of the

positions.

The methods used by a covered banking entity to calculate

sensitivities to a common factor shared by multiple trading units,

such as an equity price factor, should be applied consistently

across its trading units so that the sensitivities can be compared

from one trading unit to another.

Calculation Period: One trading day.

4. Risk and Position Limits

Description: For purposes of this appendix, Risk and Position

Limits are the constraints that define the amount of risk that a

trading unit is permitted to take at a point in time, as defined by

the covered banking entity for a specific trading unit.

General Calculation Guidance: Risk and Position Limits should be

reported in the format used by the covered banking entity for the

purposes of risk management of each trading unit. Risk and Position

Limits are often expressed in terms of risk measures, such as VaR

and Risk Factor Sensitivities, but may also be expressed in terms of

other observable criteria, such as net open positions. When criteria

other than VaR or Risk Factor Sensitivities are used to define the

Risk and Position Limits, both the value of the Risk and Position

Limits and the value of the variables used to assess whether these

limits have been reached should be reported.

Calculation Period: One trading day.

B. Source-of-Revenue Measurements

1. Comprehensive Profit and Loss

Description: For purposes of this appendix, Comprehensive Profit

and Loss is the net profit or loss of a trading unit’s material

sources of trading revenue, including, for example, dividend and

interest income and expense, over a specific period of time. A

trading unit’s Comprehensive Profit and Loss for any given

calculation period should generally equal the sum of the trading

unit’s Portfolio Profit and Loss and Fee Income.

General Calculation Guidance: Comprehensive Profit and Loss

generally should be computed using data on the value of a trading

unit’s underlying holdings, the prices at which those holdings were

bought and sold, and the value of any fees, commissions, sales

credits, spreads, dividends, interest income and expense, or other

sources of income from trading activities, whether realized or

unrealized. Comprehensive Profit and Loss should not include:

compensation costs or other costs required to operate the unit, such

as information technology costs; or charges and adjustments made for

internal reporting and management purposes, such as accounting

reserves.

Calculation Period: One trading day.

2. Portfolio Profit and Loss

Description: For purposes of this appendix, Portfolio Profit and

Loss is a trading unit’s net profit or loss on its underlying

holdings over a specific period of time, whether realized or

unrealized. Portfolio Profit and Loss should generally include any

increase or decrease in the market value of a trading unit’s

holdings, including, for example, any dividend, interest income, or

expense of a trading unit’s holdings. Portfolio Profit and Loss

should not include direct fees, commissions, sales credits, or other

sources of trading revenue that are not directly related to the

market value of the trading unit’s holdings.

General Calculation Guidance: In general, Portfolio Profit and

Loss should be computed using data on a trading unit’s underlying

holdings and the prices at which those holdings are marked for

valuation purposes. Portfolio Profit and Loss should not include:

compensation costs or other costs required to operate the trading

unit, such as information technology costs; or charges and

adjustments made for internal reporting and management purposes,

such as accounting reserves.

Calculation Period: One trading day.

3. Fee Income and Expense

Description: For purposes of this appendix, Fee Income and

Expense generally includes direct fees, commissions and other

distinct

[[Page 8438]]

income for services provided by or to a trading unit over a specific

period of time.

General Calculation Guidance: Fee Income and Expense should be

computed using data on direct fees that are earned by the trading

unit for services it provides to clients, customers, or

counterparties, such as fees earned for structured transactions or

sales commissions and credits earned for fulfilling a customer

request, whether realized or unrealized, and similar fees paid by

the trading unit to other service providers.

Calculation Period: One trading day.

4. Spread Profit and Loss

Description: For purposes of this appendix, Spread Profit and

Loss is the portion of Portfolio Profit and Loss that generally

includes revenue generated by a trading unit from charging higher

prices to buyers than the trading unit pays to sellers of comparable

instruments over the same period of time (i.e., charging a

“spread,” such as the bid-ask spread).

General Calculation Guidance: Spread Profit and Loss generally

should be computed using data on the prices at which comparable

instruments are either bought or sold by the trading unit, as well

as the turnover of these instruments. Spread Profit and Loss should

be measured with respect to both the purchase and the sale of any

position, and should include both the spreads that are earned by the

trading unit to execute transactions (expressed as positive

amounts), and the spreads that are paid by the trading unit to

initiate transactions (expressed as negative amounts). Spread Profit

and Loss should be computed by calculating the difference between

the bid price or the ask price (whichever is paid or received) and

the mid-market price. The mid-market price is the average of bid and

ask.

For some asset classes in which a trading unit is engaged in

market making-related activities, bid-ask or similar spreads are

widely disseminated, constantly updated, and readily available, or

otherwise reasonably ascertainable. For purposes of calculating the

Spread Profit and Loss attributable to a transaction in such asset

classes, the trading unit should utilize the prevailing bid-ask or

similar spread on the relevant position at the time the purchase or

sale is completed.

For other asset classes in which a trading unit is engaged in

market making-related activities, bid-ask or similar spreads may not

be widely disseminated on a consistent basis or otherwise reasonably

ascertainable. A covered banking entity must identify any trading

unit engaged in market making-related activities in an asset class

for which the covered banking entity believes bid-ask or similar

spreads are not widely disseminated on a consistent basis or are not

otherwise reasonably ascertainable and must be able to demonstrate

that bid-ask or similar spreads for the asset class are not

reasonably ascertainable. In such cases, the trading unit should

calculate the Spread Profit and Loss for the relevant purchase or

sale of a position in a particular asset class by using whichever of

the following three alternatives the banking entity believes more

accurately reflects prevailing bid-ask or similar spreads for

transactions in that asset class:

(i) End of Day Spread Proxy: A proxy based on the bid-ask or

similar spread that is used to estimate, or is otherwise implied by,

the market price at which the trading entity marks (or in the case

of a sale, would have marked) the position for accounting purposes

at the close of business on the day it executes the purchase or sale

(“End of Day Spread Proxy”);

(ii) Historical Data Spread Proxy: A proxy based on historical

bid-ask or similar spread data in similar market conditions

(“Historical Data Spread Proxy”); or

(iii) Any other proxy that the banking entity can demonstrate

accurately reflects prevailing bid-ask or similar spreads for

transactions in the specific asset class.

A covered banking entity selecting any of these alternatives

should be able to demonstrate that the alternative it has chosen

most accurately reflects prevailing bid-ask or similar spreads for

the relevant asset class. If a covered banking entity chooses to

calculate Spread Profit and Loss for a particular trading unit using

the End of Day Spread Proxy, then the banking entity should

separately identify the portion of Spread Profit and Loss that is

attributable to positions acquired and disposed of on the same

trading day. If a banking entity chooses to calculate Spread Profit

and Loss for a particular trading unit using the Historical Data

Spread Proxy, the covered banking entity should be able to

demonstrate that the Historical Data Proxy is appropriate and

continually monitor market conditions and adjust, as necessary, the

Historical Data Proxy to reflect any changes.

Calculation Period: One trading day.

5. Comprehensive Profit and Loss Attribution

Description: For purposes of this appendix, Comprehensive Profit

and Loss Attribution is an attribution analysis that divides the

trading unit’s Comprehensive Profit and Loss into the separate

sources of risk and revenue that have caused any observed variation

in Comprehensive Profit and Loss. This attribution analysis should

attribute Comprehensive Profit and Loss to specific market and risk

factors that can be accurately and consistently measured over time.

Any component of Comprehensive Profit and Loss that cannot be

specifically identified in the attribution analysis should be

identified as an unexplained portion of the Comprehensive Profit and

Loss.

General Calculation Guidance: The specific market and risk

factors used by a trading unit in the attribution analysis should be

tailored to the trading activities undertaken by the unit. These

factors should be measured consistently over time to facilitate

historical comparisons. The attribution analysis should also

identify any significant factors that have a consistent and regular

influence on Comprehensive Profit and Loss, such as Risk Factor

Sensitivities that have a significant influence on portfolio income,

customer spreads, bid-ask spreads, or commissions that are earned.

Factors that influence Comprehensive Profit and Loss across

different trading units should be measured and included in the

attribution analysis in a comparable fashion.

Calculation Period: One trading day.

C. Revenue-Relative-to-Risk Measurements

1. Volatility of Comprehensive Profit and Loss and Volatility of

Portfolio Profit and Loss

Description: For purposes of this appendix, Volatility of

Comprehensive Profit and Loss generally is the standard deviation of

the trading unit’s Comprehensive Profit and Loss estimated over a

given calculation period. For purposes of this appendix, Volatility

of Portfolio Profit and Loss generally is the standard deviation of

the trading unit’s Portfolio Profit and Loss, exclusive of Spread

Profit and Loss, estimated over a given calculation period.

