Latest Volcker Rule FAQs discusses residual positions and relationships with covered transactions

By John M. Pachkowski, J.D.

The Federal Reserve Board has updated its Frequently Asked Questions regarding the application of section 13 to the Bank Holding Company Act of 1956 (BHC Act), commonly referred to as the Volcker Rule, and regulations adopted by the Fed, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Securities and Exchange Commission, and Commodity Futures Trading Commission. The Fed noted that while the FAQs apply to banking entities for which the Fed has jurisdiction under section 13 of the BHC Act, they have been developed by staff of all five agencies.

Treatment of residual positions. In FAQ No. 19, the agencies’ staff discussed the situation that may occur if a banking entity exits a permissible market-making business and the banking entity has to sell or unwind its residual market-making positions.

According to the staff, if a banking entity holds residual positions from its prior market-making activity, the banking entity may hold and dispose of these residual market-making positions, provided two conditions are met. First, the banking entity must hedge the risks of its residual positions in accordance with the risk-mitigating hedging exemption found in the implementing regulations. The second condition requires that the banking entity sells or unwinds the residual market-making positions as soon as commercially practicable.

When hedging the risks of the residual market-making positions, the banking entity must comply with the requirements of the risk-mitigating hedging exemption; and the banking entity cannot rely on the market-making exemption to manage the risks of its residual market-making positions. The staff noted that the market-making exemption only permits risk management activity conducted or directed by a trading desk in connection with the desk’s permitted market making-related activities conducted in conformance with all of the requirements of the market-making exemption set forth in the agencies’ regulations.

The staff cautioned that if a banking entity holds residual market-making positions and does not hedge the risks of those residual positions, then the subsequent sales of those residual positions would generally be considered proprietary trading under the regulations implementing the Volcker Rule.

Covered transactions. The second new FAQ examines the application of the Volcker Rule’s conformance period to existing and new “covered transactions” between a banking entity and a covered fund.

Under the Volcker Rule, a banking entity that serves, directly or indirectly, as the investment manager, investment adviser, or sponsor to a hedge fund or private equity fund—a covered fund—or that organizes and offers a covered fund cannot enter into a transaction with the covered fund that would be considered to be a “covered transaction” under section 23A of the Federal Reserve Act. Covered transactions generally are arrangements under which the banking entity would have a credit exposure to the covered fund. They include not only loans, but also other credit exposures such as investments in the covered fund’s securities, guarantying credit extended to the fund by another lender, and securities lending transactions. The restrictions apply equally to affiliates of the banking entity.

The limitation on covered transactions also applies to a banking entity’s affiliates, as well as any covered fund that is controlled by the fund with which the banking entity or its affiliates have a relationship.

The staff noted in FAQ No. 20 that as a general matter, on or after July 21, 2015, a banking entity may not enter into a covered transaction with a covered fund where the banking entity serves as investment manager, investment adviser, or sponsor to the covered fund or relies on the Volcker Rule’s organizing/offering exemption.

The agencies’ staff also believed that restrictions on covered transactions would also apply to any increase in the amount of, extension of the maturity of, or adjustment to the interest-rate or other material term of, an existing extension of credit. The staff noted that a floating-rate loan does not become a new covered transaction whenever the interest rate changes as a result of an increase or decrease in the index rate. If the banking entity and the borrower, however, amend the loan agreement to change the interest rate term, for example, from “LIBOR plus 100 basis points” to “LIBOR plus 150 basis points,” or from reference to the LIBOR index to the banking entity's prime rate, the parties have engaged in a new covered transaction.

Banking entities were also advised, with respect to any existing covered transaction, to evaluate whether the transaction guarantees, assumes or otherwise insures the obligations or performance of the covered fund since these activities are prohibited by the agencies’ implementing regulations.

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