Two of the main provisions of the Volcker rule prohibit
banking entities from proprietary trading, and from attaining
or retaining an ownership interest in or sponsoring of a
covered fund. This primer will look at the covered fund
specific aspects of the rule,
go here for a more general account of the Volcker rule from
or here for a look at proprietary trading.
What are covered funds?
A covered fund under the Volcker Rule is an entity that (i)
relies on section 3(c)(1) or 3(c)(7) of the Investment Company
Act; (ii) is a commodity pool whose operator relies on CFTC
Rule 4.7 (and certain similar pools); or (iii) a foreign fund
that either relies on section 3(c)(1) or 3(c)(7) with respect
to US investors or satisfies other criteria.
Loosely put, the Rule defines a covered fund as anything not
considered an investment company in the Investment Company Act,
including private equity and hedge funds, as well as commodity
pools with certain exclusions, and funds sponsored by a US
banking entity where the affiliate holds ownership
"It's not an easy definition
to navigate. So, it's unhelpful to ignore and not deal
with the Treasury report recommendations and fail to
address this very basic definition"
Similarly to proprietary funds, the Volcker Rule prevents
banking entities and insured depository institutions from
investing, or owning, any assets into covered funds or
vehicles, suggesting that this sort of activity incorporates
too much risk and does not benefit the customer base.
"A banking entity may not, as principal, directly or
indirectly, acquire or retain any ownership interest in or
sponsor a covered fund," reads the Rule.
What are the exclusions?
The Rule provides for several exclusions that fall into the
covered funds category, and that as such are not subject to the
Volcker Rule. These include foreign public funds, wholly-owned
subsidiaries, joint ventures, acquisition vehicles,
securitisation related vehicles, funds regulated under the 1940
Act such as mutual funds, exchange traded funds or business
development companies, foreign pension or retirement funds,
insurance company separate accounts, small business investment
and finally entities used by the Federal Deposit Insurance
Corporation to dispose of assets as receiver or
What is the problem with covered funds?
The aforementioned list is fairly extensive, which leaves a
lot of room for objections, loopholes and debate. It is a
lawyer’s paradise, according to Simpson Thacher,
Keith Noreika. He told IFLR
in an interview during his time as the acting Comptroller of
the Currency at the Office of the Comptroller of the
Currency (OCC) that "it is entirely an odd construct that can
be maneuvered around with skilled lawyering, I’m
not sure why we have it other than to keep lawyers fully
employed. An observation as a policy maker that I think we have
to be mindful of, we shouldn’t just have useless
June edition of magazine, IFLR surveyed a number of
in-house counsel and compliance officers at major banks to
identify some of the current issues with the Volcker Rule. One
of the questions posed to respondents was if the definition of
covered funds remains unchanged, whether they thought
exclusions or additional exclusions should be amended. Around
70% suggested that the exclusions should be indeed be
"We tend to use more laymen terms, and rules that are closer
to the industry, than use difficult to understand legal terms
to define some like this," said one overseas control
"It should be more laymen in this sense. Making it more
layman is the difficult part, private equity funnels, hedge
fund, there must be some tax definitions – even that
or sticking to the legal rules. Of course it will be more up to
the regulators themselves to strike a balance," he
The policy objective was aimed at hedge funds and private
equity funds. The actual definition has been seen as bringing
in more than what was intended and has created some confusion.
It is a highly contested issue, but if a way was found to
simply say that banking entities should not be permitted to
invest more than a certain amount in hedge funds or in private
equity, this could address the concern.
Referring to the foreign fund
aspects of the Rule, one respondent, a Volcker control officer
at a major foreign bank, said that many banking institutions
operate under a global universal banking model, which as an
entity that operates outside the US it is difficult to adapt
to. "Whatever entities may relate to the US, we can adopt this
exemption, but it is counterintuitive. They all have their pros
and cons," he said.