Calculation Period: 30 days, 60 days, and 90 days.

2. Comprehensive Profit and Loss to Volatility Ratio and Portfolio

Profit and Loss to Volatility Ratio

Description: For purposes of this appendix, Comprehensive Profit

and Loss to Volatility Ratio is a ratio of Comprehensive Profit and

Loss to the Volatility of Comprehensive Profit and Loss for a

trading unit over a given calculation period. For purposes of this

appendix, Portfolio Profit and Loss to Volatility Ratio is a ratio

of Portfolio Profit and Loss, exclusive of Spread Profit and Loss,

to the Volatility of Portfolio Profit and Loss, exclusive of Spread

Profit and Loss, for a trading unit over a given calculation period.

Calculation Period: 30 days, 60 days, and 90 days.

3. Unprofitable Trading Days Based on Comprehensive Profit and Loss and

Unprofitable Trading Days Based on Portfolio Profit and Loss

Description: For purposes of this appendix, Unprofitable Trading

Days Based on Comprehensive Profit and Loss is the number or

proportion of trading days on which a trading unit’s Comprehensive

Profit and Loss is less than zero over a given calculation period.

For purposes of this appendix, Unprofitable Trading Days Based on

Portfolio Profit and Loss, exclusive of Spread Profit and Loss, is

the number or proportion of trading days on which a trading unit’s

Portfolio Profit and Loss, exclusive of Spread Profit and Loss, is

less than zero over a given calculation period.

Calculation Period: 30 days, 90 days, and 360 days.

4. Skewness of Portfolio Profit and Loss and Kurtosis of Portfolio

Profit and Loss

Description: Skewness of Portfolio Profit and Loss and Kurtosis

of Portfolio Profit and Loss should be calculated using standard

statistical methods with respect to Portfolio Profit and Loss,

exclusive of Spread Profit and Loss.

Calculation Period: 30 days, 60 days, and 90 days.

D. Customer-Facing Activity Measurements

1. Inventory Risk Turnover

Description: For purposes of this appendix, Inventory Risk

Turnover is a ratio that measures the amount of risk associated with

a trading unit’s inventory, as measured by Risk Factor

Sensitivities, that is turned over by the trading unit over a

specific period of

[[Page 8439]]

time. For each Risk Factor Sensitivity, the numerator of the

Inventory Risk Turnover ratio generally should be the absolute value

of the Risk Factor Sensitivity associated with each transaction over

the calculation period. The denominator of the Inventory Risk

Turnover ratio generally should be the value of each Risk Factor

Sensitivity for all of the trading unit’s holdings at the beginning

of the calculation period.

General Calculation Guidance: As a general matter, a trading

unit should measure and report the Inventory Risk Turnover ratio for

each of the Risk Factor Sensitivities calculated and furnished for

that trading unit.

Calculation Period: 30 days, 60 days, and 90 days.

2. Inventory Aging

Description: For purposes of this appendix, Inventory Aging

generally describes the trading unit’s aggregate assets and

liabilities and the amount of time that those assets and liabilities

have been held for the following periods: 0-30 days; 30-60 days; 60-

90 days; 90-180 days; 180-360 days; and greater than 360 days.

Inventory Aging should measure the age profile of the trading unit’s

assets and liabilities.

General Calculation Guidance: In general, Inventory Aging should

be computed using a trading unit’s trading activity data and should

identify the trading unit’s aggregate assets and liabilities. In

addition, Inventory Aging should include two schedules, an asset-

aging schedule and a liability-aging schedule. The asset-aging

schedule should record the value of the trading unit’s assets that

have been held for: 0-30 days; 30-60 days; 60-90 days; 90-180 days;

180-360 days; and greater than 360 days. The liability-aging

schedule should record the value of the trading unit’s liabilities

that have been held for: 0-30 days; 30-60 days; 60-90 days; 90-180

days; 180-360 days; and more than 360 days.

Calculation Period: 30 days, 60 days, and 90 days.

3. Customer-Facing Trade Ratio

Description: For purposes of this appendix, the Customer-Facing

Trade Ratio is a ratio comparing the number of transactions

involving a counterparty that is a customer of the trading unit to

the number of transactions involving a counterparty that is not a

customer of the trading unit. For purposes of calculating the

Customer-Facing Trade Ratio, a counterparty is considered to be a

customer of the trading unit if the counterparty is neither (i) a

counterparty to a transaction executed on a designated contract

market registered under the Commodity Exchange Act or national

securities exchange registered under the Exchange Act, nor (ii) a

broker-dealer, swap dealer, security-based swap dealer, any other

entity engaged in market making-related activities, or any affiliate

thereof. A broker-dealer, swap dealer, or security-based swap

dealer, any other entity engaged in market making-related

activities, or any affiliate thereof may be considered a customer of

the trading unit for these purposes if the covered banking entity

treats that entity as a customer and has documented how and why the

entity is treated as such.

Calculation Period: 30 days, 60 days, and 90 days.

E. Payment of Fees, Commissions, and Spreads Measurement

1. Pay-to-Receive Spread Ratio

Description: For purposes of this appendix, the Pay-to-Receive

Spread Ratio is a ratio comparing the amount of Spread Profit and

Loss and Fee Income that is earned by a trading unit to the amount

of Spread Profit and Loss and Fee Income that is paid by the trading

unit.

General Calculation Guidance: The Pay-to-Receive Spread Ratio

will depend on the amount of Spread Profit and Loss and Fee Income

that is earned by the trading unit for facilitating buy and sell

orders and the amount of Spread Profit and Loss that is paid by a

trading unit as it initiates buy and sell orders. The Pay-to-Receive

Spread Ratio generally should be computed using the calculation of

Spread Profit and Loss described in this appendix, except that

spread paid should include the aggregate Spread Profit and Loss of

all transactions producing a negative Spread Profit and Loss, and

spread received should include the aggregate Spread Profit and Loss

of all transactions producing a positive Spread Profit and Loss.

Calculation Period: One trading day.

Appendix B to Part [ ]–Commentary Regarding Identification of

Permitted Market Making-Related Activities

I. Purpose

This appendix provides commentary describing the features of

permitted market making-related activities and distinctions between

permitted market making-related activities and prohibited

proprietary trading. The appendix applies to all covered banking

entities that are engaged in market making-related activities in

reliance on Sec. —-.4(b). The following commentary must be

incorporated into the covered banking entity’s internal compliance

program under Sec. —-.20, as applicable.

II. Definitions

The terms used in this appendix have the same meanings as those

set forth in Sec. Sec. —-.2 and —-.3 and appendix A to this

part.

III. Commentary

Section 13 of the BHC Act and Sec. —-.3 prohibit any covered

banking entity from engaging in proprietary trading, which is

generally defined as engaging as principal for the trading account

of the covered banking entity in any transaction to purchase or sell

a covered financial position. However, section 13(d)(1)(B) of the

BHC Act and Sec. —-.4(b) permit a covered banking entity to

engage in proprietary trading that would otherwise be prohibited if

the activity is conducted in connection with the covered banking

entity’s market making-related activities, to the extent that such

activities are designed not to exceed the reasonably expected near

term demands of clients, customers, and counterparties. This

commentary is intended to assist covered banking entities in

identifying permitted market making-related activities and

distinguishing such activities from trading activities that, even if

conducted in the context of the covered banking entity’s market

making operations, would constitute prohibited proprietary trading.

A. Overview of Market Making-Related Activities

In the context of trading activities in which a covered banking

entity acts as principal, market making-related activities generally

involve the covered banking entity either (i) in the case of market

making in a security that is executed on an organized trading

facility or exchange, passively providing liquidity by submitting

resting orders that interact with the orders of others on an

organized trading facility or exchange and acting as a registered

market maker, where such exchange or organized trading facility

provides the ability to register as a market maker,1 or (ii) in

other cases, providing an intermediation service to its customers by

assuming the role of a counterparty that stands ready to buy or sell

a position that the customer wishes to sell or buy. A market maker’s

“customers” generally vary depending on the asset class and market

in which the market maker is providing intermediation services. In

the context of market making in a security that is executed on an

organized trading facility or an exchange, a “customer” is any

person on behalf of whom a buy or sell order has been submitted by a

broker-dealer or any other market participant. In the context of

market making in a covered financial position in an over-the-counter

market, a “customer” generally would be a market participant that

makes use of the market’s maker intermediation services, either by

requesting such services or entering into a continuing relationship

with the market maker with respect to such services.2

—————————————————————————

1 The status of being a registered market maker is not, on its

own, a sufficient basis for relying on the exemption for market

making-related activity contained in Sec. —-.4(b). Registration

as a market maker generally involves filing a prescribed form with

an exchange or organized trading facility, in accordance with its

rules and procedures, and complying with the applicable requirements

for market makers set forth in the rules of that exchange or

organized trading facility. See, e.g., Nasdaq Rule 4612, New York

Stock Exchange Rule 104, CBOE Futures Exchange Rule 515, BATS

Exchange Rule 11.5.

