The deadline for submitting comments regarding the proposed regulations implementing the Volcker Rule has been extended from January 13 to February 13. As we noted in our previous update on the Volcker Rule, the timeline was already very tight if regulators intended to meet the implementation deadline of July 2012, and this postponement only makes that timeline even tighter and less feasible.

Putting this logistical problem to a side, one major provision in the proposal we have yet to discuss in-depth is the exemption provided in the Volcker Rule for risk-mitigating hedging transactions. The current proposal would allow banks to maintain, purchase, or sell hedging positions with commercial deposits provided that these positions arise from and are related to specific risks involved in the bank’s other legitimate positions, contracts, or holdings. These other risks include market risk, counterparty/credit risk, currency/foreign exchange risk, and interest rate risk (among others). Additionally, the hedged positions taken by the bank must be “reasonably correlated” (or, to be more precise, reasonably negatively correlated) with the risks purportedly being mitigated.

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On October 12th the Federal Reserve, FDIC, Office of the Comptroller of the Currency, and SEC submitted the long-awaited proposal for implementation of Section 619 of the Dodd-Frank Act, widely referred to as the “Volcker Rule.” Legislators included this section in the Dodd-Frank Act in order to divide commercial banking and depository functions, which are federally insured, from banks’ investment activities (commonly referred to as “proprietary trading”). Given the fact that many large commercial banks, such as Bank of America and JP Morgan Chase, derive a significant portion of their revenue (8% and 9%, respectively) from their trading desk, the details of the rule could have enormous implications for the future financial strength and stability of depository institutions.

The proposal has several large exceptions to its prohibition on proprietary trading in order to allow banks to continue to provide important financial services to their customers. One of the largest exceptions is for market making. Market making can involve a number of activities, but at its core it consists of financial institutions accepting client requests to purchase (or sell) any given security without that financial institution immediately going out into the market and finding a seller (or buyer). In order to facilitate this process, financial institutions involved in market making may maintain a stock of various securities that they buy and sell to clients as needed to meet client demand. Under the new proposal, banks would be allowed to purchase and sell securities under the premise of market making so long as: a.) the bank “holds itself out” as being willing to buy and sell those securities to and/or from clients, b.) the purchases or sales do not exceed “reasonably expected near term demands” of clients, c.) the activities are primarily intended to generate income from fees, commissions, and bid-ask spreads (as opposed to appreciation or depreciation in the securities themselves), and d.) the compensation arrangements of employees engaged in market making is not designed to reward large returns that may result from the appreciation or depreciation of the securities themselves.

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