There is always a difference between how the rules are
crafted and what expectations they put on institutions. With
this many definitions there is always room for modification in
the expectations that the agency would have for institutions.
Certain institutions will have to go through the process of
scrubbing their portfolios and justifying that they
don’t include any covered funds, to avoid engaging
in any impermissible trading activities to prove they are
What about the definition of banking
The definition of what constitutes a banking entity is also
up for debate. The definition is broad and covers not only
banks but also their affiliates and subsidiaries. Some suggest
narrowing the definition to apply only to banks that are
systemically important to the US financial system and some call
for the it to apply only to US banks and their US affiliates
Laura Biddle, counsel at
Hogan Lovells, suggests that the definition is picking way
too much up in its scope in the rest of the world, when it is
really having no effect on what is happening in the rest of the
US, which was unintentional.
"I would it amend it to include banks and bank holding
companies and affiliates in the US, and foreign banking
organisations to the extent that straight down the line to the
US entity or affiliation it is not creating a lot of
difficulty," she said.
Another general counsel, this time at a foreign bank, does
not advocate changing the definition. "All regulations need
definitions and carve outs. It makes sense for some senior
rates to include that, I don’t think right now
when firms complain that Volcker is unclear, it is anything to
do with the banking entities. I think that part itself, there
is no problem."
So, what steps are being taken to simplify
Since the change of administration in 2016 there have been
great steps taken to deregulate the financial industry. The
Dodd-Frank Wall Street Reform and Consumer Protection Act,
which contains the text of the Volcker Rule within its 2,300
pages, is enemy number one as far as the administration is
concerned, and Volcker is no exception. Most recently,
the Federal Reserve Board has introduced a number of
proposals to revamp the Rule, which generally somewhat further
than expect but were well received. This is in part due to the
fact that rather than repeal much of it, they have attempted to
simplify it. All proposals are out for comment, and any changes
will have to be ratified by all of the five agencies that
One thing that immediately becomes apparent throughout the
document, however, is that there are more questions than there
are answers. The Fed posed a lot of questions and asked for
comment on those, but with respect to the actual proposals that
are in there they seem to be fairly modest, said Mark Nuccio,
Ropes & Gray partner. The covered funds section
specifically leaves a lot open. "They asked a lot of questions.
They are opening the door for a more technical review of the
scope of that section - for entities that are either trying to
invest in some kind of complex fund like item or those that are
creating those," he said.
"The proposal would modify these requirements with
respect to covered fund ownership interests for third-party
covered funds to generally allow for the same types of
activities as are permitted for other financial instruments.
The proposal would also expand a banking entity’s
ability to engage in hedging activities involving an ownership
interest in a covered fund," reads the Fed paper.
"Whatever entities may
relate to the US, we can adopt this exemption, but it
is counterintuitive. They all have their pros and
Anna Pinedo, partner at Mayer Brown, the covered fund
proposals were an area of disappointment. The Treasury report
that addressed the banking sector in 2017 had many more
suggestions on how to rework covered funds, including looking
at its definition, and then when the OCC requested comments on
possible changes to Volcker, a lot of the requests for comment
related to covered funds.
"Then in the amendments to Volcker there wasn’t
actually a specific change to the definition of covered funds,"
she said. "We continue to have this very legalistic definition
of covered fund that refers to Section 3(c)(1) or 3(c)(7), and
honestly most foreign non-US lawyers are not all that familiar
with the Investment Company Act, are not necessarily familiar
with Section 3(c)(1) or 3(c)(7) and aren’t
familiar with the other exemptions under the US Investment
"I don’t think it is a very easy definition to
navigate. So, I don’t think that is helpful to
ignore and not deal with the Treasury report recommendations
and fail to address this very basic definition," she added.
"It's helpful that the agencies requested comments, but when
are we going to see actual changes? It is disappointing that
there wasn’t more there on covered funds."
PRIMER the Volcker Rule – proprietary
PRIMER the Volcker Rule