2 In certain cases, depending on the conventions of the

relevant market (e.g., the over-the-counter derivatives market),

such a “customer” may consider itself or refer to itself more

generally as a “counterparty.”

—————————————————————————

The primary purpose of market making-related activities is to

intermediate between buyers and sellers of similar positions, for

which service market makers are compensated, resulting in more

liquid markets and less volatile prices. The purpose of such

activities is not to earn profits as a result of movements in the

price of positions and risks acquired or retained; rather, a market

maker generally manages and limits the extent to which it is exposed

to movements in the price of principal positions and risks that it

acquires or retains, or in the price of one or more material

elements of those positions. To the extent that it can, a

[[Page 8440]]

market maker will eliminate some or all of the price risks to which

it is exposed. However, in some cases, the risks posed by one or

more positions may be sufficiently complex or specific that the risk

cannot be fully hedged. In other cases, although it may be possible

to hedge the risks posed by one or more positions, the cost of doing

so may be so high as to effectively make market making in those

positions uneconomic if complete hedges were acquired. In such

cases, in order to provide effective intermediation services, market

makers are required to retain at least some risk for at least some

period of time with respect to price movements of retained principal

positions and risks. The size and type of risk that must be retained

in such cases may vary widely depending on the type and size of the

positions, the liquidity of the specific market, and the market’s

structure. As the liquidity of positions increases, the frequency

with which a market maker must take or retain risk in order to make

a market in those positions generally decreases.

The profitability of market making-related activities relies on

forms of revenues that reflect the value of the intermediation

services that are provided to the market maker’s customers. These

revenues typically take the form of explicit fees and commissions

or, in markets where no such fees or commission are charged, a bid-

ask or similar spread that is generated by charging higher prices to

buyers than is paid to sellers of comparable instruments. In the

case of a derivative contract, these revenues reflect the difference

between the cost of entering into the derivative contract and the

cost of hedging incremental, residual risks arising from the

contract. These types of “customer revenues” provide the primary

source of a market maker’s profitability. Typically, a market maker

holds at least some risk with respect to price movements of retained

principal positions and risks. As a result, the market maker also

incurs losses or generates profits as price movements actually

occur, but such losses or profits are incidental to customer

revenues and significantly limited by the banking entity’s hedging

activities. Customer revenues, not revenues from price movements,

predominate. The appropriate proportion of “customer revenues” to

profits and losses resulting from price movements of retained

principal positions and risks varies depending on the type of

positions involved, the typical fees, commissions, and spreads

payable for transactions in those positions, and the risks of those

positions. As a general matter, the proportion of “customer

revenues” generated when making a market in certain positions

increases as the fees, commissions, or spreads payable for those

positions increase, the volatility of those positions’ prices

decrease, and the prices for those positions are less transparent.

Because a market maker’s business model entails managing and

limiting the extent to which it is exposed to movements in the

prices of retained principal positions and risks while generating

customer revenues that are earned, regardless of movements in the

price of retained principal positions and risks, a market maker

typically generates significant revenue relative to the risks that

it retains. Accordingly, a market maker will typically demonstrate

consistent profitability and low earnings volatility under normal

market conditions. The appropriate extent to which a market maker

will demonstrate consistent profitability and low earnings

volatility varies depending on the type of positions involved, the

liquidity of the positions, the price transparency of the positions,

and the volatility of the positions’ prices. As a general matter,

consistent profitability will decrease and earnings volatility will

increase as the liquidity of the positions decrease, the volatility

of the positions’ prices increase, and the prices for the positions

are less transparent.

As the primary purpose of market making-related activities is to

provide intermediation services to its customers, market makers

focus their activities on servicing customer demands and typically

only engage in transactions with non-customers to the extent that

these transactions directly facilitate or support customer

transactions. In particular, a market maker generally only transacts

with non-customers to the extent necessary to hedge or otherwise

manage the risks of its market making-related activities, including

managing its risk with respect to movements of the price of retained

principal positions and risks, to acquire positions in amounts

consistent with reasonably expected near term demand of its

customers, or to sell positions acquired from its customers. The

appropriate proportion of a market maker’s transactions that are

with customers versus non-customers varies depending on the type of

positions involved and the extent to which the positions are

typically hedged in non-customer transactions. In the case of a

derivatives market maker that engages in dynamic hedging, the number

of non-customer transactions significantly outweighs the number of

customer transactions, as the derivatives market maker must

constantly enter into transactions to appropriately manage its

retained principal positions and risks as market prices for the

positions and risks move and additional transactions with customers

change the risk profile of the market makers retained principal

positions.

Because a market maker generates revenues primarily by

transacting with, and providing intermediation services to,

customers, a market maker typically engages in transactions that

earn fees, commissions, or spreads as payment for its services.

Transactions in which the market maker pays fees, commissions, or

spreads–i.e., where it pays another market maker for providing it

with liquidity services-are much less frequent, although in some

cases obtaining liquidity services from another market maker and

paying fees, commissions, or spreads may be necessary to prudently

manage its risk with respect to price movements of retained

principal positions and risks. The appropriate proportion of a

market maker’s transactions that earn, rather than pay, fees,

commissions or spreads varies depending on the type of positions

involved, the liquidity of the positions, and the extent to which

market trends increase the volatility of its risk with respect to

price movements of retained principal positions and risks. As a

general matter, the proportion of a market maker’s transactions that

earn rather than pay fees, commissions or spreads decreases as the

liquidity of the positions decreases, and the extent to which the

price volatility of retained principal positions and risks

increases.

Finally, because the primary purpose of market making-related

activities is to provide intermediation services to its customers, a

market maker does not provide compensation incentives to its

personnel that primarily reward proprietary risk-taking. Although a

market maker may take into account revenues resulting from movements

in the price of retained principal positions and risks to the extent

that such revenues reflect the effectiveness with which personnel

have effectively managed the risk of movements in the price of

retained principal positions and risks, a market maker that provides

compensation incentives relating to revenues generally does so

through incentives that primarily reward customer revenues and

effective customer service.

B. Overview of Prohibited Proprietary Trading Activities

Like permitted market making-related activities, prohibited

proprietary trading involves the taking of principal positions by a

covered banking entity. Unlike permitted market making-related

activities, the purpose of prohibited proprietary trading is to

generate profits as a result of, or otherwise benefit from, changes

in the price of positions and risks taken. Whereas a market maker

attempts to eliminate some or all of the price risks inherent in its

retained principal positions and risks by hedging or otherwise

managing those risks in a reasonable period of time after positions

are acquired or risks arise, a proprietary trader seeks to

capitalize on those risks, and generally only hedges or manages a

portion of those risks when doing so would improve the potential

profitability of the risk it retains. A proprietary trader does not

have “customers” because a proprietary trader simply seeks to

obtain the best price and execution in purchasing or selling its

proprietary positions. A proprietary trader generates few if any

fees, commissions, or spreads from its trading activities because it

is not providing an intermediation service to any customer or other

third party. Instead, a proprietary trader is likely to pay fees,

commissions, or spreads to other market makers when obtaining their

liquidity services is beneficial to execution of its trading

strategy. Because a proprietary trader seeks to generate profits

from changes in the price of positions taken, a proprietary trader

typically provides compensation incentives to its personnel that

primarily reward successful proprietary risk taking.

C. Distinguishing Permitted Market Making-Related Activities From

Prohibited Proprietary Trading

Because both permitted market making-related activities and

prohibited proprietary trading involve the taking of principal

positions, certain challenges arise in distinguishing permitted

market making-related activities and prohibited proprietary

[[Page 8441]]

trading, particularly in cases where both of these activities occur

in the context of a market making operation. Particularly during

periods of significant market disruption, it may be difficult to

distinguish between retained principal positions and risks that

appropriately support market making-related activities and positions

taken, or positions or risks not hedged, for proprietary purposes.

