We knew it was coming. Section 619 of the Dodd-Frank Act
called for a prohibition on proprietary trading by certain
banking entities and limits investments in or sponsorships of
private equity or hedge funds. A leaked version of the draft
rule had been released several weeks ago. But even having that
leaked version out did little to soften the blow for market
participants who have reacted sharply as the proposed
regulations were approved for release by the banking agencies
and the SEC.
Regulators have exercised their discretion under the statute
to define various elements of the rule broadly in ways that are
certain to have a significant impact on the derivatives market,
the fixed income market, securitizations and fund activities,
as well as on the activities of foreign banks in the US.
Proprietary trading by a covered banking entity is defined
to include certain trading within a trading account of covered
financial positions. Covered financial positions encompasses
any position in any security, derivative, or commodity futures
contract, as well as options on any of these instruments.
Loans, commodities, foreign exchange and currency are among the
types of instruments excluded from the prohibition.
The proposed regulation also broadly expands the concept of
a trading account and creates rather narrowly tailored
exemptions for permissible market making activities, which are
sure to pose challenges for a number of market segments.
Certain risk-mitigating hedging is permitted. In order to
distinguish between proprietary trading and market making
activities, the proposed regulation establishes a host of
quantitative measures that are to be used regularly to monitor
compliance with the regulation.
These complex tools are accompanied by onerous recordkeeping
and compliance requirements. Finally, the proposed regulation
permits limited investments in covered funds subject to various
threshold limits provided that these exempted activities do not
result in material conflicts of interest between the banking
entity sponsor and its clients and that these activities not
expose clients to particularly high risk assets or trading
While the intended consequences of the proposed regulations
are troublesome enough to many, it is the unintended and
unforeseeable consequences that give rise to widespread