This is an updated version of the original primer that
was published on IFLR.com on June 29 2018.
Two of the main provisions of the Volcker rule, as amended
in October 2019, 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"
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
"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: "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 2018 edition of the magazine, IFLR surveyed a number
of in-house counsel and compliance officers at major banks to
identify what some of the issues with the Volcker Rule were at
the time. Respondents were asked whether they thought
exclusions or additional exclusions should be amended should
the definition of covered funds remain unchanged. Around 70%
suggested that the exclusions should be indeed be amended.
"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, partner at Venable, 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 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 public enemy number one as far as the administration
is concerned, and Volcker is no exception.
In October 2019, the final rule amendments to the Volcker
Rule were approved, and the amended final rule became effective
on January 1 2020. The amendments were principally focused on
the proprietary trading provisions, and made only modest
changes to the covered fund provisions of the rule.
Under the 2013 final rule, there was an exemption to the
covered fund prohibition for underwriting or market-making
activities relating to covered fund ownership interests subject
to specified conditions. Among these conditions, a banking
entity was required to aggregate the value of all of its
ownership interests in third-party covered funds toward a 3% of
Tier 1 capital limit and capital deduction requirement.
Pursuant to the 2019 amendments, a banking entity no longer
needs to include the value of its ownership interests in
third-party covered funds held as underwriting or market-making
positions toward the 3% aggregate limit and capital deduction
requirement. Directly or indirectly guaranteeing or assuming
the obligations of a covered fund would not cause a banking
entity to have to treat that covered fund as a related
"The 2019 amendments also allow a banking entity to engage
in additional risk-mitigating hedging activities in relation to
covered funds,: said Anna Pinedo, partner at Mayer Brown. "A
banking entity may acquire or retain an ownership interest in a
covered fund as a hedge when the banking entity acts as an
intermediary on behalf of a customer that is not itself a
banking entity in order to facilitate exposure to the covered
Holding an interest in a covered fund to hedge fund-linked
products is not viewed as posing the same risks to safety and
soundness as other covered fund activities.
These latest amendments also expand the solely outside the
United States, or SOTUS, exemption. A foreign banking entity
may rely on an exemption to the covered fund prohibition for
covered fund investments and sponsorship that takes place
solely outside the United States. A US branch or affiliate may
provide financing for the foreign banking entity’s
ownership interest of the foreign fund without jeopardising the
SOTUS exemptionhe foreign banking entity also may engage a
non-affiliate US investment adviser provided that the actions
and decisions of the banking entity as principal occur outside
of the United States.
The 2019 amendments also codify the marketing restriction
guidance (FAQ 13 from 2015) provided by the banking agencies,
such that an ownership interest in a covered fund is not
considered to be offered or sold to US residents unless sold in
an offering that targets US residents in which the banking
entity or an affiliate participates. If the banking entity or
an affiliate sponsors or serves as the investment manager,
investment adviser, commodity pool operator or commodity
trading adviser to the covered fund, then the banking entity
will be deemed to have participated in the offer or sale of
ownership interests in the covered fund.
"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