In connection with these challenges, [Agency] will apply the

following factors in distinguishing permitted market making-related

activities from trading activities that, even if conducted in the

context of the covered banking entity’s market making operations,

would constitute prohibited proprietary trading. The particular

types of trading activity described in this appendix may involve the

aggregate trading activities of a single trading unit, a significant

number or series of transactions occurring at one or more trading

units, or a single significant transaction, among other potential

scenarios. In addition to meeting the terms of this appendix, any

transaction or activity for which a covered banking entity intends

to rely on the market making exemption in Sec. —-.4(b) must also

satisfy all the requirements specified in Sec. —-.4(b), as well

as the other applicable requirements and conditions of this part.

1. Risk Management

Absent explanatory facts and circumstances, particular trading

activity in which a trading unit retains risk in excess of the size

and type required to provide intermediation services to customers

will be considered to be prohibited proprietary trading, and not

permitted market making-related activity.

[Agency] will base a determination of whether a trading unit

retains risk in excess of the size and type required for these

purposes on all available facts and circumstances, including a

comparison of retained principal risk to: the amount of risk that is

generally required to execute a particular market making function;

hedging options that are available in the market and permissible

under the covered banking entity’s hedging policy at the time the

particular trading activity occurred; the trading unit’s prior

levels of retained risk and its hedging practices with respect to

similar positions; and the levels of retained risk and the hedging

practices of other trading units with respect to similar positions.

To help assess the extent to which a trading unit’s risks are

potentially being retained in excess of amounts required to provide

intermediation services to customers, [Agency] will utilize the VaR

and Stress VaR, VaR Exceedance, and Risk Factor Sensitivities

quantitative measurements, as applicable, among other risks

measurements described in Appendix A and any other relevant factor.

This assessment will focus primarily on the risk measurements

relative to: the risk required for conducting market making-related

activities, and any significant changes in the risk over time and

across similarly-situated trading units and banking entities.

Explanatory facts and circumstances might include, among other

things, market-wide changes in risk, changes in the specific

composition of market making-related activities, temporary market

disruptions, or other market changes that result in previously-used

hedging or other risk management techniques no longer being possible

or cost-effective.

2. Source of Revenues

Absent explanatory facts and circumstances, particular trading

activity in which a trading unit primarily generates revenues from

price movements of retained principal positions and risks, rather

than customer revenues, will be considered to be prohibited

proprietary trading, and not permitted market making-related

activity.

[Agency] will base a determination of whether a trading activity

primarily generates revenues from price movements of retained

principal positions and risks, rather than customer revenues, on all

available facts and circumstances, including: an evaluation of the

revenues derived from price movements of retained principal

positions and risks relative to its customer revenues; and a

comparison of these revenue figures to the trading unit’s prior

revenues with respect to similar positions, and the revenues of

other covered banking entities’ trading units with respect to

similar positions.

To help assess the extent to which a trading unit’s revenues are

potentially derived from movements in the price of retained

principal positions and risks, [Agency] will utilize the

Comprehensive Profit and Loss, Portfolio Profit and Loss, Fee Income

and Expense, and Spread Profit and Loss quantitative measurements,

as applicable, both individually and in combination with one another

(e.g., by comparing the ratio of Spread Profit and Loss to Portfolio

Profit and Loss), and any other relevant factor.

Explanatory facts and circumstances might include, among other

things: general upward or downward price trends in the broader

markets in which the trading unit is making a market, provided

revenues from price movements in retained principal positions and

risks are consistent; sudden market disruptions or other changes

causing significant, unanticipated alterations in the price of

retained principal positions and risks; sudden and/or temporary

changes in the market (e.g., narrowing of bid/ask spreads) that

cause significant, unanticipated reductions in customer revenues; or

efforts to expand or contract a trading unit’s market share.

3. Revenues Relative to Risk

Absent explanatory facts and circumstances, particular trading

activity will be considered to be prohibited proprietary trading,

and not permitted market making-related activity, if the trading

unit: generates only very small or very large amounts of revenue per

unit of risk taken; does not demonstrate consistent profitability;

or demonstrates high earnings volatility.

[Agency] will base such a determination on all available facts

and circumstances, including: an evaluation of the amount of revenue

per unit of risk taken, earnings volatility, profitability, exposure

to risks, and overall level of risk taking for the particular

trading activities; and a comparison of these figures to the trading

unit’s prior results with respect to similar positions, and the

results of other covered banking entities’ trading units with

respect to similar positions.

To help assess the riskiness of revenues and the amount of

revenue per unit of risk taken, [Agency] will utilize the Volatility

of Comprehensive Profit and Loss and Volatility of Portfolio Profit

and Loss, Comprehensive Profit and Loss to Volatility Ratio and

Portfolio Profit and Loss to Volatility Ratio, and Comprehensive

Profit and Loss Attribution quantitative measurements, as

applicable, and any other relevant factor.

To help assess the extent to which a trading unit demonstrates

consistent profitability, [Agency] will utilize the Unprofitable

Trading Days Based on Comprehensive Profit and Loss and Unprofitable

Trading Days Based on Portfolio Profit and Loss quantitative

measurements, as applicable, and any other relevant factor.

To help assess the extent to which a trading unit is exposed to

outsized risk, [Agency] will utilize the Skewness of Portfolio

Profit and Loss and Kurtosis of Profit and Loss quantitative

measurements, as applicable, and any other relevant factor.

Explanatory facts and circumstances might include, among other

things: market disruptions or other changes causing significant,

unanticipated increases in a trading unit’s risk with respect to

movements in the price of retained principal positions and risks;

market disruptions or other changes causing significant,

unanticipated increases in the volatility of positions in which the

trading unit makes a market; sudden and/or temporary changes in the

market (e.g., narrowing of bid-ask spreads) that cause significant,

unanticipated reductions in customer revenues and decrease overall

profitability; or efforts to expand or contract a trading unit’s

market share.

4. Customer-Facing Activity

Absent explanatory facts and circumstances, particular trading

activity will be considered to be prohibited proprietary trading,

and not permitted market making-related activity, if the trading

unit: does not transact through a trading system that interacts with

orders of others or primarily with customers of the banking entity’s

market making desk to provide liquidity services; or retains

principal positions and risks in excess of reasonably expected near

term customer demands.

[Agency] will base such a determination on all available facts

and circumstances, including, among other things: an evaluation of

the extent to which a trading unit’s transactions are with customers

versus non-customers and the frequency with which the trading unit’s

retained principal positions and risks turn over; and a comparison

of these figures to the trading unit’s prior results with respect to

similar positions and market situations, and the results of other

covered banking entities’ trading units with respect to similar

positions.

To help assess the extent to which a trading unit’s transactions

are with customers versus non-customers, [Agency] will utilize the

Customer-Facing Trade Ratio quantitative measurement, as applicable,

and any other

[[Page 8442]]

relevant factor. To help assess the frequency with which the trading

unit’s retained principal positions and risks turn over, [Agency]

will utilize the Inventory Risk Turnover and Inventory Aging

quantitative measurements, as applicable, and any other relevant

factor.

With respect to a particular trading activity in which a trading

unit either does not transact through a trading system that

interacts with orders of others or primarily with customers of the

banking entity’s market making desk to provide liquidity services,

explanatory facts and circumstances might include, among other

things: sudden market disruptions or other changes causing

significant increases in a trading unit’s hedging transactions with

non-customers; or substantial intermediary trading required to

satisfy customer demands and hedging management. With respect to

particular trading activity in which a trading unit retains

principal positions and risks in excess of reasonably expected near

term customer demands, explanatory facts and circumstances might

include, among other things: sudden market disruptions or other

changes causing a significant reduction in actual customer demand

relative to expected customer demand; documented and reasonable

expectations for temporary increases in customer demand in the near

term; and sudden market disruptions or other changes causing a

significant reduction in the value of retained principal positions

and risks, such that it would be imprudent for the trading unit to

dispose of the positions in the near term.

5. Payment of Fees, Commissions, and Spreads

Absent explanatory facts and circumstances, particular trading

activity in which a trading unit routinely pays rather than earns

fees, commissions, or spreads will be considered to be prohibited

proprietary trading, and not permitted market making-related

activity.

[Agency] will base such a determination on all available facts

and circumstances, including, among other things: an evaluation of

the frequency with which the trading unit pay fees, commissions, or

spreads and the relative amount of fees, commissions, or spreads

that is paid versus earned; and a comparison of these figures to the

trading unit’s prior results with respect to similar positions, and

the results of other covered banking entities’ trading units with

respect to similar positions.

To help assess the extent to which a trading unit is paying

versus earning fees, commissions, and spreads, [Agency] will utilize

the Pay-to-Receive Spread Ratio quantitative measurement, as

applicable, and any other relevant factor.

Explanatory facts and circumstances might include, among other

things, sudden market disruptions or other changes causing

significant, increases in a trading unit’s hedging transactions with

non-customers for which it must pay fees, commissions, or spreads,

sudden, unanticipated customer demand for liquidity that requires

the trading unit itself to pay fees, commissions, or spreads to

other market makers for liquidity services to obtain the inventory

needed to meet that customer demand, or significant, unanticipated

reductions in fees, commissions, or spreads earned by the trading

unit. Explanatory facts and circumstances might also include a

trading unit’s efforts to expand or contract its market share.

6. Compensation Incentives

Absent explanatory facts and circumstances, the trading activity

of a trading unit that provides compensation incentives to employees

that primarily reward proprietary risk taking will be considered to

be prohibited proprietary trading, and not permitted market making-

related activity.

[Agency] will base such a determination on all available facts

and circumstances, including, among other things, an evaluation of:

the extent to which compensation incentives are provided to trading

unit personnel that reward revenues from movements in the price of

retained principal positions and risks; the extent to which

compensation incentives are provided to trading unit personnel that

reward customer revenues; and the compensation incentives provided

by other covered banking entities to similarly-situated personnel.

Appendix C to Part [ ]–Minimum Standards for Programmatic Compliance

I. Overview

A. Purpose

This appendix sets forth the minimum standards with respect to

the establishment, maintenance, and enforcement by banking entities

of internal compliance programs for ensuring and monitoring

compliance with the prohibitions and restrictions on proprietary

trading and covered fund activities or investments set forth in

section 13 of the BHC Act and this part.

This appendix requires that banking entities establish,

maintain, and enforce an effective compliance program, consisting of

written policies and procedures, internal controls, a management

framework, independent testing, training, and recordkeeping, that:

Is reasonably designed to clearly document, describe,

and monitor the covered trading and covered fund activities or

investments and the risks of the covered banking entity related to

such activities or investments, identify potential areas of

noncompliance, and prevent activities or investments prohibited by,

or that do not comply with, section 13 of the BHC Act and this part;

Specifically addresses the varying nature of activities

or investments conducted by different units of the covered banking

entity’s organization, including the size, scope, complexity, and

risks of the individual activities or investments;

Subjects the effectiveness of the compliance program to

independent review and testing;

Makes senior management and intermediate managers

accountable for the effective implementation of the compliance

program, and ensures that the board of directors and CEO review the

effectiveness of the compliance program; and

Facilitates supervision and examination of the covered

banking entity’s covered trading and covered fund activities or

investments by the Agencies.

B. Definitions

The terms used in this Appendix have the same meanings as set

forth in Sec. Sec. —-.2, —-.3, and —-.10. In addition, for

purposes of this appendix, the following definitions apply:

Asset management unit means any unit of organization of a

covered banking entity that makes investments in, or acts as sponsor

to, covered funds, or has relationships with covered funds, that the

covered banking entity (or an affiliate of subsidiary thereof) has

sponsored, organized and offered, or in which a covered fund

sponsored or advised by the covered banking entity invests.

Compliance program means the internal compliance program

established by a covered banking entity in accordance with Sec. —

–.20 and this appendix.

Covered fund activity or investment means sponsoring any covered

fund or making investments in, or otherwise having relationships

with, any covered fund for which the covered banking entity (or an

affiliate or subsidiary thereof) acts as sponsor or organizes and

offers.

Covered fund restrictions means the restrictions on covered fund

activities or investments set forth in subpart C.

Covered trading activity means proprietary trading, as defined

in Sec. —-.3(b)(1).

Trading unit means each of the following units of organization

of a covered banking entity:

(i) Each discrete unit that is engaged in the coordinated

implementation of a revenue-generation strategy and that

participates in the execution of any covered trading activity; 1

—————————————————————————

1 [Agency] expects that this will generally be the smallest

unit of organization used by the covered banking entity to structure

and control its risk-taking activities and employees, and will

include each unit generally understood to be a single “trading

desk.”

—————————————————————————

(ii) Each organizational unit that is used to structure and

control the aggregate risk-taking activities and employees of one or

more trading units described in paragraph (i); 2

—————————————————————————

2 [Agency] expects that this will generally include management

or reporting divisions, groups, sub-groups, or other intermediate

units of organization used by the covered banking entity to manage

one or more discrete trading units (e.g.,“North American Credit

Trading,” “Global Credit Trading,” etc.).

—————————————————————————

(iii) All trading operations, collectively; and

(iv) Any other unit of organization specified by the [Agency]

with respect to a particular banking entity.

C. Required Elements

Section —-.20 requires that covered banking entities

establish, maintain, and enforce a compliance program reasonably

designed to ensure and monitor compliance with the prohibitions and

restrictions on proprietary trading and covered fund activities or

investments that effectively

[[Page 8443]]

implements, at a minimum, the six elements required under paragraph

(b) of Sec. —-.20.

D. Compliance Program Structure

Each covered banking entity subject to Sec. —-.20(c) must be

governed by a compliance program meeting the requirements of this

appendix. A covered banking entity may establish a compliance

program on an enterprise-wide basis to satisfy the requirements of

Sec. —-.20 and this appendix with respect to the covered banking

entity and all of its affiliates and subsidiaries collectively,

provided that: the program is clearly applicable, both by its terms

and in operation, to all such affiliates and subsidiaries; the

program specifically addresses the requirements set forth in this

appendix; the program takes into account and addresses the

consolidated organization’s business structure, size, and

complexity, as well as the particular activities, risks, and

applicable legal requirements of each subsidiary and affiliate; and

the program is determined through periodic independent testing to be

effective for the covered banking entity and all of its subsidiaries

and affiliates. An enterprise-wide program established pursuant to

this Appendix will be subject to supervisory review and examination

by any Agency vested with rulewriting authority under section 13 of

the BHC Act with respect to the compliance program and the

activities or investments of any banking entity for which the Agency

has such authority. Further, such Agency will have access to all

records related to the enterprise-wide compliance program pertaining

to any banking entity that is supervised by the Agency vested with

such rulewriting authority.

E. Applicability

This appendix applies only to covered banking entities described

in Sec. —-.20(c)(2). In addition, [Agency] may require any

covered banking entity to comply with all or portions of this

appendix if [Agency] deems it appropriate for purposes the covered

banking entity’s compliance with this part.

Nothing in this appendix limits the authority of [Agency] under

any other provision of law or regulation to take supervisory,

examination, or enforcement action, including action to address

unsafe or unsound practices or conditions, deficient capital levels,

or violations of law.

II. Internal Policies and Procedures

A. Covered Trading Activities

A covered banking entity must establish, maintain, and enforce

written policies and procedures reasonably designed to document,

describe, and monitor the covered banking entity’s covered trading

activities and the risks taken in these activities, as follows:3

—————————————————————————

3 These policies and procedures must be updated with a

frequency sufficient for the covered banking entity to adequately

control the applicable trading unit for purposes of this part.

—————————————————————————

Identification of trading account: The covered banking entity’s

policies and procedures must specify how the banking entity

evaluates the covered financial positions it acquires or takes and

determines which of its accounts are trading accounts for purposes

of subpart B.

Identification of trading units and organization structure: The

covered banking entity’s written policies and procedures must

identify and document each trading unit within the organization and

map each trading unit to the division, business line, or other

organizational structure that the covered banking entity uses to

manage or oversee the trading unit’s activities.

Description of missions and strategies: The covered banking

entity’s written policies and procedures for each trading unit must

clearly articulate and document a comprehensive description of the

mission (i.e., the nature of the business conducted) and strategy

(i.e., business model for the generation of revenues) of the trading

unit, and include a description of:

How revenues are intended to be generated by the

trading unit;

The activities that the trading unit is authorized to

conduct, including authorized instruments and products and

authorized hedging strategies and instruments;

The expected holding period of, and the market risk

associated with, covered financial positions in its trading account;

The types of clients, customers, and counterparties

with whom trading is conducted by the trading unit;

How the trading unit, if engaged in market making-

related activity under Sec. –.4(b) of this part, identifies its

customers for purposes of computing the Customer-Facing Trade Ratio,

if applicable, including documentation explaining when, how, and why

a broker-dealer, swap dealer, security-based swap dealer, any other

entity engaged in market making-related activities, or any affiliate

thereof is considered to be a customer of the trading unit for those

purposes; and

The compensation structure of the employees associated

with the trading unit.

Trader mandates: The covered banking entity must establish,

maintain, document, and enforce trader mandates for each trading

unit. At a minimum, trader mandates must:

Clearly inform each trader of the prohibitions and

requirements set forth in section 13 of the BHC Act and this part

and his or her responsibilities for compliance with such

requirements;

Set forth appropriate parameters for each trader

engaged in covered trading activities, including:

[cir] The conditions for relying on the applicable exemptions in

Sec. Sec. —-.4 through —-.6;

[cir] The financial contracts, products, and underlying assets

that the trader is permitted to trade pursuant to the covered

banking entity’s internal controls;

[cir] The risk limits of the trader’s trading unit, and the

types and levels of risk that may be taken; and

[cir] The applicable trading unit’s hedging policy.

Description of risks and risk management processes: The written

policies and procedures for each trading unit must clearly

articulate and document a comprehensive description of the risks

associated with the trading unit. Such descriptions must include, at

a minimum, the following elements:

A description of the supervisory and risk management

structure governing the trading units, including a description of

processes for initial and senior-level review of new products and

new strategies;

A description of the types of risks that may be taken

to implement the mission and strategy of the trading unit, including

an enumeration of material risks resulting from the activities in

which the trading unit is engaged (including but not limited to all

significant price risks, such as basis, volatility and correlation

risks, as well as any significant counterparty credit risk

associated with the trading activity);

An articulation of the amount of risk allocated by the

covered banking entity to such trading unit to implement the

documented mission and strategy of the trading unit;

An explanation of how the risks allocated to such

trading unit will be measured; and

An explanation of why the allocated risk levels are

appropriate to the mission and strategy of the trading unit.

Hedging policies and procedures. The covered banking entity must

establish, maintain, and enforce policies and procedures for all of

its trading units regarding the use of risk-mitigating hedging

instruments and strategies. At a minimum, these hedging policies and

procedures must articulate the following:

The manner in which the covered banking entity will

determine that the risks generated by each trading unit have been

properly and effectively hedged;

The instruments, techniques and strategies the covered

entity will use to hedge the risk of the positions or portfolios;

The level of the organization at which hedging activity

and management will occur;

The manner in which hedging strategies will be

monitored;

The risk management processes used to control unhedged

or residual risks; and

The independent testing of hedging techniques and

strategies.

Explanation of compliance. The covered banking entity’s written

policies and procedures must clearly articulate and document a

comprehensive explanation of how the mission and strategy of each

trading unit, and its related risk levels, comply with this part.

Such explanation must:

Identify which portions of the risk-taking activity of

the trading unit would or would not constitute covered trading

activity;

Identify activities of the trading unit that will be

conducted in reliance on exemptions contained in Sec. Sec. —-.4

through —-.6, including an explanation of:

[cir] How and where the activity occurs; and

[cir] Which exemption is being relied on and how the activity

meets the specific requirements for reliance on the applicable

exemption.

Describe how the covered banking entity monitors for

and prohibits potential or actual material exposure to high-risk

assets or high-risk trading strategies presented by each trading

unit, which must take into account potential or actual exposure to:

[[Page 8444]]

[cir] Assets whose values cannot be externally priced or, where

valuation is reliant on pricing models, whose model inputs cannot be

externally validated;

[cir] Assets whose changes in values cannot be adequately

mitigated by effective hedging;

[cir] New products with rapid growth, including those that do

not have a market history;

[cir] Assets or strategies that include significant embedded

leverage;

[cir] Assets or strategies that have demonstrated significant

historical volatility;

[cir] Assets or strategies for which the application of capital

and liquidity standards would not adequately account for the risk;

and

[cir] Assets or strategies that result in large and significant

concentrations to sectors, risk factors, or counterparties;

Explain how each trading unit will comply with the

reporting and recordkeeping requirements of Sec. —-.7 and

Appendix A ;

Describe how the covered banking entity monitors for

and prohibits potential or actual material conflicts of interest

between the covered banking entity and its clients, customers, or

counterparties present in each trading unit; and

Describe how the covered banking entity monitors for

and prohibits potential or actual transactions or activities that

may threaten the safety and soundness of the covered banking entity.

Remediation of violations. The covered banking entity’s written

policies and procedures must require the covered banking entity to

promptly document, address and remedy any violation of section 13 of

the BHC Act or this part, and document all proposed and actual

remediation efforts. Further, such policies and procedures must

include specific procedures that are reasonably designed to

implement and monitor any required remediation and that assess the

extent to which any violation indicates that modification to the

covered banking entity’s compliance program is warranted.

With respect to any trading unit that is either used by the

covered banking entity to structure and control the aggregate risk-

taking activities and employees of one or more other trading units,

or comprised of the entire trading operation of the covered banking

entity, the description of missions and strategies, description of

risks and risk management processes, and explanation of compliance

for such trading units may incorporate by reference the policies and

procedures of the underlying trading units that the trading unit

oversees and manages in the aggregate.

B. Covered Fund Activities or Investments

A covered banking entity must establish, maintain, and enforce

written policies and procedures that are reasonably designed to

document, describe, and monitor the covered banking entity’s covered

fund activities or investments and the risks taken in these

activities or investments, as follows.

Identification of covered funds: The covered banking entity’s

policies and procedures must specify how the covered banking entity

identifies covered funds that the covered banking entity sponsors,

organizes and offers, or in which covered banking entity invests.

Identification of asset management units and organization

structure: The covered banking entity’s written policies and

procedures must identify and document each asset management unit

within the organization and map each asset management unit to the

division, business line, or other organizational structure that the

covered banking entity uses to manage or oversee the asset

management unit’s activities or investments.

Description of sponsorship activities related to covered funds:

The covered banking entity’s written policies and procedures for

each asset management unit must clearly articulate and document a

comprehensive description of the mission (i.e., the nature of the

business conducted) and strategy (i.e., business model for the

generation of revenues) of the asset management unit related to its

sponsorship or organizing and offering of covered funds, including a

description of how such activities comply with this part and, in

particular:

The activities that the asset management unit is

authorized to conduct, including the nature of any trust, fiduciary,

investment advisory, or commodity trading advisory services offered

to customers of the covered banking entity;

The types of customers to whom the asset management

unit provides such services and to whom ownership interests in

covered funds are sold;

The extent of any co-investment activities of the

covered banking entity (including its directors or employees) in

covered funds offered to such customers; and

How the asset management unit complies with the

requirements of subpart C.

Description of investment activities of covered funds: The

covered banking entity’s written policies and procedures for each

asset management unit must clearly articulate and document a

comprehensive description of the mission (i.e., the nature of the

business conducted) and strategy (i.e., business model for the

generation of revenues) of the asset management unit related to its

investments in covered funds, including a description of how such

activities comply with this part and, in particular:

The asset management unit’s practices with respect to

seed capital investments in covered funds, including how the asset

management unit reduces its investments in covered funds to amounts

that are permitted de minimis investments within the required period

of time;

The asset management unit’s practices with respect to

co-investments in covered funds, including certain parallel

investments as identified in Sec. —-.12;

How the asset management unit complies with the

requirements of Sec. —-.12 with respect to individual and

aggregate investments in covered funds;

With respect to other permitted covered fund activities

or investment, how the asset management unit complies with the

requirements of Sec. Sec. —-.13 and —-.14;

How the asset management unit complies with the

limitations on relationships with a covered fund under Sec. —

–.16;

How the covered banking entity monitors for and

prohibits potential or actual material conflicts of interest between

the covered banking entity and its clients, customers, or

counterparties related to the asset management unit;

How the covered banking entity monitors for and

prohibits potential or actual transactions or activities that may

threaten the safety and soundness of the covered banking entity

related to the asset management unit; and

How the covered banking entity monitors for and

prohibits potential or actual material exposure to high-risk assets

or high-risk trading strategies presented by each asset management

unit.

Remediation of violations. The covered banking entity’s written

policies and procedures must require the covered banking entity to

promptly document, address and remedy any violation of section 13 of

the BHC Act or this part, and document all proposed and actual

remediation efforts. Further, such policies and procedures must

include specific procedures that are designed to implement, monitor,

and enforce any required remediation and that assess the extent to

which any violation indicates that modification to the covered

banking entity’s compliance program is warranted.

III. Internal Controls

A. Covered Trading Activities

A covered banking entity must establish, maintain, and enforce

written internal controls that are reasonably designed to ensure

that the trading activity of each trading unit is appropriate and

consistent with the description of mission, strategy, and risk

mitigation for each trading unit contained in its written policies

and procedures. These written internal controls must also be

reasonably designed and established to effectively monitor and

identify for further analysis any covered trading activity that may

indicate potential violations of section 13 of the BHC Act and this

part and to prevent actual violations of section 13 of the BHC Act

and this part. Further, the internal controls must describe

procedures for remedying violations of section 13 of the BHC Act and

this part. The written internal controls must include, at a minimum,

the following.

Authorized risks, instruments, and products. The covered banking

entity must implement and enforce internal controls for each trading

unit that are reasonably designed to ensure that trading activity is

conducted in conformance with the trading unit’s authorized risks,

instruments, and products, as documented in the covered banking

entity’s written policies and procedures and trader mandates. At a

minimum, these internal controls must monitor and govern:

The types and levels of risks that may be taken by each

trading unit, consistent with the covered banking entity’s written

policies and procedures;

The type of hedging instruments used, hedging

strategies employed, and the amount

[[Page 8445]]

of risk effectively hedged, consistent with the covered banking

entity’s written policies and procedures; and

The financial contracts, products and underlying assets

that the trading unit may trade, consistent with covered banking

entity’s written policies and procedures.

Risk limits. The covered banking entity must establish and

enforce risk limits appropriate for each trading unit, which shall

include limits based on probabilistic and non-probabilistic measures

of potential loss (e.g., Value-at-Risk and notional exposure,

respectively), measured under normal and stress market conditions.

Analysis and quantitative measurements. The covered banking

entity must perform robust analysis and quantitative measurement of

its covered trading activities that is reasonably designed to ensure

that the trading activity of each trading unit is consistent with

its mission, strategy and risk management process, as documented in

the covered banking entity’s written policies and procedures;

monitor and assist in the identification of potential and actual

prohibited proprietary trading activity; and prevent the occurrence

of prohibited proprietary trading. In addition to the quantitative

measurements reported by the covered banking entity to [Agency]

pursuant to appendix A to this part, each covered banking entity

must develop and implement, to the extent necessary to facilitate

compliance with this part, additional quantitative measurements

specifically tailored to the particular risks, practices, and

strategies of its trading units. The covered banking entity’s

analysis and quantitative measurement must incorporate the

quantitative measurements reported by the covered banking entity to

[Agency] pursuant to appendix A to this part and include, at

minimum, the following:

Internal controls and written policies and procedures

reasonably designed to ensure the accuracy and integrity of

quantitative measurements;

Ongoing, timely monitoring and review of calculated

quantitative measurements;

Heightened review of a quantitative measurement when

such quantitative measurement raises any question regarding

compliance with section 13 of the BHC Act and this part, which shall

include in-depth analysis, appropriate escalation procedures, and

documentation related to the review, including the establishment of

numerical thresholds for each trading unit for purposes of

triggering such heightened review; and

Immediate review and compliance investigation of the

trading unit’s activities, escalation to senior management with

oversight responsibilities for the applicable trading unit, timely

notification to [Agency], appropriate remedial action (e.g.,

divesting of impermissible positions, cessation of impermissible

activity, disciplinary actions), and documentation of the

investigation findings and remedial action taken when the

quantitative measurement, considered together with the facts and

circumstances, suggests a reasonable likelihood that the trading

unit has violated any part of section 13 of the BHC Act and this

part.

Surveillance of compliance program effectiveness. The covered

banking entity must regularly monitor the effectiveness of its

compliance program and take prompt action to address and remedy any

deficiencies identified. Any actions taken to remedy deficiencies

and violations shall be documented and maintained as a record of the

banking entity.

B. Covered Fund Activities

A covered banking entity must establish, maintain, and enforce

internal controls that are reasonably designed to ensure that the

covered fund activities or investments of its asset management units

are appropriate and consistent with the description of the asset

management unit’s mission, strategy, and risk management process

contained in the covered banking entity’s written policies and

procedures. The internal controls must, at a minimum, be designed to

ensure that the covered banking entity complies with the

requirements of Sec. —-.11 for any covered fund in which it

invests, acts as sponsor, or organizes and offers, as well as the

following:

Monitoring investments in a covered fund. The covered banking

entity must implement and enforce internal controls in a way that

monitors and limits the covered banking entity’s individual and

aggregate investments in covered funds. At a minimum, the covered

banking entity shall establish, maintain, and enforce internal

controls reasonably designed to ensure that such investments are in

compliance with section 13 of the BHC Act and this part at all

times, including:

Monitoring the amount and timing of seed capital

investments for compliance with the limitations (including but not

limited to the redemption, sale or disposition requirements of Sec.

—-.12);

Calculating the individual and aggregate levels of

ownership interests in covered funds required by Sec. —-.12;

Describing procedures for remedying violations of

section 13 of the BHC Act and this part;

Attributing the appropriate instruments to the

individual and aggregate ownership interest calculations above; and

Making the appropriate required disclosures, in

writing, to prospective and actual investors in any covered fund

organized and offered or sponsored by the covered banking entity, as

provided under Sec. —-.11(h).

Monitoring relationships with a covered fund. The covered

banking entity must implement and enforce internal controls in a way

that monitors and limits the covered banking entity’s sponsorship

of, and relationships with, covered funds. At a minimum, the covered

banking entity shall establish, maintain, and enforce internal

controls reasonably designed to ensure that such activities and

relationships are in compliance with section 13 of the BHC Act and

this part at all times, including monitoring for and preventing any

relationship or transaction between the covered banking entity and a

covered fund that is prohibited under Sec. —-.16.

Surveillance of compliance program effectiveness. The covered

banking entity must regularly monitor the effectiveness of its

compliance program and take prompt action to address and remedy any

deficiencies identified. Any actions taken to remedy deficiencies

and violations shall be documented and maintained as a record of the

covered banking entity.

IV. Responsibility and Accountability for the Compliance Program

A covered banking entity must establish, maintain, and enforce a

management framework to manage its business and employees with a

view to preventing violations of section 13 of the BHC Act and this

part. A covered banking entity must have an appropriate management

framework reasonably designed to ensure that: appropriate personnel

are made responsible and accountable for the effective

implementation and enforcement of the compliance program; a clear

reporting line with a chain of responsibility is delineated; and the

board of directors, or similar corporate body, and CEO reviews and

approves the compliance program. This management framework must

include, at a minimum:

Corporate governance. The covered banking entity must ensure

that its compliance program is reduced to writing, approved by the

board of directors or similar corporate body, and noted in the

minutes.

Trader mandates. The covered banking entity must establish,

maintain, and enforce the trader mandates required by this appendix

to clearly inform each trader within a trading unit of his or her

responsibilities for compliance with section 13 of the BHC Act and

this part.

Management procedures. The covered banking entity must

establish, maintain, and enforce management procedures that are

reasonably designed to achieve compliance with section 13 of the BHC

Act and this part, which, at a minimum, provide for:

The designation of at least one person with authority

to carry out the management responsibilities of the covered banking

entity for each trading unit;

Written procedures addressing the management of the

activities of the covered banking entity that are reasonably

designed to achieve compliance with section 13 of the BHC Act and

this part, including:

[cir] Procedures for the review by a manager of activities of

the trading unit and the quantitative measurements pursuant to

appendix A and any other quantitative measurements developed and

tailored to the particular risks, practices, and strategies of the

covered banking entity’s trading units;

[cir] A description of the management system, including the

titles, qualifications, and locations of managers and the specific

responsibilities of each person with respect to the covered banking

entity’s trading units; and

[cir] Procedures for determining compensation arrangements for

traders engaged in underwriting or market making-related activities

under Sec. —-.4 or risk-mitigating hedging activities under Sec.

—-.5 so that such compensation arrangements are designed not to

reward proprietary risk taking.

Business line managers. Managers with responsibility for one or

more trading units or asset management units of the covered

[[Page 8446]]

banking entity engaged in covered trading activities or covered fund

activities or investments are accountable for the effective

implementation and enforcement of the compliance program with

respect to the applicable trading unit or asset management unit.

Senior management. Senior management is responsible for

communicating and reinforcing the culture of compliance with section

13 of the BHC Act and this part, as established by the board of

directors or similar corporate body, and implementing and enforcing

the approved compliance program. Senior management must also ensure

that effective corrective action is taken when failures in

compliance with section 13 of the BHC Act and this part are

identified.4 Senior management and control personnel charged with

overseeing compliance with section 13 of the BHC Act and this part

should report to the board, or an appropriate committee thereof, on

the effectiveness of the compliance program and compliance matters

with a frequency appropriate to the size, scope, and risk profile of

the covered banking entity’s covered trading activities and covered

fund activities or investments, which shall be at least once every

twelve months.

—————————————————————————

4 Such corrective action may include, among other things

divesture of the position, cessation of the activity, or

disciplinary measures.

—————————————————————————

Board of directors, or similar corporate body, and CEO. The

board of directors, or similar corporate body, and CEO are

responsible for setting an appropriate culture of compliance with

this part and establishing clear policies regarding the management

of covered trading activities and covered fund activities or

investments in compliance with section 13 of the BHC Act and this

part. The board of directors or similar corporate body must ensure

that senior management is fully capable, qualified, and properly

motivated to manage compliance with this part in light of the

organization’s business activities. The board of directors or

similar corporate body must also ensure that senior management has

established appropriate incentives to support compliance with this

part, including the implementation of a compliance program meeting

the requirements of this appendix into management goals and

compensation structures across the covered banking entity.

V. Independent Testing

A covered banking entity must ensure that independent testing is

conducted by a qualified independent party, such as the covered

banking entity’s internal audit department, outside auditors,

consultants, or other qualified independent parties, regarding the

effectiveness of the covered banking entity’s compliance program

established pursuant to this appendix and Sec. —-.20 and the

covered banking entity’s compliance with this part. A banking entity

must take appropriate action to remedy any concerns identified by

the independent testing (e.g., remedying deficiencies in its written

policies and procedures and internal controls, etc.).

The required independent testing must occur with a frequency

appropriate to the size, scope, and risk profile of the covered

banking entity’s covered trading and covered fund activities or

investments, which shall be no less than once every twelve months.

This independent testing must include an evaluation of:

The overall adequacy and effectiveness of the covered

banking entity’s compliance program, including an analysis of the

extent to which the program contains all the required elements of

this appendix;

The effectiveness of the covered banking entity’s

written policies and procedures;

The effectiveness of the covered banking entity’s

internal controls, including an analysis and documentation of

instances in which such internal controls have been breached, and

how such breaches were addressed and resolved; and

The effectiveness of the covered banking entity’s

management procedures.

VI. Training

Covered banking entities must provide adequate training to

trading personnel and managers of the covered banking entity, as

well as other appropriate personnel, as determined by the covered

banking entity, in order to effectively implement and enforce the

compliance program. This training should occur with a frequency

appropriate to the size and the risk profile of the covered banking

entity’s covered trading activities and covered fund activities or

investments. The training may be conducted by internal personnel or

independent parties deemed appropriate by the covered banking entity

based on its size and risk profile.

VII. Recordkeeping

Covered banking entities must create and retain records

sufficient to demonstrate compliance and support the operations and

effectiveness of the compliance program. A covered banking entity

must retain these records for a period that is no less than 5 years

in a form that allows it to promptly produce such records to

[Agency] on request.

END OF COMMON RULE

[END OF COMMON TEXT]

Adoption of the Common Rule Text

The proposed adoption of the common rules set forth above by the

CFTC, which are identical to the common rules adopted by the OCC,

Board, FDIC, and SEC in the Joint Release, is modified by CFTC-specific

text, as set forth below:

List of Subjects in 17 CFR Part 75

Commodity pool operators, Commodity trading advisors, Futures

commission merchants, Reporting and recordkeeping requirements, Swaps,

Futures.

Authority and Issuance

For the reasons set forth in the Supplementary Information, the

Commodity Futures Trading Commission proposes to amend 17 CFR Chapter I

as follows:

PART 75–PROPRIETARY TRADING AND RELATIONSHIPS WITH COVERED FUNDS

1. The authority citation for part 75 is added to read as follows:

Authority: 12 U.S.C. 1851.

2. Part 75 is added as set forth at the end of the Common Preamble.

3. Part 75 is amended by:

a. Removing “[Agency]” wherever it appears and adding in its

place “CFTC”; and

b. Removing “[The Agency]” wherever it appears and adding in its

place “The CFTC.”

4. Section 75.1 is added to read as follows:

Sec. 75.1 Authority, purpose, scope, and relationship to other

authorities.

(a) Authority. This part is issued by the CFTC under section 13 of

the Bank Holding Company Act of 1956, as amended (12 U.S.C. 1851).

(b) Purpose. Section 13 of the Bank Holding Company Act establishes

prohibitions and restrictions on proprietary trading and investments in

or relationships with covered funds by certain banking entities,

including registered commodity pool operators, registered commodity

trading advisors, registered swap dealers, and registered major swap

participants, among others identified in section 2(12)(C) of the Dodd-

Frank Wall Street Reform and Consumer Protection Act of 2010 (12 U.S.C.

5301(12)(C)). This part implements section 13 of the Bank Holding

Company Act by defining terms used in the statute and related terms,

establishing prohibitions and restrictions on proprietary trading and

investments in or relationships with covered funds, and explaining the

statute’s requirements.

(c) Scope. This part implements section 13 of the Bank Holding

Company Act with respect to covered banking entities described in Sec.

75.2(j). This part takes effect on July 21, 2012.

(d) Relationship to other authorities. Except as otherwise provided

in under section 13 of the BHC Act, and notwithstanding any other

provision of law, the prohibitions and restrictions under section 13 of

BHC Act shall apply to the activities of a covered banking entity, even

if such activities are authorized for a covered banking entity under

other applicable provisions of law.

5. Paragraph (j) of Sec. 75.2 is added to read as follows:

Sec. 75.2 Definitions.

* * * * *

[[Page 8447]]

(j) Covered banking entity means any entity described in paragraph

(e) of this section for which the CFTC is the primary financial

regulatory agency, as defined in section 2(12)(C) of the Dodd-Frank

Wall Street Reform and Consumer Protection Act of 2010 (12 U.S.C.

5301(12)(C)).

* * * * *

6. Section 75.10(a) is revised to read as follows:

Sec. 75.10 Prohibition on acquiring or retaining an ownership

interest in and having certain relationships with a covered fund.

* * * * *

(a)(1) General Prohibition. Except as otherwise provided in this

subpart, a covered banking entity may not, as principal, directly or

indirectly, acquire or retain any ownership interest in or sponsor a

covered fund.

(2) Commodity Pool Operators and Commodity Trading Advisors. A

covered banking entity that is a covered banking entity because it is a

commodity pool operator or commodity trading advisor identified in

sections 2(12)(C)(ii) or 2(12)(C)(iii) of the Dodd-Frank Wall Street

Reform and Consumer Protection Act of 2010 shall comply with the

restrictions on covered fund activities or investments set forth in

subpart C and Sec. —-.20 of subpart D issued by the agency

identified in section 3(q) of the Federal Deposit Insurance Act (12

U.S.C. 1813(q)) that regulates the banking entity described in Sec.

75.2 (e)(1), (2) or (3) with which the commodity pool operator or

commodity trading advisor is affiliated.

Note to paragraph (a): Nothing set forth in paragraph (a)(2) of

this section shall limit the CFTC’s authority under any other provision

of law, including pursuant to section 13 of the Bank Holding Company

Act.

* * * * *

Issued on January 11, 2012 in Washington, DC.

David A. Stawick,

Secretary of the Commission.

Appendices to Prohibitions and Restrictions on Proprietary Trading and

Certain Interest In and Relationships With, Hedge Funds and Covered

Funds. Commission Voting Summary and Statements of Commissioners

Note: The following appendices will not appear in the Code of

Federal Regulations.

Appendix 1–Commission Voting Summary

On this matter, Chairman Gensler and Commissioners Chilton and

Wetjen voted in the affirmative; Commissioners Sommers and O’Malia

voted in the negative.

Appendix 2–Statement of Chairman Gary Gensler

I support the proposed rule implementing the “Volcker Rule”

requirements in the Dodd-Frank Wall Street Reform and Consumer

Protection Act (Dodd-Frank Act).

Dodd-Frank amended the Banking Holding Company Act to provide

the Commodity Futures Trading Commission with authority to implement

Volcker Rule requirements for the entities for which we are the

primary financial regulator.

Today’s proposal mirrors the joint rule proposed in October by

the Board of Governors of the Federal Reserve System, the Federal

Deposit Insurance Corporation, the Office of the Comptroller of the

Currency, and the Securities and Exchange Commission.

Consistent with the joint proposed rule, this proposal prohibits

certain banking entities from engaging in proprietary trading. The

proposal permits, as Congress prescribed, market-making and risk-

mitigating hedging.

I look forward to receiving comments from market participants

and the public on the proposed rule.

[FR Doc. 2012-935 Filed 2-13-12; 8:45 am]

BILLING CODE 6351-01-P

Last Updated: February 14, 2012